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Goodbye February (Futures), Hello Backwardation.

Author: Brynne Kelly

Backwardation had shown up in full force along the WTI curve everywhere except the front calendar spread. BUT, with the expiration of the February WTI contract last week, we said goodbye to contango and hello to backwardation. The entire curve has now moved into backwardation as of close of business January 22 beginning with the Mar-21/Apr-21 calendar spread (now considered the M1/M2 continuous spread in the chart below, which shows each monthly calendar spread for the next 36 months).

Ever since Saudi Arabia surprised the market by announcing that it would withhold an additional 1 million barrels per day from the market through the end of March, monthly calendar spreads have been on the rise. The chart below highlights the rally path that spreads have been on since last November.

Historically, a gradual narrowing of front-month contango has coincided with declining commercial crude oil inventory levels absent short-term supply/demand disruptions. Comparing the front month crude oil spread to weekly EIA commercial crude oil inventory levels, recent history suggests that 450 million barrels appears to be the swing-level in inventories. Above 450 million barrels and the front of the market is in contango (black line vs green line), paying producers to store inventory. Below 450 million barrels and the market flips into backwardation. As of week-ending January 15 (when the latest EIA inventory report was released), the front spread (green line below) was in contango. With the Mar-21/Apr-21 now the front spread, we are in backwardation.

Yet, inventories remain well above the 450 million barrel level.

Since 2018, we note that backwardation tends to be the most volatile to the upside when commercial crude oil inventories are below 450 million barrels (1 & 2 below, continuous 1-month spreads). Yet, calendar spreads are rallying at much higher inventory levels. So, what do we make of this strength at current inventory levels (circle 3 below, hot pink)?

Could it be that given the events of 2020, the market is recognizing vulnerability at a higher inventory level due to the uncertainty of how the recovery plays out? Perhaps the market is anticipating a rapid decline in inventory levels over the next several months given production expectations vs demand?

The market is trying to select the month in which a demand recovery will reach its maximum relative to supply. Currently backwardation along the curve reaches it's peak in the Sep-21/Oct-21 spread which settled at just over $0.30 backwardation last Friday (red line below).

The movement in front spreads is not overly dependent on outright oil prices except at key inventory and price levels (below: green line = M1/M2 continuous spread, black line = M2 continuous futures), the events of April, 2020 aside. Specifically, the front spread can remain in a fairly tight range while outright prices make much more significant moves. However, there is a pattern of backwardation when outright prices are above $50, and a pattern of contango when prices are below $50.

When increasing the number of months in a calendar spread (for example, a 6 month calendar spread between month-4 and month-10, purple line below) there is a much larger correlation with outright price moves (black line below).

We would say that the front month calendar spread is more indicative of storage levels, and longer-dated calendar spreads are a reflection of the bull/bear sentiment in the market. In either case (1-month spread or 6-month spread), both appear to have gotten slightly ahead of outright prices and the inventory landscape. Is the persistent buying of bullish calendar spreads wishful thinking or a real sign that the market is on the verge of being very tight?

Commodity markets tend to be front-led. Conditions in the front of the market serve to prove widely-held narratives about market fundamentals. Said another way, expectations of over or under-supply are validated by calendar spreads. Severe contango in Q2 2020 validated the oversupply narrative. A move to backwardation in 2021 seems to be at odds with the hangover produced by the pandemic in 2020. This is highlighted in the next chart of calendar strip futures in WTI.

The bullish sentiment portrayed by calendar spreads tends to fall on deaf ears when looking at outright prices in future calendar strips. It's only the balance of 2020 strip (gold line above) that has managed to climb above the $50-level. There was actually quite a rejection of the $50 level by the calendar 2021 strip, probably due to producer hedging. Since the back of energy markets tend to be dominated by producer hedging, the onus is on strength in the front of the market to lift the complex higher.

Yet, there is a fairly soft call on future production that is unprecedented. The call on future production comes from actual production being withheld from the market rather than potential capacity. A call on active, producing but withheld production is assumed to be cheaper than a call on potential future production capacity. With calendar strips for 2021 and beyond sitting below the $50 level, it 'feels' like the backwardated structure of the market is simply trying to find the pain point where demand returns before supply. That not exactly bullish.

