Oil traders see no market rebalancing until later in 2017: Kemp

Traders are signalling they expect oil demand to exceed supply in 2nd half of 2017, throughout 2018

By John Kemp

LONDON – Crude traders expect the oil market to begin tightening and gradually move into deficit, but the shift is not forecast to occur much before the second half of 2017.

The expected timetable for rebalancing is revealed by the changing relationship between Brent futures prices for different months in 2017 and 2018.

Holbrook Working of Standard University’s Food Research Institute explained the relationship between stocks and futures prices over 80 years ago (“Price relations between July and September wheat futures”, 1933).

Traders’ expectations about the balance between supply, demand and stock levels are reflected in the shape of the futures price curve.

If supply is expected to exceed demand, and stocks are high and rising, futures prices will normally trade in a structure called contango, with prices for nearby delivery dates below those for later delivery months.

Discounts for nearby delivery months reflect the cost of financing and storing excess stocks until they can be resold and consumed at a later date.

But if demand is expected to exceed supply, and stocks are low and falling, futures prices will normally trade in the opposite structure, known as backwardation, with nearby prices above those for later delivery.

The premium for nearby delivery months helps make more supplies available immediately and discourages short-term consumption to conserve stocks for future use.

In the oil market, changes in the balance between supply and demand have usually been closely associated with changes in the structure of Brent futures prices over the last two decades.

Periods of oversupply, such as 1997/98, 2008/09 and now 2014/16, have been associated with a progressive shift into contango.

Periods of rebalancing and stock draws, such as 1999/2000 and 2010/11, have been associated with a progressive shift towards backwardation.

Futures prices are driven by expectations about future supply and demand, so they are a best guess, not an infallible forecast.

Traders can sometimes be wrong: the contango in Brent narrowed significantly in the first half of 2016 as traders anticipated an early rebalancing of the oil market that failed to materialise.

The shape of the curve can also be temporarily distorted by a lack of liquidity further along it, and large-scale hedging.

Nonetheless, the structure of futures prices can provide useful clues about how traders in aggregate expect the balance between supply and demand to shift.

WATCH THE SPREADS

The difference between futures prices for different delivery months is commonly called the “time spread” or “calendar spread”, which is simply a way of measuring the degree of contango or backwardation between two dates.

OPEC’s agreement to cut 1.2 million barrels per day from its members’ production starting in January 2017 triggered a sharp rally last week in Brent time spreads for all periods in 2017 and 2018.

Traders anticipated the planned cuts by the Organization of the Petroleum Exporting Countries would reduce global oil supplies and lead to a drawdown in stockpiles in 2017.

But in the last few days, time spreads for the first half of 2017 have given up much of their earlier gain, while those for the second half of 2017 and throughout 2018 remained firm.

OPEC and Russia have been increasing output even as they discussed future cuts, ensuring the market remains oversupplied and will enter 2017 with high inventories.

By raising output so much ahead of a production-cutting deal, OPEC members have made their task harder and pushed back rebalancing well into next year.

Crude stocks are expected to remain very high throughout the first half of the year, with the contango, currently around $2.20 per barrel between February and June 2017, still much wider than earlier this year.

But stocks are expected to start drawing down in the second half of 2017 and through 2018, with the contango in those periods now much narrower than at any point this year.

The contango for the second half of 2017 has shrunk to less than 80 cents per barrel, while the contango for the first half of 2018 is down to 25 cents and the second half to just 1 cent.

Traders are signalling they expect oil demand to exceed supply in the second half of 2017 and throughout 2018, leading to a big fall in stocks.