The global benchmark for oil Brent is currently trading near multi-year highs at around $75 per barrel amid concerns over global supply risks.
Beneath this headline number though certain dynamics are at play in the market which are worth understanding.
WHAT DOES BACKWARDATION MEAN?
The first is that Brent is in backwardation. Like the majority of commodities, oil is traded in futures contracts. The purchase or sale of a barrel of oil is agreed at a fixed price for delivery on a specified date - typically either one month, three months or six months out.
This facilitates the buying and selling of a commodity without anyone having to take physical delivery of it - in fact only a tiny fraction of these contracts are settled through deliveries. Contracts are instead 'rolled over' to the next month.
Contango refers to the market condition whereby the price of a futures contract in a commodity is trading above the spot price. The resulting futures ‘curve’ would be upward-sloping with prices for dates further in the future trading at ever higher levels.
Backwardation describes the reverse - where futures are trading below the spot price - often because of short-term tightness in the underlying market. Arguably contango is a more natural state as it reflects costs of ownership such as storage and insurance.
WHAT IMPLICATIONS DOES THIS HAVE?
This has an implication for investors in commodity-based exchange-traded products or ETCs. When an ETC rolls contracts (sells them and buys new ones) in order to avoid taking delivery of the physical product contango sees returns diminished and backwardation sees them enhanced.
The impact of the two conditions is more acute for investors in ETCs because, unlike other passive investors, the providers of these products do not pay a premium every month to cover the cost of the roll and maintain the same position. In effect the ETC is giving up a proportion of its position to cover the cost of the roll.
These types of product are therefore better suited to playing short-term swings in the price of oil than serving as a long-term holding in a diversified portfolio.
The main US yardstick for oil, West Texas Intermediate (WTI), is also in backwardation but this situation has eased thanks to plentiful supply from US shale.
As a result, the spread or difference between WTI and Brent has doubled since the start of March with WTI currently trading at around $69 per barrel.
