The futures market is saying the oil glut is over

REUTERS/Peter Morgan

According to consulting firm McKinsey, the current oil futures market is pointing to a coming balance between demand and supply—a balance which has the potential to render most oil and gas investments uneconomical.

The futures market is often a reliable guide to forcasting the future direction of oil prices, and analysts rely on both contangos or backwardation when determining their forecasts.

During a supply glut, a contango is typically observed. This is a condition where the spot price for future contracts is far higher than the current price for nearby contracts. This means that people are willing to pay more for a commodity sometime down the road than the actual price for the commodity.

Backwardation is noticed when the current demand is higher than the supply, thereby making the nearby contracts costlier compared to future contracts.

REUTERS/Peter Morgan

Until around 2005, backwardation was the normal condition, as seen in the charts. But since 2005, contango has become the normal condition, reports Reuters. Experts differ on their views regarding this shift.

Large contango is indicative of market bottoms. During the 2008-09 crude oil crash, the oil market witnessed a super-contango, when the price difference between the first month and the seventh month contract had reached up to $10 per barrel.

Similarly, during the current crisis, the contango reached $8 per barrel twice, once in February of 2015 and again in February of 2016, as shown in the chart below, after which, the markets bottomed out.

REUTERS/Peter Morgan

During the 1985-2004 period, the average backwardation was $1.07 per barrel, and during the 2005-2014 period, the average contango was $1.50 per barrel as shown in the chart below. The current contango hovers around $2 per barrel, which is close to the average during the 2005-2014 period.

REUTERS/Peter Morgan

The current oil crisis is unlike the oil crisis of 2008-2009, as there is no demand destruction this time. Demand for oil is on the rise and is likely to increase by 1.5 million barrels per day, both in 2016 and 2017, according to the latest Short-Term Energy Outlook by the U.S. Energy Information Administration.

In the short-term, the supply outages to the tune of 3 million b/d have supported oil prices by easing the supply glut and restoring the balance between supply and demand. If supply is restored, the oil markets will again return to a surplus, putting pressure on prices.

Due to low oil prices, billions of dollars in investments have either been scrapped or postponed. As and when the markets shift from surplus to deficit, new supply will find it difficult to catch up with increased demand. Markets need higher prices for investments to start trickling into the industry.

However, consulting firm McKinsey believes that oil demand will peak around 100 million barrels per day by 2030 from the current levels of 94 million barrels per day.

“This change is driven by three factors: first, overall GDP growth is structurally lower as the population ages; second, the global economy is shifting away from energy-intense industry towards services; and third, energy efficiency continues to improve significantly,” McKinsey’s Occo Roelofsen said. “Peak oil demand could be reached around 2030”, reports The Telegraph.

If oil demand behaves according to Mckinsey’s expectations, most new investments into oil will be uneconomical due to weak demand in the future.

Though the long-term is slightly uncertain, balance is maintained in the short-term. Unless we see supply outages restored, prices are likely to remain in a small range following an impressive run.

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