LONDON – Crude oil traders expect the market to be closer to balance in the next few months as production cuts are implemented and the global transport system emerges from a coronavirus lockdown.
Futures prices and swaps linked to physical prices show the market has now moved through the worst of the crisis caused by the volume war between Saudi Arabia and Russia and the pandemic-driven collapse in consumption.
In the futures market, Brent’s six-month calendar spread has narrowed to a contango of less than $5 per barrel in recent days from more than $12 in late April (tmsnrt.rs/3dDwr1l).
In the swaps market, the six-week calendar spread for dated Brent cargoes has shrunk to a contango of less than $3 per barrel from more than $6 in early April.
The spread is an implicit measure of the ease and cost of storing crude – with the contango comprising the cost of storing, financing and insuring physical barrels.
Contango, where prices for near dates trade lower than those for later dates, is associated with an over-supplied market with high and/or rising inventories.
In March, the contango flared out as global crude stocks swelled following the breakdown of talks between the OPEC+ group of oil exporters on March 6 and Saudi Arabia’s subsequent decision to boost production.
It grew even further in early April, as the United States and other advanced economies shut many businesses and transport systems to suppress the coronavirus epidemic.
By the middle of last month, global production was exceeding consumption by as much as 30 million barrels per day (bpd), causing the volume of oil in storage to surge.
With onshore tank farms filling rapidly, by tens of millions of bpd, and increasing volumes of crude being stored on vessels moored offshore, the cost of renting tank space soared.
By mid-April, access to tank space onshore or offshore had become the most valuable commodity in the oil market.
The near-record contango reflected expectations tank space would become entirely full at some point during May or June if inventories continued rising at the same rate.
Since then, however, the contango has forced a rapid market rebalancing by restraining production by U.S. shale firms and members of the expanded OPEC+ group of exporting countries.
CRASH REBALANCING
By depressing cash prices, the contango, with its sharp discounts for cash crude, has forced a halt to new well drilling and the closure of existing wells in the United States.
The most recent weekly data indicates output has already fallen by more than 1 million bpd since the middle of March, with more cuts likely later in May and June.
Ultra-low prices have also compelled Saudi Arabia and Russia to implement production cuts, as slumping export earnings threaten government budgets and foreign exchange reserves.
On the consumption side, the gradual reopening of economies and transport systems in North America, Europe and Asia as the epidemic is brought under control has increased fuel use.
Provided producers continue to limit output, the market should gradually move into deficit over the second half of the year as transport systems reopen, which should arrest and then start to reverse the stock build.
Crude inventories will remain very high through the end of the year but they are no longer expected to continue swelling uncontrollably or threaten to exhaust available tank space.
The six-month contango in Brent futures has eased to the 4th percentile for all trading days since 1990, still very wide, but no longer extreme, and down from within the 1st percentile late last month.
Like most other features of the oil market, calendar spreads exhibit cyclical behaviour, and should continue to narrow over the rest of 2020 and into 2021 as inventories gradually return to more typical levels.
The main risk comes from a premature increase in production, if either U.S. shale firms or members of OPEC+ try to boost output before consumption and stocks return closer to normal.
(John Kemp is a Reuters market analyst. The views expressed are his own)
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