London, 29 Apeil 2010

The structure of the crude oil market has undergone a profound shift in the last five years. A market which formerly traded most often in backwardation before 2005 is now trading in persistent contango.

Contango is the market structure in which prices for future contracts are above those for nearby contracts, while the opposite is the case for backwardation. The rise in stocks has helped reduce price fluctuations in response to short-term changes in supply and demand. But it has also changed the returns to investments in commodity derivatives.

Backwardation discouraged traders and refiners from holding substantial inventories; contango pays them to hold much more stock on hand. The shift in the oil market's forward structure has been significant, as the attached charts illustrate (download below).

Chart 1 shows the half-year spread between front-month and seventh-month crude oil futures since 1988, and the half-year spread between seventh-month and 13th month futures over the same period. To make the analysis clearer, Chart 2 shows the same spreads over five year periods.

During the 1990s and early 2000s, the market typically traded in backwardation. The backwardation for the first six months averaged about 44 cents per barrel in 1990-1994, 66 cents in 1995-1999 and $2.25 in 2000-2004. But from 2005, the spread inverted to an average contango of $2.60.

It is not just the averages that have changed; the amount of time the market trades in contango and backwardation states has altered significantly. In the five-year periods 1990-94, 1995-99 and 2000-04 the market traded in backwardation for 32 months, 40 months and 55 months respectively. But since 2005, the market has been in backwardation in just 13 months.

The same shift is evident further along the curve. The second six months of the time spread shows a similar shift from backwardation trading to contango. As outright prices have risen during the past decade, the same dollar backwardation or contango reflects a smaller proportion of the flat price.

Charts 3 and 4 reproduce the analysis but with spreads expressed as a percentage of the flat price. The shift in percentage terms is smaller but still significant.

Passive Investor Impact

In a submission to the Commodity Futures Trading Commission (CFTC)'s position limits consultation, respected oil industry expert Philip Verleger attributes the shift to fund flows: "In recent years, passive investors such as pension funds have allocated a portion of their assets to buying commodity futures to diversify portfolios. This diversification has had the ancillary effect of promoting the accumulation of privately held oil inventories. The rise in these stocks has tended to reduce price variations" (letter dated 23 April 2010).

Verleger welcomes the role of investors, the switch to contango and the associated rise in stocks as helping to promote supply security. He urges the CFTC not to adopt the proposed position limits. "Inventories will decline if the regulations are adopted as proposed and volatility will increase".

The rise in stocks has helped reduce price fluctuations in response to short-term changes in supply and demand. But it has also changed the returns to long investments in commodity derivatives.

By their sheer size, however, passive investors have moved the market against themselves. The very backwardations that provided so much of the return to a long investment in crude oil futures in the past have disappeared as what CFTC Commissioner Bart Chilton refers to as the "massive passives" have pushed the market into semi-permanent contango.

As a result, passive investors may have altered the very feature of the market that made it so attractive in the first place. It has also created something of an inconsistency problem. For the market to support a high level of stocks, reducing volatility, it needs strong interest from passive investors and a contango.

But for passive longs to remain interested and continue adding to their positions, they need stocks to fall and the contango to be reduced. Passive investors are unlikely to want to continue funding inventory accumulation indefinitely unless they get something in return. The benefits from being long during a future price spike have to be set against the contango cost of remaining long until it happens.

Chilton and others have openly worried about the "distortions" created by the presence of long-only massive passives in commodity futures markets. But unless the contango disappears, and returns improve, investment inflows into commodity futures are likely to slow. The massive passive problem, if that's what it is, may well be on the way to curing itself.

Ends --

John Kemp, Reuters market analyst - for Commodities Now

The views expressed are his own.

Attachments:

WTI-TIMESPREAD1.pdf	8 Kb
WTI-TIMESPREAD2.pdf	7 Kb
WTI-TIMESPREAD3.pdf	8 Kb
WTI-TIMESPREAD4.pdf	7 Kb