COLUMN - IEA stock release crushes Brent spreads: John Kemp

Fri Jun 24, 2011 5:06am IST

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-- John Kemp is a Reuters market analyst. The views expressed are his own --

By John Kemp

LONDON (Reuters) - Forget the spot oil price. The real action Thursday following the International Energy Agency's decision to order a release of emergency stocks was in the timespreads.

The main effect has been to erase fears about a summer shortage of seaborne light sweet crude, crushing the Brent timespreads and largely eradicating the backwardation in place since the loss of Libyan output in February.

The attached chart shows inter-month timespreads for Brent and U.S. light sweet crude futures for the remainder of 2011. (Graphic: link.reuters.com/mav32s )

While both Brent and WTI spreads tightened significantly following the unrest in Libya in February, they have since diverged sharply. Brent spreads have remained exceptionally tight, while WTI spreads began to soften again starting in late April, shortly before the heavy sell off in oil markets on May 5.

Prices for Brent contracts nearing expiry have commanded a substantial premium over both forward months and WTI amid worries about the shortfall of light sweet oil from Libya compounded by drop in North Sea output during the summer maintenance season and the likely ramp up in European refinery throughput during Q3 and Q4.

The comparative resilience of the Brent timespreads, in contrast to softening WTI spreads, explains the blowout in the spread between Brent and WTI for nearby trading months during June.

Fears about a shortfall of seaborne light sweet crude over the summer have been cited by the major commodity banks to justify forecasts of sharply higher oil prices during the rest of the year. It has also been cited by many market participants as the reason why the market remains in steep backwardation and at a record premium over WTI.

Potential shortages of seaborne light sweet oils were specifically cited by the IEA as the reason for its decision to call on member countries to release 60 million barrels from emergency stockpiles over the coming month "to help bridge the gap until sufficient additional oil from [producing countries such as Saudi Arabia] reaches global markets."

POLICY SUCCESS

If the IEA's objective was to ease fears about near-term tightness in the market, the policy has been a brilliant success.

The premium for Brent delivered in August rather than September had shrunk to just 15 cents per barrel by 1925 GMT, sharply down from 45 cents on Wednesday, and a high of 59 cents as recently as June 13.

Brent for September delivery compared with October had actually swung to a discount of 8 cents, down from a 32 cent premium Wednesday, and the first time it has traded at a discount since mid-February.

As intended, the impact of the stock release has been concentrated on the Brent market (where fears of shortages have been greatest) rather than WTI (where bulging inventories at Cushing and other parts of the Midwest have ensured the market is well-supplied). It explains why Brent has led the market lower, at least for nearby contracts.

Some market participants have criticised the stock release and questioned whether it was really necessary. Iran and other OPEC price hawks have claimed the market was well supplied and there was no need for more oil. While that may have been true globally, certain segments of the market appeared tight, as shown by the backwardation in Brent.

Some market participants have also criticised the agency for attempting to manipulate prices and questioned whether there was really the sort of immediate physical shortage of oil that justified a stock release. But again the backwardation suggests there were genuine fears about tightness and that it was therefore appropriate for the agency to meet that specific short-term shortage of particular crude grades.

The market called for more oil -- and the agency responded.

DAY TO FORGET

Nonetheless, the collapse in the Brent timespreads will have caused immense pain for many physical and paper oil traders. Taking positions in the time spreads is a popular strategy, particularly for the largest physical oil traders and market makers, since it is seen as strategy which maximises their advantages from market knowledge.

Mercuria chief executive Marco Dunand told the Reuters energy summit earlier this month "My guess is we could have backwardation in Brent for the rest of this year and it might even get tighter". Many other physical traders shared the same view given the characteristics of this small and not terribly representative market.

It is not just physical traders. Many index investors and hedge funds have been encouraged to ditch long positions in WTI and switch to Brent to benefit from better roll yields, according to Dunand.

Until today, long positions in the Brent timespread (long a nearby futures contract and short one further forward) were extremely profitable. The IEA's action has thrown a big wrench into that trade and left some market participants nursing large mark-to-market losses.

(Editing by David Gregorio)

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