The prompt-month (Jan’ 23) WTI contract settled Friday at $76.28, marking its third consecutive weekly loss. However, market bulls are likely more concerned with the changing oil curve structure signaling physical oversupply. The January to February and the February to March WTI futures contracts are now in contango or upward sloping. A curve in contango means the shorter-dated contracts are trading at a discount to the farther-dated tenors. The structure encourages more oil into storage and enables the “cash-and-carry” trade, where you can store oil and sell it at a higher price in the future (assuming the premium outweighs storage costs), which usually leads to growing inventories.
Still, the contango in the first few contracts will likely be short-lived unless the oversupply situation is corroborated and persists. If the market turns out to be oversupplied, you would expect the discount for near-term oil to grow until the discount is large enough that the carry-trade market participants can buy and store the volumes for a profit. This would effectively provide an outlet for the additional barrels on the market that aren't consumed at a refinery.
The weakening curve structure could be more financial trading amid lower holiday liquidity, but there is genuine concern about oil demand in China as Covid cases surge. Mobility in Beijing’s streets has been severely restricted as surging Covid infections trigger lockdowns across the Chinese capital. According to Bloomberg transit data, subway ridership plunged more than 64% for the week through Wednesday, compared to 2019. China’s adherence to its policy of zero-tolerance Covid could continue to keep oil demand growth subdued for some time. However, dissent has grown recently concerning their harsh stance towards the virus as the country continues to set new daily infection records.
AEGIS has previously stated that China’s oil consumption growth likely has more upside than downside as WTI prices trade below $80/Bbl. Therefore, any capitulation to China’s zero-tolerance policy would provide a tailwind to oil prices by our estimates, as muted growth was probably already priced-in. We have seen evidence of this when signals, or rumors, about China moving away from its current policy results in material oil rallies. However, as Covid cases hit new records in China, oil bulls may have to be more patient before seeing oil demand pick back up in the world’s largest oil importer.
AEGIS hedging recommends costless collars in the current market environment. However, some clients may find swap structures more workable as the oil curve has shifted lower rather quickly, and Cal ’23 and Cal ’24 are near $75 and $70, respectively.