Kemp: Brent Spreads Become Battleground Amid Doubts Over Oil Rebalancing

In a heavily oversupplied market, the premium for immediate availability falls to zero, and the shape of the futures curve is determined entirely by the cost of finance and storage, ensuring futures prices are in contango.

But as the market becomes less oversupplied, or even undersupplied, the premium for immediate availability rises and starts to offset the discounts for finance and storage.

If the supply-demand-stocks balance tightens sufficiently, at some point the premium for immediate availability becomes bigger than the discounts for finance and storage, and futures prices move into backwardation.

Holbrook Working of Stanford University’s Food Research Institute explained the relationship between stock levels and futures prices more than 80 years ago (“Price relations between July and September wheat futures”, 1933).

Working was examining grain markets, but the same relationships are present in the market for any storable commodity.

Similar price relationships are evident in spot and forward prices for wine and whisky, natural gas, gasoline and crude oil.

Over the last 25 years, the calendar spreads between Brent crude futures for adjacent months have provided a reasonably reliable signal about the shifting balance between production and consumption (http://tmsnrt.rs/2mnwWS9).

Periods of oversupply such as 1996-1998, 2008-2009 and 2014-2016, have seen Brent spreads move into contango.

Periods of undersupply, such as 1999-2000, 2006-2008 and 2010-2011, have seen the spreads move towards backwardation.

But the shape of the futures curve also provides an opportunity for traders to speculate against the prevailing market consensus. “The futures curve is what we bet against,” as one experienced trader puts it.

Traders who believe the supply-demand balance will be tighter than commonly expected can speculate on a move towards backwardation by taking a long position in the calendar spreads.

Buying nearby futures contracts while selling futures further forward, bullish traders profit if nearby prices move higher relative to further forward prices.

Conversely, traders who believe the supply-demand balance will be less tight can bet on a move towards contango by taking a short position in the calendar spreads (short nearby futures and long forwards).


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