London, April 2010

Crude oil spread traders scent blood in the water; the market is going after those participants still running long spread positions in a bid to force them out. The price differential between NYMEX oil futures expiring in June and December has continued to surge, hitting just over $7 at last night's close, up from $5.37 on Friday, and just $1.50 at the beginning of the month.

Part of the problem stems from rising stocks and possible congestion around the NYMEX delivery point at Cushing (Oklahoma). The sudden widening of the contango has coincided with an unexpected build-up of inventories around the delivery point. Stocks have risen 4.2 million barrels, or 14 percent, in the last five weeks, and the weekly builds have been getting bigger.

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The softening of the spreads in NYMEX WTI futures has not been matched by a similar move in ICE Brent, which is not afflicted by the same delivery problems. While Brent spreads have risen, the increase has been much smaller. NYMEX WTI is trading in a contango of $7 for the second half of the year; Brent spreads are just half that at around $3.70.

Congestion at Cushing is only part of the answer. Inventories are relatively high (34 million barrels) and rapidly approaching the area's maximum operable level (estimated at around 37 million barrels), but the stock rise cannot fully explain what is happening in the spreads.

Inventories in the rest of the Midwest ( PADD II) outside Cushing have been rising steadily since February -- mostly as a result of strong flows of Canadian crude down the Spearhead pipeline and low refinery runs. But it is only in the last few weeks this surplus crude has suddenly become more "visible" by being delivered into the Cushing tank farms.

The market's sudden reversal, from drawing stocks and a narrowing contango to stock builds and bigger contangos, seems to have caught many analysts and traders by surprise. Most had predicted the contango would narrow further, even move into backwardation by the end of Q3, as the market continued to tighten and stocks fell. Bullish forecasts led many traders and investors to set up long positions in the spread (buying nearby futures and selling those further forward) in a bid to gain from any shift into backwardation.

When that trade went wrong earlier this month, the rush to exit long spread positions contributed to record turnover in the first seven or eight months of the NYMEX crude contract. Spreads jerked out even further as investors and traders dumped their longs. But the violent movement in the spreads in the middle of this month should have flushed out most of the weak longs; the big turnover certainly suggests a lot of long positions were dumped or closed out.

In other circumstances, the spread should have stabilised after the initial jagged movement. Instead it has continued to soften. The spread has more than doubled since April 14, when it stood at just $2.98. The market is still pushing the spread wider each day. The most likely explanation is that participants sense there are still one or more big longs out there. They have absorbed substantial pain already, and the market is trying to force the spread wide enough to force them out of their positions. Spread longs are trapped. If they run those positions to maturity, they must arrange to take delivery of millions of barrels of crude oil around Cushing, where tank farms and pipeline space is almost exhausted.

Others may have tried to establish fresh longs as the spread has widened only to be caught out by its continued weakening. The last time the time spreads were this wide was in H2 2008 and early 2009, when global oil inventories were rising rapidly amid the financial crisis and worldwide recession.

The situation looks very different now. While the market may not be as tight as some commentators have suggested, it is not suffering from a glut either. The current massive contango looks unsustainable. At some point it should begin to narrow, presenting an opportunity to re-establish long spreads on a much more favourable basis. The spread already shows signs of tightening this morning.

The prospect has encouraged longs to cling on and wait for a reversal to avoid crystallizing losses. But time in the meantime the experience is likely to have been painful.

Ends --

John Kemp, Reuters market analyst - for Commodities Now. The views expressed are his own.

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