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

Three steps to planning your spending in retirement

What happens when a superannuation expert sets up his own retirement portfolio using decades of knowledge? He finds he can afford much more investment risk in his portfolio than conventional thinking suggests.

Five stock recoveries not hanging on COVID predictions

The focus on predicting the recovery from the pandemic is the wrong emphasis. Better to identify great companies benefitting from market changes over a three- to five-year horizon with or without COVID.

Peak to peak, which LIC managers performed during COVID?

A comprehensive review of dozens of LICs shows how they performed in the crucial 'peak to peak' of COVID. This 14 months tested the mettle and strategies of a sector often under fire, with many strong results.

Finding sustainable dividend stocks on the ASX

There is a small universe of companies on the ASX which are reliable dividend payers over five years, are fairly valued and are classified as ‘negligible’ or ‘low’ on both ESG risk and carbon risk.

Blink and you missed a seismic shift in these stocks

Blink and it happened. If announcements in this sector were made by a producer of iron ore, gas, copper or some new tech, the news would have been splashed across the front pages. Have we witnessed a major change?

How inflation impacts different types of investments

A comprehensive study of the impact of inflation on returns from different assets over the past 120 years. The high returns in recent years are due to low inflation and falling rates but this ‘sweet spot’ is ending.

Latest Updates

Shares

Platinum’s four guiding investment principles

Buying mispriced stocks is often uncomfortable when companies are outside the spotlight and markets are driven by emotions. And it's inescapable that the price paid ultimately determines the end result.

Interviews

Andrew Lockhart on corporate loans as an income alternative

Loans to corporates were the traditional domain of banks, but as investors look for income alternatives to term deposits, funds have combined hundreds of loans into a single structure to create a diversified investment.

Retirement

10 things I learned in my faux-retirement

Pre-retirees should ‘trial run’ their retirements. All those things you want to do - play golf, time with the family, a hobby, write a book - might not be so appealing in reality, but you might discover other benefits.

Retirement

Achieving a sufficient retirement income portfolio

Retirees require a reliable income stream to replace the wages they received when they were working and should focus on the dollar income generated over time rather than the headline yield percentage.

'Wealth of Experience' podcast and ASA webinar on ETFs v LICs

Peter reveals some top stock picks with an emphasis on long-term assets like Sydney Airport, Graham discusses spending in retirement and valuing assets, the key to Amazon, guest Andrew Lockhart and plenty more.

Strategy

Lucy Turnbull’s three lessons on leadership and successful careers

From promoting women to boost culture to taking opportunities as they arise, Lucy Turnbull AO says markets should not drive decision-making and leaders must live and breathe the company's mission and values.

Economy

Are concerns about inflation inflated?

While REITs and some value stocks are considered 'inflation-sensitive' assets, the data provide little support that they are good inflation hedges, and energy stocks and commodities are too volatile. So what works?

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.