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Backwardation: on balance, higher oil prices over the next few months seem inevitable

http://www.vheadline.com/readnews.asp?id=10033

VHeadline.com petroleum industry commentarist Gerry Agnew writes: At the risk of becoming Johnny-One-Note on the energy markets, let us again revisit them here. We are seeing a definite pricing anomaly which deserves to be explored somewhat as "Backwardation."

Simply put, if the price of gasoline/crude oil/whatever commodity has the price of its front month above that of the next month we are witnessing backwardation.
Today's September crude oil price was at US$32.40 and the October price was at $32.08: a backwardation of 32 cents ... if the price is reversed, in other words October prices are larger than September's, we have a "Contango" = surplus, backwardation is a shortage ... if we can put it that simply.

The difference is crucial.

If we are in backwardation, it tells us that the oil companies (and other consumers) simply cannot wait for prices to come lower (as the lower prices in the next month imply) and are bidding for product "here and now." In other words there is a shortage.

When we hit $40 a barrel last winter (March contract we believe it was), the backwardation was extreme and we saw something like $3.20 between March and April contracts at one point. Between March and December contracts we saw a gap of $12 a barrel ... which is beyond extreme.

In other words, the US was desperately short of oil and it showed.

The unusual condition reversed itself, but now comes the anomaly we spoke of earlier ... now we still have backwardation, but it is very small: something in the order of 30-50 cents/barrel per month. September is $32.40 and December is $30.80 or so. In other words December has RISEN a bit while the front months have collapsed from March!

This should not happen, and one able oil analyst we know is flummoxed by this. It should not be happening as narrow backwardations tell us that supplies are coming into line with demand and the whole term structure is about to fall dramatically. We do not think that this is the case right now. What IS happening then?

We believe that the oil consuming community took Washington at its word over Iraq.

After the invasion and occupation it was widely thought that Iraq oil would flow in such quantities that there would never be shortages again, and that OPEC would be on the ropes.

It hasn't happened.

The Iraqi oil fields are stripped bare of any useable machinery and output is barely enough to cover domestic needs. OPEC cannot/will not make up the difference, and so the squeeze continues month after month.

Oil companies are starting to do the math and are realizing that there is no benefit to holding off buying crude because the price structure is not likely to come lower. Therefore they are starting to commit themselves to deliveries in the out months (i.e, the balance of this year) in order to lock in prices now before the whole pricing structure goes higher.

This tells us that shortages are very real ... and that the price of oil is going up for literally any reason that suggests itself.

It is driven by panicky traders who simply do not believe that oil prices should be this high and are letting their emotions dictate to their trading reason.
This is usually a good way to lose money in our view!

The pricing structure is also telling us that the oil majors now are convinced that Iraqi oil will not be forthcoming anytime soon ... which in turn tells us that informed money is trying to see what term price structures will be for the next year or so.

Forget the simple platitudes from Washington: the market is telling us a different story.

We also see these shortages cropping up in oil derivatives. During the "Iraqi pipeline panic" last Friday, Heating Oil was the big winner! Yes, August is a good month for those who do not wish to wait for the last moment, and they clearly didn't.

Big demand, and possibly only moderate supply.

Is this a valid interpretation? Yes, we feel it is.

US refineries are generally operating at about 96/98% capacity according to various press reports we have seen. This is inherently unsustainable, and today saw an excellent story on Bloomberg about a sudden fear in the gasoline pits that there could/would be spot shortages of this product in the US this Summer Driving Season.

Simple inability to refine enough product is being blamed, even with operating rates near 100%. Together with shortages of refining capacity as individual refineries shut down for desperately needed maintenance, the situation must be serious.

However, we look at the Heating Oil market for clues ... when the summer is over, refineries switch over to making Heating Oil from their crude stocks. If Heating Oil is in strong demand at the same time as gasoline, then this is another way of defining the refining shortage. It is a disaster waiting to happen.

So far the US has managed to duck a rather large bullet. How long this can be maintained is open to conjecture. In the current bureaucratic frenzy over terrorist worries, this has all the hallmarks of a security issue.
Just imagine what would happen (in a situation where refineries are having terrible problems meeting demand) if a couple of large refineries were attacked somehow by terrorists. They could do more damage to the US economy than all of the guerrilla activity in Iraq and Afghanistan combined!

In short, there are very real supply problems both here and elsewhere in the world. Keep an eye on market pricing activity; it will tell you all you need to know about the underlying supply situation.

On balance, higher prices over the next few months seem inevitable...

Gerry Agnew
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