Brent's burgeoning backwardation

Longer dated oil futures are firming up their view on the direction for both the WTI and Brent markets. Brent December time spreads for 2017-19 have established a fairly sticky backwardation since around the middle of December 2016, with the near-dated contract closing more than USD 1.20/b higher than the Dec 2019 contract at the end of last week. Indeed the spread has been widening since it first emerged as the market fixates on the issue of OPEC compliance and how long it will take before the crude market returns to balance. 

In the WTI market, however, the premium to longer dated prices has been far more fleeting and narrower than in Brent markets. The Dec 17-19 spread in WTI has returned to a small contango although the shape of the curve is not consistently upward sloping. Explorers hedging off of 2018 prices have helped to put a dent into the middle of the calendar 2018 curve before the contango picks up again at the end of the year. We would attribute the difference in the shapes of the Brent and WTI curves to a far more confident production outlook in the US where explorers have continued to add rigs (up nearly 270 rigs since a recent low in May 2016).

Will this backwardated Brent curve persist? We are still skeptical that the curve—including the front end—will move more assuredly into backwardation for several reasons:

• The OPEC deal to cut output is only set to last until the end of May and compliance may deteriorate before then. Production levels from OPEC countries and non-members who are part of the deal may tick higher as prices stabilize at USD 55/b or above.
• Demand is unlikely to be sufficient to erode inventories. Backwardation imposes a negative carry on keeping commodities in storage but without enough demand, oil may be released only to find its way into less transparent stockpiles. Physical prices for ME grades have been rising—on the back of the OPEC deal—but time spreads have so far resisted flipping into backwardation, a sign to us that the price rise has been supply rather than demand driven.
• The US may emerge as a significant crude exporter. If proposed changes to US corporate tax law are enacted US producers will be able to export crude tax free, disrupting markets that are tentatively on their way to balance.
• A shortage of conventional projects. Long-term growth in reserves has essentially ground to a halt as low oil prices have led to major cuts to exploration budgets. The shortage of conventional crude should start to worry markets from mid-2018 onward and we would expect to see longer-dated futures rising steadily from that point.

Click here to download the full publication