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Schork: Keep An Eye On The Forward Curve

Per the latest weekly oil inventory report from the Department of Energy, domestic supplies of crude oil drifted back towards a 21-month high for the week ended March 06th. It was the twentieth weekly increase (out of 24) since Hurricanes Gustav and Ike disrupted Gulf of Mexico shipping channels back in September. At the same time the government shoehorned another 0.79 MMbbls into the Strategic Petroleum Reserve (SPR). As such, net U.S. supplies of crude oil (public & commercial) rose to an all-time high, 1.057x109 barrels.

Under this backdrop, OPEC expressed concern regarding the global economic downturn (the global economy is expected to contract by 0.2% this year) and the knock-on to oil demand. Precisely, OPEC expects demand for oil to fall by 1.0 MMbbl/d in 2009 to 84.6 MMbbl/d and for supply cover to persist at 59 days.

On the other hand, the NYMEX forward curve in crude oil flattened over the last month. That is significant. For example, four weeks ago, April WTI closed at a $9.28 discount (-18%) to the September contract. This market structure is what is known as a contango. This contango is more than enough of a margin to allow me to buy and hold spot barrels in storage.

The implication of a commodity market in contango is that demand, relative to supply in the spot market is weak. As such, it makes sense for me to buy oil today and store it. I can then sell the more expense futures contract.

When it comes time for that futures contract to expire, I can delivery the oil I have in storage against it. The difference between what I paid for the spot oil and what I sold the futures contract at, $9.28 net of expenses (which in this case would run around a $1 a barrel per month), would be my profit.

If on the other hand the market is still in contango, I can then hold onto my storage and buy back my futures contract that I sold and then I can sell a more expensive contract out in the future, thereby locking in a profit as we roll forward.

In other words, a contango provides an economic incentive to build storage… and storage builds (even when OPEC cuts production) because demand is weak. And, when storage rises and demand falls, prices act accordingly.

However, by last Friday this spread between the NYMEX April and September contracts had narrowed to $4.96 (-11%). That is important. When a contango narrows that is a sign that the market is growing concerned regarding the future availability of oil, ostensibly because demand is rising. Thus, refineries want to secure oil in the spot market and are therefore willing to pay a premium for it. This is the opposite of a contango. This is called backwardation.

In a backwardation there is an incentive to draw down inventories and sell them into the spot market where the oil fetches the highest price. Thus, a backwardated market provides an economic incentive to reduce inventories because demand in the spot market is strong. And, when storage falls and demand rises, prices act accordingly.

Now, oil markets are still a long way from backwardation. But, the sharp flattening of the forward curve from a month ago is a telltale that the market is growing wary of future supply and this could mean demand is rising or at the very least, demand has stopped falling.

In this vein, according to OPEC’s post meeting communiqué, the producer group noted “… a reversal in crude oil stocks trends, and a narrowing of the contango in the front price structure, indicating that the adjustment process instigated through OPEC measures vis-à-vis excess supply in the market is gradually helping to redress balance…”

That is to say, the flattening of the contango was a key driver in OPEC’s decision to maintain the status quo in regard to its production ceiling.

Therefore, as we look ahead to OPEC’s next scheduled meeting in May, keep an eye on the forward curve. If the curve has flattened further or has even moved into backwardation, then OPEC will not cut. If on the other hand the contango moves back out and prices are still below $50, then the pressure within the Group to cut production will be immense.

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Stephen Schork is the Editor of, "The Schork Report" and has more than 17 years experience in physical commodity and derivatives trading, risk systems modeling and structured commodity finance.