Tuesday, February 18, 2014

Phil Verleger On Oil: "Backwardation, tightening inventories and higher prices ahead…one view of the future"

As I said in last year's "'Izabella at Dizzynomics: "Fed, QE and commods'":
I have very mixed feeling about Mr. Verleger.
I am naturally suspicious of anyone who spends as much time on self-promotion as he does. On the other hand Craig Pirrong seems to respect him and, although I don't have much interest in Pirrong's snark, the Prof. probably knows as much about commodity storage as anyone.
Storage, being the nexus between physical and financial, is the aspect of the commodity biz that matters most so anyone who can instruct me is jake in my book....
The post goes on to note some of Mr. Verleger's pronouncements that were dubious at best, worth a read if interested in this stuff.
From Platts whose "One view of the future" seems to indicate some reluctance to embrace the thesis:
Energy economist Phil Verleger has been waging a steady war against the argument that “too much” trading of energy futures contributes to higher prices.

To the contrary, as he has written many times, in the long run it will contribute to lower prices, and current government efforts to curb speculation by diminishing volume is laying the groundwork for a reduction in US output and higher prices down the road.

The background of his argument can be found in the curve for WTI prices. A market that is facing plenty of supply, as the US market certainly is, tends to be in contango, with prices rising toward the future to reflect the time value of money and the cost of storage, among other things. It is rarely a prediction of what the price will be in the future.

The WTI curve, on the other hand, is in backwardation, with prices sliding further out in the future. A market where people are talking about just how high US production can increase to is generally not the sort of one you would expect to see in backwardation, but it’s a market that also keeps hearing how US production will continue to soar for the rest of the decade. So this may be one of those times where the backwardated market is based more on future price projections than more current factors.

Last Friday, when March 2013 WTI settled at $100.30, March 2018 crude settled at $79.97, more than $20 less. With production costs in the Eagle Ford, Bakken and Permian anywhere between $60/b and $80/b, a hedge five years out that’s only 10 bucks more than the cost of production is going to be seen as a loser’s bet by most.

“Producers require high current prices and high future prices,” Verleger wrote in the February 17 edition of his weekly report, “Notes at the Margin.” “If they cannot hedge, market backwardation will increase and US output fall even if cash prices are high.”

Verleger’s reports for many months have been been promoting a basic premise: pressure in the form of things such as position limits discourage trade, which discourages longs, which pushes down the forward curve. You need those longs to take on the sales of hedged crude by producers. The result is a disincentive to build inventories....MORE
After the 2013 post we followed up with "The Set Up For a Collapse of Oil Prices": 
Twice in the last six weeks FT Alphaville has referred to Philip Verleger's call for lower oil prices.
The thesis is higher interest rates would cause currently financialized inventories to come out of storage.

I agree but I wish to heck it hadn't been Verleger making the argument....