Guest Writings
15/03/04 Backwardation – Fast Forward into the future by Edward Teague

The international trade in oil its refined products, jetfuel, heating oil, and gasoline is a huge, openly traded commodity market. Trades are made in US dollars as a matter fact, habit and convenience.

Current spot prices (i.e for immediate delivery) and those traded for the last 3 months are at all time highs. Future prices, that is, for products delivered in future months are trading at a premium. Why ?

Backwardation and Contango

Commodity markets use some terms daily, which most people rarely hear or use and understand even less.

When this month's delivery price for a commodity is lower (e.g Brent Crude Spot US$ 32.0) than next month, i.e oil for May early today was US $ 32.80 and June was $32.08 this is backwardation. The reverse is Contango i.e prices for delivery in future are lower than today.

The Crucial Difference

Simply, Backwardation translates as, a current shortage, i.e oil traders, oil companies and ultimately consumers want the product now, and a guarantee of product in future, even if they have to pay a premium. They do this in anticipation of a shortage, just as you might store tins of soup before they run out. Contango is a surplus, we can wait for delivery and will wait, confident that supplies will be available in future.

Oh yes we have too little oil

The US is short of oil and it shows in US Energy department figures with stocks at the lowest for 20 years and demand the highest. However the Strategic Oil Reserve is at the highest ever, but the SOR is a a one card trick – once the market see the US dipping into it, they see the US on the run. Today's backwardation is of the order of 30/80 cents per barrel per month which is anomalous, as supplies are said to be coming into line with demand. Another index is the Lundberg retail which tracks US pump prices nationwide and Friday announced an all time high of $1.77 cents a gallon (US = 3.86 litres UK gallon = 4.6 litres) with $2.10 in California. Prices do NOT rise when there is a surplus. Incidentally UK prices at the pump hit an all time high of 80p per litre Monday March 15th 2004, just ahead of the Budget.

What is happening?

Probably the oil traders initially believed what Washington was telling them about the post invasion and occupancy plans, when Iraqi oil would start flowing freely there would be no more shortages and the OPEC cartel was floundering on the ropes.

But that didn't happen and it hasn't happened.

OPEC, the cartel controlled by suppliers who operate more than 50% of supply – the exact proportion is impossible to judge because there are non-member countries like Mexico, who, whilst not card carrying members are "observers" and broadly follow OPEC policy on controlling production to maintain world prices.

The Iraqi oil fields, rescued and then left behind as the military moved swiftly on, have been looted, any useable machinery, plant, air conditioning, pipework spirited away (even whole electricity power cables for miles have been stripped of their copper cable and towers melted for scrap). The result 12 months later is output barely sufficient for domestic needs, gas queues in cities testify to the local shortage. OPEC cannot/will not make up the difference, and so the squeeze continues month after month.

Oil companies have done their sums and realize there is no benefit to holding off buying crude because prices are not coming down. Therefore they are starting to commit themselves to spring deliveries locking in prices now.

The shortages are real … the oil price is going up for literally any reason that suggests itself to suppliers.

Panicky traders, who simply do not believe that oil prices should be this high are letting their emotions dictate their trading experience and reason.

The oil majors are now convinced that Iraqi oil will not be forthcoming anytime soon, and Libyan, Caspian oil is way down the road. They understand the hard commercial reality that OPEC are really in the driving seat … the smart money is on prices NOT going down.

Ship owners who are exploiting the position and sheer physical shortage of ships to their own advantage.

Maritime insurers, emphasizing war risks, now made doubly uncertain by the events in Madrid.

US Refiners are gearing up for the summer gasoline demand, closing plants for maintenance and changing over from winter heating oil schedules, with spillovers from the rising natural gas price which is rising for other reasons, global and local.

Who says this is true?

Well, US refineries are generally reported as operating at about 95-98% capacity, (prices have risen when Hurricanes have shut refining capacity in the Gulf for only a day or two). Bloomberg reports that US stock shortages narrowed slightly, now 9% below targets higher than 10% reported last month.

Inability to refine product is being blamed, even with operating rates near 100% so the situation must be serious.

The Heating Oil market gives us some pointers … when the summer is over, refineries switch over to making Heating Oil from their crude stocks. If Heating Oil is in strong demand at the same time as Gasoline, then refining shortages backup.

A disaster in the making.

Why worry ?

In mid 2003 the the California based Rand Corporation produced a little noticed report, "New forces at work in refining: industry views of critical business and operations trends" by D.J.Peterson and Sergej Mahnovski. The US uses 12 Million barrels per day for transport, trucking miles have doubled in the last ten years and gasoline markets have grown and continue to grow by 1.7% per annum.

Refining plants have halved in 20 years and their utilised capacity increased from 75% to 97%. The number of owners has been reduced from 135 to just over 50 in ten years and half the capacity is held by 10 companies. Contrary to popular belief the refiners are largely independent of the oil majors, due to stripping out what they have increasingly seen as a capital intensive, internally subsidised part of the company, where intense retail competition has cut margins to the bone. The oil majors don't like living on slim margins or in the shadow of federal regulators.

Increased regulation on refiners and environmental demand have led to shutting capacity, improved plant performance has little room for in further improvement, so there is no safety valve built into the system. One industry executive stated, that " we just take product shortage, there is no reward in being long on capacity". This downsizing, has had a secondary effect in problems of staff recruitment as plant numbers diminish and staffing levels due to efficiency gains have allowed them to shed workers and led to an ageing workforce.

So far it appears that Washington is either unaware or is quietly and discreetly planning to cope with the problem. For how long this can be maintained is open to conjecture. Given the bureaucratic and press frenzy over terrorist worries, this has all the hallmarks of a major security issue.

Imagine, US refineries are having problems meeting demand, a couple of large refineries were attacked or threatened somehow by terrorists. That's more damage to the US economy than all the guerrilla activity in Iraq, Afghanistan and Columbia combined!

Imagine Venezuela plays hardball with supplies. President Chavez is not likely to fall over himself to help out the Government who tried to have him overthrown last year.

Imagine Nigerian offshore supplies are hit by strikes or worse?

Imagine widespread disruption to supplies in the Mid East, caused by terrorist blackmail, major problems with the Saudi Royal family dynastic succession, massive and successful attacks on the greenhorn troops now arriving in Iraq.

Somebody on the Beltway should be scratching their heads about this – meanwhile the market is making all the moves.

There are real oil supply problems looming in the US and elsewhere in the world. Watch market pricing; the guys who run these markets know their lives depend on it.

One thing is certain, it's going to cost more to pump gas this summer and for US citizens to heat their home next winter. That's higher prices for homes, transport and industry – bigger trade deficits, more layoffs, lower consumer confidence.

…and Don't even mention…

The consequences of the suppliers seeing the dollars they sell their oil for, declining in value and deciding to shift to selling the mucky stuff in Euros, something that Mr Schroeder and Mr Chirac keep suggesting to the now triumphantly re-elected Mr Putin.

Perhaps Mr Blair and Mr Brown, facing the huge January UK Trade deficit (not forgetting that the UK actually ran a trade deficit in oil in September 2002) of £5Bn and his criminal colleague in the US facing a record January US$46Bn trade deficit aren't taking any notice.

The legendary Mr Buffet of Berkeley Hathaway, George Soros, Marc Rich are meanwhile piling into Euros, just as reports are surfacing of the move for laundering the proceeds of drugs, and trafficking in guns and humans, and terrorists, is being fuelled by Euros because of the increased vigilance by the banks of dollar funds.


Curious word …. Strange and unexpected trading behaviours …. Unimagineable consequences.

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