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Crude Oil Backwardation Facts and Myths
Crude Oil Backwardation Facts and Myths
PORTFOLIOS
Summary DWT - -
VelocityShares 3x Inverse Crude Oil ETN
Create Portfolio Theories of backwardation: buyer risk premium, undersupply, and
"disruption risk" premium.
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Backwardation is more frequent with lower crude inventories.
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Top ETFs Empirical testing shows backwardation does not lead to higher oil
Stock Screener prices.
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ETF Screener The market is more sophisticated for that to be true.
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Trending Analysis
"Normal Backwardation"
John Maynard Keynes was one of the most influential economists of the
20th century. He developed theories on the causes of business cycles and
Trending News
advised on the economic policies of governments.
All things being equal, this also makes sense from an insurance risk
standpoint. Producers want greater certainty for their future revenues and
are willing to pay a risk premium. Speculative buyers are willing to take the
risk, but they want to be paid a risk premium to do so.
I initially reviewed WTI crude oil futures weekly time spreads (Month 1-
Month 4) for the 10-year period from January 2007 through January 2017. I
found that the market was in contango 76 percent of the time.
U.S. crude oil stock levels are one important measure of whether the
market is undersupplied or not. An undersupplied market is another factor
that could create backwardation, in addition to the risk premium Keynes
wrote about. Low stocks increase the potential for a supply disruption,
causing oil prices to spike.
Inventories (mmb) 265 300 350 360 393 400 450 500
Note: The statistics refer to the percentage of time that inventories were at
that level or higher. The midpoint was 393 mmb.
Based on this analysis, with crude stocks at 393 million, its five-year
average, prices had been backwardated 0% of the time in that condition.
Inventories had to be about 360 million barrels or less for backwardation to
be present.
Inventories (mmb) 265 300 350 360 393 400 450 500
Note: The statistics refer to the percentage of time that inventories were at
that level or higher.
However, backwardation was present in two recent weeks (April 12th and
April 26th) while stocks were high. In a true-false test, if stocks were above
450 million and backwardation was present, those were the only weeks
since 2009:
This was the period just ahead of Trump's announced decision to terminate
the waivers to Iran sanctions. Clearly, the market was concerned about a
potential disruption to supply and required a "disruption risk" premium.
Price Implications
I frequently read in articles and in reader comments the belief that the
presence of backwardation implies oil prices are likely to rise. I tested that
theory empirically and found that is, in fact, not the case.
I performed a linear regression of the time spreads to subsequent price
changes over the following 1, 2, 3 and 4 weeks. I found that the relationship
is actually slightly the opposite; i.e., that prices were more likely to drop!
However, the r-squared values are so low that neither a price gain nor a
price drop should be expected. The T-ratios of the coefficient were also
statistically insignificant.
1 -0.06828 4%
2 -0.07286 2%
3 -0.07885 2%
4 -0.07979 2%
Conclusions
There is evidence that backwardation is more frequent when crude oil
stocks are at lower levels. However, there is no evidence that oil prices are
more likely to rise over the next one to four weeks, if backwardation is
present.
Therefore, it is a myth that time spreads lead price changes because they
may simply reflect a risk premium, as theorized by Keynes or reflect a
"disruption risk" condition I explained above.
My theory is that time spreads are a result of market risk premiums, not a
leading indicator of future prices. The market is more sophisticated for that
to be true; i.e., it would be too easy to make money trading if the price
change could be predicted from the time spreads, and so that effect is
arbitraged out of existence.
The empirical data analysis supports my view that time spreads do not
provide predictions of future price changes. Therefore, I do not view them
as a determinate in trading.
Source: Barchart
Source: Barchart
Using time spreads to predict future oil price changes is no better than
consulting a fortune teller using tea leaves.
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Risk ServicesHarvard College, Economics (Honors), BA Undergraduate thesis: "OPEC Pricing
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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions
within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving