"Super-Contango" and the Bottom in Oil Prices

As such, it’s reasonable to ask what indicators we should look for to know when the price has hit bottom. We see three factors as being key:

1. Inventories of crude oil.
2. Inventories of products derived from crude oil (gasoline and heating oil).
3. The steepness of the oil curve’s contango, and the possibility of a “super-contango.”

Crude oil inventories are continuing to soar and this is likely to prove bearish for WTI and Brent. The picture for oil products is, however, less clear. Gasoline inventories have been declining as expected during what has been a very active summer driving season. They are closely in line with their July 2014 levels, a bit below their 2013 levels and a bit above their 2012 levels (Figure 4).

Why gasoline inventories have fallen is partly a consequence of Americans driving about 5% more miles than last summer. Another factor is that refining capacity has not expanded in line with oil production. Refiners in the US are operating at close to full capacity (96-98%) yet just keeping pace with the expanded consumption of gasoline. Gasoline production is up about 3.5% year on year, according to the Department of Energy.

Reasonably low inventory levels of gasoline combined with record high crude oil inventories have translated into a wide crack spread between gasoline and crude oil, and high margins for refiners (Figure 5).

While gasoline inventory levels have been healthy, the level of distillates (mainly heating oil and diesel) is of greater concern. As of mid-July, distillate inventories were 10-15% higher than at a similar point in 2012, 2013, and 2014 (Figure 6). Not surprisingly, this has put downward pressure on the price spread of distillates with respect to crude oil. The NYMEX ULSD crack spread is close to its lowest level since 2011 (Figure 7). An additional source of concern is El Nino, which appears to be strengthening in the Equatorial Pacific. Historically, El Nino has generated warmer-than-normal wintertime temperatures in the Northern US and Canada -- the primary region for heating oil consumption. If winter does turn out to be warmer than normal in the Northern US and Canada, it could be bearish for the spread.

While inventory levels are key to understanding what is happening in the crude oil market, the data has limitations. The fact remains that the US is the only source of up-to-date inventory numbers, which is part of the reason why WTI plays such an important role in the global crude oil market’s price discovery. The rest of the world is comparatively opaque regarding its inventory and production levels.

US inventory numbers aside, one can also look at the degree of contango in the oil market as an indicator of whether or not prices have hit bottom. While there is no guarantee that the eventual bottom in oil will coincide with a steep contango, past bottoms in oil prices do provide some guide.

For example, when oil prices hit bottom in late 2008 and early 2009, the market was in a steep contango (or super-contango) with spreads between some of the monthly contracts exceeding $1. On February 12, 2009, one of the lowest points in crude oil during the past decade, the March 2009 future traded at $33.98/barrel, whereas the March 2010 future traded at $55.95/barrel for a 12-month contango of $21.97. Basically, the market priced (and later got) a V-shaped recovery in oil prices as excess inventory cleared at a low cost, paving the way for higher prices later on.

Currently, the oil curve is much less steep than it was at the bottom in 2009. As of August 3rd, 2015, the August 2015 settlement price was $45.08, whereas the August 2016 contract was at $50.88, with the 12-month contango at $5.80. (Figure 8). This might indicate that oil prices have substantial further downside before supply and demand are brought in line.

Overall, with high inventories, growing supplies, more efficient vehicles, and slowing demand in emerging market economies, the market is not pricing a rebound in oil prices like it did during the 2009 low. This indicates that market participants expect oil prices to remain subdued for a long time, and it might also mean that the market hasn’t yet reached its ultimate bottom.

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only.  The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions.  This report and the information herein should not be considered investment advice or the results of actual market experience.