Oversupply fears cloud outlook for U.S. crude in 2019

NEW YORK - 15 November 2018: The U.S. oil market is scrambling to adjust to a deep selloff over the last several weeks, with forward prices signaling a supply glut which could upend plans for producers and traders through 2019.

U.S. crude futures CLc1 plunged 7 percent on Tuesday, to settle at $55.69, their lowest level this year, down from a four-year high only a month ago. Tuesday marked a 12th straight session of declines, which is the longest losing streak on record, shaking a market that was bracing for supply shortfalls just a month ago.

“We were definitely in the bullish narrative for the past three months, and now we’re seeing that narrative shift,” said Michael Cohen, head of energy markets research at Barclays. “If the narrative gets unwound or undermined, so, too, does the positioning by the market.”

In the biggest sign of the shift, an increasing number of later-dated futures contracts are trading at a premium to current prices. That is a signal that the market expects supply to outpace demand next year and into 2020.

That trend could inhibit producers from drilling and deal a blow to shale companies, which have raked in profits as U.S. production surged to a weekly record of 11.6 million barrels per day (bpd) in early November.

Already, the Organization of the Petroleum Exporting Countries is considering a production cut to boost prices. Adding to concerns, the International Energy Agency said on Wednesday that supply will outpace demand in 2019.

“I think there’s a genuine shift,” one trader at a top commodities merchant said. “Everyone is talking about global oil builds in 2019.”

Many traders saw $100 oil on the horizon just a month ago, but oil is now closer to $50 a barrel. U.S. production is expected to surpass the 12 million bpd milestone by mid-2019, according to U.S. Energy Information Administration forecasts.

As prices fall and market structure weakens, U.S. shale producers may pare their drilling plans for 2019, said R.T. Dukes, research director for U.S. lower 48 upstream at Wood Mackenzie. “I think, instead of a big ramp-up into next year, we get flatter activity than what we might have seen otherwise,” he said.

Still, any changes would take time to alter the trajectory of production, especially as the largest oil companies, including Exxon Mobil Corp (XOM.N) and Chevron Corp (CVX.N), are increasing activity in U.S. shale plays.

The weakening in 2019 contracts pushes the market’s structure, or curve, more firmly into contango, where forward prices are higher than spot prices.

Contango is a symptom of an oversupplied oil market or rising levels of inventories. It makes it more profitable for crude traders to store large volumes of oil for later, rather than sell for immediate use.

The spread between U.S. crude futures expiring in December 2019 and December 2020 CLZ9-Z0, a popular trade in oil markets, flipped from a premium to a discount of about 42 cents on Tuesday. It is the first time the spread traded in negative territory since October 2017.

U.S. crude for delivery in December 2018 plunged to trade as much as $1.43 a barrel below futures for delivery in June 2019 CLZ8-M9 last week, the widest spread on record. The December 2018 contract dropped to trade as much as $2.10 per barrel below the December 2019 CLZ8-Z9 contract last week, the widest since early 2016.

A change in the market structure has ramifications for investors as well. When far-dated contracts trade below the spot price, funds and other investors benefit from what is known as “positive roll yield.”

In that situation, funds holding a contract shift into the next month’s contract before it expires, profiting from buying the cheaper later-dated futures. But with those contracts now more expensive, rolling the long positions forward is less lucrative and is one reason why traders have pulled back on bullish bets.