Paper vs Physical: Inside Oil’s $30 Backwardation Shock with Veteran Trader Adi Imsirovic

Unpacking Oil's Historic Disruption: Dated Brent vs. Futures Welcome back to another episode of the Oil Ground Up podcast. I'm your host, Rory Johnston. A reminder to hit, subscribe and leave us a review. And if you have any questions of us or any feedback on the show, please drop us a line at [email protected]. Oil Ground Up is distributed in partnership with the [email protected] and also the Oil and Gas Global Network, the leading podcast network for oil and gas. Our guest today is Addie Mcevich, a lecturer at the University of Oxford, former head of oil trading, author of the new book River, the Rivers of Money, Social and Economic History of Modern Oil Trading, as well as multiple other fantastic books on oil trading, the Brent crude complex and Crude Price Discovery. Our conversation largely focused on the massive backward spread between dated Brent and Brent futures, what drives crude term structure and the shape of the futures curve, and how markets should be expected to act weird in a moment of especially weird policy making. Addie Mcevich, welcome to the Oil Ground Up podcast. Speaker 2 Thank you, Rory. Good to be here. Speaker 1 Thank you for coming back. I should say you were actually my first guest when I took over as host of this podcast. And it is almost exactly a year since we last chatted on the podcast. And I think it could not be coming at a more fascinating time for the global oil market. So just want to, I just want to get your initial thoughts, tell me how you're feeling and what your days over the past six weeks have been like. Speaker 2 It's pretty crazy. Absolutely insane. It's it's hard to explain to to to younger viewers, including yourself. There is, you know, I've been in the oil industry for 35 years trading plus what now about five years observing whatever you want to call it, teaching. And I've never seen anything like it. Speaker 1 No, I mean both in terms of, I mean the largest confirmed supply loss in the market's history. Speaker 2 And then? Speaker 1 This kind of crazy memory and, and I think honestly, so I first it was introduced to you through your work on the Brent complex for Oxford Energy Institute, Oxford Institute of Energy Studies back in the day and all the work you've done since. And I, what I really want to talk to you about is the structure of oil prices, price discovery, all these various prices people are quoting like, oh, what's fizz oil versus paper barrels and all this stuff. And I was hoping to discuss with you both how this system works, how, what, what the connection between ICE Brent futures and dated Brent and CFDS and everything else in between. So like just to give the, the viewers and quite frankly, my, my subscribers a better view of how to interpret what these things mean. And then I think after that a little bit talking about, you know, how this is manifesting through, but let's start with the mechanics. The Mechanics of Brent: Physical vs. Financial Futures What I think in terms of the most 2 most frequently quoted prices right now, one being very routinely, notably abnormally higher than the other is the difference between dated Brent, the physical benchmark and prompt Brent ICE Futures, which is the price that virtually every other person in the world sees on their screen when they type in price of oil, either Brent or WTI. So talk to us starting between the difference between the physical Brent market and what that means and ice Brent future. Speaker 2 Totally, Rory. I, I just just do a little quick intro from this side. I just wrote something for the CSIS as well, exactly on the same subject. I've been asked this question many, many times and it's, it's, it's almost embarrassing when you talk to a few people on a on, on like I've had podcasts and interviews and people say like, so why is WTI higher than Brent? And I'm like, no, no. Speaker 1 It's not. Speaker 2 Exactly and, and it's just amazing that, you know, it's a little bit like COVID during COVID, we're all experts on on, on viruses and now we're all experts on oil. And, and obviously it doesn't help that there are quite a few people these days who are retail traders, small trade it at home and they don't tend tend to read what's written on the tin. You know, young folks don't read the small print and yet they want to trade it anyway. To go straight to your point, it's it's some things are Brent complex. The complex is the right word. It is the most complicated, probably not probably, I'm sure it's the most complicated commodity market in the world. But that's because not because people want to make complicated, but it just grew gradually over time. And I like to compare it to like a human eye or a human body. Like, you know, we have an appendix and we may not need it and it's just sticking out there or, you know, molars and and things like that, you know, and, and, and people say, Oh yeah, it's totally sorry, smooth Lewis, but it's it's just the way it is and it's grown over time. And you know what the best thing Rory is? It works. Look, we've just had an unprecedented oil shock and actually the bread market, we had some issues with Dubai. We had some issues with I fad. We had some issues with other things, but Brent worked just fine. OK, one of the things that worked fine, and a lot of people think it didn't, was this massive suppose supposed divergent between dated and futures. Now dated and futures are not the same thing. Dated Brent is essentially physical Brent. It, as the word says, dated means with dates. It's a brand that has dates to it. So it has a loading dates. Once it has a loading date, that means it's been nominated as a physical cargo. And once you once the PR as price assessment agencies assess the value of that, that's a value of physical cargo that's loading between 10 and 30 days forward from the day when it's being assessed. And futures cargoes, futures contracts are, you know, particularly