Backwardation, Tightening Inventories, and Higher Prices Ahead: One View of Oil’s Future

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Energy economist Phil Verleger has been waging a steady war against the argument that “too much” trading of energy futures contributes to higher prices.

To the contrary, as he has written many times, in the long run it will contribute to lower prices, and current government efforts to curb speculation by diminishing volume is laying the groundwork for a reduction in US output and higher prices down the road.

The background of his argument can be found in the curve for WTI prices. A market that is facing plenty of supply, as the US market certainly is, tends to be in contango, with prices rising toward the future to reflect the time value of money and the cost of storage, among other things. It is rarely a prediction of what the price will be in the future.

The WTI curve, on the other hand, is in backwardation, with prices sliding further out in the future. A market where people are talking about just how high US production can increase to is generally not the sort of one you would expect to see in backwardation, but it’s a market that also keeps hearing how US production will continue to soar for the rest of the decade. So this may be one of those times where the backwardated market is based more on future price projections than more current factors.

Last Friday, when March 2013 WTI settled at $100.30, March 2018 crude settled at $79.97, more than $20 less. With production costs in the Eagle Ford, Bakken and Permian anywhere between $60/b and $80/b, a hedge five years out that’s only 10 bucks more than the cost of production is going to be seen as a loser’s bet by most.

“Producers require high current prices and high future prices,” Verleger wrote in the February 17 edition of his weekly report, “Notes at the Margin.” “If they cannot hedge, market backwardation will increase and US output fall even if cash prices are high.”

Verleger’s reports for many months have been promoting a basic premise: pressure in the form of things such as position limits discourage trade, which discourages longs, which pushes down the forward curve. You need those longs to take on the sales of hedged crude by producers. The result is a disincentive to build inventories.

And Verleger cites a few companies by name. Occidental announced last week that it was cutting its exposure to proprietary trading, leaving the future of trading legend Phibo–owned by Oxy–in doubt. Hetco is still for sale by Hess, which is going through divestitures on its way to being solely an upstream company. And while he doesn’t mention it, various banks have announced their plan to exit physical commodity trading.

“These withdrawals remove buyers from the futures market,” Verleger wrote. “(T)his increases backwardation. The consequence is a rise in price spreads…(The market) is imposing growing punishments on those who hold oil.”

With backwardation increasing, the end result, according to Verleger, is a decline in inventories. The International Energy Agency last week reported a significant decline in worldwide inventories, though just a few months ago the supply-demand forecast looked likely to lead to an inventory glut. The IEA reported that OECD end-December commercial inventories were 2.56 billion barrels, “the lowest absolute level since 2008.” The fourth quarter decline of 137 million barrels was described as “whopping” and the biggest quarterly decline since 2009.

“The IEA did not bother to explain that government policies, particularly regarding derivatives and strategic stock accumulation, promoted the liquidation of stocks,” Verleger wrote. “This makes the coming glut increasingly illusional…(The market) is imposing growing punishments on those who hold oil.”


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