The full article with additional charts can be accessed here
Something’s got to give in the oil market
Oil prices have rallied sharply from their January lows. At the time of writing, ICE Brent and NYMEX WTI front month prices are up 64% and 71%, respectively. While the media and commodity analysts have focused mainly on the recent rally in the spot price, in our view the more interesting development was in the curve structure. The entire move up happened in the front end of the curve. Longer-dated oil prices have remain almost unchanged. This has led to a sharp rally in crude oil time-spreads; 1-60 month ICE Brent time-spreads moved from -USD20.64/bbl in January to -USD8.82/bbl at the time of writing. In commodity markets, the shape of the forward curve is primarily a function of inventories. In our view, the inventory time-spread mechanism is the strongest and most robust relationship in commodities. Any divergence presents a physical storage arbitrage opportunity which will inevitably be exploited quickly by the market. Hence any deviation between spreads and inventories is typically very short lived. And this is where the oil market is now completely out of balance in our view. The rally in front month prices combined with the lack of any price action in the back has pushed time-spreads roughly 20-30% above the levels they should normally be. This is the largest discrepancy between time-spreads and inventories we have witnessed over the entire time-horizon in which 5-year forward prices are available. In our view, either near-dated crude oil prices will sell off again or longer dated prices appreciate.
Clearly the market is expecting a tighter crude oil market in the near future given all the production outages. However, this alone does not warrant the move in spreads. It seems that the move up in oil prices was exacerbated by a general move up in commodity prices overall. Since the lows in mid-February, prices of copper, aluminum, zinc, nickel have all been moving up in a similar fashion to oil.
It thus appears that investors have been pouring money indiscriminately into commodities of late. This is visible also in positioning. Open interest in WTI has reached an all-time high. Net speculative positions and open interest in WTI and Brent are near all-time highs. In our view, it is investor flows that have pushed time-spreads up, hence time-spreads will ultimately revert back to fundamentals (inventories).
We can speculate about the rationale of the buyers. Some would argue that ever-more dovish central bank policies in Europe and Japan, as well as the clear shift away from the promised hawkish path in the US have heightened inflation concerns again. Arguably this should have the exact opposite effect on commodity forward curves though, as this should drive up longer-dated prices while spot prices should remain unaffected by inflation expectations. However, while correct in theory, one has to look at how the market can express an inflation view in practice. Trading longer-dated futures is something typically reserved to hedge funds. The bulk of asset managers such as pension funds are only allowed to invest in securities, and thus if a pension fund or an insurance company seeks exposure to commodities they typically have to buy a commodity index product.
So what gives?
We are confident that this discrepancy between inventories and time-spreads will self-correct in the near future as well. However, the question is how. There are two ways how stocks and time-spreads could realign, either inventories drop sharply or spreads will weaken dramatically again.
We strongly doubt that inventories can be the correcting factor in the short run. While there are multiple short term production outages around the world, there has yet to be a real impact on inventories. We ran dozens of models using different type of inventories as input variables (total petroleum, excluding NGLs, just crude etc.) and they all come roughly to the same result. Total industrial petroleum inventories would have to be more than 250 million barrels below current levels to justify current spreads. Crude oil inventories (without NGLs) alone would have to be about 100 million barrels lower. Even should current production outages as well as the declines in US output persist, inventories are unlikely to fall to these kind of levels until well into 2017.
Hence, in order for time-spreads and oil inventories to realign, we believe time-spreads will have to weaken again. But there are two ways how this can happen as well. Either via a renewed sell-off in front month prices or a move higher in the back end of the curve. In our view, both can happen:
The back end of the curve is too low in our view in order to encourage enough investment in replacement production. At roughly USd50-55/bbl, there aren’t enough oil project sanctioned to ensure that future demand can be met. According to Wood MacKenzie, an energy consultant, oil companies put on hold or scrapped oil projects worth USD380 by January 2016. This accounts for 27 billion barrels in oil reserves. To put this into perspective, the US Energy Information administration (EIA) states that US crude oil reserves increased by only 15.7 billion barrels from 2009 to 2014 (17.7 including lease condensates) thanks to shale oil. And given the price collapse, a large junk of these reserves are likely no longer economical viable. The oil from these abandoned projects will be missing at some point in the future. Hence ultimately we expect longer-dated oil prices to move higher so that some of the global projects become economical again. However, what speaks against a sudden appreciation in the back end is the need of producers to hedge their forward production. Thus, any immediate rally in the back end will likely be sold. So that would suggest that the reversal in spreads will be driven by a renewed collapse in prices in the front-end.
Hence either outcome is possible in our view: either near-dated crude oil prices will sell off again or longer dated prices appreciate. What does that mean for our readers? The most obvious way to trade this is by selling crude oil time-spreads. But not many people have the ability or feel comfortable trading crude oil time-spreads. But the two possible outcomes described above open an interesting opportunity in gold. As we outlined in our framework report: Gold Price Framework Vol. 1: Price Model, gold prices are driven by longer-dated energy prices. Importantly, we found that changes in oil spot prices have little to no effect on gold. Hence a renewed sell-off in the front end of the curve would in our view have little impact on the gold price. A move higher in the back end however would be hugely positive for gold prices, all else equal. Hence, the expected reversal in the crude-oil time-spreads creates an optionality for gold prices. If oil spot prices sell off – all else equal - , nothing happens with gold, if longer-dated oil prices go up, gold most likely goes up.
We estimate that in order for time-spreads to move back in line with inventories, either front end prices have to sell off by USD10-15/bbl or the back end has to appreciate USD15-20/bbl. Given the parameters of our gold pricing model, the latter would add roughly USD100-150/oz to the gold price. In the end, we think something has got to give in the oil market and a clever way to take advantage of this move is to build a long position in gold.