The market is always showing early warning signs as to which direction it is heading into. The forward curve or term structure of the markets is one of those signals that offer a considerable amount of information as to the market sentiment and the potential direction of the market.
The term forward curve refers to a series of consecutive month’s prices for future delivery of an asset – like WTI or any of the main energy products traded on NYMEX. The NYMEX futures market (as well as the cleared over the counter markets) trade many months well into the future for the main oil commodities – WTI, Brent, HO, RBOB and Nat Gas.
Let’s start by discussing what the forward curve is and is not. The forward curve is not a price prediction model. The forward curve, or all of the forward months, trade all day long in dynamic patterns. A price along the forward curve does not necessarily mean that will be the price of oil when the market gets to that point in time. Rather it represents what both buyers and sellers agree (via a transaction) that the forward price of oil is that instant in time and subject to change in the next instant.
Thus the term structure or forward curve of the market is in essence a model showing how future months are valued relative to the nearby or spot contract month given all of the available market information at any instant in time. From an activity viewpoint, the majority of the activity, and thus liquidity, tends to be in the front to the forward curve with the far back months mostly following.
The shape of the forward curve is important to energy market participants. The forward curve or term structure of the forward market is looking at prices from many different maturities as they extend into the future. The curve trades in three different structures depending on market conditions. The least common configuration is a flat forward curve or when all prices going forward basically are mostly equal to each other. This represents a market that has no conviction with buyers and sellers indifferent as to the direction of the market. Rarely does the energy market trade in a flat formation.
I will use the following NYMEX HO forward curve (based on settlement prices for 6/6/14) to point out the two dominant structures that the forward curve generally trades in -backwardation and contango.
Source: NYMEX ULSD Data on 6/6/2014
The front part of the HO forward curve (July, 14 to Jan, 15) shows the curve structure in a contango – sometimes called a carry formation. A contango formation occurs when prices are higher in succeeding delivery months than the nearby or spot months. Generally a contango forms when the market is over-supplied (and/or demand is low). The market does not need all of the oil being produced (in the above case, HO) and the oil over and above what is needed generally winds up in inventory. Thus during periods of contango inventories generally build.
The back end of the above curve is in a backwardation (Jan, 15 through Dec, 15). A backwardation is a structure that suggests the market is undersupplied and/or demand is outstripping supply. In the above example it is the time of the year when demand for heating oil rises as a result of the winter weather or a period when normal supply flows cannot keep up with demand. It is during a period of backwardation in the market that inventories are normally depleted as an additional source of supply to meet demand.
The following forward curve of the NYMEX Nat Gas contract shows a similar pattern to the above HO curve.
Source: NYMEX Natural Gas Data on 6/6/2014
The front end of the curve moves into a mild contango starting with the Oct, 14 contract and into a backwardation during the heart of the winter heating season beginning with the Jan, 15 contract. Both the HO and Nat Gas contracts move into contango and backwardation on a seasonal basis. Both commodities are over produced during the summer season while demand outstrips demand during the winter heating season. The degree of contango and backwardation are very fundamentally driven. If supply strongly outstrips demand the contango will get very wide and vice versa during periods of demand strongly outstripping supply – like during periods of much colder than normal winter weather (similar to the winter of 2013/14 in the US).
The WTI forward curve is less seasonal and primarily dependent on both US domestic and international crude oil supply and demand balances. The WTI forward curve based on 6/6/14 settlement prices is shown below.
Source: NYMEX WTI Data on 6/6/2014
This particular curve is in a backwardation throughout its entire forward period suggesting that demand is outstripping supply. Even though this is the forward curve for a US based crude oil that in early June of 2014 is oversupplied the crude oil market is internationally based. Events around the world insofar as supply and demand, impact WTI as well as the Brent marker crude oil. The world of oil in 2014 is still being impacted by various geopolitical events in several oil producing countries (i.e. Libya, Iran, and Iraq) that has resulted in a reduction in crude oil exports from these countries offsetting the surplus of crude oil that has formed into the US and thus the term structure in a backwardation.
Some of the key takeaways from the forward curves are as follows:
- The shape of the forward curve is primarily driven by fundamentals.
- The fundamentals or the relationship between supply and demand at any point in time will push the term structure into a contango or backwardation.
- When a market is in a backwardation demand is generally outstripping supply and thus prices in the front end of the market will generally be supported and have limited downside until the market moves back in balance.
- On the other end, when a market is in contango supply is outstripping demand and thus prices in the front end of the market will generally be sold into and have a downside bias until the market moves back in balance.
- The fundamentals that drive the shape of the forward curve can be driven by seasonal conditions i.e. winter heating season or by other reasons that impact the supply and demand. Some of these reasons are:
- Geopolitical risk to supply in producing countries.
- Weather related impact to supply i.e. natural disasters like hurricanes.
- Normal operating impact to supply like refinery and producing maintenance schedules.
- Unscheduled downturns in the refining sector resulting in under producing various refined products.
- Economic growth that results in a growth spurt for energy products.
- Above or below normal weather related demand for heating fuels like HO and Nat Gas.
The above is an overview of the term structure of several of the key energy commodities traded on the NYMEX futures market.
Peter Knight Advisor