VIENNA: How can oil fall 25 percent in a matter of months when the principal futures market has signaled all along a situation of dearth, not plenty?
Or put another way, why have buyers of oil this year been paying a premium for prompt delivery when supply has far outstripped demand?
Front-month Brent crude futures have traded at a premium to contracts for delivery two and three months later every single day but one this year.
This market structure, known as backwardation, is generally interpreted as a bullish signal of tight supply. When near month prices are higher than longer-dated prices, holders of inventory have an incentive to sell stocks into the market.
In other words, the market is signaling that it needs to draw down inventory to meet prompt demand.
But the oil market has been building stocks all year.
This is the paradox. How did the futures curve retain this shape when the global oil market was oversupplied relative to prompt demand?
Why was the futures market signaling to holders of inventory to sell stocks at precisely the moment when they were building stocks?
What we are seeing is the oil market equivalent of a violation of the fundamental laws of physics.
This is something that should not occur and which demands an explanation.
The first quarter of 2012 saw an unusually high level of stock building, estimated at as much as 2.1 million barrels per day, according to OPEC.
Other market watchers like the International Energy Agency put the global stock build at lower levels than that, but what remains very unusual is the fact that stocks were growing in the first quarter of the year, normally a season of strong demand.
Moreover this stock building has surely continued on a global basis into the second quarter, if estimates of global supply and demand are accurate.
OPEC has been producing 31.6 million bpd in recent weeks, a level far in excess of the amount believed needed to balance the market.
Yet for months bullish commentators have seized upon Brent’s backwardated structure as a signal of general supply tightness.
Could it be that backwardation in Brent is no longer a reliable market indicator?
A complete explanation of what went on in the market will probably need to wait for more accurate data on supply and demand to be issued, but for the moment some theories can be advanced.
First, it seems logical that much of the stock building in Asia was of a strategic nature.
With the flare-up of tensions between Iran and the West at the start of the year, and the unexpected escalation of sanctions against Tehran, Asian strategic buyers almost certainly felt compelled to add to emergency stockpiles.
Strategic stocks differ from commercial inventories in that they are generally held regardless of economic conditions. In other words, there is no need to hedge the position.
No selling of futures by the inventory holders to hedge, no reflection of the stock build in the futures curve?
Perhaps that’s it, but somehow that explanation does not seem complete.
It is not the case that all of the stock build has gone to strategic buyers. There has been a marked increase in commercial inventories too. Certainly in the developed world there has been no major accumulation of strategic stocks.
So a second, perhaps related theory, comes into play. Perhaps the internal distortions of the Brent market itself are a factor.
The Brent futures market is precariously balanced on an increasingly narrow physical basis as North Sea oil output declines.
This narrow basis has made Brent, viewed by many as a proxy for “the” world oil price, susceptible to distortion, and, perhaps, decoupling from global oil market fundamentals.
Indeed, the fundamental flaws in the Brent market have been made plain to see this year by the distorting impact of a surge in South Korean demand for North Sea crude.
This South Korean buying has come due to a cut in import duties on European crude under a trade agreement, which has made North Sea oil far more attractive to Korean buyers than competing grades from West Africa, for instance.
Simple arbitrage economics would suggest that the competing West African crudes would fall in price due to lower South Korean demand, which ought to balance out the added demand for North Sea crude.
But this ignores the tricky logistical issues to this balancing act and the fact that West African barrels cannot be delivered against a Brent position.
So is that it? Strategic buying of crude for storage plus the fundamentally flawed Brent contract explains everything?
Or is there something else?
The importance attached by analysts to Brent timespreads suggests that the increased financialization of the Brent market may have exacerbated the distortion in the contract.
Due to the extremely poor and limited data on oil demand and stocks in most countries, analysts rely heavily on timespreads to show the relative balance of oil demand.
Traders have also honed in on timespreads as a way to play the market without exposing themselves to flat price movements.
But perhaps we are now in a situation similar to a dog chasing its own tail.
Bullish oil analysts see the market in backwardation, assess global oil supplies as tight and financial players jump into the spread trade, sustaining and amplifying the backwardation.
Physical traders are unable to take advantage of the arbitrage opportunity due to the structural flaws in the Brent market so the backwardation persists.
The distorted structure of the Brent curve reinforces perceptions of tight supply, which in turn drives the flat price of oil higher.
If the above theories are true, then serious questions need to be asked about the oil market.
Is it really a good idea to base trade on such a narrow basis as Brent? Is it really a good idea to interpret the structure of the Brent market as a proxy for the global oil market?
At the very least oil traders should learn lessons from this year. Backwardation is not always a sign of an under supplied market.
— Robert Campbell is a Reuters market analyst. The views expressed are his own.
Flaws in Brent market: The 2012 oil paradox
