Will Crude Oil Continue to Rally?

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June 1, 2020 11:42am NYSE:USO

NYSE:USO | News, Ratings, and Charts

  • Contango took NYMEX futures into negative territory on April 20
  • The price came a long way in a little over one month
  • Contango has narrowed- Lots of profits for the cash and carry crowd

 

In the world of commodities, contango occurs when the price for deferred delivery of a commodity is higher than nearby delivery. Contango tells us that a market is in equilibrium or a glut condition. The higher the contango, the more of an oversupplied condition. Backwardation is the opposite, where price prices for nearby delivery are higher than for deferred dates. Backwardation is a sign of tightness or supply concerns or shortages.

The forward curve is a part of a market’s structure that provides real-time clues when it comes to supply and demand fundamentals. In the crude oil market, the energy commodity came into 2020 with a small backwardation as tensions in the Middle East fostered some supply concerns. The nearby futures contract was trading at a higher price than those for delivery in the future. The evaporation of demand because of the pandemic and increased supplies when OPEC abandoned production quotas in early March pushed the term structure into a rising contango. Increasing US production, which rose to a record high of 13.1 million barrels per day in mid-March, moved the contango to even higher levels.

Rising contango set the stage for NYMEX crude oil to move into negative territory for the first time in modern history on April 20 on the expiring May futures contract. Since then, contango has been falling, and the price of crude oil recovered. The forward curve in the crude oil market often serves as a real-time indicator of the supply and demand equation. The United States Crude Oil Fund (USO) is an ETF product that moves higher and lower with the price of the energy commodity.

Contango took NYMEX futures into negative territory on April 20

 

The differential between crude oil for delivery in July 2020 and July 2021 moved from backwardation at the start of 2020 to a significant contango in late April.

(Source: CQG)

As the chart highlights, the July-July one-year spread moved from a $5.65 backwardation on January 3 to a $13.46 contango on April 27, 2020. The May-May spread moved to a far higher contango over the period, leading market participants to purchase crude oil for nearby delivery, store and insure the petroleum against the obligation to deliver it to a buyer in the future. Oil traders with access to capital to finance the spread and store the oil pocketed the differential between the costs and contango. At the peak, the July-July spread traded at an almost 78% premium for the deferred contract, which created a substantial profit. Meanwhile, some market participants synthesized the spread without the ability to take delivery when storage capacity disappeared in late April. Those holding long positions in the May contract were in a situation where they had to sell the energy commodity at any price.

(Source: CQG)

The chart shows that crude oil became a bearish hot potato in April and the price of the nearby futures contract fell into negative territory as the expiration approached. The wide contango caused the decline as some traders were left holding a very expensive long position. Many believed the price could would never drop below zero, they were wrong.

The price came a long way in a little over one month

Traders and market participants learned an expensive lesson in late April. Since then, oil producers around the world have been cutting production to address the decline in demand on the back of the global pandemic. Before the move into negative territory, OPEC, Russia, and other world producers announced the most substantial output cut in history as they reduced production by 9.7 million barrels for at least two months. In May, Saudi Arabia announced that it would reduce output by another one million barrels per day starting June 1, and other Middle Eastern producers followed. The Saudis also said they support an extension of the cuts past the two-month initial period.

The US is the world’s leading oil-producing nation. The falling price caused daily output to fall from 13.1 mbpd in mid-March to 11.4 mbpd as of May 22. The number of rigs operating in the US declined to 222 as of

May 29. Last year, 800 rigs were pumping the energy commodity from the crust of the earth. The low price level of crude oil caused a natural decline in output in the US.

At the same time, social distancing guidelines have eased over the recent weeks, which has increased the demand for energy. Chinese demand has been rising over the past weeks. The decline in output and rising demand caused a rebound in the price of crude oil.

(Source: CQG)

As the daily chart of July futures shows, the price rose from $17.27 on April 28 to a high of $35.77 on May 29. The price of July futures more than doubled in a little over one month.

Contango has narrowed- Lots of profits for the cash and carry crowd

Falling output and rising demand have caused the contango in the oil market to fall.

(Source: CQG)

The chart illustrates the decline in the June 2020 versus June 2021 NYMEX crude oil spread from $13.46 to around the $2.24 per barrel level as of May 29. The contango took a U-turn since April as the price of petroleum recovered.

The cure for low prices in commodities is low prices. The decline into negative territory on the May contract, to $6.50 on June NYMEX futures, and $17.27 on the July contract pushed the price to a level where production costs were above the market price. The drop in output and increase in the demand caused May 2020 to be the month where oil experienced its most significant percentage gain in history. The energy commodity made history in both April and May on the up and the downside.

The downward trend in contango will continue if crude oil moves higher over the coming days and weeks. The forward curve often serves as a real-time indicator of the supply and demand fundamentals for the energy commodity. The trend is telling us that crude oil may have further to run on the upside during the current price recovery.

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The United States Oil Fund LP (USO) was trading at $25.73 per share on Monday morning, down $0.15 (-0.58%). Year-to-date, USO has gained 114.24%, versus a 14.57% rise in the benchmark S&P 500 index during the same period.

USO currently has an ETF Daily News SMART Grade of F (Strong Sell), and is ranked #65 of 112 ETFs in the Commodity ETFs category.


About the Author: Andrew Hecht

andrew-hechtAndy spent nearly 35 years on Wall Street and is a sought-after commodity and futures trader, an options expert and analyst. In addition to working with StockNews, he is a top ranked author on Seeking Alpha. Learn more about Andy’s background, along with links to his most recent articles. More…


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