COLUMN-Curve flattening overstates oil's strength: John Kemp

- John Kemp is a Reuters columnist. The views expressed are his own --

By John Kemp

LONDON Oct 22 (Reuters) - Much of the recent strengthening in oil prices has come from a flattening in the forward curve rather than a rise in outright levels. Curve flattening accounts for perhaps a third of the rise in the front end since February, and as much as half the gains since the summer.

While front-month CLc1 prices have doubled since February (rising $42 per barrel), and the soon-to-mature Dec 2009 contract CLZ9 is up 66 percent ($32), prices further forward such as the Dec 2013 contract CLZ3 have risen just 37 percent ($24). In the last three months, prices for the Dec 2009 contract have risen almost twice as fast (17 percent) as prices for Dec 2013 (10 percent).

The massive contango at the front end of the curve has largely evaporated. The discount for expiring futures contracts (CLc1-CLc3), which was running at an average annualised rate of 68 percent in January, has now shrunk to just 7 percent. The contango is barely enough to cover the cost of storage and finance.

A bullish story can be told about the need for higher prices in the medium term, based on the rising marginal cost of production and need for substantial investment to meet growing demand. But strength at the front end is more surprising, given the high level of stocks, continued demand weakness as a result of the recession, and forecasts of a fairly mild winter in the northern hemisphere because of the El Nino effect.

Forward cover remains 61 days, according to the International Energy Agency, compared with OPEC's target of 53 days, with another 120 million barrels of crude and products at sea in floating storage. In the United States, commercial inventories of crude oil (339 million barrels) and refined products (760 million barrels) are both still at the highest seasonally-adjusted level for more than five years.

For the time being, however, the market appears comfortable looking through near-term weak conditions and focus on the prospect of a substantial improvement over the next 1-3 years, while counting on continued investment flows and technical factors to support nearby prices in meantime.

RISING AT THE SHORT END

Several factors seem to be coming together to push the short end of the curve higher:

(1) Despite the high level of inventories, the worst of the stock build may be over. OPEC compliance with production curbs is patchy, and appears to be declining, but has probably been enough to stabilise the physical market. OECD stocks seem to have peaked, and both crude and products stocks in the United States show a clear downward trend. The market is pricing on the basis that things can only get better from here.

(2) Falling inventories have relieved some of the extreme pressure on the front of the curve. As usual there is the chicken-and-egg question of whether the contango or rising stocks comes first -- does a contango structure encourage stock building or do rising stocks force a contango to finance them? But whatever the cause and effect, as stocks have fallen and the contango has narrowed it has provided disproportionate support to the front end.

(3) Nearby prices have received an extra boost from the need to unwind the large number of short positions in the time-spread. In late 2008 and early 2009, inventory holders and investors established substantial short positions in the spread (selling futures nearby and rolling them forward, while hedging with physical inventory or long positions further along the curve) to profit from the contango.

As the contango has shrunk, these positions have come under pressure, forcing holders to close them, buying nearby contracts to cover their shorts (and selling the long positions further forward). Once it started to narrow, the unwinding of the spread trades ensured the process would accelerate under its momentum.

(4) The increased correlation between oil (and other commodity prices) on the one hand with equity markets and especially the trade-weighted value of the U.S. dollar seems to have been expressed most strongly at the short end of the curve. As equity markets have climbed, and the dollar has depreciated, it is the front end of the curve which seems to have been affected most.

(5) Ignoring slack fundamentals, institutional investors, hedge funds and even retail customers (via exchange-traded funds) show increasing appetite for using oil futures as a way to get exposure or protect themselves from reflation, inflation and devaluation.

Elsewhere, I have expressed scepticism about whether correlations with the dollar and equity markets really reflect fundamental influences [ID:nLU733472] or simply the common inflationary impact of excess liquidity and mistakes in central bank interest rate policy [ID:nLE34383].

The fact that fears about inflation (presumably a medium term risk) appear to be expressed most strongly at the short end of the curve tends to confirm the link is driven more by herding behaviour than real fundamentals. Nonetheless, it is strong enough to be self-fulfilling.

(6) Nearby prices are benefiting from the high concentration of upside call options in the December 2009 contract, which is pulling the front part of the curve higher as prices close in on the strikes and option writers are forced to start hedging their potential exposure by buying near-dated futures. [ID:nLL168130]

RISKS ROUGHLY BALANCED

While these factors explain why so much of the strengthening in oil prices has been concentrated at the short end, it does leave the market vulnerable to a sharp correction, especially once the Dec 2009 option expiry is out of the way, if the winter proves mild, or industrial and transportation demand for middle distillates fails to recover as quickly as analysts expect.

It would come as no surprise to see nearby prices pull back in December and January if the initial cyclical rebound starts to falter [ID:nLG388052] and distillate demand does not come back.

It is, of course, possible that momentum, together with excess liquidity and continued fears about inflation and devaluation, will carry the market higher in H1 2010, regardless of ample physical supplies, in what would be a re-run of the bizarre conditions in H1 2008.

But conditions are very different now. The last spike caused both lasting economic damage and substantial demand destruction. In today's weaker economy, with policymakers already focused on conservation and substitution measures as part of the climate agenda, both impacts would be immeasurably greater.

Current prices are more than sufficient to incentivise new production and investment in conventional oil production; make alternative technologies such as gasification, carbon sequestration and enhanced oil recovery viable; and restrain demand growth in both developed and developing countries [ID:nLB688017].

With the major emerging markets gradually phasing out gasoline and diesel subsidies and implementing mechanisms to ensure greater pass-through from international prices, price rises will curb demand much more quickly.

Clearly sensitive to concerns about the impact of high prices, OPEC officials have already begun to raise the possibility of reversing some of the current production cuts. [ID:nLM539505] This time around there is a reasonable amount of spare capacity, at least in the near term.

So while no one can rule out another price spike, another one so soon would be founded on even more unstable dynamics.

* here * here * here (Editing by James Jukwey)