Shah Nitesh WisdomTree

Oil futuresbackwardation signalsmarket tightness

Oil futures curves have been in backwardation for most of the past year, yieldinginvestors a return when rolling their contracts in addition to gains they have made on the spot price movements in oil….

By Nitesh Shah, Director, Research, WisdomTree

An investor would have gained 44% in price and 9% in roll yields over that period when investing in a front-month Brent strategy1 in theyear to September 2018. Backwardation has been driven by perceived tightness in supply in the short-term.

Curve backwardation has largely been engineered by the Organisation of Petroleum Exporting Countries (OPEC). Since January 2017, the oil cartel has restricted the supply of oil by assigning its members and partners a quota for the amount of oil that they produce. Although the cartel has historically had a poor history of complying with quotas, this timeit hasdone exceptionally well.Part of the reason is an economic implosion in Venezuela. Production from the country is declining strongly, while other OPEC members have-until recently–not been increasing their production.

Right now,we believethe global oil marketisin balance.However, even though OPEC is expanding production and US shale oil keeps growing, that balance is fragile. It will just take another supply shock to Libya or Canada to put doubts on supply. The US’s extraterritorial sanctions on Iran is a potential source of tightness.

The US has set an earlyNovember deadline for countries to conform to its embargo on importing Iranian oil. Between 2016 and 2017, Iran was a large contributor to OPEC production growth. In recent months its production has declined. The magnitude of Iranianproduction decline could increase if sanctions are strongly enforced.

Iranian exports to Japan and India are declining. For now, we expect Chinese authorities, to largely ignore the US’s sanctions. But even China, as the largest importer of Iranian oil, isat risk of shutting the country off. A trade deal with the US could involve adherence to the sanctions as a prerequisite. Even in the absence of a trade deal, the US’s reach is strong. Sinopec-a Chinese State oil refinerhas reportedly reduced Iranianimports following pressure from the US to comply. Sinopec is listed on the Hong Kong and New York stock exchanges. To worsen matters Iran may block shipments around the Strait of Hormuz-a 21-mile-wide strategic choke point in the Arab Gulf-which would further tighten global oil supply.

Although OPEC is highly unpredictable, we doubt the group will return to the 2014-2016 period of no quotas.None of the member nations want to go back to the situation in 2014, when the fall in oil prices was so great that the economic and financial health of the OPEC nations was put under threat. Being a spectator of Venezuela is painful enough.

The main area ofglobalsupply growth is in US tight oil. But even with this source, there are limitations to growth. Infrastructure needs to grow in lock-step with growth in oil production. That WTI Midland is trading at such a deep discount to WTI Cushing indicates that there is glut in oil produced in the tight oil regions that is not making its way to the right places quick enough. Infrastructure limitations could slow the pace at which US shale can help satisfy global oil needs.

1 Calculated using Bloomberg Commodity Index excess returns for Brent and WTI and front month futures prices as the spot, in the year to 30 September 2018. Calculation based on index, not product and therefore does not include fees. An investor wouldalso gain a collateral yield of close to 3% in Brent.


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