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Is Backwardation a Possibility?

Updated: Nov 17, 2020

Author: Brynne Kelly (w/Lee Taylor technical levels)

Mild contango helps oil markets facilitate the movement of crude oil through 'time', as it takes 'time' to move oil from point A to point B. The presence of a small amount of contango simply acknowledges the costs associated with holding oil in storage whether that is at a refinery, in a pipeline in transit or in traditional on-shore working inventory. With the low cost of money in today's environment, the cost of holding oil is relatively small. However, when a market is stressed as it was earlier this year, contango can reflect more than just the traditional cost of holding oil and also price in a lack of space in the system to comfortably hold on to more barrels. Severe contango is a sign of trouble, a sign that the system is buckling under current supply/demand forces and needs to price in a higher cost of carrying inventory into an uncertain future.

Normal 'cost of carry' contango helps oil markets operate efficiently. Producers have time on their side as their expected realized output values appreciate into the future, exports have the time to sail around the globe into appreciating future values, and hedgers can lock in higher future prices than today.

On the other side of the coin we have backwardation, which has long been the friend of long-only ETF's and long-only funds as it allows them to gain on their monthly position roll (sell the higher priced front contract, buy the lower priced 2nd contract). Backwardation often exists when a current supply/demand imbalance is not expected to last into the future. It is generally event-driven, as is the case with hurricane-induced production shut-in's or any other unexpected supply disruption. Backwardation entices barrels to come out of storage and head to market in order to avoid paying storage costs and hold inventory into declining prices.

In the span of just 6 months, oil markets have gone from backwardation to severe contango to mild contango. To jog everyone's memory, prior to 2020 oil markets had been on a slow grind from contango to backwardation, with the help of OPEC production cuts.

Growing shale production in the US had pushed markets from backwardation to contango in early 2015. This finally resulted in an OPEC production cut of 1.2 million barrels per day in January of 2017. From there, it took almost a year for the market to clear out the excess inventory created by the shale boom for front calendar spreads in WTI, to finally move into backwardation in early 2018. OPEC continued to extend their 2017 production cuts which finally allowed oil markets to tighten-up and move into backwardation.

Beginning in 2019, the market began to have a healthy fear that OPEC would eliminate their production cuts before the market was ready. This was a bullish short-term scenario with a bearish backdrop. This all came to a head in 2020 when the market experienced one of the most severe demand shocks in its history. What ensued in March and April of 2020 is something for the record books as OPEC allowed their extended 2017 production cut agreement to expire. A new production cut agreement was eventually put in place and OPEC and its allies agreed to a new 9.7 million barrel production cut from May 1 which tapered off starting in July of 2020. This first easing of the cuts starting in July was pushed back to August. Now the second one, due at the start of January, is in question.

The unprecedented nature of 2020, and the demand destruction brought about by the pandemic, dramatically decreased global demand and forced the supply side of the equation to take drastic measures. Here in the US, we can see this via the weekly EIA data. Year/Year comparisons of demand (crude oil input to refiners) vs supply (US crude oil production) reveal that after the initial shock to demand earlier this year (when refiners almost instantly reduced the amount of oil it refined and utilization rates fell 20% to an historic low of 67.6% in a mere 4 weeks), the system reached a semblance of equilibrium at lower levels.

Judging by US commercial crude oil inventory levels, the reduced US oil supply (production plus net imports) has been enough to not only stop the swell of inventory but also resulted in a draw down from the high levels seen in Q2 of this year.

US net imports of crude oil are also below the 5-year average, however this is a trend helped by growing US exports and are not too dissimilar to levels seen in 2019 (yellow vs green line below).

The entire market is operating at a lower capacity. The entire system is being underutilized.

Underutilization generates insufficient revenues and leads to a lack of investment in the future. This type of environment requires proof of concept before bringing resources back on line. One such 'proof of concept' is backwardation. Keep in mind that backwardation doesn't mean a bull market, rather it means utilization. We think the market is going to require proof before capacity is brought back online.

