Physical crude market a tenuous anchor for crude futures prices

“Like pushing a rock up a hill”

That’s how some trader’s view the current disconnect between the physical market for crude oil and the futures market with speculators pushing futures prices higher while the physical market remains moribund.

Before continuing it’s important to make the distinction between the physical market for crude and the crude futures market.

Physical (also known as cash) market prices are determined by the supply and demand for physical crude. Here traders buy oil from the producer and sell it to the refiner, for immediate delivery. Physical buyers and sellers have a direct pulse on the market and may feel immediately when it is well supplied, or not.

Futures prices on the other hand are determined by the supply and demand for crude futures positions. Futures markets provide a means for trading the probability of where crude prices will be at certain points in the future; this allows physical market participants a means by which they can hedge their position and so reduce risk.

The physical crude market tends to show weakness (i.e. too much crude swashing about) when the premium for the best crude grades weaken against the benchmark Brent. One of the most favoured grades in Europe is Azeri Light due to its high quality.

Over the past couple of months physical crude traders have noted the weak premiums for Azeri Light versus Brent as other cargoes, particularly from West Africa compete to supply crude into an already oversupplied Atlantic Basin market.

This apparent disconnect between the futures and the physical market appears eerily similar to mid-2014, just prior to crude prices collapsing. So is the current weakness in the physical crude market a precursor to an imminent weakening in crude futures prices?

Don’t bet on it – at least not based solely because of what the physical market is doing.

While the physical fundamentals of supply and demand prevail eventually, the physical market may not always be able to anchor futures prices for days, months or even years.

If commodity futures prices rise too much, perhaps as a result of speculative interest as there is now physical supplies will start to be delivered against short positions (a manufacturer looking to hedge its inventory of raw materials might have this kind of position).

In practice, there is never enough physical material readily available to deliver against all the short positions, so rising futures prices can only be offset by buying back crude futures contracts rather than making physical delivery. It takes time to divert and accumulate sufficient physical crude supplies to meet a rise in futures prices driven by speculative rather than fundamental factors.

To get an idea of the extent to which this process is occurring take a to look at the net contract short position for commercial hedgers from the US CFTC weekly Commitments of Traders report. Back in mid-2014 the net short position amongst commercial hedgers (actual producers and users of crude) rose to around 500,000, a record level. This position has since fallen to just over 300,000, but it is still high on an historical basis.

Chart
Source: Barchart.com

As we know from the months leading up to the oil market crash that began in the middle of 2014, oil futures prices can divorce themselves from the physical fundamentals for a long time.

The price of crude, as with any other commodity is only worth what someone is prepared to pay for it. The markets perception of scarcity in mid-2015 is such that participants in crude futures markets are now willing to pay less than half what they were paying just one year ago.

While theory suggests crude futures markets are anchored to the physical market as contracts expire, in reality the link is a lot more tenuous. As with the myth of Sistyphus the rock will eventually start to roll back. Timing when that will take place and the catalyst involved is a whole different matter.

First published at www.oilprice.com

Goldman Sachs forecasts $55 per barrel oil in 2020

Goldman Sachs now expect Brent crude prices to remain between $58-$65 per barrel during 2015-19 before falling to $55 per barrel by 2020.

Global oil markets are likely to face three supply drivers over the medium to long term: 1) Continued rise in US shale productivity; 2) sustained OPEC growth (Iraq/Saudi Arabia); and 3) new projects, which would add to deflationary pressures, in our view.

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The bank had said that the recent rally in crude futures is premature given that the market remains “well oversupplied”, despite the perception of improving fundamentals.

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Bumper harvests to curb El Niño impact on food prices

Commodity investors, producers and consumers are bracing themselves for more extreme weather this year after Australia’s meteorological agency confirmed the return of the weather phenomenon known as El Niño. However, record grain production and high stock levels is likely to mean the impact on agricultural prices will be much more muted.

To recap El Niño – caused by an increase in water temperatures in the tropical Pacific – recurs every 3-5 years and typically results in drier conditions across Australia, other south east Asia, Brazil and West Africa but wetter conditions around the southern US states and coastal areas of South America.

The agricultural crops most at risk of supply disruption from El Niño include wheat (particularly Australia), rice, soybeans (mainly India), palm oil and corn (most at risk is China) with those producers based in Asia most at risk of being negatively impactedHowever, grain production in other parts of the world might actually improve (report) with it creating cooler conditions in the US, helping to raise yields, although by no means guaranteed.

At first sight the strength of the El Niño doesnt appear to be correlated with higher volatility (the first chart below). However if you pick out the period in which agricultural stocks were low (particularly the 1970’s and the 2000’s) the impact becomes much more prominent.

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