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The Oil Futures Market Tells Us The Glut Is Over

Oil Rig

According to consulting firm McKinsey, the current oil futures market is pointing to a coming balance between demand and supply—a balance which has the potential to render most oil and gas investments uneconomical.

The futures market is often a reliable guide to forcasting the future direction of oil prices, and analysts rely on both contangos or backwardation when determining their forecasts.

During a supply glut, a contango is typically observed. This is a condition where the spot price for future contracts is far higher than the current price for nearby contracts. This means that people are willing to pay more for a commodity sometime down the road than the actual price for the commodity.

Backwardation is noticed when the current demand is higher than the supply, thereby making the nearby contracts costlier compared to future contracts.

(Click to enlarge)

Until around 2005, backwardation was the normal condition, as seen in the charts. But since 2005, contango has become the normal condition, reports Reuters. Experts differ on their views regarding this shift.

Large contango is indicative of market bottoms. During the 2008-09 crude oil crash, the oil market witnessed a super-contango, when the price difference between the first month and the seventh month contract had reached up to $10 per barrel.

Similarly, during the current crisis, the contango reached $8 per barrel twice, once in February of 2015 and again in February of 2016, as shown in the chart below, after which, the markets bottomed out.

(Click to enlarge) Related: Aviation Giants To Ramp Up Biofuels Usage

During the 1985-2004 period, the average backwardation was $1.07 per barrel, and during the 2005-2014 period, the average contango was $1.50 per barrel as shown in the chart below. The current contango hovers around $2 per barrel, which is close to the average during the 2005-2014 period.

(Click to enlarge)

The current oil crisis is unlike the oil crisis of 2008-2009, as there is no demand destruction this time. Demand for oil is on the rise and is likely to increase by 1.5 million barrels per day, both in 2016 and 2017, according to the latest Short-Term Energy Outlook by the U.S. Energy Information Administration.

In the short-term, the supply outages to the tune of 3 million b/d have supported oil prices by easing the supply glut and restoring the balance between supply and demand. If supply is restored, the oil markets will again return to a surplus, putting pressure on prices.

Due to low oil prices, billions of dollars in investments have either been scrapped or postponed. As and when the markets shift from surplus to deficit, new supply will find it difficult to catch up with increased demand. Markets need higher prices for investments to start trickling into the industry.

However, consulting firm McKinsey believes that oil demand will peak around 100 million barrels per day by 2030 from the current levels of 94 million barrels per day. Related: Why Did Natural Gas Prices Just Rise 25% In Two Weeks?

“This change is driven by three factors: first, overall GDP growth is structurally lower as the population ages; second, the global economy is shifting away from energy-intense industry towards services; and third, energy efficiency continues to improve significantly,” McKinsey’s Occo Roelofsen said. “Peak oil demand could be reached around 2030”, reports The Telegraph.

If oil demand behaves according to Mckinsey’s expectations, most new investments into oil will be uneconomical due to weak demand in the future.

Though the long-term is slightly uncertain, balance is maintained in the short-term. Unless we see supply outages restored, prices are likely to remain in a small range following an impressive run.

By Rakesh Upadhyay of Oilprice.com

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  • JHM on June 08 2016 said:
    We can just flip into backwardation. There is some extra 350M barrels in OECD stock and about as much in developing countries that would flood the market under backwardation. At 1 mb/d this would take 12 to 18 months for the spot market to absorb.

    Essentially, contango is the price the market pays to keep this oil in storage and off the market.

    So while a flat futures price curve may tell us that the market is balanced in the near term. The massive inventory overhang tells us it will take a long time to recover from this glut.

    Moreover, it is not clear that there is sufficient demand at price levels high enough to sustain current production levels. We may in fact be post peak demand, which could also induce long-term backwardation based on falling demand. This would be an extremely bad scenario for oil.

    In my view, oil peak demand will happen within 5 to 10 years. McKinsey is being unconservative by underestimating the potential for EVs. You have to assume very slow EV growth to get to peak demand as late as 2030. It would be much more conservative for the oil industry and investors to assume that 50M EVs and peak demand will arrive by 2025. But there are scenarios in which peak demand arrives much sooner.

    Under a peak demand scenario, backwardation occurs as longterm demand expectations decline. Under a tight supply scenario, backwardation occurs on expectation of increasing supply. So simply the observation of a declining futures curve does not by itself tell us whether this is a rising supply or declining demand scenario.

    In our current market, I don't see how expectations of rising supply are warranted or desirable. So the flattening of the futures curve could simply be that the market does not belive that demand is robust. A certain degree of contango is needed to keep inventory off the spot market, but beyond that there may not be enough rising demand to get excited about.
  • James on June 17 2016 said:
    Remember the CEO of Enron and Valeant were ex-McKinsey guys. That firm has dispatched more bad advice than Paul Krugman.

    http://www.independent.co.uk/news/business/analysis-and-features/mckinsey-how-does-it-always-get-away-with-it-9113484.html


    "McKinsey's fingerprints can be found at the scene of some of the most spectacular corporate and financial debacles of recent decades. The energy-trading firm Enron was the creation of Jeff Skilling, a proud McKinsey consultant of 21 years. But this wasn't guilt by association. Enron, under Mr Skilling, was paying McKinsey $10m (£6m) a year for advice"

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