Tale of the Curves

In each of the past four years the spot oil market has traded around US$80 per barrel (see chart 1 below). Over that time, we have seen a high of US$147.27 and a low of US$32.40.

Chart 1: NYMEX WTI Crude Oil 1st Month Price (click chart to enlarge)

What is interesting is the change in the shape of the forward curve each time we have traded at or close to US$80 (see chart 2 below).

For example, December 2015 was US$69.07 on September 14, 2007 (point A in chart 2 ) and is currently US$93.95 (point B). In other words, the expected price of oil in December 2015 has risen by almost US$25 per barrel in the past 2 years.

Chart 2: NYMEX WTI Crude Oil Forward Curves (click chart to enlarge)

The back end of the oil curve has risen steadily due to three reasons: 1. the expected marginal cost of future supply has increased over the past two years; 2. the US dollar is expected to weaken in oil terms; and 3. an early 1980s-type efficiency drive is expected to make demand more resilient to higher prices than demand has been over the past twenty years.

As you may be aware, oil forward curves have historically not been a good predictor of future prices. Forward curves are a summation of current market expectations. Expectations change over time as new information becomes available.

I don't think that the current forward curve correctly reflects the most probable oil price scenario over the next ten years. However, humility in the face of market expectations and an understanding of those expectations is essential before one can disagree with them.

For an explanation of forward curves, look at Chpt. 18 of Oil 101.

Floating Storage Holds Oil Price Key

(chart 1: model based on tanker data. click to enlarge)

Floating inventories should typically decline as demand picks up seasonally moving through the third and fourth quarter. Yet floating storage is increasing (see chart 1 above) to a new record high. Anecdotal evidence lends support to the above analysis.

(chart 2 above: AG to USGC VLCC in US$ per barrel. click to enlarge)

Low freight rates (see chart 2 above) result from OPEC not using tankers they had been using last year when they were producing flat out. This provides the first and most important of a few key incentives to increase floating storage. Another incentive is the shape of the forward curve which needs to be in sufficiently upward sloping contango (see chart 3 below). Future prices have to be above today's price plus the cost of the tanker. There are also financing costs which need to be covered.

(chart 3 above: NYMEX WTI Crude forward price curve. click to enlarge)

As OPEC increasing production will be the supply factor which ends the current oil price rally, changes in the above three charts may provide leading indicators to determine when oil prices have topped out and will begin to move sideways or fall.

Bear in mind that the above analysis is of the supply side of the oil market. As mentioned previously, above US$80 per barrel (oil spending equivalent to 4% of GDP) demand is likely to fall. OPEC may be able to created supply-driven price spikes above US$80 per barrel, but these are unlikely to last.

Tale of the Curves

(click to enlarge - data is NYMEX WTI Crude forward curves)

OPEC members play a market balancing act. They want prices to be as high as consumers can bear, but no more. OPEC do not want oil prices to move so high that consumers stop buying and the oil begins to fill storage tanks.

After flattening as oil prices recovered from just above US$30 per barrel at the beginning of 2009, crude oil forward curves have been steepening (contango has become more pronounced) over the past three weeks on oil reaching over US$70 per barrel.

Increasing contango is often a bearish oil price signal as it shows storage owners are seeing more demand for oil to be stored rather than consumed.

We may finally have reached a price point (just above $70) in the 2009 supply driven rally where OPEC's supply cuts have caused prices to rally to a level at which demand wanes.

This is a genuine economic recovery. However, it is a fragile glass-like economic recovery, ready to shatter at any moment. OPEC now have to tread more carefully to ensure that oil prices are not the stone which breaks it.