Middle East Crude Futures Prices Lag Behind Spot Market

Oil Market Plunges into Record Level of Backwardation, Signaling Intense Fear of Supply Disruption

Crude oil prices, historically sensitive to geopolitical events, have seen unprecedented volatility in recent times. The ongoing Middle East conflict and supply disruptions have led to the emergence of new price patterns. While current price levels dominate the popular narrative, understanding the future prices of crude oil and its level relative to spot prices is crucial for planning and building scenarios to assess the imminent impact on the economy.

Commodity futures differ significantly from derivatives of financial products. The future price, assuming no arbitrage, is given by the sum of the current spot price and the cost of carry (CoC), which includes the cost of holding and maintaining the asset until the delivery date.

Futures Price = Spot Price + Cost of Carry

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For financial securities, the CoC is primarily the cost of funds or opportunity cost of buying the spot and holding it until delivery date. In commodity futures, however, there are additional costs such as storage, insurance, and transportation of the commodity, resulting in a physical premium.

The pricing structure of oil futures can be either contango or backwardation. Contango occurs when futures prices are higher than spot market contracts, with longer-dated futures priced higher than near-month futures. Backwardation, on the other hand, occurs when future prices are lower than spot, with longer-dated futures priced lower than shorter near-month futures.

In the case of crude oil, backwardation implies that the market expects the security's price to fall, but with a twist. Commodity users, fearing supply disruption or non-availability, buy the commodity at any price, causing the spot price to spike. This extra premium is called convenience yield (CY), and the future-spot equation takes the form:

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Futures Price = Spot Price + Cost of Carry - Convenience Yield (CY)

The Dubai Fateh Index, which tracks the spot price of sour, heavy crude, currently stands at $102-103/bbl. However, the one-month future is priced at $98/bbl, while the three-month, six-month, and twelve-month futures are hovering around $90/bbl, $84/bbl, and $79/bbl, respectively. This strong backwardation indicates higher uncertainty about future supply, which is reflected in the increasing convenience yield with delivery tenure.

The current level of backwardation is the highest since January 2000, with the intensity of backwardation (backwardation divided by spot price) being 5x to 10x higher than any other stretch of backwardation since 2000. The volatility of crude prices, both at monthly and quarterly intervals, is among the highest ever recorded.

Given the uncertainty about crude prices and its potential impact on India's fiscal deficit and forex reserves, the government's "moral suasion" to curtail discretionary foreign expense and promote responsible energy usage is a relevant action to handle this uncertainty.