Wednesday, March 22, 2006

When Will Peak Oil Tip? (from Backwardation to Contango)

No, I didn't just make up those words. As you probably know (but I just recently learned), Backwardation and Contango are two terms used to describe trends in the prices of a futures contract over time. Contango is the norm, and it is where the price of a commodity farther in the future is higher than the price of that commodity nearer in the future. Backwardation is the reverse, where the cost of a commodity in the more distant future is less than it is in the near future. Backwardation is not normal, and is suggestive of supply insufficiency. Funny, for quite some time now crude oil has been in backwardation:

"CLZ" in the above graph represents the December NYMEX WTI Crude Oil future, and the number after CLZ represents the delivery year. Prices are in US dollars, current as of market close on March 21.

Let's examine a bit of the mechanics--and the psychology--behind contango and backwardation. Basically, for any non-perishable commodity, contango is the norm because of arbitrage: the price of a commodity one year from now should be today's price plus the "cost of carry," that is, the cost to store that commodity from now until the future delivery date, including the relevant time-value of money. If the future cost rises any above that, then arbitrageurs can simply buy the commodity today, sell the future contract for the same commodity, and store it until that future is due--locking in a profit. Of course to do so also locks up the arbitrageurs funds for that period--which could be used in some other investment--so the time-value of that money must also be included. Backwardation, the reverse of contango, is indicative of supply shortages in today's spot market because if there is ANY spare capacity for production it would be used to take advantage of today's higher prices, resulting in those prices declining. It doesn't make sense--under backwardation--to reserve any available supply because future prices are lower than today.

Of course, when we factor in the phenomenon of Peak Oil into this equation, it becomes clear that backwardation and contango are largely based on psychology and the standard free-market assumption that higher prices will increase supply. It is my theory that backwardation and contango are THE CRITICAL INDICATORS to determine when the phenomenon of Peak Oil has "tipped" (in the Malcolm Gladwell sense) in the perception of the market. Backwardation--accepted wisdom tells us--is indicative of current supply shortages, but ALSO of the ASSUMPTION that these shortages are only a short term market inefficiency and will eventually be corrected. However, should the crude oil market switch from backwardation to contago without a significant decline in current prices (suggesting that current supply problems have not been solved), that will suggest that the "market" has accepted the Peak Oil hypothesis that oil supplies will increasingly decline in the future, and hence that the commodity will get increasingly expensive. For this reason, I believe that the switch from backwardation to contango will be the market indicator that the peak in crude oil production is not only here, but perhaps more importantly that it is accepted by the broader financial community...

Interestingly, while it is too early to make any definitive conclusions, it looks like that transition may already be happening--Compare the graph below (from Bank of England, showing February '06 backwardation) to the graph above (showing late March '06 backwardation):

I don't, unfortunately, have sufficient historical data to make a convincing case--yet, but there certainly appears to be a significant shift towards contango in the '09 - '10 time-frame, DESPITE an actual increase in spot price since February 15th. Are the markets beginning to accept that Peak Oil is real, and that it is imminent?


Jeff Vail said...

If anyone has access to Energy Intel, or wants to spot me the $3,595 it would cost to access this article, it might just have some very interesting information along these lines...

Steven Lagavulin said...

I've got many years experience in the investment industry and I wanted to say that I think this is a great observation, and I agree with you that a return to normalization/contango will probably be an important indicator of an "awareness tipping point" being reached. In fact, in my gut, I'm quite sure it will be--but there are a lot of caveats at play.

It's probably not important at this point to go into details, but I would say from my own experience that the most fascinating thing about markets is that any notable 'occurance' will always have two completely believable explanations, one for the bulls and one for the bears. That's why perfectly rational and "professional" people can advocate buying Google and selling Google at the same time.... For big oil traders/hedgers there are very, very normal and acceptable reasons for the backwardation we're seeing. And backwardation can be a self-perpetuating event for a time, so it's no surprise that it proceeds for a while before correcting back to a contango pattern.

Also, the oil industry has been in decline for going on two decades or more until recent years, so a backwardation pattern in oil markets is now perceived by most traders as 'normal' in response to a (perceived) short-term rise in prices.

So with oil markets it's important to remember that a return to contango could also be viewed by institutional traders as a normal, everyday expectation....but I would add that that's only if world events and information surrounding the oil situation also return to "normal and everyday". And I highly doubt they will--actually I'm positive they won't but we're talking 'general perception' here. But if things did seem to be getting back to normal in the world--if Iran wasn't bombed, if no big hurricanes strike this fall, if the situation in Iraq "improves" promising increased oil outputs in the future, if China or India announce their intention to develop greater alternative energies infrastructure, etc., etc.--then a return to a contango formation would not be an indicator of anything special. All of which could very well happen. Even if we're past peak already. It's called a head-fake.

(Actually, now that I read this comment over it doesn't really seem to go anywhere so I'll try to summarize it in a different way...)

