Large rallies in oil prices have had an unfortunate side effect in recent years. As prices rise, the near-term prices, those for oil-delivery futures contracts in the most immediate months, rise more than longer-dated contracts do. This is often called “backwardation,” or a downward slope of a forward curve. Oil producers, trying to hedge the prices, perceive this backwardation as a discount on future oil prices.
But backwardation is not a penalty. Rather, it has been a matter of fact and something to be expected. As prices rise, especially when they rise by a lot, backwardation has been very common.
The chart above shows a comparison between the strength of an oil-price rally and the degree of downward slope (backwardation) in the forward curve, since January 2014. The chart demonstrates that when prices rise to be $20 higher than the trailing 12-month average, there has been an average premium of $6/Bbl for near-term oil, compared to oil delivered a year later.
How common is backwardation? Since January 2014, a rally of more than $12/Bbl has always come with hefty backwardation. As shown in red, the past two months of curves this year are very near the trend line. This backwardation is normal.
So, instead of lamenting the so-called “discount” that a backwardated curve has, celebrate that prices are up. After all, rallies of this magnitude have reliably brought backwardation with them.
In commodities markets, the shape of the forward curve – upward sloping (contango) or downward sloping (backwardation) – is the result of concentrations of buying and selling. If a particular tenor has more aggressive buyers, that tenor tends to rise more than other tenors do.
When the physical market is undersupplied, there are more buyers than sellers in the prompt month, meaning the first, most immediate contract on the forward curve. In today’s oil market, there is not enough production to satisfy all the demand. Therefore, after all the daily production is sold, there are still buyers looking for oil. (The consumers keep bidding prices higher because they have to buy it out of storage, but that's a topic for another article)
The result is a high concentration of buyers for immediate delivery of oil. During most of July, the demand side would be buying prompt-month (August) oil as they try to procure the oil needed. They keep buying until their planned consumption is satisfied.
This concentration of buyers, in an undersupplied market, causes a rise in near-term prices. Voila. Backwardation.
Therefore, backwardation is more of a premium on near-term supply, not a discount for later delivery. It’s a bullish sign that buyers need more oil right now, not a penalty.