Crude futures are doing a slow-motion backflip, stoking speculation about the next move for oil prices.
The futures curve, plotted with prices of oil to be delivered in successive months, has flattened; accessrx.Late last year, a barrel of US oil for immediate delivery cost $2.35 less than one due a month later; accessrx.Today the spread is about 40 cents, approaching the narrowest in 1½ years.
Several Wall Street analysts say the market is poised to flip even further, with spot prices rising above longer-dated futures for the first time since mid-2008; accessrx.The inverted price pattern they envisage – called “backwardation” among economists – would signal a world in which oil demand catches up with supply after a severe, recession-induced lag; accessrx.This would skim excess inventories from storage terminals.
(source: “Oil futures turn upside down ,” Gregory Meyer, Financial Times, March 8 2010.)
Here’s your guide to what will happen if crude oil futures prices move into backwardation and stay there:
(1) Crude inventories will drop precipitously and head-in-the-sand economists will say “see the market anticipated the rising of demand” and they will be wrong because inventories are largely held by “cash and carry” arbitrageurs who will sell their physical holdings of oil to take their profits on the trade.
(2) Every commodity index salesman in the world will speed dial every institutional investor that he’s talked to about commodity indices in the last 3 years and tell them “there’s never been a better time to invest in commodities” because, of course, oil is as much as 40% of these indices and the “roll yield” is critical to returns. In a contango market investors face a stiff headwind, but in a backwardated market they experience a nice tailwind.
(3) Huge amounts of money will begin to flow into these investments as an “inflation hedge.” The amount of money will dwarf the $60 – $100 billion that poured into commodity investments in 2009. It was the flattening of the oil futures curve in 2007 that set off the “gold rush” mentality that caused the Great Oil Bubble of 2008.
(4) You will have numerous Wall Street banks out there touting oil as an inflation hedge, making $200 per barrel predictions, etc. All this will be necessary to help the salespeople get more investors to enter the trade, keeping the good times rolling while the bubble expands. Rising oil prices will become the self-fulfilling prophets of inflation.
Make two additional notes regarding why oil prices might skyrocket:
First, the CFTC’s attempt to limit speculation with it’s Position Limit Rule (which does not tackle passive commodity investment) will either be defeated because Commissioner Dunn refuses to vote responsibly or it will lack teeth because it is adopted in its currently weak state (92,000 contracts is so high it’s like no limit at all).
Second, while many Democrats will shriek and wail about “speculation” it will take them weeks if not months to hold all the hearings, craft bills, etc. And because it is an election year the Republicans will ridicule them while chanting “drill, baby, drill.” Wall Street lobbying efforts will delay any legislation by months – just enough to get us to the election recess.
The greatest risk to this analysis is the initial premise that oil futures prices will become backwardated “and stay there.” As the huge cash and carry trades are unwound the selling of spot oil and the buying back of longer-dated futures would tend to exert a contango-like effect. Likewise as the amount of money being rolled by investors grows that also would tend to push things toward contango. If the producers scramble to hedge by selling production forward and/or the consumers decide to hedge less and therefore buy less then that might be enough to tip the curve into a sustained period of backwardation. For that reason I think we need to be in backwardation for 3-6 weeks before this whole juggernaut starts snowballing.
UPDATE: Goldman Sachs released a report today (3/12) entitled “Timing the return to backwardation as the cycle turns” in which they predict the oil market will return to backwardation by this summer (see #4 above).
All I can say is “Hold Onto Your Hats!”
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