Many people in the oil markets don't know anything about Peak Oil, they're just doing their jobs business-hedging and speculating based on the way the markets have "worked" for the past twenty years. Old habits die hard, especially when money's at stake, so selling forward on a run is only prudent to them (which is what creates the backwardation pattern). They'd much, much rather lock in good gains today than "let it ride" on future higher prices. And there's a lot of other influences going on here as well, so the situation is complicated to say the least. But the point is that if traders fully expect to return to a more normal contango pattern at some point, doing so may not necessarily indicate any greater peak oil awareness.

But all that said I think you're absolutely right to bring this up, because a return to contango in the face of worsening world events (as they impact our oil situation) would certainly be a profound, profound signal. In fact if it happens I daresay it would likely be a very fast and forceful move which would likely coincide with or even trigger a "lightbulb" moment for our world.

Which is, you know...basically what you said already.


thelastsasquatch said...

Several comments:
1)good post and good observation
2)contango isnt necessarily the default structure for futures markets - alot depends on the storability of the product - anecdotal evidence suggests there just isnt the storage capacity for crude oil right now, and the only people who WOULD store it would also be the people who could also refine it - for an airline company what good would it be to store crude, before it was processed into jet fuel? Other products, like gasoline, are hardly storable at all - they go bad after 5-6 months unless they are treated. Gold, on the other hand, is infinitely storable, and the 'carrying cost' is largely the interest rate.

3)During hurricane Katrina I had oil positions on in many contracts - Id have to do some digging to get exact price histories but front month at the time was over $71 while Dec 2009 was $60. Front month and 2009 ARE in backwardation ($63 vs $65). This has happened only in the past couple of weeks. I think youre on to something, but as a previous poster suggested, its one piece of a complicated puzzle.

4)Look at the futures strip for NG - clearly we have tumbled from over $15 for front month down to $7. However, backdated contracts are only $1 off their highs. AND, the entire structure gradually declines until 2011, suggesting that an increase in US LNG is priced in market. Another trend since October is the difference between summer peaks and winter peaks - it has gotten alot narrower, possibly due to expectations of global warmings impact on future demand for NG.

JCamasto said...

If anyone has access to Energy Intel, or wants to spot me the $3,595 it would cost to access this article, it might just have some very interesting information along these lines...

I'd cash out some oil futures for you... but that would require me slipping into backwardation...

henpecked said...


Just sell some forward contracts, dude. You can give Jeff the $$$ he needs and you won't have to deliver the physical product 'til, like, 2010.

By then we'll have nuked all the oil field anyway so you probably won't even HAVE to deliver.

C'mon. Just do it...

Dom said...

The problem with futures is that they are traded now.

If I expect resources to be scarce in, say, one to five years, I will be willing to pay more for it NOW. As traders say, it's already in the price.

If the world believes we are past peak, they would be willing to pay 10$ gasoline prices NOW - simply because it will be harder to get in 5 years. That means that the prices it will take to produce the stuff in 5 years are already considered NOW and do not need to be put into the futures prices in five years. The futures prices will therefore remain a sort of running average of past prices MINUS what you would get by putting your money into bonds.

Otherwise you fall into the thought trap that Greenspan fell into a while back. PO doesn't exist because the future markets don't show it. As he made his comments, oil was priced somewhere under 40$.

Jeff Vail said...

Futures are traded now, but they are traded for several different and discrete distant delivery dates in the future. The pertinent part here is the difference between these future prices--because of arbitrage, there is also a link that prevents future prices from getting too far ahead of current prices. Futures prices for oil are already not a "running average of past prices minus what you get from putting money into bonds." Already you can get more money for a December 2007 future than the current spot price (and bond yields aren't negative).

Take a look at some of the discussion of this over at The Oil Drum:

Anonymous said...

Nymex Light Sweet Crude Futures strip to March 2011 more or less in Contango. Compare with year ago, or March 2004 strip for same future delivery dates. Market views of price have shifted markedly upward, where "normal backwardation" used to be the norm. Cheap oil is gone.

Jeff Vail said...

An interesting article by Tom McClellan of McClellan Financial:

McClellan discusses the increasing spread between spot price and the future price 11 months out, along with some interesting analysis, though as much technical as fundamental...

Anonymous said...

I don't understand what you mean when you say "contango is the norm." From a little research done online, it appears that backwardation is, in fact, the norm for oil - almost 70% of the time. Am I just not reading you right on this?

Anonymous said...

backwardation is the norm.. do a search for convenience yield and you can find numerous articles explaining why the oil market is normally backwardated. also search for the theory of normal backwardation. this post is unfortunately an ill informed person attempting to explain peak oil using information he doesn't understand.

Anonymous said...

oh and btw, the graphs you posted show the market in contango then falling into backwardation.

Anonymous said...

oh and btw, the graphs you posted show the market in contango then falling into backwardation.

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