10/01/2007 (13:34)
ANALYSIS-Long oil funds should hang on for backwardation
By Jonathan Leff
SINGAPORE, Jan 10 (Reuters) - Investors losing faith in oil after a year of negative returns may want to think again -- OPEC, anxious to regain control of the market, could bring them good news.
The cartel's apparent determination to drain consumer stockpiles and focus on a target around $60 a barrel should eventually return the market to backwardation, ending over two years of contango and allowing investors to benefit from market structure even if prices are flat.
Falling stocks should eventually push prompt prices above longer-dated contracts -- a market condition known as backwardation -- allowing index funds to profit by selling prompt contracts each month and buying later ones.
"Backwardation makes everybody happy," said Keith Sano, manager with the commodities business at Sumitomo Corp.
In contango, the opposite of backwardation, those same investors suffer losses with every roll, a bitter pill to swallow for pension or investment funds who have poured some $100 billion into commodity indices.
Last year the Goldman Sachs Commodities Index (Total Return) , the preferred vehicle for most passive investors with a near three-quarter weighting to energy markets, fell 15 percent. But excluding the negative roll yield it rose 0.5 percent.
A realisation by funds that market structure may return to their favour might help staunch the 10 percent slump in oil prices in the first 10 days of this year, blamed in part on investors moving into less energy-intensive indices or shifting to hedge funds that can profit by selling short.
While the extent of asset reallocation is hard to gauge, the funds could be forgiven for losing heart.
Oil's slump from its mid-July $78.60 a barrel peak is its deepest and most prolonged since prices began rising in 2003.
A Reuters survey shows analysts expect average U.S. crude prices to fall $3 a barrel to $63.24 this year, and further to $51.20 a barrel by 2010. O/POLL
While OPEC expects its output cuts to eventually stop the market falling, they will also restore the cartel's spare capacity, giving the group more leeway to cover shortages and cap any sudden price gains, raising the prospect of prolonged price stability.
"Clearly OPEC much prefers to have a market that is in backwardation. It makes the market much easier to manage," said Frederic Laserre, head of commodities research at SG CIB.
HARD WORK AHEAD
The fear of future instability coupled with flush prompt supplies has put the oil market into a steadily deepening contango since early November 2004.
"What OPEC's doing in cutting back is reverting back to their old policy in managing inventories," said one Swiss-based fund manager. "It's a total reversal of position. Ultimately, reducing inventories will pressure the market into backwardation."
Although reversing the market's contango will be hard work due to high stocks and weak demand, the process is underway.
The spread between first- and second-month U.S. light, sweet crude has rallied from a more than $2 a barrel contango in mid-October -- just as OPEC was agreeing its first 1.2 million barrel per day (bpd) cut -- to around minus $1.10 on Wednesday.
Another 500,000 bpd cut due to take effect Feb. 1 should hasten the process, sapping near-term supplies.
Laserre estimates that stocks would have to fall by about 3 to 4 days worth of forward demand -- on the order of 60 to 80 million barrels for the U.S. market alone -- to end contango.
But activity happening further down the curve may also help.
The past week's price decline has also stirred up talk of forward hedging by one or more oil companies, putting pressure on far-forward prices that have been buoyed by sustained hedging by consumers who feared oil's rally would run for years.
Despite the nervousness over a possible fund exodus, many analysts say the majority of index investors will stay put -- one year of poor performance does not void the argument that commodities are a good route to portfolio diversity.
But the recent unease may finally prompt OPEC make its peace with financial funds, whom it has frequently attacked for driving oil prices beyond levels dictated by fundamentals.
"If they (funds) decided to exit then the market could be $20 lower," Sumitomo's Sano said. "I'm sure (Saudi Oil Minister Ali) al-Naimi has good intentions to ensure pension-fund managers feel less anxious about holding long positions."
