Gadfly

OPEC's Steep Learning Curve

Bending oil futures to the cartel's will is easier said than done.
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Traders work in the crude oil futures pit, left, and crude oil options pit, right of the New York Mercantile Exchange in New York.

Photographer: Jin Lee/BLOOMBERG NEWS

The fact that OPEC's dreams revolve around something that goes by the ungainly name of "backwardation" isn't even the dreariest of the would-be cartel's problems. It's the possibility that even this dream's realization won't be all it's cracked up to be.

In a backwardated commodity market, longer-dated futures prices are lower than the cash price, so the futures curve slopes downward. Here's an example from a few years ago so you can see what this looks like (using Brent crude oil futures):

That example is so old because, for most of the time since then, the curve has been flipped to the opposite shape, sloping upward, or in "contango." (Who says jargon can't be fun?) This is not good for OPEC.

That's because a market in contango usually results from excess supply depressing cash prices relative to those further out. Since OPEC members earn their revenue from the cash market, this leaves them out of pocket.

The contango also reflects excess barrels going into storage. If the upward slope is steep enough, traders can buy physical crude and lock in a higher price further out, netting a profit after storage and financing costs. Meanwhile -- and, again, if futures prices a year or so out are high enough -- shale producers can hedge tomorrow's barrels to help fund today's.

Which is how you end up with an oil glut and OPEC roping in everyone from Russia to South Sudan in an effort to drain the tanks.

Just lately, there are signs this may be having an impact. A run of outflows from U.S. oil inventories and possibly some buying ahead of further turmoil in Venezuela have sent the Brent futures curve into backwardation. Well, sort of:

You can almost visualize OPEC officials in Vienna high-fiving and shouting "It's working! It's working!"

Except this is only true up to a point. Because for backwardation to really do the trick, forward prices need to drop to a level that throws sand in the gears of the shale machine. Judging from the messages coming out of second-quarter earnings, while sub-$50 oil is leading some E&P firms to "tap the brakes" on spending, the real pain threshold appears to be lower than where we are now; maybe sub-$45 or sub-$40.

As it stands, even if higher cash prices put some extra change in OPEC's pockets, it doesn't mean E&P firms have necessarily lost the crucial ability to hedge their future production at adequate prices. Looking at the futures curve today, a month ago and just before OPEC and associates announced supply cuts last November, it's clear that near-term futures (and cash) prices have moved around a lot, but forward prices have remained pretty stable:

It is possible that OPEC and its associates could cut supply to a level that sends cash prices higher and simultaneously signals it will increase production further out, in order to send futures prices further out down enough to prevent shale producers from hedging. But expecting such balletic market management even in Vienna's refined environs is unrealistic, as Saudi Arabia's resort to gimmicks like cutting exports in August attests.

There are simply too many moving parts in what has become a more competitive global oil market. Say, for example, cash prices keep rising. As energy economist Phil Verleger pointed out in a recent report, this would encourage investors to buy longer-dated futures in expectation they would rise in price as they neared maturity -- which in turn would provide E&P companies further opportunities to hedge.

Moreover, with Saudi Arabia planning on selling shares in its national oil company next year, investors and E&P companies have good reason to expect the country won't try to engineer an outright collapse in forward oil prices, whatever it says to the contrary.

The fundamental issue is that shale producers -- and, increasingly, other parts of the industry -- are learning to live with oil prices that start with a 4 or a 5, whereas many OPEC members don't look capable of doing so. That remains true regardless of how the futures curve shapes up.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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