Analysis: Oil producers hedge as oil climbs over $90

By Christopher Johnson

LONDON (BestGrowthStock) – Oil producers are taking advantage of prices above $90 per barrel to hedge long-term production, driving forward oil futures below prompt prices for the first time in more than two years.

With oil for delivery in the next few months supported by northern winter heating demand and some product shortages, the forward price curve has flipped into a downward-sloping “backwardation”, erasing the upward-sloping “contango” in place since 2008.

But traders and analysts say the current market structure is highly volatile and, with crude oil stocks very high in many parts of the world, the backwardation could evaporate as quickly as it appeared.

Crude oil prices are now trading around 26-month highs at above $90 for both U.S. light, sweet crude and North Sea Brent, encouraging forward hedging. That could stop abruptly if prices plunge.

“If we have a price correction, the backwardation will be relatively short-lived,” said Olivier Jakob, an oil analyst at consultants Petromatrix in Zug, Switzerland.

The change in the structure of the oil market has been dramatic.

Benchmark front-month U.S. crude prices, now January, hit an intra-day high of $90.76 per barrel on Tuesday, their highest level since early October 2008 and more than $3.50 above where they were a month ago.

But the U.S. crude contract for December 2014 has fallen over the past month from above $92 to below $88.50, erasing its former premium over prompt prices.

“The change in the curve is coming from extreme weakness at the back end,” said Jakob.


Producers such as state oil companies and major oil companies have been selling forward hedges to lock in current prices, a physical oil trader at one of the biggest U.S. banks said.

“Producers are selling the back end and that is making the spreads rally, pushing up the front end in relative terms,” said the trader, who declined to be identified.

That forward selling has in turn pushed up nearby oil prices in relative terms, having a psychological impact on the market and “making people bullish”.

At the same time, prompt contracts for both U.S. crude and Brent have stayed at small discounts, keeping the curve in contango over the next few months. Backwardation only kicks in significantly from mid-2011.

Analysts say surplus oil inventories explain this phenomenon.

The International Energy Agency says stocks of oil in the developed industrialized countries of the Organization for Economic Cooperation and Development (OECD) are historically high, equivalent to around 59.9 days of forward consumption in September, the last month for which it has data.

That overhang of stocks is being depleted due to consumption of heating oil as winter sets in across Europe, North America and parts of China, but it will take some time to dissipate, and analysts say that could mean backwardation will be short-lived.

“Oil stocks are very high,” said Michael Wittner, commodities analyst at French bank Societe Generale in New York. “I don’t think backwardation is justified unless you get much bigger stock draws.”

Analysts and traders said that while backwardation of the oil market could last some time, the market was likely to switch back to contango, possibly within a month or two or maybe even earlier.

“It might hold for some weeks,” said Eugen Weinberg, head of commodity research at Commerzbank in Frankfurt.

“I think it is temporary, and the normal form of the curve for the next years I think will be probably contango most of the time, because I do believe the markets will stay oversupplied.”

Thorbjoern Bak Jensen, a Global Risk Management analyst in Middelfart, Denmark, said he thought high prompt demand had helped flip the oil price curve into backwardation.

“I expect the curve to follow the weather forecasts. We could be back in contango by late winter or early spring.”

(Additional reporting by Emma Farge and Alex Lawler; editing by Jane Baird)

Analysis: Oil producers hedge as oil climbs over $90