Oil Markets Turn Bullish With Shift To Backwardation

This week both Brent Crude and WTI (Light Sweet Crude Oil) made a new price high in more than 2 years with Brent Crude rising to $64 per barrel and WTI to $57 per barrel. These price gains come before the OPEC’s meeting later this month on Nov 30. In the past two years, OPEC has imposed production cuts in its member countries in order to remove excess inventory and halt the price drop. In their last meeting on May, the cartel agreed to extend 1.8 million barrel a day cuts into the first quarter of 2018.

Recently, OPEC officials have given a signal that they will extend the production cuts beyond March 2018 at their next meeting in Vienna later this month. More importantly, this extension will occur at a time when the oil market has already tightened. The OPEC’s attempt to reduce the inventories appears to be bearing fruit. The chart below shows US crude and product inventories fall by 93.8 million barrels since the start of the year.

One of the reasons for this success is OPEC members’ compliance to the agreed upon production cuts from last year. In October, the compliance reaches 104% as the chart below shows

Further evidence that oil market is tightening could be found in oil futures market. Both Brent and WTI are now in the state of backwardation. This is a situation where the current price of oil for immediate shipment is higher than the price for future delivery. It signals that the market is tightening and discourage traders from stockpiling barrels. Conversely, contango is when the futures price of oil is higher than the current spot price. Brent has been in backwardation earlier this year, while WTI just recently moved to backwardation as the chart below shows:

This shift to backwardation from contango have an important implication. First of all, it suggests that OPEC’s production quotas in the past two years have been successful. Secondly, the shape of the oil curve is an important predictor of future returns. For example, subsequent four and 12-week returns for long oil future position in a backwardated market have averaged 1.3% and 2.9%, respectively. In comparison, the same periods see a return of -1.7% and -3.8% on average during contango markets.