Something’s got to give in the oil market

Introduction
Crude oil time-spreads have completely dislocated from inventories. Historically, such dislocations have proved to be short lived. We expect that either spot prices will sell-off again or the back end of the curve will move sharply higher. As per our proprietary gold pricing model, the latter would be very supportive for gold prices.
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Oil prices have rallied sharply from their January lows. At the time of writing, ICE Brent and NYMEX WTI front month prices are up 64% and 71%, respectively. While the media and commodity analysts have focused mainly on the recent rally in the spot price, in our view the more interesting development was in the curve structure. The entire move up happened in the front end of the curve. Longer-dated oil prices have remain almost unchanged. This has led to a sharp rally in crude oil time-spreads; 1-60 month ICE Brent time-spreads moved from -USD20.64/bbl in January to -USD8.82/bbl at the time of writing. In commodity markets, the shape of the forward curve is primarily a function of inventories. In our view, the inventory time-spread mechanism is the strongest and most robust relationship in commodities. Any divergence presents a physical storage arbitrage opportunity which will inevitably be exploited quickly by the market. Hence any deviation between spreads and inventories is typically very short lived. And this is where the oil market is now completely out of balance in our view. The rally in front month prices combined with the lack of any price action in the back has pushed time-spreads roughly 20-30% above the levels they should normally be. This is the largest discrepancy between time-spreads and inventories we have witnessed over the entire time-horizon in which 5-year forward prices are available. In our view, either near-dated crude oil prices will sell off again or longer dated prices appreciate.
The two possible outcomes described above point to an interesting opportunity in gold. Gold prices are driven by longer-dated energy prices while changes in oil spot prices have little to no effect. Hence a renewed sell-off in the front end of the curve would in our view have little impact on the gold price. A move higher in the back end however would be positive for gold prices. We estimate that in order for time-spreads to move back in line with inventories, either front end prices have to sell off by USD10-15/bbl or the back end has to appreciate USD15-20/bbl. Given the parameters of our gold pricing model, the latter would imply roughly a USD100-150/oz rise in the gold price.
Oil prices have rallied sharply from their January lows. At the time of writing, ICE Brent and NYMEX WTI front month prices are up 64% and 71%, respectively. Interestingly, the whole price rally took place even as petroleum inventories continued to rise. Total global commercial petroleum stocks are now at an all-time high, up 285 million barrels year-over year and 550 million barrels above the 5-year average (see Figure 1).

This post was published at GoldMoney on MAY 03, 2016.