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ENERGY

The Oil Market Is Flirting With ‘Backwardation.’

That’s a Positive Sign.
By Avi Salzman May 21, 2020 1:42 pm ET

Oil prices have been trading in a pattern

known as contango this year, where
spot prices and near-term futures are
worth less than futures expiring several
months from now. Demand is weak
today because fewer people are driving
and flying, but it will likely be higher in
later months as economies open up
from Covid-19 restrictions.
Photograph by Getty Images

The contango in the past few weeks was so steep—futures for oil to be delivered in
June briefly traded at half the value of January 2021 futures, for instance—that analysts
were calling it “super contango.” When oil went negative on April 20, the spread
between the May and June contracts was as wide as $58, an unprecedented gap.

But suddenly this week, the super contango pattern shifted into a pattern called
backwardation, if only briefly. Backwardation means oil today is worth more than oil in
the future.

As June West Texas Intermediate crude futures were about to expire on Tuesday, they
actually traded higher than July futures, by as much as 90 cents per barrel. With WTI
trading at about $30, that 90 cents is significant.

Backwardation is theoretically a bullish sign for oil, because it means traders no longer
have an incentive to store oil and sell it at a later date. Instead, it’s best for them to sell
oil now because prices could be lower in the future.

Is it bullish today?

The answer is a qualified yes. In the current pandemic, backwardation is a somewhat

trickier sign, because oil use is depressed and likely will remain that way. But it is at
least a sign of somewhat better times for producers.

Factors aside from prices for oil futures point to a healthier market, though one that
hasn’t fully healed. Analysts had been predicting that oil demand would be depressed
for months as lockdowns slowly lift. But early signs have pointed to a slightly faster
recovery in the global economy, and thus in oil demand. In some Chinese cities, for
instance, auto traffic is actually higher than it was before the pandemic hit.

Production has also declined quickly, with cuts in Saudi Arabia and other countries
keeping excess oil off the market. Inventories in the U.S. have been declining faster
than analysts had been expecting, meaning that the oversupply may not be as drastic
as feared. That has led near-term oil prices to snap back, even as expectations for future
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oil prices have News &about
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the same—flattening the price curve and triggering the
brief move into backwardation. Topics Magazine Data Advisor Penta

Oil stocks have been on a tear, with Chevron (ticker: CVX) rising 55% in the past two
months and the Energy Select SPDR ETF (XLE) up 52% in that period. WTI prices were
on their way to a sixth straight day of gains on Thursday, rising 2.1% to $34.18.

Oil futures tend to rise after backwardation begins, according to a PIMCO analysis in
2017.

“The shape of the oil curve has historically been one of the best predictors of future
returns, so the move to backwardation has significant implications for commodity
investors,” PIMCO portfolio managers Nicholas Johnson and Andrew DeWitt wrote at
the time. “For example, subsequent four- and 12-week returns for long oil futures
positions in backwardated oil markets have averaged 1.3% and 2.9%, respectively,
compared with returns of -1.7% and -3.8% for the same periods during contango
markets.”

To be sure, backwardation may not be here to stay. After that brief shift into
backwardation when the June contract expired on Tuesday, the market settled back
into contango and has remained there. At Wednesday’s settle, WTI futures for July
delivery traded at $33.49, while futures for January delivery were at $35.48.

“S&P Global Platts Analytics believes backwardation is not sustainable in the near term
and that WTI’s structure should stay in contango, despite all the supply cuts in North
America,” said Rick Joswick, head of oil pricing and trade-flow analytics at S&P Global
Platts.

But with the curve so much flatter now, backwardation has at least become a realistic
possibility.

A shift from super contango to backwardation in a matter of weeks would shock the
market. Super contango, after all, forced the leading exchange- traded-fund for oil
futures to completely change its investment strategy.

That product, the United States Oil Fund (ticker: USO), has historically invested entirely
in the front-month contract, shifting to the next month two weeks before expiration. But
when the market is in contango, that shift is expensive: The front month is less
expensive than the following one, so the fund has to sell cheaper futures and buy more
expensive ones.

USO responded to the super contango and overall disruption in oil markets by shifting
its assets into longer-dated contracts.

Backwardation could inspire a shift back because it would have the opposite effect.
Rolling the contract forward each month would entail selling high and buying low, the
kind of dynamic that investors like.

That could theoretically make USO a more attractive option for investors going forward.
A USO spokesperson wrote that the fund’s investment strategy could change in the
future.

There are certainly negatives to this change. For oil companies, backwardation could
complicate hedging strategies that had depended on oil rising considerably in later
months. It is a particularly important issue for shale producers who try to lock in prices
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The curve is flattening, but the reasons for the shift aren’t entirely encouraging. Supply
and demand for the immediate future are more balanced, lifting nearby prices, while
longer-dated futures have stayed pretty stagnant. That indicates investors expect
prices to remain low overall.

Oil prices of $35 for January 2021 aren’t high enough to fund producers’ expansion
plans. They need $45 oil or more to make money in the longer-term.

But on the margins, the move toward backwardation has been bullish, because it
points to a healthier market where demand is returning. Oil stocks are lately surging,
though most remain about 20% lower for the year. A more dramatic reversal would
make most investors happy.

Write to Avi Salzman at avi.salzman@barrons.com