Implications of WTI Oil Futures In Backwardation Amid the Supply Crunch

In recent weeks, volatility has been concentrated in contracts for nearer term delivery, notably May and June futures, while December prices have been far more stable (Figure 2). December WTI contracts are especially interesting as points of comparison because liquidity tends to congregate in year-end contracts.

Figure 2: May and June WTI contracts are priced relatively higher and have been more volatile than futures further out the curve

A Brief History of Oil Price Movements Under Contango and Backwardation

Contango happens when prices for contracts further out on the futures curve are higher than those for the spot and front-month prices. This usually occurs when markets are oversupplied. In this situation, those who can't sell their oil immediately have to pay the "cost of carry," which includes storage costs, insurance and interest expenses. A positively sloped futures curve (contango) leads to a negative roll yield.

By contrast, backwardation occurs when prices for near-term delivery exceed prices for delivery further out in the future. Backwardation typically happens in tight, undersupplied markets with either scarcity of supply or high demand. This creates a strong "convenience yield" when the value of having oil on hand exceeds storage, insurance and interest expenses, leading to a negatively sloped futures curve and a positive roll yield.

Since 1985, the crude oil market has been in contango around 42% of the time and in backwardation 58% as measured by the price difference between the front-month contract and contracts six months in the future, but contango and backwardation are usually overlooked by casual market observers.

Normally, when one looks at historical crude prices, one sees a time series of front- month contracts. While stringing together front-month prices is extremely useful for gauging where crude prices were historically, they don't convey an accurate picture of what sort of return one could have achieved in the oil markets simply by holding a long (or short) position in the futures market and rolling the contracts forward at a set period (say 10 days) prior to contract expiry.

Imagine a case where an investor who had been long the April 2026 Micro WTI contract at the start of the war on February 28 and had rolled the contract on March 6 (10 days ahead of that contract's expiry) into the May 2026 contract. Between the market close on Friday, February 27 and the afternoon of April 9, the spot price rose by 48% from $67.02 per barrel to around $99. However, the actual return on a long position (ignoring transaction costs) would have been greater owing to the backwardation of the curve. Between February 27 and March 6, the April contract rose from $67.02 to $90.90, a 35.6% gain. Meanwhile, on March 6, the May Micro WTI contract closed at $87.52. If one had closed out the April contract position and initiated a May contract position at the March 6 closing price, the May contract price would have risen from $87.52 to $99, a further 13.1% gain. If one compounds out the gains, (1+35.6%)(1+13.1%)-1, one finds a 53.4% gain, around 5.4% more than the simple variation in strung together front-month prices would have suggested. This 5.4% is the positive roll yield in March stemming from the backwardation in the crude oil curve.

Over time these seemingly modest differences between the variation in historical WTI front month prices, which ignore roll yields, and the actual return of rolled futures positions can be extremely large. For example, at the beginning of 1985, WTI's spot price was $25.92 compared to around $100 at the time of this writing. On that basis, one might have imagined that holding crude oil and rolling the contracts forward for the past 20-plus years would have resulted in a gain of nearly 300%. However, rolling the contracts forward prior to expiry, thereby taking into account the accumulated cost of interest-rate carry, storage costs etc., would have resulted in a gain of closer to 191% since 1985 (Figure 3).

Figure 3: There is a big difference between spot prices and cumulative futures returns

From 1985 to 2008, the crude oil curve was most often in backwardation. Backwardation means a positive roll yield, and from 1985 until 2008 being long front- month contracts rolled 10 days prior to expiry generally outperformed the times series of unrolled front month (or spot) prices. Since 2008, the crude curve has more often than not been in contango leading to a negative roll yield. As such, the investment performance of simply being long futures contracts and rolling them prior to expiry has generally been less positive than what the simple evolution of spot prices would suggest.

However, if one examines the rolled return series closely, looking at how it performed during periods of contango and backwardation, one notices a pattern. Most of the crude oil bear markets happened during periods of contango, whereas during periods of backwardation, prices have more often been flat or rising (Figure 4). Also, if one looks at cumulative returns of the strategy of being long only during contango versus being long during backwardation, the differences are far more striking (Figure 5).

Figure 4: Most losses on long positions have come during periods of contango

Figure 5: Being long during backwardations would generally have led to gains while being long during contango would have generally led to losses

Since 1985, an investor who was long front-month WTI futures only on days when WTI had previously closed in contango would have lost 95% of their money. By contrast, a trader who was long front-month WTI only on days when the market had closed the previous day in backwardation would have gained around 5,250%. This analysis assumes that one would have traded at the previous day's closing prices and ignores transaction costs. Furthermore, it assumes that futures positions are fully funded (no financial leverage) and that there was no return on underlying cash instruments and hence focuses only on trading profits and losses.

So, does extreme backwardation mean now is a good time to be long oil futures? Not necessarily. If the conflict ends soon and supply disruptions resolve quickly, crude prices could fall across the curve leading to losses for anyone who is long. That said, the fact that the returns of holding long positions during periods of contango have tended to be negative, while the returns on holding long positions during periods of backwardation tend to be positive tells us two two things:

1. Traders tend to underestimate how long periods of oversupply last. Hence markets in contango tend to remain at depressed prices for longer than investors initially imagine.
2. Likewise, traders had historically tended to underestimate how long periods of undersupply last. This can be true for demand shocks, such as the rapid increase in demand from Chinese and other emerging markets between 2003 and 2011, and can also be true during periods of supply disruption, such as following the U.S. invasion of Iraq.

Investors should also be warned: While being long crude oil futures often corresponded to losses during periods of contango and gains during periods of backwardation, there is risk either way. There are plenty of examples of rising prices during periods of contango and falling prices during periods of backwardation.

Whether this current period of supply disruption lasts longer than traders are currently pricing via the WTI Crude Oil futures and Micro futures curves is anyone's guess. That said, when gauging whether to hedge risk or gain exposure to the market, the degree of backwardation or contango is a factor that investors may wish to take into account, especially when looking at some of the less lower priced contracts for delivery (or financial settlement in the case of Micros) further out on the curve, including the December 2026 contract.

Finally, market participants might also want to take into account both the degree and the duration of disruption in oil supplies. During the 1973 Arab oil embargo, the 1979 Iranian Revolution and the ensuing hostage crisis, and the 1980 Iraqi invasion of Iran, around 5-7% of oil came off the market and prices rose by 200% within a few months. Likewise in 1990, following Saddam Hussein's invasion of Kuwait, around 6% of oil came off the market and this was followed by a 120% rise in prices (Figure 6). This time around, twice that amount of oil has come off the market and spot prices have risen by a relatively smaller amount of around 50-70%. This could be attributed in part to generally soft demand, significant levels of inventory and the willingness of governments to sell inventory from strategic reserves. If governments sell reserves today, however, they could choose to replenish reserves in the future, potentially boosting prices.

Figure 6: Crude oil prices rose 120-200% with 5-7% of oil off the market in 1973, 1979-80 and 1990

One key indicator to watch is shipping traffic through the Strait of Hormuz (Figure 7). Also, what happened to shipping traffic through the Red Sea and the Suez Canal offers a warning about how supply disruptions can carry on for longer than initially expected. After Suez traffic dropped off in late 2023, it never recovered in part because insurance companies withdrew from the market (Figure 8).

Figure 7: Tanker traffic through the Strait of Hormuz remains depressed

Figure 8: Suez traffic hasn't recovered from its late 2023 dropoff

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.