Brent curve collapse in animation02 Feb, 2015
The Brent crude forward curve had a wild ride across 2008 and 2009. The commodity supercycle peak dragged spot crude towards 150 $/bbl, with forward prices following almost in parallel. Then the financial crisis saw spot prices crash and a deep contango open up along the curve. But since 2010, crude prices have moved in a tighter range accompanied by a relatively flat and stable forward curve. That is until Q4 2014.
The wild ride is back again. As the crude market has taken on board the reality of shorter term oversupply, spot prices have slumped in a similar fashion to 2008. A steep contango has again opened up along the curve reflecting a pronounced near term supply glut.
Last week we set out two important benchmarks that are influencing crude price behaviour via the marginal cost dynamics of US shale oil production:
- Spot prices may need to breach the SRMC of US shale (~40 $/bbl) to curtail production and stabilise the market.
- The curve may need to sit below the LRMC of US shale (70-80 $/bbl) to curtail investment in new US shale wells.
In today’s article we use an animation of the evolution of the Brent forward curve to illustrate how these benchmarks relate to spot vs curve behaviour. We also look at a third important benchmark driving oil curve dynamics: the contango driven physical storage arbitrage.
Brent in animation
Chart 1 shows a monthly time step animation of the evolution of the front 5 years of the Brent curve since 2008 (note the animation may not work in some older web browsers). This follows on from a similar animated analysis we did previously of UK NBP gas curve evolution.
Chart 1: Evolution of Brent crude spot and forward prices
Source: Timera Energy (based on ICE Brent Futures settlement prices)
The chart illustrates some interesting characteristics of crude curve behaviour:
- 2008-09: A period of major market transition with the commodity supercycle peak followed by the financial crisis crash and then a relatively sharp recovery. There was a strong parallel curve shift during the move up towards 150 $/bbl. This then gave way to a spot price slump to 40 $/bbl. However the tail of the curve held up at around 70 $/bbl (similar to the current Brent curve).
- 2010-14: Both spot prices and the curve recovered into 2010 as the demand shock from the financial crisis eased. Across this period crude moved in a tighter $90-120 range. The tail of the curve was anchored between $90-100 (which led to curve backwardation in periods of tighter spot prices). A market consensus developed across this period that there was an $80-90 floor in crude prices driven by LRMC of unconventional oil production.
- Q4 2014+: A strong market consensus rarely bodes well for price stability. The spot and curve price decline since Q4 2014 has so far followed a similar path to the 2008 slump. However the sharp recovery bounce seen in 2008 is unlikely to be repeated this time given the time required for supply side response to impact prices, as we described last week. As in 2008, a pronounced curve contango has again opened up.
Contago is back
Physical storage arbitrage is an important driver of crude curve dynamics. Curve contango means that oil can be bought at today’s spot price, stored in tanks or on anchored vessels and sold forward at higher prices. The contango price spread is locked in subject to delivery of the stored oil. A recent pickup in interest for US storage capacity and the chartering of tankers for floating storage plays illustrates the market reaction to the widening crude curve contango.
It is interesting to contrast physical arbitrage in the crude market with the LNG market. While there are genuine arbitrage opportunities available to the owners of seasonal gas storage capacity, the LNG market is more complicated. Much pain has been suffered over the last year on attempted intertemporal LNG price spread plays. A number of portfolio players purchased what appeared to be cheap LNG cargoes last summer (around 10-11 $/mmbtu) with a view to selling them into higher Asian winter prices. But the buyers retained seasonal price spread risk, given an inability to sell the cargoes forward (because of liquidity constraints). This has left buyers exposed as LNG spot prices have now plunged well below the price levels from last summer (currently trading around 7 $/mmbtu).
During the 2008 crude price slump, the 12 month contango opened up to 20 $/bbl and storage arbitrage provided a key source of spot price support. The current Brent and WTI curve 12 month contangos are ranging around the 10 $/bbl mark. Not yet as pronounced as 2008, but still presenting an attractive arbitrage opportunity subject to storage capacity access. As the fallout from the current decline in oil prices continues, storage arbitrage will act as an important force supporting spot prices and pulling down forward prices.
Crude impact on gas pricing
This article concludes our three part series on crude pricing dynamics. While we have explored forward curve dynamics in today’s article it is spot oil prices that have the most important impact on gas and LNG prices. European long term gas contract prices are predominantly linked to oil product spot prices (which trade at a basis to spot crude), typically with a six month time lag. Asian LNG contracts are indexed to crude, often with a shorter time lag.
So it is possible to predict today within a reasonable margin of error the level of European and Asian gas contract prices coming out of spring and into summer. And those levels are substantially below current contract price levels. As a result there is going to be heavy downward pressure on European hub prices from cheaper pipeline contract gas and an increased flow of cheap flexible LNG back into Europe. Add the potential for rapid withdrawal from well stocked gas storage facilities and there may be a wild ride to follow in the European gas market in 2015, a theme we will return to in subsequent articles over the next few months.