Just a reply in relation to a technical point raised.
Backwardation is one thing and traditionally contango is another.
Was not clear enough in my definition.
When using the contango I was of course referring to the relationship that has existed for over 20 years where the forward oil market has been in deep backwardation and the real expectation of traders was the forward prices of oil contracts despite being in backwardation the presumption was the ACTUAL spot price when it got there would be lower than the implied futures price.
In a traditional sense one has falling prices as time goes on, backwardation and the other rising prices as time goes on contango.
The markets and traders had an expectation that the price of say 2010 oil futures contracts would be even lower than the implied price that was US$15- below the spot price when it got there. Whilst in backwardation the real expectation was the current spike was only temporary and prices would fall back to old norms.
In effect you really cannot have a market in backwardation without some expectation of the forward prices actually being above where the spot price will be when it gets there. There would be no reason to have a forward curve in backwardation without strong expectations of a contango existing. Why would you price a curve cheaper as time went on without this expectation ? The steeper the curve as with oil the stronger the expectation of falling spot prices as time goes forward. Whilst a textbook may say one is the opposite of the other, the steeper the backwardation the stronger the contango implied relationship is. In reality it is impossible to have one without the other. Especially true of markets that sit either in contango or backwardation for long periods of time.
For an example, when spot oil was US$55- mid last year the 2010 contract was trading at USD $40- so it was in backwardation. On top of this most of the market seemed to believe when it came to 2010 the actual spot price would be lower than US$35- so in fact the expected real price in 2010 was implied at say USD$30- so in fact the price was a contango, where as the futures price was higher than what in reality was the expected price for 2010.
You are correct of course one is different to the other, however the relationship that has changed and eroded and seems to have turned is twofold. One the discounting of the forward prices or backwardation as we go out the curve has flattened. The difference between spot and the 2010 contract has narrowed from US$15- to US$ 9.80. On top of this the front 2 years of the curve have almost flattened. Now conversely the implied contango relationship has also changed. If the curve flattens and on top of this the price goes up, the relationship at the other end changes. In other words the pricing of the 2010 contract with a flatter curve implies a much higher forward price expectation. In other words the price of the where 2010 oil has gone up and dramatically.
Contango in the normal sense one would expect the spot price to be say US$40- and the 1 year price to be US$50 and the 2 year price to be US$55- and so on. As time goes on the price rises.
With the oil market since the backwardation curve was so steep, having the 2010 futures at US$40- when the spot is at US$55- actually implied the expected when we got to 2010 the spot price would be well below the US$40- level, hence my use of the term contango. The steep nature of the curve implied that oil was expected to fall BELOW the implied futures price by the time it got there.
In a traditional sense you are correct, but for a long time the spike in the spot prices was seen as just that, a temporary blip and the spot price over time would retreat .... this relationship is the key change I am trying to convey.
Oil forward markets would not price 2010 oil at USD$40- when the spot was at US$55- if it did not expect the price to be there or below there by 2010.
"Backwardation" Glossary
Definition: Backwardation is a phenomenon of an inverted market. To understand backwardation, here is an example: In the futures market the price of a contract usually trades above the current/spot price because the owner of the futures contract gains the advantage of holding cash taking delivery. This cash can potentially earn an interest in the interim. Backwardation occurs when the current/spot price exceeds the futures price.
Contango When the futures price is above the expected future spot price. Consequently, the price will decline to the spot price before the delivery date. This is the opposite of backwardation.
In a traditional sense you are absolutely correct.
However the rise in the oil market over the last 18 months was viewed by the market as a blip. The longer out you went the deeper the backwardation or discounting to the spot price. Normally I would agree with the strict relationship between the two, one has rising prices the further out you go and the other falling. But when looking at the forward implied actual price when working out a swap the real expectation was in fact contango despite the prices actually appearing in backwardation. The market was viewing the oil spike as temporary and in fact expected the spot prices as time went on to fall and looking at the curve back in 2004 to fall heavily.
Because of the steepness of the curve the futures prices were actually above the expected future spot price being implied by the market at the time. Whilst the whole strip of futures may be in backwardation, when the shape of the curve changes some contracts in a strip will change and ergo the future implied expectation of price.
Confused .... good .... Two simple thoughts. Market has changed since the fall to USD $40- for the spot late last year. One the discount of backwardation of contracts has contracted and the curve has flattened. This implies higher expectations for forward prices. Looking at the very long end of the curve, the deep discount of USD$15- has been eroded by 33% making the future expectations of prices higher. When looking at the spot price, it sits basically near its old recent highs. When looking at the 2010 price it now sits US$5- higher.
The real expectation during 2004 was the spot price would come off and back below the implied forward prices as time went on. In fact the expectation was by 2010 the spot price would be below the US$40- price implied at the time. Now the opposite is happening. Market is still in backwardation, but to a much lesser extent, as a result the expectation of the 2010 future price has gone up. In fact the 2005 curve by strict definition is in contango for some contracts. The June 2005 contract is above the current spot contract.
Not sure I have explained my position well enough.
The relationship is changing and has changed in a dramatic way in the last 3 months.
I expect futher changes as time goes on. At some stage I expect the curve will go positive the whole way out as supply and demand forces change the whole equation.
My own belief is that we are seeing a basic fundamental change to the whole structure of the forward pricing of oil which will continue as time goes on.
The presumed assumption that oil will go down is disappearing. In fact that seems to have almost totally disappeared for 2005 and to some extent 2006.
Clear as mud ? Sorry but concept is complicated.
WPL Price at posting:
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