Indications have emerged that as OPEC’s cuts begin to drain the world’s bloated fuel inventories, short-term crude should appreciate further, presenting financial investors with a new opportunity: a buy-and-hold strategy that once incurred losses will instead offer rewards.
Since 2014, short-term crude traded at a discount because of a global surplus. This generated stellar profits for suppliers from BP Plc to Vitol Group BV who stockpiled oil for later sale. But for financial investors in crude futures, holding onto a position meant buying ever-costlier contracts that often wiped out returns. As OPEC’s cuts shift the premium from long-term to short, holding a speculative oil wager could become lucrative again.
“In that environment, it’s hugely more attractive,” said Doug King, chief investment officer of RCMA Capital LLC, whose Merchant Commodity Fund manages $230 million. “For a financial investor, that’s like the glory days of market management from OPEC.”
The Organization of Petroleum Exporting Countries is trying to flip the oil market from a structure known as contango, where longer-term prices are stronger, to backwardation, where short-term prices have a premium, said Ed Morse, head of commodities research at Citigroup Inc. That should discourage companies from adding to their oil inventories, and instead spur them to process excess stockpiles, he said.
There are signs the strategy is already working. A week after OPEC’s Nov. 30 decision to cut production, Brent contracts for settlement in December swung to a premium over contracts for December 2018. The spread was at 82 cents a barrel on Thursday.
Keeping a lid on later prices is also intended to impede rivals like U.S. shale drillers, which will be dissuaded from locking in future revenue streams to fund their operations, said Craig Bethune, a fund manager at Manulife Asset Management Ltd. in Toronto.
While traders of physical oil would see profits from storing crude dwindle with the end of contango, futures traders would be set to benefit. From their perspective, “backwardation makes a commodity more attractive,” Bethune said.
An investor seeking to stay long in a contango market would lose money transferring their investment into the next, pricier contract, but keeping a position during backwardation means moving to a cheaper contract and collecting the difference, said RCMA Capital’s King. Buyers are “being paid every month” just to stay invested, he said.
“The move to backwardation is a significant driver of returns,” said Greg Sharenow, executive vice president at Pacific Investment Management Co., who oversees investments of $13 billion. “Over a three- or five-year period, it’s probably one of the biggest determinants of absolute returns for the investor.”
Still, the nearest monthly oil contracts are the most important for investors and these remain in contango, according to Sharenow. The market may struggle to reach a backwardation durable enough to attract investors, as OPEC could falter in its commitment to reduce output and higher prices may allow U.S. shale producers to come back, he said.
“We haven’t quite hit an inflection point,” Sharenow said. “It’s highly dependent on continued compliance from OPEC over an extended period.”
Yet initial signs of OPEC compliance are encouraging. De facto leader Saudi Arabia has said more than 80 percent of the targeted reduction of 1.8 million barrels a day has already been implemented by the group and its partners, including Russia.
