What does contango in crude oil market indicate?

CRUDE oil is now trading below $30 per barrel-the lowest in 12 years-amid persistent excess supply in the global oil market. However, long-dated future prices are higher than the spot price (or near-dated contracts). For example, the contract for delivery of Brent crude oil in March 2016 is currently trading at around $29 per barrel compared with $35 for delivery in January 2017. Does this mean the markets expect oil prices to rise in future? That appears counter-intuitive with the oil market being in surplus and Opec (Organization of the Petroleum Exporting Countries) appearing determined to flood the market with its oil to defend market share. What gives? One possible explanation for the current contango-the market jargon for future prices being higher than spot or near-term contract prices-is the shortage of immediate storage capacity, which is pushing down spot prices. The International Energy Agency's December report observed that the contango in US WTI crude oil was steeper for the first four months of the year compared with the following eight months, signalling that the storage capacity at the terminal (Cushing, Oklahoma) is under pressure.

According to the US Energy Information Administration's (EIA's) January report, oil storage utilization in Cushing, the delivery point for WTI oil contracts, is 87.5%. However, contango in oil markets is not limited to WTI, where it can be explained away by excess oil for immediate delivery. Contango has also been persistent in Brent crude oil contracts as well as Middle East crude oil contracts. Also, contango in oil markets cannot be explained away as the premium that buyers of oil futures pay due to interest rate costs. This is a crucial way in which crude oil markets differ from most financial markets. In case of financial assets such as equities, or investment commodities like gold, the future price is generally the spot price plus the interest rate. Hence, markets of most financial assets are always in contango. However, crude oil is different from financial assets due to significant storage costs. Therefore, markets often tend to be in backwardation, i.e. when long-dated futures are cheaper than nearer contracts. In fact, between 1998 and 2015, the oil market was in backwardation for about 55% of the time.

To be sure, it is possible that part of contango indeed reflects expectations of higher prices in future. According to Svetlana Borovkova, associate professor atVU University Amsterdam, the shape of the forward curve reflects market participants' perceptions of fundamentals and expected price trends. Thus, it appears that market participants deem the current prices to be too low for supply and demand to balance in the coming years. Investment bank Standard Chartered, in a note released last week, said that "Prices are already well below the minimum required level to allow for global supply to increase in the medium term. Prices at USD 45/bbl a few months ago were already too low to balance the markets in 2016". The assessment that lower oil prices will hamper oil production, especially outside the Opec, is shared by most experts. The US EIA expects US crude oil production to fall to 8.5 million barrels per day (mbpd) in 2017 from 9.4 mbpd in 2015. It further expects the global oil market to turn into slight deficit by late-2017 compared with a surplus of around 2 mbpd in 2015 (See chart 1). World petroleum supply averaged around 97 mbpd in 2015 while consumption averaged 95 mbpd.

Thus, persistent contango might be a sign that the market believes the current oil prices are too low to adequately incentivise a rise in future oil production. The last time global oil markets were in a similar contango for a sustained period of time was in 2008-09 during the financial crisis, as Chart 2A shows. That situation lasted till about early 2011, when oil prices eventually rebounded to $110 per barrel. In hindsight, it seems that oil markets in late-2008, characterized by higher future prices, correctly predicted a rise in oil prices and apparently anticipated the end of the then-prevailing situation of excess supply. Indeed, Opec cut its oil output in early 2009 (See chart 2C) and the global oil market turned from surplus to deficit by 2009 (See chart 2B), which in turn aided the recovery in oil prices However, the situation today is different, given that all the chatter from Opec countries indicates that the cartel is willing to pump in more oil in order to maintain its market share, regardless of the impact on prices. Thus it seems any cut (or slowdown) in oil production, which is necessary to balance the market, would come from non-Opec countries such as the US rather than from Opec countries like Saudi Arabia.