14 April 2016, London — The structure of Brent futures prices shows most market participants believe the oil market will begin to rebalance, in the second half of 2016 and through 2017.
Prominent oil analysts continue to warn the recent rise in prices is premature and risks postponing the additional production cuts needed to force supply and demand back into balance.
But the majority of market participants now seem convinced rebalancing is now on the horizon and the balance of risks in the medium term is tilted towards the upside.
The International Energy Agency echoes the theme in an editorial in its latest oil market survey entitled “market balance draws near” (“Oil Market Report”, IEA, April 14).
“For some months … we have anticipated steady oil demand growth and falling non-OPEC supply. This scenario is now taking shape and the oil market looks set to move close to balance in the second half of this year.”
Even Goldman Sachs, one of the most influential banks in the commodity market, and among the most bearish, has issued a commentary entitled “rebalancing gathers pace” (“Oil gauge”, Goldman Sachs, April 13).
Goldman’s researchers write they have “increasing confidence in rebalancing, but risks remain” and note “the forward curve has flattened and risen, as at the end of previous bear markets”.
Watch The Spread
Futures prices point to a more balanced market over the next 18 months with the contango narrowing across all maturities.
Economists have demonstrated a close relationship between the supply-demand balance, stockpiles and the shape of the futures curve (“Price relations between July and September wheat futures”, Working, 1933).
In the oil market, shifts in the structure of futures prices between contango and backwardation have corresponded with shifts in the market balance (“Brent contango is hard to square with missing barrels”, Reuters, March 9).
In general, the end of a bear market has been accompanied by a narrowing of the contango and then a shift into backwardation (tmsnrt.rs/1Q9cjQV and tmsnrt.rs/1Q9clID).
Over the past three months, the degree of contango has been narrowing across all maturities, which suggests the market sees less oversupply ahead, and is consistent with the start of a sustained recovery in prices.
The price spread between Brent futures contracts for deliveries in June and July 2016 has even flirted with backwardation this week (tmsnrt.rs/1Q9cr2F).
Tightness in the nearby Brent spread is likely the result of idiosyncratic factors – including summer maintenance in the North Sea, recent pipeline outages in Nigeria, and a possible short squeeze.
But the contango is also narrowing along the rest of the curve, including at more deferred dates where idiosyncratic factors should have much less influence.
The contango between futures prices in the fourth quarter of 2016 and the average of 2017 has shrunk from $3.75 per barrel in December to $2.50 at the end of February and just $1.65 in recent days (tmsnrt.rs/1Q9cpb2).
A Fallible Guide
Given the intimate relationship between supply, demand, inventories and forward prices, the shape of the futures price curve is closely monitored by professional traders.
The futures curve is not an infallible guide to turning points in the oil market, as shown by the strengthening of spreads in the first five months of 2015 which collapsed when the market did not tighten as expected.
But the spreads are tied closely enough to the supply, demand and stocks outlook that big shifts in the curve structure demand should not be dismissed lightly.
The gradual softening of the spreads in the first half of 2014 arguably indicated the growing oversupply in the market even as fighting in Libya and Iraq sent spot prices surging to a peak of $115 per barrel.
The softening of the spreads arguably prefigured the collapse in prices which started towards the end of June 2014.
The current tightening of the spreads signals that many market participants think the worst of the oil slump is over.
The spread tightening could once again prove to be a false guide, as in the first half of 2015, but it is consistent with other indicators pointing to a big shift in sentiment, including the large rise in bullish hedge fund positions.
There is more bullishness about the outlook for stocks and prices around the market than at any time for the last six months.
*John Kemp, Editing – David Evans – Reuters