Iran masks signs of Brent weakness

The headline price for Brent crude, the global benchmark for high quality crude oil, of roughly $110 a barrel points to a strong market amid the crisis in the Middle East.

But a closer look at the structure of the Brent oil market reveals growing signs of weakness which the standoff between Iran and the west is masking. If anything, the physical and financial Brent market suggest that oil prices could fall, not rise.

The most crucial signal of weakness is an abrupt change in the so-called shape of the oil curve – the price difference between contracts for immediate delivery and those with a longer delivery date.

For the last year, the curve has shown a downward slope, known in the industry as “backwardation”, with contracts for immediate delivery trading at a significant premium to forward contracts. The backwardation was particularly extreme last October when the difference between the price of the Brent contract for immediate delivery and that of the following month escalated to nearly $3 per barrel due to lack of supplies from Libya.

But since then the backwardation has melted away. On Friday, the price difference between the February and March contracts was just nine cents. In the physical Brent crude market, several indicators such as the so-called contracts-for-difference – a type of derivative product akin to spread betting – also suggest a shift away from backwardation.

Oil traders in London and Geneva believe that if not for the tension around Iran the shape of the Brent curve would be already upwards, a condition known as “contango”. Some oil traders and analysts believe that Brent oil will shift into contango by the end of the quarter unless the situation in the Middle East deteriorates further in the short term.

The shift in the Brent curve is due to both supply – with a faster-than-expected recovery in Libyan production – and demand – with weak consumption due to warm weather in most of Europe and the US, and closure of refineries on both sides of the Atlantic.

On the demand side, Petroplus, Europe’s largest independent refiner, has shut down three plants with a combined processing capacity of 330,000 barrels a day, and two others are running at low rates. Moreover, Sunoco, the US-based refiner, and ConocoPhillips have closed plants on the US east coast with a combined capacity of 360,000 b/d. All the plants were processing a relatively large chunk of Brent-like crude streams.

Also on the demand side, the price curve of US heating oil and European gasoil has already flipped into contango, suggesting that warm temperatures are denting energy consumption.

On the supply side, Libyan oil is coming back. Tripoli claims that production is now more than 1m b/d. The true level, traders say, is probably a little lower – around 750,000-800,000 b/d. Yet the surge in output is sizeable from just zero in early October.

However, the weakness that the shallow backwardation in Brent crude is broadcasting should be treated with caution. If the crisis in the Middle East deteriorates, the strong backwardation of last year could return with a vengeance.

Source: The Financial Times