London, 23 September 2011: Reuters

Persistent supply shortfalls have kept Brent oil supported around $110 per barrel, even as the economic outlook in Europe and North America darkens and the market prices an increasing risk of recession. But the relative weakness of forward prices suggests most market participants expect the current tightness to prove temporary, gradually easing in the next 12 months.

Forecast growth in non-OPEC oil supplies in 2011 has been cut from 600,000 barrels per day to just 200,000, exactly offsetting IEA downgrades in projected consumption, according to a thoughtful note published by my colleague Javier Blas at the Financial Times on Tuesday ("Supplyside support keeps Brent over $100").

Blas examines in detail the knife-edge split between hedge funds and other macro traders concentrating on the deteriorating economic environment, and contrasts it with the views of physical crude traders and funds who focus more on the extreme tightness in cash markets at present.

But shift the focus further forward along the curve and it is clear supply shortfalls are expected to be temporary as Libyan exports resume and other problems are resolved, while the probability of recession and stagnating demand weighs on futures prices for December 2012 and December 2013.

SPOT AND FORWARD

Observers point to big premiums for nearby futures contracts over those for deferred delivery ( backwardation) as an indication the market is worried about the availability of physical supplies.

The nearest-to-expire November 2011 Brent futures contract is today commanding a premium of $1.50 per barrel over the next-to-deliver December 2011 contract as European refiners scramble for limited supplies of precious light sweet crudes.

But it might be more accurate to say backwardations are an indication tightness is expected to be temporary rather than permanent. Compare the current structure of forward prices with those during the last price spike, in 2008.

At the height of the price spike in May-July 2008, futures curves for Brent and U.S. light sweet crude (WTI) were trading close to flat or showed small premiums for future delivery ( contango).

The difference was that in 2008 the tightness in Brent and WTI markets was expected to be permanent as a result of fears about peak oil production and continued strength in demand from both emerging markets and the advanced economies.

The market saw no relief from extreme tightness any time in the foreseeable future. Futures prices commanded the normal premium over the spot market reflecting the costs of storage and financing avoided by the owner of a futures contract.

In 2011, market concerns about supply shortfalls are concentrated at the near end of the curve, pushing nearby contracts to a strong premium, while deferred contracts trade at increasingly large discounts.

ICE Brent futures for December 2011 delivery are this morning trading a little over $106 per barrel (up around 11 percent since the start of the year). But Brent for December 2012 is trading lower at around $102.50 (up 8 percent) and futures for December 2013 are under $100 per barrel (up less than 6 percent).

Prices for December 2012 have fallen 13 percent from their peak in April, while prices for December 2013 are down by almost the same amount from their July top. Some commentators analyse flat prices and the shape of the forward curve separately -- arguing the shape of the curve is a better guage of the supply-demand-inventory capacity balance, while flat prices are more heavily influenced by macro concerns and expectations about the long term supply-demand outlook.

It is certainly true many market professionals and physical traders prefer to trade the forward structure rather than flat prices, since it maximises their informational advantage from being active in near-term physical flows. But the two are not really separable.

In 2008, the combination of high prices and a flat curve was an indication tightness was expected to persist indefinitely. In 2011, the combination of moderate prices but a steep backwardation is an indication tightness is expected to gradually ease.

REBALANCING UNDER WAY

While the timing of resumed Libyan exports remains uncertain, most observers believe military and political stabilisation will permit the export of several hundred thousand barrels per day to resume within the next 3-6 months, and production problems elsewhere may also ease with time. Meanwhile, manufacturing surveys point to the euro zone tipping into recession this month.Significant downside risks to the outlook in the United States and the United Kingdom have also been highlighted in the past 24 hours by both the Bank of England and the Federal Reserve.

As expected, the threat of recession is helping rebalance the (forward) oil market .Worsening economic conditions are expected to help rebalance the market by cutting crude consumption in line with diminished expectations for future supply, helping maintain a sufficient margin of spare capacity.

Forward prices are a notoriously bad guide to future realised spot prices. The oil market famously failed to spot the emerging slowdown in the first half of 2008, which turned into a savage downturn in the second half as the financial crisis intensified.

But while the physical market remains tight in the absence of Libyan oil and with continued problems in the North Sea, the majority of market participants think tightness will ease significantly in the next 12 months, according to the price structure.

Ends --

By John Kemp, Reuters market analyst – for Commodities Now.

The views expressed here are his own.