Distillate markets by comparison reveal a bit of a different story.

The February 2021 contracts for gasoline and distillate futures have not expired and don't until the end of January. Looking at the curve shape of continuous 1-month calendar spreads in US distillate markets, we note that the Feb-21/Mar-21 spread (currently Month-1/Month-2 on a continuous chart) is still in contango, as was the same spread in WTI at expiration (yellow line = 1/22 settlement).

In fact, for the next 12 months, there are only 2 HO calendar spreads that are in backwardation (month-2/month-3 and month-11/month-12). This follows the contango in the Feb-21/Mar-21 expiration in WTI.

Similar to WTI, there appears to be an inventory 'pain point" in distillate markets at which markets flip from contango to backwardation. This has, in recent history, been around 150 million barrel level (black line below) in distillates.

From mid-2017 to the end of 2019, front distillate spreads remained mostly in backwardation territory (blue line above). Lower inventory levels and the impending IMO 2020 marine fuel standards kept the market on it's toes. From there, inventories soared back above the 150 million barrel level in 2020 as a result of the pandemic. Yet, by November, 2020 they briefly dipped below the 150 level once again, prompting a rally in calendar spreads. In the last 4 weeks (up to and including EIA reporting week ending 1/15/2021) additions to distillate inventories in the US have once again pushed us above 150 million barrels. Perhaps why only the Mar-21/Apr-21 spread clings to backwardation. Seasonally, winter heating demand leads to distillate inventory draws through the end of March and then summer inventory builds begin in anticipation of next winter. If we don't see a similar pattern this year of winter/spring inventory draws, distillate spreads could remain weak all summer.

Bottom line, market participants appear to be focusing on current and projected inventory levels at the swing points noted above. It is now up to the front-month calendar spreads to prove-up market conditions. If front month spreads once again slide back into contango, this will apply pressure across the board and weaken the market's bullish resolve.

Of Note Last Week

Last week, newly inaugurated President Joe Biden enacted a 60-day ban on new oil and gas drilling permits and leases for federal lands and waters, including the Gulf of Mexico. During his campaign, Biden vowed to halt new oil and gas leasing on federal land and waters and made addressing climate change and environmental pollution a centerpiece of his platform. Thursday’s order does not impact drilling already underway or permits and leases that have already been issued, but it does require aggressive methane pollution limits for new and existing oil and gas operations.

The Gulf produces about 17% of the nation’s crude oil, federal data show. The more immediate impact of this order will be felt in US shale regions that lie on federal lands. The top six states with the highest number of producing leases on federal land are: Wyoming, New Mexico, Colorado, Utah, Montana & North Dakota (in descending order). The shale plays in these states lie in the Bakken and Niobrara shale regions. Crude oil production by shale region pulled from the EIA drilling productivity report is shown on the left chart below and total US shale production is shown on the right.

Isolating Bakken (green line) and Niobrara (purple line) production we can see that production in both regions has been on the decline since early 2020 and combined account for about 1.7 million bpd. Thursday's order merely adds insult to injury in these regions where production has already been on the decline.

Biden’s campaign pledge has raised concerns throughout the industry, particularly in oil-dependent Louisiana. Most of the oil and gas jobs that fuel Houma-Thibodaux and south Louisiana’s economy are associated with drilling and production in federal waters off the state’s coast.

According to data from the Bureau of Land Management, through 2019 the total number of acres leased on federal lands has been on the decline over the years, while the total number of producing acres has been on the rise. In essence, we have reduced the number of acres that can be called on if supply gets tight. It doesn't appear that available acreage will be on the rise any time soon.

This is a headline risk at the moment. But the trend above suggests that production is beginning to reach it's hand into excess capacity that may take a long time to recover, if ever.

EIA Inventory Statistics

Weekly Changes

The EIA reported a total petroleum inventory BUILD of 4.50 million barrels for the week ending January 15, 2021 (compared with a build of 6.00 million barrels last week). This weekly change was fairly in-line with prior year changes for the 2nd week of the year.

YTD Changes

Year-to-date total inventory changes for 2021 stand at 10.50 million barrels, with crude oil inventory accounting for a scant 1.10 million barrels of this build.

Inventory Levels

Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years are now slightly higher than prior year levels for the same week.


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