Clyde Russell, Reuters
Crude oil’s flirtation with backwardation has been hit by the market dislocations caused by Hurricane Harvey, the massive storm that is disrupting the U.S. crude oil import, export and refining hubs along the Gulf of Mexico coast.
Two weeks ago the Brent crude futures curve was backwardated, with the front-month contract commanding a premium over the following four months.
But by the close on Aug. 30, the global benchmark oil was once again mainly in contango, with the front-month at $50.86 a barrel, a discount of 27 cents a barrel to the six-month future.
The very front of the curve was still in mild backwardation, with the second-month contract 13 cents cheaper than the front-month, and the third-month a mere 7 cents.
On Aug. 15 the front-month Brent future was at a premium of 17 cents to the second-month and 18 cents to the third.
Backwardation is usually seen as a sign that the market is rebalancing and that prices are likely to head higher in future months. Backwardation, when the front-month contract is more expensive than subsequent months, makes it uneconomical to store crude, resulting in the drawdown of inventories. It also makes it harder for marginal producers, such as many U.S. shale drillers, to effectively hedge future output, which may result in lower spending on exploration and developing new wells.
The move to a backwardated curve in mid-August was generally viewed by market participants as proof that crude oil was re-balancing, and that the efforts of OPEC and its allies to restrict their output were finally paying off.
But Hurricane Harvey has nipped this hope in the bud, at least for now.
With some 4.4 million barrels per day (MMbbl/d) of refining offline, representing about 24% of U.S. capacity, the storm represents a major demand shock to crude oil markets.
But also of importance is the idling of both offshore and onshore oil production in the region, with more than 320,000 bbl/d of offshore output remaining idled as of Aug. 30
Onshore production from shale formations such as the Eagle Ford, which S&P Global Platts said was producing about 1.34 MMbbl/d of oil prior to the storm, is in the process of being restarted.
But even if output does return to pre-Harvey levels, it’s unlikely that it will be able to move out of the Gulf Coast region for at least a few more days, as ports along the Texas coast remain shut and some pipeline operations are disrupted. This dislocation of both U.S. crude imports and exports is likely to have an impact across global oil and product markets.
The immediate impact has been to drive U.S. gasoline prices sharply higher, prompting cargoes to move from regions as far away as Asia to the U.S.
Harvey Impact To Linger
In crude markets, the impact from Harvey could linger for some months, and alter trade flows as market participants seek to take advantage of arbitrage opportunities.
Right now U.S. shale crude won’t be leaving the U.S. Gulf Coast, meaning buyers will have to seek short-term alternatives, such as buying light grades from West Africa or Southeast Asia. But once Gulf Coast terminals are able to resume exports, demand for this grade of crude could rise dramatically, given the widening discount of West Texas Intermediate (WTI) futures to Brent.
As of the close on Aug. 30, WTI was at $45.96 a barrel, some $4.90 below Brent, a far bigger discount than the $2.62 that prevailed at the start of August. This makes it likely that traders in Asia will be especially tempted to book U.S. cargoes priced against WTI in favor of other light crude grades priced against Brent.
While Asia’s imports of U.S. light crude will no doubt be lower in October and November because of the hurricane's impact, they may come back strongly in subsequent months.
The loss of U.S. refining capacity should be bearish for heavy crude grades, given many of the refineries now idled used imports of this type for feedstock. This crude will now either have to be put in storage, or find other buyers.
However, the demand shock from Harvey is likely to be short-lived, and once the damage has been repaired and refineries re-open, it’s also likely they will run as fast as they can in order to rebuild product inventories currently being drawn down.
There is little doubt that Harvey has complicated the efforts by OPEC and its allies to force global inventories lower, but if they respond by tactically allocating different grades of crude among customers, it could still work to their benefit.
This would mean restricting heavy grade supplies to refiners in Asia and Europe, but boosting the supply of lighter grades priced against Brent in order to narrow the premium to WTI. It remains to be seen whether this can be done at relatively short notice, but as things stand now, Harvey is providing a wealth of trading opportunities.
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