Oil traders have become increasingly doubtful that OPEC will manage to cut crude stocks down to the five-year average in 2018 and keep them there.
Calendar spreads for Brent futures throughout the rest of 2017 and 2018 have weakened significantly since OPEC agreed to roll over its production allocations at the end of May.
Calendar spreads (price differences between futures contracts for delivery in different months) are closely linked to the expected level of oil inventories.
Physical traders and refiners use spreads to hedge oil stored at tank farms and refineries as well as onboard ships in transit or acting as floating storage.
But spreads can also be used by traders and specialist hedge funds to speculate on the level of global oil stocks in future.
High and/or rising inventories are normally associated with a contango structure, where the price for oil delivered in future is higher than for immediate delivery.
Low and/or declining global inventories are normally associated with a backwardation, where the price for future deliveries is below the spot price.
The theoretical relationship between stocks and spreads was formulated by economist Holbrook Working in the 1930s in relation to U.S. grain futures.
But the same relationship has been visible in oil, where the shift in Brent spreads between contango and backwardation has mirrored the build up and draw down in inventories since the 1990s.
Brent spreads have therefore become one of the favourite ways for speculative traders to express a view on the outlook for oil production, consumption and stocks.
Spreads for the remaining months of 2017 have moved into an increasingly wide contango since May 25.
Spreads for 2018 have seen an even more startling move from a small backwardation into a broad contango over the same period.
On May 24, the day before OPEC last meeting, Brent futures for December 2017 were trading at a premium of 99 cents per barrel over contracts for December 2018.
By June 21, December 2017 futures were trading at a discount of $2.69, a shift in the spread of more than $3.50 per barrel in less than a month.
Calendar spreads are not an infallible guide to future stock levels especially beyond the next few months. Spread traders are often proved wrong.
But the emergence of a large contango implies many hedgers and speculators now expect stocks to remain higher than before.
OPEC, led by Saudi Arabia, and its non-OPEC allies, led by Russia, have pledged to do “whatever it takes” to bring OECD inventories down to the five-year average.
But many analysts and traders are sceptical the current level of cuts will be enough to bring stocks down to the target this year or prevent them rising again next year.
The U.S. Energy Information Administration (EIA) forecasts global inventories will fall by an average of 0.2 million barrels per day in 2017 before increasing by an average of 0.1 million bpd in 2018.
EIA forecasts OECD commercial stocks will still stand at 2,989 million barrels at the end of 2017, almost 230 million barrels higher than the year-end average for 2012-2016.
The agency also predicts OECD stocks will rise to 3,020 million barrels at the end of 2018, which would be almost 260 million barrels over the 2012-2016 average.
The forecasts assume OPEC’s output agreement is extended beyond March 2018 but compliance deteriorates (“Short-Term Energy Outlook”, EIA, June 2017).
If these forecasts prove correct, OPEC will only have made limited progress towards its goal of rebalancing the market even by the end of 2018.
STORAGE AND SHALE
The recent drop in oil prices has been concentrated in near-term futures contracts.
Brent for delivery in October 2017 has fallen by $9.50 since May 23, while Brent for delivery in December 2018 is down by only $5.50 per barrel.
Sharp falls in the cost of crude for delivery in the near future provide an enhanced incentive to buy and store excess oil, helping the market carry a higher level of inventories than anticipated before.
Near-term price declines also send a strong, urgent signal to U.S. shale producers to curb their drilling to avert an even bigger build up of inventories in future.