In recent weeks Brent crude oil, the global oil benchmark, has shifted into backwardation – a state when spot prices are higher than prices for futures contracts, creating a downward-sloping curve for futures prices (see chart). This is essentially the opposite of a contango market (which has prevailed since 2014), when near-month futures sell at a discount to those expiring further out.
Implications for the markets
The pivot to backwardation is notable for market participants for three key reasons:
First, the move to backwardation from contango indicates that OPEC’s production quotas are having some success in reducing the overhang of inventory, and thereby supporting a spot price for oil that exceeds the futures price one year out. This gives OPEC an edge from a relative competiveness perspective given that OPEC producers sell almost all of their oil on a spot basis, while U.S. shale producers hedge a significant volume of their production in the futures market.
Second, the shape of the oil curve has historically been one of the best predictors of future returns, so the move to backwardation has significant implications for commodity investors. For example, subsequent four- and 12-week returns for long oil futures positions in backwardated oil markets have averaged 1.3% and 2.9%, respectively, compared with returns of -1.7% and ‑3.8% for the same periods during contango markets.
Third, backwardated markets give rise to “roll yield” opportunities for commodity investors – that is, the ability to generate returns by rolling a short-term contract into a longer-term contract. Simply put, with the oil market in backwardation, investors can earn a positive return from being long oil even if the spot price doesn’t change.
Roll yield – a potential boon for commodity investors
Given our view that oil prices are likely to be range-bound over the short to medium term due to natural stabilizers (including OPEC’s spare capacity on the upside and shale producers’ ability to quickly cut production on the downside), potential returns from rolling futures contracts may be an even more powerful source of long-run returns than in the past.
Moreover, the impact on roll yields from backwardation also provides a meaningful tailwind to the broader universe of investable commodity indexes, for which petroleum is typically the largest sector. Similar to the trend for Brent futures, when oil is in backwardation the Bloomberg Commodity Index has delivered subsequent four- and 12-week average returns of 0.49% and 1.28%, respectively, compared with returns of -0.18% and -0.30% during contango markets.
In an environment of low global bond yields and expectations for lower equity returns, along with the negative returns for commodities over the past few years, the potential incremental boost to commodity indexes from backwardated oil markets is worth noting.
Read our 2018 Commodity Outlook for more insights into investing across commodity market.
Nicholas Johnson and Andrew DeWitt are PIMCO portfolio managers focused on commodities and are contributors to the PIMCO Blog.