Over the last twelve months ended May 2010 (the latest date for which monthly data is available) the DoE reports that total commercial crude oil stocks have dropped by 1.13 MMbbls. That is 40% below what we would have expected based on a seasonally adjusted time series. This is likely the residue of poor demand fundamentals, which has resulted in a persistent contango along the Nymex crude oil curve.
Per preliminary data for June, we saw a 4.74 MMbbl build in stocks as opposed to an expected drawdown of 5.46 MMbbls. This event is explained by the second graph in the Chart of the Day in today’s (Wednesday's) issue of The Schork Reportwhere we illustrate the steep discount (contango) on spot crude oil in May on the Nymex relative to the second month.
At one point (May 12th) the June 2010 contract closed at a $4.59 (!) discount to the July. In fact, on average the spot June contract traded at a $2.89 discount.
As such, the market had tremendous incentive to build storage in June and then turn around and draw it down to deliver it against the July contract one month hence. To wit, preliminary data shows a 5.14 MMbbl draw in July against an expected draw of 3.67 MMbbls.
What does this mean going forward? Based on the time series we expect to see a combined drawdown in crude oil stocks for the months of August and September of approximately 10 MMbbls. Notice in the first graph in today’s Chart of the Day that as we move along the x-axis from the bottom right to the upper left (i.e., as inventories decline) the discount on prompt barrels narrows. In other words, the market moves away from contango and towards backwardation.
Intuitively this makes sense. As inventories fall, concerns arise regarding the future availability of supply. As such, a premium returns to the front of the curve as this uncertainty encourages end-users to lock-in supplies. The assumption here is that demand is driving supply concerns rather than just the seasonal ebb-and-flow of the market.
In this vein, apparent demand as measured by the DoE has been falling steadily since 2005, i.e., since the first time retail gasoline topped out at over $3 at the pump… go figure.
More to the point, demand for finished petroleum products will peak this month and then enter a seasonal downturn in September and October. This brings us back to the current market structure; the contango is much stronger than we would have anticipated given the glut in supply. As such, the table is set for further weakness, with a potential shift to backwardation as supplies begin to shift back up the x-axis.
However, in order for backwardation to occur we are going to need strong demand through this month. To wit, demand this summer is running 3.8% below the average since the start of the decade. Bottom line, we are skeptical the bulls will be able to get the shift to backwardation, which is required, in our view, to break current resistance in the mid $80s.
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Stephen Schork is the Editor of The Schork Reportand has more than 17 years experience in physical commodity and derivatives trading, risk systems modeling and structured commodity finance.