The February 2018 West Texas Intermediate (CLG18) contract finished the year strong, closing Friday, December 29, 2017 at $60.42. This marked an approximate 10.48% increase in value from $54.69 on October 31st, 2017 (the day the WTI calendar spread switched from contango to backwardation), to year’s end. This has occurred against a background of record oil inventory draws, dwindling U. S. crude oil stocks, and tepid U. S. oil production growth.
Contango, where the front month contract is discounted to the back-month contracts, reflects the normal price curve of a futures market. Backwardation however, occurs when the back-month contracts are discounted to the front month contract, reflecting increasing immediate demand.
As discussed in our article posted June 5, 2017, several experts anticipated this shift. According to Thomas Lee, a veteran analyst at Fundstrat, the last two times this occurred, the market rallied 53% and 25%, respectively.
The industry has taken note. Mark Papa, CEO of Centennial Resource Development, stated in his Q3 Earning Call to Investors in November that “Oil markets have recently responded to the combination of high global demand, rapidly reducing crude and product inventories, and tepid U.S. production growth.”
Papa went on to state that “Centennial’s strategic response to this tightening global oil supply demand picture is as follows: first, we are remaining unhedged regarding oil, we may hedge some gas and may add to our gas FT commitments to ensure that our products move out of the Permian Basin, but we like the supply and demand picture on oil and with our low debt see no reason to hedge oil.”
The move from contango to backwardation is bullish oil, as is the industry’s response. Only time will tell if the recent rally matures into a further bullish price move. Being an optimist, I see higher prices ahead.