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--Clyde Russell is a Reuters market analyst. The views expressed are his own.--
By Clyde Russell
LAUNCESTON, Australia, July 12 (Reuters) - The curve for Malaysian palm oil futures has moved into a rare contango as the market frets over the possible re-emergence of the El Nino weather pattern and lower soy oil supplies in the United States.
But the curve may have steepened too quickly and appears to be factoring in a worse El Nino than the last major occurrence in 1997-98 and a fairly disastrous soybean harvest in the Americas.
Palm oil futures traded in Kuala Lumpur now have a steeper curve than soy oil contracts in Chicago.
However, the steepening of the curve doesn't necessarily mean that prices for palm oil won't rise, with the benchmark 3-month contract at its widest discount to its soy oil equivalent since October last year.
Given that palm oil has a fairly close correlation to soy oil, it's possible that the prompt month contract could still gain even as the curve flattens out.
To justify the curve steepening in palm oil, there will have to be a significant reduction in future supplies, but this means the threat of El Nino has to become reality, and it has to be a strong event.
The El Nino phenomenon is a warming of sea-surface temperatures in the Pacific that typically leads to wetter weather in the Americas but brings drought to Australia, Southeast Asia and India.
Japan's weather bureau said this week its climate models indicate El Nino will emerge in the northern hemisphere summer, while the U.S. Climate Prediction Center said last week El Nino may strike as early as the third quarter of 2012.
However, the severity of a possible El Nino has yet to be determined. A mild event will have minimal impact on agricultural output and if this turns out to be the case, the curve steepening in palm oil will have been overdone.
The palm oil futures curve was in backwardation, where front-month contracts are more expensive than those for later delivery, as recently as three months ago, when the nine-month future was 3 percent cheaper than the three-month, while the six-month was at a discount of 1.6 percent.
By Wednesday, the curve was in contango with the six-month future at 3,099 ringgit ($973) a tonne, 0.6 percent premium to the three-month, and the nine-month at a 1.2 percent premium.
Given that these futures, which are quite liquid with an open interest of more than 35,000 contracts in the three-month and 5,000 in the nine-month, rarely trade in contango, the switch from backwardation is significant.
If you go back to the last severe El Nino, the nine-month contract traded at a premium of 2.5 percent to the three-month in July 1996, before the event, but by the time it was full-blown in January 1997, it was back to a discount of 3.9 percent.
The curve reverted to contango by July 1997, but returned to backwardation by January 1998.
It is also worth noting that the three-month contract gained 24 percent between July 1996 and January 1997, and then rose a further 97 percent up to July 1998.
This indicates that a severe El Nino will boost the prices of the futures, but that moves into contango along the curve are infrequent and not long-lasting.
There are reasons to be bullish on palm oil, given a slowing in output in major producer Malaysia coupled with strong demand from top buyer India.
Malaysia's production dropped almost 18 percent in the second quarter from the same period last year, while exports rose in June.
This has reduced inventories by 5 percent at the end of June from a month earlier, thereby tightening the market.
Palm oil is also being boosted by soy oil, with the U.S. Department of Agriculture lowering its yield and production estimates in its latest report on the outlook for the world's largest soy bean producer.
But while outright prices may rise in the next few months, it will take confirmation of a strong El Nino to justify the current steepness of the palm oil futures curve. (Editing by Clarence Fernandez)