Backwardation in oil futures points to market shortage

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Special circumstances such as Venezuela's decline led to OPEC's successful cartel policy, according to WisdomTree's Nitesh Shah. The accompanying oil shortage could be further exacerbated by U.S. sanctions.

Crude futures curves have mostly been in reverse over the past year, giving investors a return on extending their contracts in addition to the gains they have made from spot oil price movements. "An investor would have gained 44% from price movements and 9% in rolling returns if they had invested in a front-month Brent strategy for a year to September 2018", analyzes Nitesh Shah, Director Research at WisdomTree. The backwardation had been driven by what was perceived as a short supply situation in the short term.

OPEC reliably keeps quotas
The Backwardation is to a large extent brought about by the organization of the oil exporting countries (OPEC), thinks Shah. Since January 2017, the oil cartel has restricted oil supplies by allocating its members and partners a quota for the amount of oil they produce. "It's true that the cartel has done a poor job of meeting quotas in the past; but this time it's being extraordinarily reliable about it", he explains. One reason for this, he says, is the economic collapse in Venezuela. Its oil production is declining sharply, while other OPEC members have not increased their production until recently. For now, Shah believes the global oil market is in balance. But even though OPEC is expanding production and U.S. shale oil output continues to grow, that balance is fragile, he says. "It only takes one more supply shock after Libya and Canada to put supply in doubt", he states.

Sanctions could complicate global oil supply
One potential source of aggravation, he said, was U.S. sanctions against Iran. The U.S. has set a deadline of early November for other countries to join the embargo on imports of Iranian oil. Between 2016 and 2017, Iran was a big contributor to OPEC production growth. In recent months, however, the production has declined. "Iranian production could decline further if sanctions are strictly enforced", says Shah.

Iranian exports to Japan and India are already declining. For now, however, Shah expects Chinese authorities to largely ignore U.S. sanctions. However, China, as the largest importer of Iranian oil, could also see itself forced to seal off the country. "A trade deal with the U.S. could include sanctions compliance as a precondition", concludes the Director Research. Even if there were no trade agreement, the U.S. sphere of influence would be large. Sinopec a Chinese state oil refiner has reportedly reduced Iranian imports under pressure from the U.S. "To make the situation worse, Iran could block the transport route through the Strait of Hormuz, which would further complicate global oil supply", fears Shah.

Growth is limited by infrastructure
Although OPEC's course of action is difficult to predict, he doubts the group will return to a state without quotas, as it did between 2014 and 2016. None of the member countries wanted a situation like the one in 2014, when the drop in oil prices was so severe that it threatened the economic and financial health of OPEC countries. Being a bystander to the situation in Venezuela is painful enough, he says.

The bulk of global supply growth is in U.S. tight oil, Shah says. But also with this source there are limits to growth, it said. Infrastructure would have to grow in step with the growth of oil production. "The deep discount that WTI Midland is giving to WTI Cushing shows that there is an oversupply of oil in the producing regions, but it is not getting to the right places fast enough", Shah explains. Limited infrastructure could slow the pace at which U.S. shale oil production can help meet global oil demand.

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