While both the ICE Brent and NYMEX crude contracts are currently well established in a backwardated structure, moving forward both contracts face changes that should see a return of WTI into contango and a flattening of the Brent curve, Bank of America Merrill Lynch analysts said Friday.
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"We broadly maintain our view that the Brent crude oil futures market will remain in structural backwardation for some time to come, but some things have changed," the BofA ML analysts said in their Global Energy Weekly note.
"The basic argument that supports our term structure view has three elements, which are common to most commodity markets: supply, demand, and inventories."
In this regard, the BofA ML analysts said OECD oil and petroleum product inventory levels outside the US remained exceptionally low and require considerable time to rebuild; Brent prices below $100/b would likely elicit a strong demand response, allowing for a rapid absorption of any surplus; and the long-term cost of oil extraction remains in the $70-90/b bracket, a range that allows for investment in Canadian sands and US shale.
"Looking forward, we believe Brent backwardation will likely persist until OECD crude oil and petroleum stocks outside North America start to build," the BofA ML analysts said, noting stocks remained "well below" the 1.6 billion barrels held prior to the outbreak of the Libyan civil war.
"Importantly, if we assume 100 million barrels of oil are needed to normalize oil inventories outside the US, simple math suggest that we would need about a 300,000 barrel a day global surplus accruing over the course of a year to do so. Moreover, newly found spare storage capacity also greatly diminishes the chances of 'storage containment' issues in oil," the analysts said."
"So while Brent is unlikely to move into contango on a more permanent basis for the foreseeable future, the term structure of the market could well continue to flatten. After all, cost inflation is rampant all around the world, lending support to a move higher in longer-dated prices."
WTI TO SHIFT INTO CONTANGO IN 2H14
In contrast to the Brent contract, however, the BofA ML analysts said they expect a significant shift in the term structure for NYMEX crude, with the WTI backwardation unlikely to hold in the second half of this year.
"First and foremost, WTI backwardation seems extreme over the next 18 months, averaging $0.71/b per month from July 2014 to January 2016," the BofA ML analysts said, noting Brent backwardation over this period had average a smaller $0.46/b per month.
"In fact, the strong historical relationship between time-spreads and inventory levels at Cushing seems to have broken down pretty badly in recent years... crude oil prices at Cushing are no longer heavily driven by Brent crude oil price dynamics but instead are much more of a function of regional US grades markets," the BofA ML analysts said.
As such, they postulated the ongoing US production growth -- which started the year at 8.1 million b/d and was expected to reach 8.7 million b/d during the fourth quarter -- could ultimately result in higher inventories at Cushing, pushing the price back down.
In addition, they said the fact refineries were currently operating at their "highest seasonal utilization rates ever" meant their was "little margin for error" as the "system became increasingly overstretched" and improving storage levels the most likely outcome.
"Of course, the extreme backwardation at Cushing does not encourage any barrels to go into storage for now, but refinery maintenance season is just around the corner," the BofA ML analysts said.
"For this reason, even a modest surplus at the Oklahoma pricing point in 2H14 could result in an abrupt shift in the term structure of the WTI market. Given this backdrop, we see a risk of the WTI market moving into contango and maintain our view that WTI crude oil prices will head down to $94/b in the second half of the year."