8/17/2010
By Conley Turner, Research Analyst

Crude oil prices have exhibited a significant amount of volatility over the past several months.  While much of this movement is occurring at the front end of the forward curve of futures contracts traded on the New York Mercantile Exchange, the back end of the curve tells a different story.

The action in oil can be attributed to the series of global and domestic macroeconomic data released in recent months along with the flurry of geopolitical events.  The result has been that the front month crude contracts are trading in a range of $75 to $79 per barrel. The longest dated contracts however are trading at a significantly higher level.  In fact, crude oil futures for delivery in 2018 are trading just below the $100 per barrel level and some market participants even consider that price to be undervalued.  This variance in pricing showcases a contango market as the price of oil in the forward market, exceed that for immediate delivery. 

There are a number of factors that account for this price differential.  Among them is the outlook that the global economy will have sufficiently recovered in the next five to eight years so that a recovery in oil demand would have occurred by then.  The increase in demand would then drive up the price. Also, the ability of operators to explore and exploit new oil deposits is likely to become even more challenging and increasingly expensive.  This is already the case presently where universally operators have found that the easily accessible oil has been found.  It follows that the discoveries currently being made are in areas geologically very difficult and or in jurisdictions that are politically unstable or even hostile. 

It is important to note too that the rate at which new discoveries are being made trail the rate at which existing reserves are being depleted.  It stands to reason then that the continuation of this trend bolsters the argument for the back end of the oil curve to remain at current levels and even register additional gains.

The recent oil spill by BP in the Gulf of Mexico showcases the difficultly operators face in locating and exploiting new oil deposits.  The now infamous Macondo well was located 5,000 feet below the ocean surface where the pressure is about 2,200 pounds per square inch.  It is a place in which only robots could operate and the accident showcased that fact.

The accident which killed 11 oil workers and caused millions of gallons of the commodity to spew into the Gulf of Mexico will likely be a watershed event for the U.S. oil industry.  In order to prevent a reoccurrence of the disaster, the Obama administration has instituted a more thorough review process before any new offshore drilling permits are approved. The move is part of a series of new and updated safety, environmental, technical and financial requirements for companies wishing to conduct operations off the U.S. coast.

The fallout is that many in the industry now feel that these new regulations will make future exploration and production significantly more expensive.  These increased costs will then translate into higher oil prices.  This outlook is currently being manifested in the higher prices already being seen on the back end of the oil curve.  This contrasts vividly with the current headlines that result in volatility being observed on the front of the curve. The back end in contrast has been comparatively stable.

Some forecasters have even suggested that the current market is not taking into consideration the impact of inflation a few years from now.  The argument is that an inflation rate of over 2 percent per year over the next five to eight years is in fact offering investors the chance to acquire forward crude futures for a lower cost than the spot oil of oil today, in real terms.  As such, there is a belief that existing futures contracts are mispriced and are likely to realize significant appreciation.
The fact of the matter is that at this juncture, these aforementioned factors in aggregate point to a commodity that appears to have a tremendous amount of upside potential in the long run.

Conley Turner
Wall Street Strategies