The oil market is slipping into a state known as contango. And while that may sound vaguely dance-inspiring, history suggests the shift isn’t a positive sign for crude prices.
Contango is trader lingo to describe when prices for nearby futures contracts — right now, say December West Texas Intermediate crude
CLZ23,
-4.62%
— trade at a discount to deferred futures contracts, such as January WTI
CLF24,
-4.56%
or other contracts down the line.
What is contango?
The term, according to Dictionary.com, is thought to have originated in the 19th century on the London Stock Exchange, describing a fee paid by a buyer of securities to the seller for the privilege of deferring payment.
Granted, the oil market — and other futures markets — are often in contango, reflecting the cost of storage and other factors. But a move out of contango into a state known as backwardation — when nearby contracts trade at a premium to deferred contracts — is often seen as bullish, indicating a tight physical market in which end users are scrambling to secure supplies.
The oil market has been in backwardation for much of this year, a move that preceded a summer rally fundamentally tied to tightening supplies as Saudi Arabia in July implemented a production cut of 1 million barrels a day on top of production cuts by fellow OPEC+ members.
The WTI price curve briefly traded in contango earlier this month for the first time since July 20, three weeks after Saudi Arabia’s extra 1-mbd cut took effect, noted Robert Yawger, executive director for energy futures at Mizuho Securities.
WTI, as measured by the spread between the front-month and second-month contract, closed in contango again on Wednesday and was on track to do so again Thursday. WTI hasn’t seen a sustained period in contango since July, according to Dow Jones Market Data (see chart below).
Much of the market’s previous backwardation was erased as oil futures have retreated from 2023 highs set in late September, with market bears penciling in potential crude surpluses moving into the first half of next year.
Soft physicals?
“We have a weak oil market, the physical market is soft,” Vikas Dwivedi, global energy strategist at Macquarie, said in an interview earlier this week.
The U.S. has seen crude oil inventories build this month and Macquarie expects that to continue into January. As a result, a period of elevated backwardation has eroded or been erased.
Dwivedi said Macquarie had not only expected a move into contango, but expects some WTI contracts “could move into substantial contango along the curve.”
That scenario is “just very key to our thinking the that the oversupply is real,” he said. “It doesn’t require real demand challenges from a hard landing or a global recession.”
Trouble with the curve
The bearish cast to contango might seem counterintuitive. After all, wouldn’t futures pointing to higher prices down the road seem to indicate oil will rise in the future? It doesn’t necessarily work that way.
Investors pay attention to the shape of the so-called futures curve, a line representing prices across futures contracts. Nicholas Johnson and Andrew DeWitt of Pimco said in a 2017 paper that the shape of the futures curve has historically been one of the best predictors of future returns.
They cited, for example, that subsequent 4- and 12-week returns for long positions in oil futures during backwardation averaged 1.3% and 2.9%, respectively. By comparison, long positions saw returns of negative-1.7% and negative-3.8% for the same periods during contango.
The culprits behind the move into contango, according to Macquarie, are rising production of sweet crude in the U.S., the North Sea and Brazil alongside growing signs of noncompliance with OPEC+ production cuts.
That said, crude could be due for a near-term bounce, potentially rallying into year-end due to portfolio management concerns, after a decline to mid-July levels left futures oversold, Dwivedi said.
When contango becomes a ‘big problem’
Meanwhile, a deeper move into contango, which hasn’t yet arrived, can become self-reinforcing.
The contango becomes a “big problem” once the spread becomes larger than the cost of carry, which generally hovers around 50 cents a barrel, Yawger explained in a Wednesday note. The cost of carry includes storage, transportation, interest and other fees.
“Once the contango spread blows out to levels greater than cost of carry, big players who can make and take delivery can buy at the front of the curve and sell one month out and auto book a profit,” he wrote. “As those barrels pile up in storage, they put pressure on spot, perpetuating the bearish skew.”
There’s still a long way to go before crude gets to that point, “but deep contango in any commodity becomes a tough place for a [speculator] to make money,” Yawger noted.
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