With all of that in mind, we now turn to the structure of the market. Over the last several months, the shape of the futures curve in WTI has been churning in a fairly tight range. It has seemed as though the entire curve is just shifting higher and lower in response to the latest covid-19 restrictions or easing of restrictions (yellow line vs dark purple line, below left).

But, if we take a closer look, what we see is an astonishing move lower in the way-back of the curve since June 2020 (yellow line vs dark purple line, below right).

Imagine the balance sheet hits producers will face on their reserves this year-end as a result! With the back of the market under pressure, it will now be up to the front of the market to lead us back up again. This is a very difficult environment for producers to hedge in. At this point, an extension of current OPEC production cuts into 2021 could result in a scenario where the front of the market is perceived to be tighter than the back and front spreads could - gasp - even move into backwardation. This scenario causes 'max pain' with producers running at minimum production where prices could be the strongest, yet unable to capture that value via hedging if term markets remain under pressure.

Before we proceed, let's remind ourselves of the headlines we were dealing with last week.

Last Week in Review - Major Themes

  • Rystad Energy said lockdowns in Europe could result in the loss of a further 1 million barrels per day of oil demand by the end of this year, while it would take several more months before a vaccine would be available.

  • Shell announced they are going to halve the capacity of their largest refinery - the 600,000 bpd Bokum plant in Singapore - as part of its drive to reduce its carbon footprint and grow its biofuels business.

  • EIA Short Term Energy Outlook (STEO)

  • IEA November 2020 Oil Market Report

  • Inventory disappointment - EIA Inventory showed a build of 3.70 million bpd which was a disappointment after the previously released API inventory data suggested a draw of 5.15 million bpd

  • Minnesota regulators granted a stack of important permits and approvals last Thursday for Enbridge Energy's planned Line 3 pipeline replacement across northern Minnesota, setting the long-delayed $2.6 billion project on the road toward beginning construction soon.-AP

Key Charts to Watch Going Forward

Grade Spreads

Over the last 4 weeks, we finally started to see some movement in key oil spreads. The chart on the left represents closing prices for the 8 month Midland/WTI futures spread and the chart on the right depicts the WTI/Brent futures spread during the same period.

As Midland prices gained on Cushing, Cushing prices lost value to its European counterpart, Brent.

Calendar Spreads: The Trend vs the Shape

As we saw earlier, one-month calendar spreads finally turned a corner and moved into backwardation only after sustained production cuts from OPEC. Continuing our earlier chart of 1-month calendar spreads below (yellow line, below left) we note that since July, the front calendar spread has strengthened relative to the next 2 month spreads.

Furthermore, the entire spread curve has shifted higher since the lows made in May and June (yellow line vs dark purple line, above right). Absent the fear of new covid-19 lockdowns affecting current demand, we think front spreads would have already moved into backwardation - reflecting the impact of production cuts vs demand recovery and the fact that production cuts will eventually be reduced. This is already happening if you consider the relative strength in the continuous front month calendar spread.

By contrast, the front 12-month calendar spread is relatively weak as shown via the Dec/Dec spreads below (dark purple line = Dec-20/Dec-21). Since the roll period for most funds from the December to January contract took place last week, the December 2020 contract is now dead weight in the market, most large players have moved on to place their bets in the January contract. What happens with the December contract from now until expiration may be of little interest to most players. The focus will now shift to the Dec-21/Dec-22 spread as a barometer for production constraints going forward.

3:2:1 Crack Spreads

Keep an eye on refining margins. The traditional 3:2:1 crack spread (which attempts to mimic a refiners output of 2 units of gasoline and 1 unit of distillate for every 3 units of crude oil refined.

The 12-month 3:2:1 WTI crack spread has stabilized around the $10 level. This appears to be where the market is valuing the output from the 75% of capacity that is currently online. What will it take to bring the next incremental unit of capacity online? We think refiners will wait for a market signal via the spread before they bring incremental units of refining capacity online.