for Brent, it's interesting because they're financially settled, but I'll come back to that in a second. They, they, you normally trace two months forward. So they exactly the apples and oranges, the same commodity in a very, very different time period. So you can be trading day to Brent loading 1010 to 12 days from now and you can't compare that up to brand that's loading two months from now or 2 1/2 months from now. Very different now of course. And there there is a divergent that that divergent always exists in backwardation. Obviously data is always higher than futures in contango. It's always below. Now the, the, the crazier the market, the bigger the contango is, the bigger the differential is going to be. And we've reached a a value of $30 basically between the two, which which I'd never seen. Speaker 1 No. And just actually just to kind of hammer this point home one to your point, yes, largest, I mean most backwardated markets we've ever seen both in Brent and WTI, we saw a record-breaking prompt backwardation of $15 a barrel first like crazy stuff. And I think it's important for you to visualize and you can find a couple charts on this. I've I've tweeted a couple that people think of them as different things, but they are function. They while they are slightly different in what they are referring to financial settled versus physical settled etcetera. It is a functional continuation of the same curve that the curve continues trace like if you're really backwardated then the CFD curve. Can you describe what the CFD curve is? CFDs, EFPs, and Panic-Driven Demand for Immediate Barrels I will. So the CFD curve is is comes from the word contract for differences. Contract for difference is the first CFD that was ever used in in oil markets, which is basically dated swap. It's it's basically dated to the to a month to forward cargoes. It could be, could be for example, the CFD could be dated relative to June. But, but keep in mind, please, for just for time being, it's not relative to futures, it's relative to forwards, Yeah. Speaker 1 OK. So the difference, yeah, Thank you. Speaker 2 Yeah, I was just about to say the difference. Forward Brent is actually not many people know this, but now Bravey for you first on the show, you know, forward Brent is the most important instrument in Brent and very, very few people know that. Not many people in Pras, not many traders know that. Obviously traders that trade Brent, they're specialized. They know exactly what they're talking about. Forward Brent, that's how Brent started. It started by trading forward or so-called 15 day Brent. I would sell you, Rory, December 2026 Brent at a price and that's how we started trading Brent. Then futures came next and started mimicking exactly the same contract. And futures are actually a sort of a mirror image of forward Brent. And there is a very strong link, even though unlike WTI, Brent is a financial settlement, There is a link, it's called EFP, which is exchange of futures for physicals. So Rory, if you, if you're long 700,000 barrels of Brent or on futures market in June, you can, you can call your broker and say I want to buy an EFP normally under normal circumstances. Now that's another separate story, but we'll come back to that. Under normal circumstances you pay 4 or $0.05 a barrel and you will go to physical cargo from your futures, no? Speaker 1 Problem. So I'm actually looking at the chart right now of of front month or month one, Yeah, Efps for Brent. Speaker 2 Much harder. Speaker 1 And normally like a couple cents a barrel and I think and when people talk about the spread between physical and paper barrels, this is actually the spread, right? Is this is? If we're not, this is the actual spread between an. Speaker 2 Objective this is the spread for this is yeah, this is a spread between financials and and and and and and and. Well, you say physical. I, I just want to be careful because we have different language. In a way it's fair, but in, in, in, in, in, in the US you call cash basically essentially means physical. Over here, cash means forward. Speaker 1 Fairpoint. Speaker 2 And forward. Forward is not physical yet, OK. Speaker 1 Because and there are physical, one of the other things that happened with this is you've had physical premium explode on top of dated Brent as well. Speaker 2 Absolutely, absolutely. So come back to EFPEFP is now trading for June. It traded over $0.20 a barrel, which is wow, pretty amazing. Now it's come down to 1415, I think. OK, so, but it's still very, very high. Normally it's four or five cents. No, that for a start is a indicator. And now let me just tell you what I think I mean and then you know kind of punchline and then go back. What's happening now, it's little bit the equivalent of equity markets when suddenly there everyone gets really scared of financial crises 2008 and everyone puts money into either bonds or brick and mortar, as we would call brick and mortar, and I call this in oil, brick and mortar trade. Everyone's going for physical. You buy physical, you know you're going to get it. You know it's going to go into refinery. You know what you're getting with futures. You you don't know whether you know, we've had, as I said, some wobbly things with a couple of contracts. What's going to happen? You know, this is the safest thing you have. But more importantly, as you know, refinery, if refinery runs out of oil, it has to shut down. Refinery shut down when they go usually typically below 5060% of operation capacity for various reasons, which I won't go into. But the refinery shuts down when it shuts down it it, it takes weeks to to bring it up. So it's extremely expensive in every sense. So when the refinery tells you get me the oil, you go out there and get the oil, whatever it costs. So that's crazy number of 30 when data brands was $30 over futures essentially meant panic. It was panic. That's what it is. Speaker 1 What Bloomberg called, you know, spot deliverable or ASAP barrels, there