MILAN CACIC
September 02, 2022
Money Financial literacy Social media Commentary In the news News Trending Weekly update Weekly commentaryA DEEPER DIVE INTO THE PRICE OF OIL.
We have had quite a few questions regarding the price of oil since my last update. The oil market is acting strangely right now, and I find it very interesting. For those that are interested I'm going to talk a little bit about the forward curve and backwardation of the oil market and whether it's bullish or bearish. I apologize in advance for the technical nature of this update but thought this might be a good time before the long weekend for those that have the time and patience to read it.
What is the forward curve in the oil market?
The forward curve in the oil market is a snapshot of what you can sell your oil for today as well as what price you can lock in for in the next month to up to three years from now. Oil companies will sometimes lock in the price that they can sell their oil for so that they have a guarantee of their future cash flows. A good example of why a company may do this is if they are building a large project and need assurance of future cash flows.
What is backwardation in the oil market?
Backwardation is when the current price of oil is higher than what you can receive selling it in the futures market. Theoretically, this is bullish because anyone who has inventories would be incentivized to sell it now at a higher price than hold it till the next month when they are more likely to get a lower price.
This past week's unusual behaviour.
This past week the price of oil dropped $10 in three days. What is interesting about this price drop is that the futures market dropped by an equal amount. Normally when the oil spot price drops significantly, like it did this week, the futures market does not drop as much and future prices stay higher than the current spot price (this is called contango). Meaning that backwardation disappears. This did not happen.
Overall, this can only be viewed as a very bullish sign. Basically, what the market is doing by dropping the futures market lower than the spot market is punishing anyone who continues to hold storage and is calling for that supply to come out now. Again, this is very bullish and unusual.
The oil market has been in a strange place for the past two years. Remember, it was not long ago when oil prices actually went negative. Those negative prices and low prices that followed destroyed any new production as well as any mega projects. This lack of new production appears to have now put us into a situation where supply and demand is very tight.
As a matter of fact, supply is currently being aided by the release of up to 1 million barrels per day from the United States strategic petroleum reserves. This extra supply will come to an end at the end of October. The US administration has committed to replace the supply by June of next year. That means that 1 million barrels per day of supply will disappear in November right after the midterm elections and new demand will come online to refill the strategic petroleum reserve.
It looks like there's two potential outcomes from the current action in the oil market. Either the oil market is coiled up and ready to move significantly higher on supply and demand imbalances or we are going to go into a hard recession and demand for oil is going to drop significantly to bring the market back into balance. As I said last week, November and December should be a very interesting time for the oil market.
I have also included a piece from our CIBC Capital Markets oil and gas research group that discusses industry positioning and company specific themes.
Large-cap Energy Model Refresh
If you have any questions, please feel free to give us a call at any time.
Have a great long weekend.
Milan