by Tajinder Dhillon.
Commodities have been at the forefront of global markets for over a year now given its meteoric rise and its key role in supply chains during times of extreme market turmoil.
The Refinitiv/Core Commodity CRB® has significantly outperformed global equities in 2021 and 2022, up 38.5% and 26.7% respectively vs. 16.1% and -11.1% for global equities. The last time commodities outperformed global equities in a consecutive two-year period where returns were positive for both asset classes were back in 2004-2005.
The Refinitiv/Core Commodity CRB® Index represents 19 commodities grouped into four major category weights including Energy (39%), Agriculture (34%), Metals (20%), and Livestock (7%). The Reuters Instrument Code (RIC) is “.TRCCRBTR”.
While prices are important, looking at the shape of a commodities curve can also provide rich insights as to whether the market is trading in ‘backwardation’ or ‘contango’ which influences the behaviour of most participants including speculators, hedgers, producers, and consumers.
Using Refinitiv Workspace, we can access the Forward Curve Chart app and focus on brent crude as shown in exhibit 1. The app allows users to load any commodity curve such as corn, wheat, soybeans, aluminium, and copper.
Exhibit 1: Brent Crude Forward Curve
A downwards sloping curve indicates a market trading in backwardation, a market condition in which a futures price is lower in the distant delivery months than in the near delivery months. In other words, consumers are willing to pay a premium to receive oil today than wait for oil to be received in the future. This behaviour exists if markets believe oil is ‘tight’. Indicators of a tight market include low or falling inventories and lower production.
The app allows users to display the entire curve or a specific number of contracts. It also allows to overlay a curve at a historical date in time – for example we display the curve as of March 8th when oil prices reached a ten year high of $127.98 a barrel.
For comparison, exhibit 2 displays the brent crude curve during the trough of March 2020 where the market was trading in contango as demand for oil collapsed, leaving supply without a home.
Exhibit 2: Brent Curve Forward Curve in March 2020
Reverting to the current market environment, we can go one step further to assess the degree of backwardation in brent crude using Refinitiv Datastream. Exhibit 3 highlights the six-month brent calendar spread (month 1 vs. 7) which reached an all-time high of $21.58 on March 8th, surpassing the prior high of October 1990.
The long-term average calendar spread is only $0.2 per barrel and a calendar spread greater than $5 is significant. For example, when Saudi Arabia experienced a drone attack on one of its processing facilities in September 2019, the six-month calendar spread increased to approximately $5.50 a barrel (Recapping the Attack on Saudi Oil, September 24, 2019).
Exhibit 3: Brent Calendar Spread
The brent curve has broadly remained in backwardation since the beginning of 2021 as OPEC+ began to curtail production to balance the market once the COVID pandemic began. Furthermore, U.S. oil producers have maintained production discipline for several years now and have focused on increasing shareholder value through share repurchases and dividends.
Exhibit 4 highlights crude stock levels at Cushing, Oklahoma which have declined rapidly over the last 18 months as economies opened after the pandemic, resulting in a rapid increase for oil demand relative to inadequate supply. Stock levels have now declined to a three-and-a-half-year low of 22.2 million barrels.
Exhibit 4: Crude Oil Stocks at Cushing, Oklahoma
Lower stock levels place further pressure on supply and demand and only gets worse when exogenous shocks occur. Reuters news announced on March 4th that the International Energy Agency will release 61.7 million barrels of oil, led by the United States who will contribute 30 million barrels followed by Japan (7.5m), South Korea (4.4m), and Germany (3.2m).
The United States strategic petroleum reserve currently reads 577.5 million barrels which is almost at a ten-year low.
A market in backwardation is often triggered by a disruption in supply and to reverse course, it typically requires either a) oil production to increase, or b) oil consumption to decrease, or a combination of both.
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