London — Oil markets only exhibit the current combination of falling spot prices and a calendar spread in backwardation relatively infrequently, which suggests the contradiction between them will resolve itself rapidly.
Falling spot prices imply the production-consumption balance is expected to become less tight – but backwardation implies the opposite, with a further drawdown in inventories from already low levels.
The contradictory combination of falling prices and backwardation normally occurs when prices have passed a cyclical peak, whether a major multi-year cycle or a more temporary short-term one.
But of the four possible states for spot prices (rising, falling) and calendar spreads (backwardation, contango), this is the least common, present on only 18% of trading days since the start of 1993.
Other combinations of rising prices and contango (21%), falling prices and contango (25%) and especially rising prices and backwardation (37%) are all more common.
Like the other infrequent combination of rising prices and contango, the current mix of falling prices and backwardation is unstable, apt to resolve itself relatively quickly.
If producers respond by cutting anticipated output, the expected rise in inventories will be reduced, reversing the slide in prices and keeping the market in backwardation (path 1 in the attached diagram).
If they leave output unchanged, inventories will swell, the market will move from backwardation to contango, and prices drop further, until the incentive to cut production becomes irresistible (path 2).
A third possibility is that anticipated consumption increases because the epidemic’s trajectory is not as bad as feared, the market remains in backwardation and prices rise again (path 3).
The final possibility is consumption declines because the epidemic worsens, accelerating the expected rise in inventories, the move to contango and the fall in spot prices, signalling the start of a deeper and more protracted slump (path 4).
Combinations of these paths are possible, which makes predicting the next move in both spot prices and spreads more challenging.
But at this point, there are two major sources of uncertainty, which will determine whether the current pull back is small and temporary, or larger and more enduring.
First, whether OPEC+ and U.S. shale producers respond to lower prices by cutting projected output (which will determine whether the market follows path 1 or 2).
Second, whether the upsurge in coronavirus cases has more or less impact on domestic and international travel than currently feared (the difference between paths 3 and 4).
Producer responses are largely reflexive and endogenous: the more spot prices fall and spreads weaken, the more they are likely to react by cutting output, helping stabilise the market.
But the course of the coronavirus is determined outside the market, so its impact on the economy and travel is likely to be the primary driver for prices and spreads in the next few months.
- By John Kemp (Reuters)
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