Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 195

Future oil prices: it takes two to contango

The recovery in oil prices during the past year, as measured by the price of Brent Crude Oil, has provided a welcome respite for investors exposed to direct commodities, energy-related stocks and high-yield debt, particularly for North American shale oil producers.

While short-term predictions are fraught with danger, futures markets provide context as to where market participants believe oil prices should be over the medium term. This article provides a deeper understanding of oil pricing dynamics and the prospects for crude oil prices [Editor's Note: a 'contango' is where the futures or forward price of a commodity is above the spot price].

Forward curve dynamics

Futures markets provide an insight into the incentive pricing for producers, hedgers, and speculators to act. The spot price is typically quoted on news and business channels, but futures markets provide price points for multiple tenors in the future which can be used by market participants to either hedge production, hedge-pricing risk for buyers, or take a position, as is the case for speculators.

Further ‘along the curve’ (looking at prices that are at least six to 12 months in the future), there tends to be less noise and more signals which are reflective of market fundamentals. If this were not the case, there would be an opportunity to arbitrage for those investors able to participate in both the physical (spot) market and hedge using futures.

Brent Crude Oil forward curve fair value per barrel in US Dollars

The chart shows forward pricing for Brent Crude Oil as of 7 March 2017 (the ‘forward curve’, shown in red) and compares this to the forward curve one year ago (shown in grey).

The chart provides a number of insights:

1. Oil markets are back in balance

Since the announcement by OPEC in late 2016 of production limits, oil markets have been rebalancing. While this doesn’t negate the effect of currently high levels of global inventories, the forward curves illustrate how the forward curve has effectively shifted up and flattened. This is historically associated with positive performance for the immediate future as there is less incentive to produce today and forward hedge (prices are flat for the immediate future).

2. Shale picks up market share, ‘ROPEC’ picks up revenue

The wild card in the oil market deck is now North American shale oil production. A combination of recent increases in rig counts and falling marginal costs for certain oil basins mean that OPEC shares swing production with US shale producers.

Current pricing provides an incentive for more marginal production to come on line in the US, so this will likely translate into higher market share for shale as a percentage of global oil production, while OPEC and Russia (AKA ‘ROPEC’) benefit via increased revenues, albeit at lower production levels.

3. Aramco IPO in the balance

It is in the interests of the Saudi Arabians to maintain prices around these levels. With the proposed IPO of Aramco in the next two years, its oil assets would be priced at the average price of the past 12 months. A major objective of Saudi oil production would be to maintain pricing at these levels to keep them low enough not to encourage a major increase in shale production, but high enough to provide a reasonable valuation on oil reserves. The Aramco IPO could potentially make it the largest listed oil company in the world, above Exxon Mobil Corporation.

Conclusion on the oil market

Current oil market pricing in the mid-US$50 range is a ‘sweet spot’ for all major oil market participants, including OPEC, Russia and the more productive and cost efficient North American shale producers. Barring unexpected events, oil prices will likely remain range-bound for the medium term, with an effective floor of around US$50 as the base case. The abyss oil markets experienced in early 2016 provided an insight into the instability created by an oversupply in energy markets, and this will be front and centre to ‘ROPEC’ in encouraging strict compliance with production quotas.

 

Andrew Kaleel and Matthew Kaleel are Co-heads of Global Commodities & Managed Futures at Henderson Global Investors. This information is general only and does not take into account the personal circumstances or financial objectives of any reader.

 


 

Leave a Comment:

     

RELATED ARTICLES

Oil does not have a supply side problem

Momentum or rupture: has demand for oil already peaked?

Oil and the storm before the really big storm

banner

Most viewed in recent weeks

Unexpected results in our retirement income survey

Who knew? With some surprise results, the Government is on unexpected firm ground in asking people to draw on all their assets in retirement, although the comments show what feisty and informed readers we have.

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Three all-time best tables for every adviser and investor

It's a remarkable statistic. In any year since 1875, if you had invested in the Australian stock index, turned away and come back eight years later, your average return would be 120% with no negative periods.

The looming excess of housing and why prices will fall

Never stand between Australian households and an uncapped government programme with $3 billion in ‘free money’ to build or renovate their homes. But excess supply is coming with an absence of net migration.

Five stocks that have worked well in our portfolios

Picking macro trends is difficult. What may seem logical and compelling one minute may completely change a few months later. There are better rewards from focussing on identifying the best companies at good prices.

Six COVID opportunist stocks prospering in adversity

Some high-quality companies have emerged even stronger since the onset of COVID and are well placed for outperformance. We call these the ‘COVID Opportunists’ as they are now dominating their specific sectors.

Latest Updates

Retirement

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Interviews

Sean Fenton on marching to your own investment tune

Is it more difficult to find stocks to short in a rising market? What impact has central bank dominance had over stock selection? How do you combine income and growth in a portfolio? Where are the opportunities?

Compliance

D’oh! DDO rules turn some funds into a punching bag

The Design and Distribution Obligations (DDO) come into effect in two weeks. They will change the way banks promote products, force some small funds to close to new members and push issues into the listed space.

Shares

Dividends, disruption and star performers in FY21 wrap

Company results in FY21 were generally good with some standout results from those thriving in tough conditions. We highlight the companies that delivered some of the best results and our future  expectations.

Fixed interest

Coles no longer happy with the status quo

It used to be Down, Down for prices but the new status quo is Down Down for emissions. Until now, the realm of ESG has been mainly fund managers as 'responsible investors', but companies are now pushing credentials.

Investment strategies

Seven factors driving growth in Managed Accounts

As Managed Accounts surge through $100 billion for the first time, the line between retail, wholesale and institutional capabilities and portfolios continues to blur. Lower costs help with best interest duties.

Retirement

Reader Survey: home values in age pension asset test

Read our article on the family home in the age pension test, with the RBA Governor putting the onus on social security to address house prices and the OECD calling out wealthy pensioners. What is your view?

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.