As a trader cited by Reuters said “Brent’s flattening contango since January comes as many producers want to cash in immediately on recent price rises. They’ve been heavily selling 2017/2018 and beyond, and it shows that they don’t quite trust the higher spot prices yet.”

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He further explained that “This means that even the producers don’t really expecting a strong price rally until well into 2017 or later,” and Reuters added that the companies that explore for oil and pump it out of the ground have been locking in price gains by selling off future output as a financial hedge, pulling down prices for those contracts.

We will have more to say on the topic of producer oil hedging, and specifically how they do it, in a subsequent post but for now it is worth noting that since last week the contango has flattened further as the spot price rose while the long end declined, suggesting even more hedging has taken place in recent days.

 

One analyst who notes this trend, is Saxo Bank’s Ole Hansen who observes that the rally in oil prices to 3 month highs has coincided with narrowing contangos that alter storage economics and threaten oil flooding back into the market. The reason for this is that storing oil, either on the ground or on ships, becomes less profitable the greater the flattening in the contango.

“As we’ve seen both Brent and WTI climb above $40 we have also seen the contango collapse.”

As examples, Bloomberg observes the WTI M1-M2 contango narrowing to earlier $1.25 today, the tightest since Jan. 22; while the WTI M1-M3 contango has reaches just $2.21, or the smallest in two months.

The long-end has seen even sharper moves with the WTI M1-M13 contango contracting 86c to close at $4.97 yesterday, compared to $6.64 Tuesday.

Hansen also added what we warned about two weeks ago, namely that $40-plus oil “could also stop the production slowdown, which with the weakness of the dollar has been the main driver for oil prices,” posing another downside risk.

Hansen adds that “If we rally too high the contango will collapse further and the storage economics reduce – that could trigger storage in tanks to be reduced,” increasing supply and putting pressure back on crude prices. Recall that several producers made it clear that once oil rises above $40, the pumping will resume, although not all. Today Bank of America laid out a useful chart showing the incremental production sensitivity, with the delta between $40 and $50 being critical.

But back to the contango, about which Hansen warned that “if we rally too high the contango will collapse further and the storage economics reduce – that could trigger storage in tanks to be reduced,” increasing supply and putting pressure back on crude prices.”

What does this mean? One example is the tanker Distya Akula shown below.

 

As Bloomberg writes, the Akula is a 1 million bbl-carrying Suezmax, currently loaded with cargo, which is not only not going anywhere, but which has been waiting near the southern entrance of Egypt’s Suez Canal to 22 days.

The ship, with cargo on board, left Kharg Island, Iran’s biggest crude-export terminal, in early February, and reached its present location on Feb. 24 or one month ago.  Elektrans, the ship’s joint owner, said Wednesday that the tanker’s cargo is probably destined for buyer in Mediterraneanm but didn’t know which because vessel is on long-term charter to another company.

In other words, the ship is hoping that prices rebound high enough to where a buyer will be found. For now, there is no buyer, and the bigger the contango drop, the less profitable such storage will be in the future, forcing companies to unload tanker cargos and to flood the market with tens of millions of currently “inert” inventory.

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