The growing optimism in the oil market in recent weeks has resulted in tangible evidence that traders expect an increasingly tighter crude market going forward this year.
Oil market participants now expect OPEC’s cuts and U.S. sanctions on Venezuela and Iran to continue to tighten the market through the end of 2019.
The evidence is that the Brent Crude calendar spread for the second half of this year has flipped into a backwardation of as high as US$0.90 a barrel, compared to a contango of US$0.70 at the end of last year, Reuters market analyst John Kemp notes.
Backwardation is the market situation in which front-month prices are trading at a premium compared to prices further out in the future—a sign of a tighter or undersupplied market. In the opposite structure—contango—front-month prices are lower than prices out in the future months—pointing to a crude oil oversupply and making storing oil for future sales profitable.
So the shift to backwardation—which was one of OPEC’s officially stated goals when it started to limit oil supply in 2017 in tandem with Russia—signals that many oil market participants expect a tighter oil market in the second half of 2019, and as a result, higher oil prices.
The recent flip to backwardation in Brent Crude’s calendar spread was also helped by the return of bullish hedge fund positioning in Brent’s near-month futures contracts, Kemp argues. Portfolio managers usually focus their bets on contracts closer in time because of the higher liquidity. So the return of bullish speculators also contributed to the shift to backwardation for the contracts further out in time, those for later in 2019.
Over the past two weeks, the sentiment on the oil market has been increasingly bullish. First, Saudi Arabia signaled it would cut in March 500,000 bpd more than its share of the cuts in the OPEC deal and would further slash exports to below 7 million bpd. Then, signs started to emerge that the U.S. and China could reach some sort of a trade deal, thus potentially averting the much-feared global economic slowdown that could dent oil demand. Next, there are the U.S. sanctions on Iran and Venezuela restricting supply, while there is uncertainty how much additional crude barrels will be choked off from those two OPEC members as Nicolas Maduro is digging in to cling to power and as there isn’t any certainty how the U.S. would approach the waivers on Iran’s oil customers once they expire in early May 2019.
So, hedge fund and other money managers boosted their long positions in Brent by 10 percent in the week to February 12, the latest available data, and this was the highest rise in bullish betssince late August 2018, according to exchange data compiled by Bloomberg. Bets that Brent Crude prices will drop declined by 5.5 percent in the most recent reporting week. This was the first clear signal this year that portfolio managers are turning bullish on oil prices. The net long position in Brent—the difference between bets that prices will rise and bets on a drop—has increased in the previous weeks as well, but mostly as a result of the closing of the many shorts from late 2018, rather than a renewed bullishness that oil prices would be rallying.
In the week to February 5, portfolio managers added more long positions on Brent Crude, but short positions also rose for the first time this year. Although the speculative positioning in the week resulted in a slight rise in the combined net long position, the increase in short positions suggested that hedge funds were much more undecided where oil prices will be heading next.
In the week to February 12, however, the hedge funds’ general oil market mood shifted from undecided to bullish, with speculative buying in the near-term Brent contracts accelerating the backwardation—the perception that the oil market will be tighter in the second half of the year.
Saudi Energy Minister Khalid al-Falih said this week that he hoped the market would return to balance by April, reiterating that OPEC leader’s resolve to do whatever it takes to rebalance supply and demand is “unquestionable.”
Saudi Arabia and OPEC’s cuts, sanctions on Venezuela and Iran, and hopes that a U.S.-China trade war would be averted are all boosting the bullish sentiment on the oil market. Yet, surging U.S. oil production and a return of fears of a global economic and oil demand growth slowdown could sour market sentiment again.