Brent crude oil grabbed all the attention after spot prices hit US$80 a barrel last week. And yet, almost unnoticed, a perhaps more important rally has occurred in the obscure world of forward prices, with some investors betting the “lower for longer” price mantra is all but over.
The five-year Brent forward price, which has been largely anchored in a tight US$55-to-US$60 a barrel range for the past year and a half, has jumped over the last month, outpacing the gains in spot prices. It closed at US$63.50 on Friday.
“For the first time since December 2015, the back end of the curve has been leading the complex higher,” said Yasser Elguindi, a market strategist at Energy Aspects Ltd. in New York. “It seems that the investor community is finally calling into question the ‘lower for longer’ thesis.”
Bob Dudley, the chief executive of oil giant BP Plc, coined the “lower for longer” mantra in early 2015, warning of a protracted period of cheap crude. He later clarified that he meant “lower for longer, but not for ever.”
More to Run
While spot prices fluctuate wildly, often driven by geopolitics such as U.S. sanctions on Iran, the five-year forward usually trades in a narrower range, anchored by longer views about future supply and demand.
Over the past three years, long-dated prices had been weighed down by the belief the growth in U.S. shale production, combined with the adoption of electric vehicles, would keep prices under control.
Investors are now questioning that hypothesis, pushing up forward prices. Over the past month, Brent five-year forward futures gained 11 per cent, compared with a 6.8 per cent increase in futures for immediate delivery.
“We think there is more to go for the longer date contracts,” SEB chief commodities analyst Bjarne Schieldrop said. “This will send very positive price signals into the whole oil space with higher confidence, optimism and evaluations as a likely consequence.”
Demand Surprise
There are several reasons for the sudden surge in forward prices. Oil consumption is expanding much faster than anticipated, adding growth in two years that would normally take three. At the same, oil investment has dropped significantly over the past three years, particularly in projects that take longer to develop such as ultra-deep water offshore, raising doubts about future supply growth despite the gains in Texas, North Dakota and other U.S. shale regions.
Moreover, a change in marine fuel oil specifications by 2020, which should increase significantly the demand for diesel-like refined products, is further reinforcing the belief among some investors that the oil market will be tighter than expected in the future.
The buying has sparked a rally in later-dated contracts in the past week-and-a-half that traders say is even more impressive than Brent’s march past US$80. The grade for delivery in December 2022 has surged 10 per cent since to beginning of the month to nearly US$64 a barrel. The December 2023 has risen above US$63 a barrel.
The higher forward prices are also catching the attention of some equity investors as they usually use longer-dated prices to value energy companies.
Despite the rally in forward prices, oil exploration and production companies, which typically hedge their production further out in the curve, have remained reticent to buy in, according to John Saucer, vice president of research and analysis at Mobius Risk Group in Houston. Oil producer selling typically puts pressure on the back of the curve.
Investors aren’t just buying outright long-dated futures, but also betting through the options market on much higher prices in the early part of next decade by buying call options. The contracts, which give investors the right to buy at a predetermined price, are popular among commodities hedge funds.
Call options that would profit from Brent rising to US$130 a barrel by the end of 2020 traded 2,000 times on Friday. That follows a similar amount of US$100 contracts for the same period trading over the past two weeks.
“The war premium at the front of the market masked the fact that future significant demand increases and questions over supply levels equate to higher prices down the line,” said Richard Fullarton, founder of commodity focused hedge fund, Matilda Capital Management Ltd.
Bloomberg.com
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