Oil Slump ?

The past five years have been brutal for the oil industry. An upstream producer that could once get over $100/barrel in 2013 saw that number plummet to below $30 in 2015 thanks to a large supply glut coupled with a slow global economy. Since then, crude oil has made a sharp recovery, but still has a lot of room to go to make it back to triple digits.

When discussing prices for crude oil (or any commodity for that matter), it is important to make key distinctions. The first distinction is which class or type of that specific commodity.

Just saying crude oil, for example, is very broad, as there are many different types based on the chemical composition of the specific crude oil and from what region it comes from. Because of these differences, each type is traded as a different entity on the commodities market, where prices between the two can vary.

The two most common types which are used as benchmarks to gauge oil prices are West Texas Intermediate (WTI) and Brent.

(In the first paragraph, I was referring to WTI crude prices, which I will use consistently throughout this article.)

The second distinction to make is whether the price represents the spot price or the futures price. The spot price is simply the current value that the commodity can be bought/sold in the market. The futures price, however, is the value of a financial contract in which a buyer and seller agree to exchange the commodity at some future date.

For example, a seller and I can agree to exchange one barrel of oil in July at an agreed price in the future.

The futures price can give a good indication of market’s view of where the price may be heading. For example, if the spot price of an apple is $1 today and the futures price one month from today is $1.50, there clearly are some opinions floating around that the price of apples may go up soon.

This is not as simple as it may seem though. The wide gap between the spot price and futures price in the example above gives rise to an arbitrage opportunity.

That is, someone can buy apples at the spot price of $1 and immediately enter into a futures contract to sell the apples at $1.50 in one month. (Let’s assume these apples don’t go bad.) Because of this, the demand for apples should increase, effectively driving up the spot price.

Thus, in an arbitrage-free market environment, ceteris paribus, the futures price of a commodity should be priced accordingly:

This equation considers the principle of the time value of money as the seller’s cost, where “r” represents the theoretical risk-free rate of return compounded continuously (hence use of “e”) with the time until maturity “t” representing the length of receiving the risk-free rate. I left out other factors such as storage and transportation costs to keep the model simple.

Based upon this model, a forward curve, which plots the spot price and multiple futures prices on the same graph, should theoretically always be upward sloping, or what is known as in contango.

Logically, even beyond the time value of money, if apples were $5 today on their spot price and $1 on their one-month futures price, the demand for them should decrease causing the spot price to drop.

The futures market for WTI crude, however, seems to break this thought process. Below is a chart that shows the two-year forward curve for WTI:

From this graph, we can determine that WTI crude is in backwardation, meaning the futures prices are lower than the spot price. Based upon what was explained above, this seems completely wrong, but there are reasons behind this which may show signs that crude oil is closing in on its high-water mark.

The first thing to consider is that crude has climbed steeply in the last 12 months. Last year in April, the WTI spot was around $45-50/barrel, which represents a roughly 40% upside since that point. This run was aided by OPEC production quotas alongside of strong oil demand from an accelerating global economy.

As we continue to move closer to the end of the business cycle, many traders believe that demand may be nearing its max despite the strong run in the past few weeks from the low $60s to the high $60s. This downward slope implies that these short-term demand spikes may not be significant and oil prices may fall in the near to mid-term.

Another thing to consider is the supply side of the equation. Certainly, the OPEC quotas have helped prices move out of their deflated state but increases in production technologies continue to improve efficiency. This is leading to crude oil being more readily available, which should increase reserves over time. As well, independent shale drillers continue to extract greater quantities which should have the same effect.

More long term, the rise of electric vehicles in established markets will create weaker demand for crude oil. Gasoline is one of the leading products of crude oil, and while the transition may be long, cars are heading in a direction of being gasoline-free.

Combining this with the fact that production efficiency should only continue to rise with time, it seems logical to have a long-term bearish view of crude oil. Prices may not plummet overnight, and emerging markets may not acquire electrical vehicle technology as quickly as established ones, but a few decade’s time could severely put the oil industry in a tougher place.

Obviously, it is impossible to predict the future, but what is more important is drawing conclusions based upon what the forward curve is telling us. People are willing to pay more money today for oil than they are in two years, which shows that there is strong demand in the present.

It is projected, however, that oil will not continue to climb higher based upon the factors discussed, which is why the curve remains downward sloping.