In Step-3 of my report, “Confessions of an Energy Price Forecaster”, I discuss the terms “contango” and “backwardation”. Recent market trends have caused me to ponder these terms and their forecasting merits anew.
First some definitions:
Contango - A situation in which the future price of a commodity is higher than the current price of that commodity. This usually occurs when the current price is in the lower end of the range of the expected distribution of prices for that commodity. The price out in the future is generally higher with the farthest contracts approaching the mean of this distribution.
Contango reflects not only the time value of money, holding costs of inventory, etc., but also a market sense that the commodity will become in scarce supply out in time.
Backwardation - This is the opposite situation. Current price is in the upper range of the distribution with future prices becoming lower approaching the mean. This usually indicates the market believes a current shortage or tightness in the supply of the commodity, reflected by this high price, will be relieved by the producers taking advantage of the current price to increase production and in finding new sources of supply.
With the current price of oil at a recent all time high, the usual backwardation in the futures curve disappeared and shifted to contango. The current price peeked at over $135/bbl and the December 2016 contract hit $145/bbl. (Note: In recent years as the price of oil ran up to its current lofty levels, the market produced a short-term, less than 4 to 6 months, contango followed by longer-term backwardation. A situation probably driven by non-physical financial players rolling over contracts as they expired.)
So what was going on and why?
Points to Ponder
How does one dance this contango?
- One suggestion was that the global markets believed that additional scarcity and/or increasing demand would drive prices even higher in the future. This would occur in spite of any impact such prices would have on the global economy, the future strength or weakness of the dollar and any political stability issues to be faced in this brave new world.
- Another driver may have come from the financial institutions themselves. As they partially fund E&P (Exploration and Production) activities, these institutions usually require the producer to hedge the price of that future production. Therefore, the producers may have been buying these futures contract to fulfill these requirements thus driving up the demand for them.
- My reason for pondering this point is that I have used the extremes of the contango and backwardation curves to support my probabilistic forecast (or hypothesis or gut call) for oil price. If that assumption were to hold, then my entire rage would have had to be shifted up by $100/bbl. This contango in the $100 to $140 range would imply that the extreme spot price in backwardation could be as high as $200/bbl further implying that the mean price of oil in this brave new world would be in the $140 to $160 range.
- Does this idea give further credence to the recent Goldman Saks forecast of $200 oil in the next 2 years?
- Thanks to the more recent correction in oil prices into the low 120s along with a flattening of the futures curve with an even larger correction in the futures curve to be also in the 120s, I do not have to step on to this dance floor yet. But it is a point, albeit a very scary one, to ponder and be aware of in case this really is a fundamental shift in market for oil.
4/01/09 April Fool's Day Update
Hope still springs eternal and this spring is no different. Betting on an economic
recovery in spite of the build in inventory is the only explanation I can find.
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