WTI backwardated – temporary or a trend shift?

On June 20th it finally happened – the WTI contract flipped from having been in contango for the best part of 5 years, to flipping into backwardation in not only the first month, but along the curve.

Let’s start by taking a step back and understand why the forward curve behave the way they do, or rather why traders and market participants behavior shifts and why they are willing to pay up more for a commodity today than tomorrow, when yesterday it was the other way around.

A good analogy to explain contango and backwardation is the availability of beer. In the case of a potential strike at the brewery – what happens? People flock to the store to buy beer, i.e spot beer will be bid up relative to the actual price in the store. First month beer prices will rise relative to second month, or in other words – people will stock beer in the fridge rather than letting supplies sit at the store.

In a scenario where supply disruption is not a problem, the incentive of bidding up first month relative to second will fade. People will let beer sit in the store and only keep enough for daily consumption in the fridge. Tomorrows prices will be equal to or higher than current prices.

So what’s new in Cushing, OK? Well, the place is still one enormous pipeline hub and tank farm, but a number of recent developments have changed the fundamentals of the market structure. First and foremost it has been an ongoing attempt from pipeline companies to boost demand by allowing access to USGC cracking refineries through the reversal of existing pipelines (Seaway), utilizing existing ROWs (Seaway expansion) and new-builds (Cushing Market link). These three project combined will allow 800 kbd of crude to flow from Cushing to Houston. Quite a demand boost.

The second effect is secondary. The main producing area for the WTI stream is the fields in the Permian basin in West Texas and south-eastern New Mexico. Once a dwindling giant expected to go into permanent decline, struggling to keep up production longer-term, the ongoing bonanza in the Permian through development of tight resources (Bone Springs, Wolfcamp, Spraberry) have made production curves in the Permian skyrocket. More production calls for more pipelines, and the rightful question producers asked themselves is why they would want to go to a landlocked tank farm in Oklahoma with their new pipelines, when they might as well get direct access to waterborne prices on the USGC? And that is exactly what happened. Plains Cactus, Magellans Longhorn and Sunocos Permian Express are all going towards Houston.

So, more demand from pipelines draining Cushing, and less supplies due to new infrastructure avoiding Cushing. On top of that we are probably seeing deliveries to operational storage in the coming months picking up (more demand!), where traders are forced to deliver increasing volumes already bought on the curve, to start filling Cushing Marketlink and BP1, which is once again starting to pull volumes out of Cushing to BPs massive Whiting refinery south of Chicago.

Conclusion

The NYMEX traded WTI contract will eventually be leaning towards increased periods of backwardation, as Cushing becomes less of a storage hub and more of a transit point of northern crude going south. It will also become less relevant as a hedging contract for exporters of crude to the US, who will increasingly use the USGC sour contract, ASCI, as their main tool for hedging and pricing.

Anyone want to buy a tank in Cushing, OK?

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