Crude Oil has an active futures calendar spread market on global exchanges like CME/ICE which are pretty liquid up to a few years down the line. These calendar spreads can be used to price long dated outright prices and imply a term structure for Crude oil.
Theory
Backwardation is when futures prices back in the curve are lower than prices in the front. Historically there has been a general understanding of what backwardation and contango mean in commodity markets:
Backwardation pulls oil out of storage
Contango invites oil into storage
Contango invites producers to produce and invest in production while Backwardation leads to future production uncertainty if future prices are unusually low. A wider contango suggests that the conventional, less-expensive means of storing and transporting have been exhausted and more money is needed to cover the costs of less conventional, more expensive options.
Backwardated markets generally reflect an immediate shortage of product not expected to exist in the future. For example, a major disruption in supply like a pipeline leak will cause the spot market to price at a premium to future markets that reflect the value of the pipeline being fixed. The front of the curve is the first to react.
Seasonality
All commodities have some seasonality, some more than the others. In the case of oil, its seasonality comes from its end products (gasoline, distillates, heating oil), not by itself. So, during summers you would expect a build up heating oil inventory and a draw on the gasoline inventory.
Term structure curves
This capture is from 10-02-2020 and it shows the Brent-WTI Futures spread term structure (top) as well as the separate term structures for Brent and WTI (bottom)
A thumb rules is that flat curves tend to rise and fall together. However, if the entire curve is in carry, you as a producer have 2 options – put in ground or sell in the market.
In reality, it costs around 15 to 20 cents to carry from one month to next + plus other costs. Whenever carry gets narrower – you can expect more barrels to get sold in the market.
Trading the curve
Based on inventory levels, you may have an opinion that the shape of the curve would get under lot of pressure in the front – maybe because there is not much carry and you think the market was going to be selling out barrels in the front of the curve. However, to put a term structure trade on, you must also believe that prices at the back of the curve wouldn't see producer type selling.
Interpretation of Calendar spreads
Calendar spreads is the signal that markets sends to the producers/system and the system sends back to the market about whether the condition is loose or tight. It signals whether the market wants to build inventory levels or draw down inventory levels.
A WTI 6m calendar spread is a storage spread. It usually closely follows inventory levels in Cushing, Oklahoma. Cushing is considered the commercial trading inventory group, utilised by market players to balance out month on month spreads. These calendar spreads are used by traders across the world to gauge their bull/bear sentiment and get a sense of how tight/lose the market is.
Market uses 1m calendar spreads to load barrels on to a ship; they use them to protect themselves against time risk. A contango is beneficial in such a case -- they can load barrels on to a ship and since the future price is higher than current, they can sell next month spread instead of the same month. Consequently, a backwardated market makes it difficult to facilitate movement of barrels in the world.
This capture is from 10-02-2020 and it shows the
1) Brent-WTI Futures spread curve (top left); 2) Term structure of the spread between the Brent and WTI 1m spreads (top right); 3) Term structure of the 1m spreads of Brent and WTI (bottom left)
Calendar strips
These 12 month strips are used in the market to price hedging structures for producers. If a company is focused on the midstream or production side of the business, they have to base value on these calendar strips (despite their visible lack of liquidity). Most options structures also are usually priced off these strips.
In a geopolitical event, if the long dated strips are not responding to moves in the front, it means the market thinks that this event won't change the longer term value of oil or cause any structural disruptions. The opposite is also true, the front curve may make a quickly recovery after an event, but if the back fell with it and refuses to recover, it is a sign that all is not well.
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