Frac Spreads

As discussed in last week's report, frac spreads measure progress towards completing a drilled well. Reported frac spreads rose slightly last week from 115 to 130. This is not a significant increase, but it is an increase and something to keep an eye on.

Oil markets are now a delicate jig-saw puzzle, with each final piece requiring careful placement. Frac spreads can't get ahead of refiner demand, and refinery utilization can't get ahead of end-user demand. Not one player wants to be the straw that broke the camels back. Therefore, we think market participants will be cautious and would rather ask for forgiveness for resuming too late than punishment for returning too early.

Influencing Theme Going Forward

Bottom line, this is a market worried about oversupply. One of the largest influences on supply is OPEC and they are scheduled to meet at the end of this month.

Upcoming OPEC Meetings

The next OPEC meetings will take place as follows:

November 30, 2020: The 180th Meeting of the OPEC Conference

December 1, 2020: The 12th OPEC and non-OPEC Ministerial Meeting

The chance that OPEC+ delays its planned supply increase will show a potential of bolstering crude oil prices more broadly. If the JMMC meeting next week reveals little appetite for OPEC postponing its production increase, however, commodity traders might steer crude oil price action sharply lower.

EIA Inventory Statistics

Weekly Changes

The EIA reported a total petroleum inventory DRAW of 3.90_million barrels for the week ending November 6, 2020 (compared to a draw of 8.10 million barrels last week).

YTD Changes

Year-to-date, total inventory additions stand at a BUILD of 45.40 million barrels (vs 53.40 last week).

Inventory Levels

Commercial Inventory levels of Crude Oil (ex-SPR) Gasoline and Distillate are slightly above or within their 5-year ranges considering where we have been. This is a major accomplishment.


Lee Taylor - Technical Levels


Resistance: 43.26 / 44.50 / 45.30

Support: 41.68 / 40.56 / 39.43

The Brent market fared slightly better than WTI this past week as it has a little bit more room before we hit some big support levels below. Just as in WTI, there is plenty of support from 41.69 to 40.56 below but a break below projects back down to mid-30s. It is challenging to envision a scenario where the Brent market can break out of the 25-week range of 46.54 down to 34.35. Jan/Feb Brent surpassed our objective but seems toppy here on an RSI basis.


Resistance: 41.32 / 42.45 /43.34

Support: 38.69 / 37.59 / 36.02

December WTI Crude Oil goes off the board at the end of this week so let us look at January. WTI started to get heavy on Wednesday and gave up over $3 plus of the rally last week. There are still many fundamental issues hovering over the market like a black cloud, the resurgence of Covid-19, the uncertainty of the election plus the closings of many refineries due to economic reasons. There is plenty of support basis January WTI from 39.79-38.69, and if the market can hold this area, we can expect a retest of 43.33-44.59. A settlement below 38.69 projects down to 37.30 then 34.04. It appears as if Jan/Feb WTI will continue to stay in a range between -45 to -25.


Resistance: 1.1395 / 1.1729 / 1.2055

Support: 1.1158 / 1.0881 / 1.0604

1.0881 held last week and now we reset our levels up to 1.1028. The area from 1.1028-1.0716 will be a major foundation for the gasoline market if it can begin to trade in the upper range of the never-ending range. One thing to look at, which does not bode well for gasoline, are the spreads. There was a great deal of pressure on the spreads late last week, so unless the selling pressure ends, it may be too much for flat price to offset.


Resistance: 1.2251 / 1.2407 / 1.2982

Support: 1.1933 / 1.1758 / 1.1610

Just like the rest of the oil market, heating oil gave back much of its early gains this past week. There is major support for December Heating Oil from 1.1933 to 1.1610. It seems likely that we may test those levels again. One important note is that Heat almost got up to the Covid-19 gap which now sits above between 1.3054-1.3783. After two different runs at -200 for Dec/March spread, it now seems primed for a retest of -400.

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