Oil Futures Curve Overview
Looking at the futures curve for major oil benchmarks such as WTI or Brent is important for oil and gas investors (both debt and equity) and speculators or physical oil traders. The front end/short end of the curve is more politically driven and will fluctuate based on OPEC rhetoric (whether their agreed upon cuts will deepen or expire), anticipation on Chinese or American economic data and purchases, inventories (barrels of crude stored in crude batteries) and product inventory (gasoline/diesel stockpiles, kerosene).
Contango and Backwardation in Oil Markets and Hedging
Contango is when the futures price (recall what this is in our sales & trading questions) is higher than the expected future spot price. Backwardation is when the futures price is lower than the expected future spot price.
Oil traders and producers pay close attention to the relationship between spot oil price s (current oil prices) and the futures price – for oil producers, their projects have budgeted cash flows just like any other business that sells something.
However, while for a toy company prices are fixed but volumes are not known, oil and gas companies have a good idea of what volume (production) will be but have less certainty on price (due to the final product being a global commodity). As such, to be assured of cash flow needs or project return hurdles for shareholders, oil producers will hedge.
On the other side of the coin, consumers of oil such as refineries will hedge for the same reason, except oil is the cost instead of the revenue.
Spot prices are as a result of current supply and demand. If production is not meeting demand, inventories will be drawn on and the price will go up. If stockpiles rise, and oil is plentiful, spot prices will fall. The expected future spot will reflect the same supply-demand dynamics.
However, futures prices are less so about actual future supply and demand and more so on hedging activity. As such, if producers are rushing to hedge (US shale drillers see the future price above $45 per barrel and try to lock in as much as possible), the futures price will fall.
If refiners see that feedstock can be locked in cheaply in the future, they may overhedge.
Contango leads to physical arbitrage activity by oil traders – if the futures price is higher than spot plus carrying costs (storing it in a tanker or oil battery) and interest, they can purchase the cheaper spot barrel now and lock in a profit by selling at the contracted future price later.
Short End of the Forward Curve
The short end of the curve and short dated futures (futures that will expire and settle soon) is reflective of the spot market. Every day a certain amount of oil is required and a certain amount of oil is required to shipped – immediate changes to the oil supply via cuts (decreasing supply) or production being brought back online (increasing supply) will affect the oil price.
Long End of the Futures Curve
The longer end of the curve reflects hedging activity and long term fundamentals. If more producers are looking to lock in an oil price tomorrow to ensure that their returns to shareholders are met, this will push the back end of the curve down. If refineries or national security stockpiles are looking to ensure barrels of oil at a certain of price going forward, this will push up the back end of the curve.
When the curve is upward sloping, the phenomenon is known as contango. When it is downward sloping it is known as backwardation. Contango cannot be too steep, otherwise physical oil traders will see arbitrage opportunities so long as the difference between the back end of the curve and the front end of the curve exceeds their storage costs and required return as they can just buy oil today and store it in tankers to be sold at a later date.
The long end of the curve also is a point of evaluation for making decisions in the petroleum industry. On the supply side, an acceptable price that can be hedged in will lead to projects being sanctioned. On the demand side, a certain long term price justifies looking at alternative sources of fuel as it is too expensive (demand destruction).
Price can accordingly be seen as the marginal cost of full cycle production in the long term – although with technology advancing as it does, this dynamic is always changing, making it hard to predict.
Current Shape of the Futures Curve
Currently, the curve is backwardated – the front end of the curve is higher than the back end of the curve.
This is caused by strong near-term physical demand. Further down the curve, expectations for higher supply and higher hedging demand from oil and gas producers pushes down the futures price. Given the more conservative nature of North American oil & gas production after the collapse in 2014, shale producers have been more eager to hedge.