Global oil prices have declined in July, but Goldman Sachs commodity guru Jeffrey Currie touts a strong upside risk for oil on the back of wide, “unprecedented” spread between physical global oil and oil futures prices.
Oil’s loss this month follows an overall decline in commodities that looks to pull the S&P Goldman Sachs Commodity index
down for second straight month, after posting six consecutive monthly gains.
“The physical markets are trading at a substantial premium to the futures market,” Currie, who’s global head of commodities research at Goldman Sachs, told MarketWatch during an interview Thursday.
Physical Brent oil prices on the spot market traded around $112 a barrel on Thursday, while “paper oil or financial oil” – the front-month September futures contract
traded at roughly $106, with the Brent contract for October delivery
Delivery of Brent oil one year out is at $90, Currie said. “This doesn’t mean that the price of oil is expected to decline — it means consumers are willing to pay a big premium to take delivery of that oil today as opposed to tomorrow,” he said.
The price spreads between future deliveries “have never been this high,” he said. With current Brent prices at $106 and futures at $101 — that’s $5 of backwardation. “It’s unprecedented.” Backwardation is a condition in which futures prices are below the spot market.
If prices stay at $106 for the rest of the year, rolling that front month contract would make you $5 on the $101 contract every single month until the end of the year, said Currie. “That’s a 60% return.”
For now, however, some traders are staying out of the market because they don’t believe in the persistency of the story, he said. They believe that the energy and food crisis has been resolved and this is behind us, and nobody believes that prices are going to go up again because there’s a likely recession occurring and “history says you don’t want to be long commodities during [a] recession.”
Even so, we are still in an environment where demand remains above supply despite slowing demand growth, as evidenced by the current draw on inventories, said Currie. “The tell-tale sign of a deep recession is contango, which we clearly aren’t seeing now.” When the market is in contango, the futures price of a commodity is higher than the spot price.
Also, “we have liquidated all the investor length in this market,” Currie said, adding that last week, there was roughly $60 billion in this market, compared to $330 billion in March 2008.
For July, front-month Brent crude futures are on track for a decline of more than 7%, as of Thursday, but looked to pare some of those losses amid a sharp climb in prices Friday.
The front-month September contract, which was set to expire at the end of Friday’s trading session, settled at $107.14 a barrel on the ICE Futures Europe exchange Thursday.
The money could “come back in,” Currie said. “We think there’s a lot of upside risk in these markets, near term.”
A 60% return, if oil prices stay at $106 from now until the end of the year and the curve shape stays the same, is “a pretty attractive return for markets doing nothing,” he said.
So the risk reward for being long oil here is “significant,” Currie said, with positioning extremely tight. The market also remains in a million barrel per day deficit, with the recent pullback in prices “stimulating demand by potentially another million barrels per day.” Supply, meanwhile, remains severely constrained due to years of underinvestment, he said.
Given all of that, Currie is bullish on oil. Goldman’s end-of-the-year target for Brent oil is $130 a barrel and $125 a barrel for U.S. benchmark West Texas Intermediate oil.
Still, he warned about inherent volatility that comes with trading commodities.
““Commodity markets serve a purpose in the real world of moderating demand and creating supply, which means they’re going to be far more volatile than financial markets.” ”
“Unlike financial markets, commodity markets serve a purpose in the real world of moderating demand and creating supply, which means they’re going to be far more volatile than financial markets,” said Currie.
Traders won’t get a “nice steady upward trend and a supercycle type of environment,” he said. Instead, they’ll get “spikey prices…either to moderate demand growth in line with supply or create new supply.”
Currie also pointed out that while no one in this world has to buy a financial asset, they “do have to buy physical commodities” such as food. That difference is “what is being captured in that roll yield and the backwardation” in oil.