Schork Oil Outlook: What Makes Those Bulls Happy

WTI Contango is flattening… is that bullish?

Last Thursday we examined the flattening of the NYMEX contango, stating:

”To wit, we have seen a material contraction in the NYMEX forward curve since August. At the end of last month spot WTI was trading at 95.6 cents on the dollar to the 6th contract on the curve. As of last Friday (the cutoff for yesterday’s DOE report) spot WTI was trading at 96.7 cents.” - The Schork Report, September 17, 2009

That sentiment continues to hold true this week, with spot WTI still trading at 96.7 cents to the 6th contract on the curve. This is not a recent irregularity but a gradual change over the last several months - spot was trading at 92.3 cents to the dollar in July and 95.6 cents in August. Overall, the relationship can be described as a decreasing gradient, July had a gradient of 0.725, Augusts’ was 0.484 and September’s 0.373, almost half the value for July.

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Spot prices becoming more expensive relative to future prices will encourage producers to convert crude into product.

We include the September ’06 contango to demonstrate a situation when the contango was much flatter, with a gradient of just 0.306.

This flattening in ’06 meant producers had a great incentive to run crude through their refineries, which they did with gusto. The average September input into refineries for 2006 was 15.772 MMbbls 5.8% higher than the seasonal average. As runs grew, so too did product stocks, gasoline in three months between September and November 2006 were 4.9% higher than the seasonal average, and distillates were 13.3% higher than normal. By the time winter came around, those products were snapped up. By the end of the fourth quarter, gasoline stocks were only 1.9% higher than normal and distillates 10.2%.

The historical implication is that an incentive to refine crude will lead to a temporary increase in product stocks, whose prices will fall accordingly as equilibrium is reached.

However, there are two differences between now and 2006. Firstly, as mentioned in past issues of The Schork Report, consumer price sensitivity to gasoline prices has weakened, so lower prices do not automatically lead to a higher uptake of products. Secondly, as of last week’s DOE report, the year on year gasoline surplus was 12.1% while distillate fuels rose to their highest level since January 1983.

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So the question for 2009 is, will the flattening of the curve cause producers to boil more oil despite there already being too much product in the market? And if they do, will the resultant decrease in crude stocks lead to a further increase in crude oil prices despite concerns that prices are already inflated relative to fundamentals?

With regards to the first question, it appears high inventories are slightly slowing down gasoline production. For August and the first two weeks of September 2009, inputs have been 2.25% lower than a regression on gasoline inventories would suggest. That’s not much wiggle room, and if the contango continues to flatten a la 2006, production could ramp up quickly. The second question is harder to answer quantitatively, i.e. will low crude stocks lead to even higher prices? It appears that crude prices of late have been tied closer to the dollar or the S&P 500 index, but as Wednesday‘s price spikes show, the bulls are happy to take low builds in crude as encouragement to bid higher.

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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.