What is ‘backwardation’ and what does this time mean for the price of oil and OPEC?

The fight against covid-19 has caused a bullish rally in the markets, which has not gone unnoticed for oil, one of the assets considered risky. Brent crude, a benchmark in Europe, has risen 28% so far this month. The future price of a barrel for delivery in January exceeds 48 dollars, levels not seen since March. In addition, the structure of the futures market has changed from contango to backwardation, which usually indicates that in the shortest term there could be a certain oil deficit in the market (more crude is demanded than supplied). However, one week before the OPEC meeting, experts are calling for caution: we are facing a backwardation that is still weak and unfounded.

Commerzbank: “Backwardation is often interpreted as a sign of tight supply. But right now there is no evidence of this, at least in the most recent inventory data”

The backwardation structure occurs when the current (spot) price of physical oil is higher than the prices traded in the futures market. This means that the present demand for oil is strong with respect to the supply. In the case of oil, it does not have to mean that more crude oil is being consumed today than is produced, it may simply be that after the encouraging data on the vaccine, traders and companies have launched to buy crude oil to store and sell it in the future (hoping that the price will be higher when the economy grows more strongly).

The barrel of oil has risen 28% so far in November

The opposite of backwardation is what is known, where the futures price is higher than the price of physical crude oil or the nearest future (usually one month future). For example, when oil fell below zero dollars (the West Texas benchmark) during the first lockdown, the contango was over ten dollars. Investors gave away physical oil (they didn’t know where to put so much oil) while futures still had positive prices, anticipating that at some point the situation would improve.

Beware of this backwardation!

The truth is that the current backwardation is very small, just a few cents on the dollar, because the short-term situation for oil continues to be highly uncertain. However, this structure shows that the situation has improved and that investors are somewhat more optimistic after the emergence of the different vaccines against covid-19. “It’s taken some time, but Brent is already in backwardation,” ING analysts Warren Patterson and Wenyu Yao said in a note.

The oil price rally, coupled with tighter spreads (along the oil futures curve), appears to be largely driven by expectations that we could see a release of Covid-19 vaccines much sooner. than expected. Importantly, that obviously means that we are going to start to see oil demand pick up very quickly as well,” the ING experts warn.

Despite the risks, the situation is better today than it was a few weeks ago. “OPEC+ will obviously be very happy to see the backwardation structure, however we still think there is a risk that the market is reacting too soon. We have the OPEC+ meeting in a week, and the The key question is whether the cartel will decide to delay reducing the cuts until January 1.”

Eugen Weinberg, Commodity Analyst at Commerzbank, explains that “in recent weeks we have repeatedly pointed out the risks to the oil price on both the demand and supply sides. This makes the price rise even more More surprising: Brent is now moving vigorously towards the $50/barrel mark, and has already reached almost $49 this morning.In this context, the forward curve has shifted to backwardation for the first time since June, that is, the “previous month’s futures contract is priced higher than subsequent contracts. Backwardation is often interpreted as a sign of tight supply. But right now there is no evidence of this, at least in the most recent inventory data,” says the German economist.

This rise in oil prices could prove counterproductive in terms of OPEC+ cohesion. Some members could use the crude rally to call for an end to production cuts when the future of demand remains very uncertain, as it has warned recently. “After all, it could encourage the members of the alliance to adopt a more lax attitude that puts the production cut policy in check,” concluded the Commerzbank expert.