During a hectic week the oil market performed well. In fact, it refused to be manipulated by weak equities and a strong dollar. Major stock indices all lost value last week and the dollar index strengthened 0.6% yet, the two crude oil futures contracts returned more than 3% during the same period. This resilience originates from a solid fundamental backdrop. We learnt from the latest monthly reports that global oil demand is set to rise in coming month. Supply disruptions, on the other hand, have significantly affected the output side of the oil equation. Global oil inventories are set to thin for the balance of the year.
The stage is set for a tighter oil market and consequently prices should remain stable in the foreseeable future. Developments on the financial side could cause brief corrections just like the one we are experiencing this morning. Far East stock markets and the strong dollar are affecting oil. The threat of default of Chinese property developer, Evergrande, is a growing concern and the Fed’s FOMC meeting this week will also be eagerly watched for clues on tapering. Nonetheless, unless all hell breaks loose the positive sentiment ought to prevail. The most important development to watch out for is the threat of government shutdown in the US. An unlikely failure to raise the US $28.5 trillion debt limit in coming weeks and an eventual default on sovereign debt would shake the very core of the US financial systems that would reverberate through markets, including oil. This is, however, an implausible scenario and apart from the occasional corrections no major upset is anticipated in our market this year.
Brent structure helps spot trend reversal
As we have pointed out on the pages of this report a few times the economic recovery from the pandemic is irrevocably taking place. Anyone who follows the stock and energy markets would agree. The MSCI Global Equity Index has nearly doubled in value since the bottom was reached in March 2020. Brent fell to as low as $16/bbl at the height of the panic the pandemic caused and now it is well above $70/bbl. Economies are growing worldwide even though the uneven distribution of the Covid-vaccine puts developing countries in a disadvantageous position compared to their richer peers. The price war between Saudi Arabia and Russia more than a year ago that sent the price of the US crude oil marker to negative territory is a distant memory. The sporadic spread of the mutants of the virus leads to growing concerns about the unabated rise in risky asset prices but retracements of the past year have proven just that – retracements.
As economies recover and the oil balance tightens ominous signs emerge about the sustainability of the underlying confidence. In a way it is a self-fulfilling prophecy, a fact of life. Growing demand leads to higher prices and when they reach a certain level demand is withdrawn, consumption falls, and the cycle starts all over again. Inflated prices could put unbearable burden on consumers whilst producers will jump on the opportunity to maximize their revenue by stepping on the accelerator.
There are hundreds and thousands of factors that drive oil prices – just think of the market management strategy of the OPEC+ group, unintended supply disruptions in some of the member countries, weather-related events, financial markets or the withdrawal of monetary help that would affect the dollar and dent physical oil demand. These factors do not point unambiguously in one direction but judging by the developments of the past few months the majority of the market remains confident. However, the sentiment can quickly turn and what considered cheap today could be expensive tomorrow.
The general consensus is that financial players or money managers are responsible for the direction of outright prices and physical traders play a huge role in shaping market structures. Of course, the flat price and the curve more often than not go hand in hand. The market structure, together with changes in the paper positions of financial investors can help spot potential trend reversal.
An oil market that is in equilibrium displays a slight contango. The extent of it is the cost of storing one barrel of crude oil for a month. The backwardated nature of an oil contract implies tightness in the underlying physical commodity. It serves as an incentive for money managers to own futures contract since extra profit is offered by rolling paper positions over from one delivery month to the next.
Given that Brent is the most important benchmark in physical trading, and it also has deep and liquid derivative markets we have chosen this crude oil marker to examine the relationship between net speculative length (NSL) and market structure. The M1/M6 Brent spread has shown a very high correlation -more than 80%- with the weekly NSL figures ever since the virus outbreak at the beginning of 2020. The deeper the backwardation the more speculative money pours into this contract. At the end of March 2020 Brent NSL fell to 56 million bbls with the first month Brent contract trading more than $11/bbl below Month 6. As the market started to tighten the structure turned into backwardation and the demand for paper Brent barrels started to grow. Depleting physical oil inventories supported the Brent structure and financial investors were happy to take advantage of the change in the curve. Strong physical market aided outright prices and the added bonus came in the form of backwardation. Since the beginning of June, the M1/M6 spread has been steadily between $2/bbl and $4/bbl whilst Brent NSL has been fluctuating around 300 million bbls – it jumped 19 million bbls last week. Whenever the underlying oil balance changes it will be reflected in the weakening of the backwardation, which could ultimately turn into contango making length unattractive to hold. There are, however, no signs of such reversal. As long as the Brent structure shows solid backwardation (the M1/M6 Brent spread settled at $3.48/bbl last Friday, in the upper half of the recent range) money managers will have no reason to reduce length thereby providing support for outright prices.