Funds prepare $2 billion oil market play as supply tightens

EghtesadOnline: Passive investment funds are poised to shift an estimated $2 billion from far-term to near-term crude futures over the next week, anticipating an energy market rally as a historic OPEC output cut slashes supply.

News ID: ۷۷۴۲۰۷

27 February 2017

The switch may foreshadow the end of a global oil glut that built up during a two-year price war.

On Friday - for the first time in six years - a rule in one of the most popular commodity market indices was triggered, requiring funds tracking the index to sell Brent crude futures contracts for December LCOZ7 and to buy contracts for June LCOM7.

According to Reuters, the S&P GSCI Enhanced Commodity Index rule aims to ensure that investors are positioned to cash in when oil market fundamentals change - in this case, when supply becomes so tight that the current price of oil becomes higher than the price of oil for delivery many months or years into the future. That structure is called backwardation.

When markets are oversupplied, the opposite is true: It is cheaper to buy crude now than to buy it for delivery later. That structure is called contango.

An S&P bulletin late Friday confirmed the rule had been triggered for Brent contracts. It stipulates that the funds must bring their money forward if the second and third month contract settles at a difference of less than 0.5 percent on the third to the last day of any given trading month.

On Friday, the Brent May contract LCOK7 price settled at $56.31 a barrel, while the June LCOM7 price settled at $56.55 a barrel. That would make the difference about 0.4 percent.

The threshold was not breached for West Texas Intermediate crude.

Investors will need to start the shift on March 1 and complete it over the next five business days, moving 20 percent of their money each day. Two traders with knowledge of the indices told Reuters that they estimated that rule impacts between 35,000 and 45,000 Brent contracts.

Each contract represents 1,000 barrels. So if those predictions prove true, about 40 million barrels - worth about $2 billion - will change hands.

"This is just another reason to be very bullish" about oil prices, said one trader involved with the deals, who spoke on condition of anonymity.

OPEC IMPACT

When the Organization of the Petroleum Exporting Countries (OPEC) and some non-OPEC producers agreed in November to cut output, they wanted to stem a flood of supply that had left the contango so deep that traders found it profitable to buy crude and store it for sale later.

That dynamic pushed worldwide inventories to record levels and helped drive oil prices to multi-year lows.

OPEC's output cut, however, has tightened supply and narrowed contango, prompting traders from the United States to Asia to start selling oil from more expensive storage facilities because the contango is no longer enough for them to make a profit by holding oil.

If contango narrows further, tens of millions more barrels could flood out of storage.

That could put downward pressure on prices in the short term, but the move to unleash stored oil is viewed by analysts as a first step toward rebalancing global markets after a period of oversupply.

The fast flow of capital into front-month contracts will make it uneconomical for traders to store physical barrels, said Michael Tran, director of energy strategy at RBC Capital Markets.

"The unintended consequence" of the trading shift, he added, "is helping OPEC in its objective to draw barrels from storage."

It's not clear exactly how much money is managed by firms that benchmark off the indices, but exchange-traded funds linked to them, such as the iShares S&P GSCI Commodity-Indexed Trust, have more than $1.1 billion in assets, according to ETF Securities LLC.

STORAGE PLAY THREATENED

Since the OPEC output cut, the spread between the front month and second month Brent contracts LCOc1-LCOc2 has tightened to as little as 5 cents from 79 cents. June and December contracts LCOM7-Z7 traded near parity on Friday.

To make money by holding crude, the spread between oil prices for future months needs to be wide enough to cover the cost of leasing tank space and borrowing the money to buy the fuel to fill it.

For the last two years, U.S. traders have rushed to that opportunity as those price spreads widened. Now, they may be forced to rush out of it.

"When there's a shortage, there's no value to storage. So, there's a premium put on having the oil right now," said Jodie Gunzberg, global head of commodities and real assets at S&P Dow Jones Indices. "That's where you want to be sitting up front in the near contract."