(John Kemp is a Reuters market analyst. The views expressed are his own)
* Futures prices 1992-2016: tmsnrt.rs/1TKTUl7
* Futures prices 2014-2016: tmsnrt.rs/1TKU4sJ
By John Kemp
LONDON, March 9 (Reuters) - Commodity traders and academic economists agree there is a close relationship between stock levels and the strip of futures prices.
Holbrook Working of Stanford University’s Food Research Institute explained the relationship between stocks and the futures price curve over 80 years go (“Price relations between July and September wheat futures” 1933).
In a market with ample inventories, the price of a commodity for future delivery tends to be above the price for immediate delivery, a condition known as contango.
In a market with tight inventories, the reverse tends to be true, with price for immediate delivery trading above future prices, a condition known as backwardation.
By extension, in a market characterised by excess supply, inventories will be rising, so the market will tend to move from backwardation into contango, or if it is already in contango into a deeper one.
Conversely, in a market characterised by excess demand, inventories will be falling, so the market will tend to move from contango into backwardation, or a deeper backwardation.
Given the intimate relationship between supply, demand, inventories and forward prices, the shape of the futures price curve is closely monitored by professional traders.
Contango and backwardation are avidly watched in trading rooms because shifts can send important signals about the balance between supply and demand and changes in the level of stocks.
In the traditional theory of futures prices, the cost of owning and storing a commodity (cost of capital plus cost of storage) tends to ensure future prices trade above spot prices.
But producers, consumers and traders will pay to avoid the risk of being without adequate supplies on hand, which can impart a premium to spot prices if stocks are short.
The balance between cost of capital, cost of storage and scarcity premium varies depending on the rate of interest and stock levels, determining whether the market trades in contango or backwardation.
Contango is both a symptom of a market that is adequately or over supplied, and an enabler of storage, since it provides a financial incentive to hold excess stocks.
In a market characterised by contango, traders can buy and store physical stocks of the commodity and cover the cost by establishing a short position in the futures market, a strategy known as “cash and carry”.
(The etymology of “contango” is obscure but it seems to have emerged in the mid-19th century in the context of stock exchange trading and may be derived from “contingent” or “continue”.)
In the oil market, there has been a close correspondence between the supply-demand balance, stocks and the degree of contango or backwardation in Brent futures prices (tmsnrt.rs/1TKTUl7).
Progressive oversupply of the oil market between 1996 and 1998 was associated with a shift in Brent futures prices from backwardation to contango.
The tightening of the market in the course of 1999 was accompanied by a return to backwardation in futures prices (“Oil Market Report”, IEA, Dec 1999).
The same shift from backwardation to contango and then back to backwardation was evident during the price spike of 2008 and subsequent recession in 2008/2009.
Even as spot oil prices raced towards their peak of more than $140 per barrel in July 2008, the backwardation in futures prices began to soften from November 2007 and especially May 2008.
The easing backwardation should have been a warning signal that the global economy and oil demand were stalling and the stock situation was improving.
The U.S. National Bureau of Economic Research Business Cycle Dating Committee would later (in December 2008) determine the U.S. economy had begun to contract in December 2007.
Most indicators of oil demand would subsequently show oil consumption growth had begun to slow or even turn negative in the first half of 2008.
At the time, many analysts dismissed talk of a recession and insisted there was no evidence that high oil prices were harming demand.
But the gradual lessening of the backwardation was a real-time indicator that strongly suggested the balance between supply and demand was shifting.
As the financial crisis and economic recession intensified in the second half of 2008 and early 2009, the oil market became heavily oversupplied, stockpiles surged and the market moved into a large contango.
Rapidly increasing stocks and fears about a potential shortage of storage space pushed spot prices to an unusually steep discount, dubbed the “super-contango”.
As the global economy stabilised and OPEC’s production cuts took effect, the supply-demand balance moved into deficit in late 2009 and throughout 2010 and 2011.
Oil inventories were gradually drawn down, and the market returned to backwardation from March 2011 onwards.
In a broad sense, the current slump in oil prices has conformed to the pattern associated with the East Asian financial crisis in 1997/98 and the great recession in 2008/2009.
The degree of backwardation in Brent peaked in October 2013 and had already begun to weaken by the time spot prices started to slide in June 2014.
The softening structure of futures prices should have been a clue the market was becoming actually or prospectively oversupplied thanks to the acceleration of shale output from the United States.
As spot prices tumbled, the futures curves shifted from backwardation to contango, and the contango became progressively larger until February 2015.
Since then the contango has narrowed, albeit erratically. The contango between the first and seventh listed futures contract has averaged around $4 per barrel over the last 30 days, compared with around $6 per barrel at the same point in 2015.
The contango has narrowed even as official statistics have shown supply exceeding demand by as much as 2 million barrels per day, and stockpiles rising by hundreds of millions of barrels.
Drawing lessons from previous episodes of contango trading in the oil market for current circumstances is not straightforward.
Interpreting the structure of futures prices is an art rather than a science because it responds to multiple factors all of which can be changing at the same time.
Factors include the availability of storage space, interest rates, current and anticipated stocks, actual and expected shifts in supply and demand, current and anticipated spot prices.
Reasoning backwards from prices, even time spreads, to supply, demand and inventory fundamentals is fraught with risk.
The current Brent contango is much smaller than the one in 2008/2009, though substantially larger than in 1997/98.
However, the cost of capital, a key component of the contango, is lower than in the late 1990s, while large amounts of new storage space have been constructed in recent years.
The degree of contango evident in the Brent market has been increasing over time especially since around 2004/2005, which some analysts attribute to the increased “financialisation” of commodities.
However, past experience strongly suggests oil market rebalancing will be accompanied by a narrowing of the contango or even a return to backwardation.
In this respect, recent moves in the contango have been ambiguous. The contango is much narrower than in the first few months of 2015 but shows no sign of disappearing yet. (tmsnrt.rs/1TKU4sJ)
The contango in the Brent market does not suggest the market has swung from surplus to deficit yet. But it is hard to reconcile with predictions of continued enormous stock builds shown in some official statistics. (Editing by Susan Thomas)