Brent spreads have been gradually moving from contango to backwardation since early 2015 or early 2016 as the oil market has gradually rebalanced after the slump in 2014/15. Shell photo.
Brent calendar spreads the most useful, reliable indicators of oil market’s changing balance
By John Kemp
LONDON – Brent calendar spreads have risen significantly over the last week, erasing an earlier decline and indicating traders have become more bullish about the outlook for the oil market later this year.
The Brent calendar spread for the second half of 2018, which measures the difference in price between futures for delivery in June and December, has climbed to more than $2.50 per barrel from $1.65 on March 13.
Calendar spreads reflect expectations about the balance between supply and demand in the physical market, and are seen by many traders and investors as a more useful signal than spot prices.
The relationship between spreads and inventories was identified by economist Holbrook Working in the grain market (“Price relations between July and September wheat futures at Chicago since 1885 here”, Working, 1933).
But similar relationships between spreads and inventories exist in other commodities including Brent crude.
By convention, calendar spreads are normally expressed as the price of the nearer futures contract minus the price of the contract with longer until expiry.
Negative spreads, known as “contango”, when the price of the nearby contract is below the longer-dated one, are correlated with high and rising inventories, when production exceeds consumption.
Positive spreads, termed “backwardation”, when the price of the nearby contract is above the longer-dated one, are correlated with low and falling inventories, when production falls short of consumption.
For the last quarter of a century, Brent crude futures have cycled between contango and backwardation as the global oil market has alternated between periods of over- and under-supply.
Brent calendar spreads have been one of the most useful and reliable indicators of the changing balance in the global oil market.
The Brent spreads have been gradually moving from contango to backwardation since early 2015 or early 2016 as the oil market has gradually rebalanced after the slump in 2014/15.
Recently, however, the calendar spreads appeared to peak and start softening, coinciding with a downturn in spot prices.
Traders and investors seemed to react to an unexpected surge in crude and condensates output from U.S. shale producers.
Forecasts showed additional production from the United States as well as Brazil, Canada and Norway would be more than enough to meet the increase in oil consumption this year.
Hedge funds and other financial investors have been gradually reducing their bullish positions in crude oil over the last seven weeks, intensifying the downward pressure on spreads and spot prices.
But in the last week, both spreads and spot prices have rallied sharply, regaining most of the ground lost during February and March, suggesting a return to a more bullish sentiment or at least a tempering of bearishness.
Oil prices and spreads do not rise and fall in straight lines or even in a simple cyclical pattern. In addition to the main cycle, there are smaller epicycles operating at various time-scales from months to weeks, days or even minutes and seconds.
The weakening of the spread since early February appears to have been one of those epicycles within the framework of a larger cyclical upswing, but that epicycle seems to have reversed course over the last week.
The reasons are not entirely clear, but could include rising tensions between the United States and Iran, OPEC discussions to tighten its inventory target, or another factor entirely.
Some epicycles arise from within the market itself, rather than as a result of fundamental external factors, as prices move in response to the accumulation and liquidation of positions by traders.
The bigger question is whether the oil market is still tightening – or whether the rise in prices since June 2017 has already done enough to ensure supply will match demand for the rest of 2018 and into 2019.
Editing by Edmund Blair
John Kemp is a Reuters market analyst. The views expressed are his own.