was this premium on like give me the barrel now. Speaker 2 Now, yes, give me the barrel that, that basically as I said, dated Brent trades. Now the rent 1010 days to 30 days forward. So we're talking about 10, let's say let's call it 10-15 days forward. Now loading, that's now barrels and there was a panic and people went in there to buy those barrels and they were paying whatever they had to pay. And did they overpay? Yeah, probably they did. But certainly there was a panic and and and market went totally crazy. And people say, well, it's a little bit unusual, but we don't live in usual times at the moment. It would even be crazy times. And you know what? Yes, people will overpay. Market will overshoot. And when, when, when, hopefully this war ends. We, we discussed this just before the show. If and when it ends, we'll all be not just relieved, but the market will probably undershoot as well. Negative Refinery Margins, Product Shortages, and Market Overreaction Yeah. So and OK, so on top of that you mentioned dated Brent is for delivery for loading 10 to 30 days in the future. And then we were talking about those physical delivered premiums like 40s delivered basis. What does that mean? Speaker 2 Well, you know, not to confuse the listeners, let me talk about some different barrels because 40s a path of Brent and then we're going to get really technical and confuse everyone. Let's talk about 40s, not 40s. Sorry, Folkardos FF Folkardos Nigerian crude was trading two or three weeks ago about $5 over. That's a quality differential reflecting the fact that Folkardos is very distillate rich. There is a bit of a need at the moment for distillate crudes, which we can discuss if you want. But the main reason being that PG crudes, the, the, the Persian Gulf crudes are rich in distillates and that's what we are missing. OK. Also the refineries from that part of the world export a lot of jet and diesel which we are missing as well. And you know, Folkardis is looking great now. Nigerian Folkardis was last week trading or well talked around $15 over. So that was that premium. So you're talking about $30. If let's assume, I mean that this is the extreme case that last week you were trading for Carlos, which was loading well pricing this week, you would have paid $30 over June Brent, then you would have paid $15 over that, which is $4545 over. So it's almost 50 bucks when you throw into that higher freight that you're paying, OK, insurance over here is not much higher, but in other places it is. It's just ridiculously expensive. So we ended up in a situation and this is, this might be interesting to your listeners, you probably know. But last week there, there, there was a rumor of one particular European refinery that we shall not name. And they, like most refineries they had, they had two different groups. There was 1, you know, crude traders, acquisition traders. And there, there was a derivatives team that, that, that hedges margins. And the, the, the, the derivatives teams were hedging amazing margin over 30 bucks because they were hedging it on futures. But the physical team was buying crude where they're paying 50 bucks over and actually having a negative margin for the crude that they were buying. Speaker 1 Yes. Speaker 2 Just tells you how crazy the market is. Speaker 1 Yeah. And, and I've heard even that there are like there's, I don't have as much visibility into some of the physical product markets, which I don't see as clearly as I do Brent. But I've also heard that you know, a lot of particularly Northwestern refineries are currently in Europe are currently seeing because of those exceptionally high dated levels and the exception high physical delivery people. You're seeing effectively negative margins for a lot of refineries in Northern Europe, which is if persists will prompt run cuts which will theoretically then starve physical products and be and reduce the the relative bid on on crude. Speaker 2 Which is a bit of a death spiral spiral, isn't it? Because because you essentially we are lacking products. Nobody needs crude, right? We don't need crude, we need products. But if you cut refinery runs, you actually ending ending up with not having products at all. And, you know, that spirals, but this is how crazy the market is because, you know, the adjustment, the, the, the, the, the swings in this market have been so violent that the, the, the, the product versus crude futures versus physical, it just all, all kind of went from left to right so violently because of panic. Yeah, I don't think there was anything more sinister than that. People are saying, oh, well, the markets are diverging. They're not working. It's just not true. The markets are, to be honest, working as well as they can under these crazy conditions. Speaker 1 No, I, I, I agree. And I, and I think I've been describing it as well that like these these markets and the and, and again, physical oil markets move very slowly relative to the pace of tweets or the pace of news floor and everything else. We're talking, you know, weeks and weeks, sometimes months for these ships to clear and arbitrages to close and all these other things. And I think that's the part that's crazy is that we've never seen a shock this large. And now we had this potentially now initial overreaction that is now seeding into what is a kind of a in the market, oil market kind of a bearish narrative. It's feeding that on the downside. So now people have decided like even let's say that that let's say I completely agree with you that the initial price spike was an overreaction in its steepness. And so these physical premium in, in the Brent complex. But now that we're coming down the other side, instead of just returning to like a, let's say a rising crisis price level, now it's confirming the narrative that we're kind of coming down the other side. So like, talk to me a little bit about how you think about, and this is a, a topic that we could, you know, spend literally like a full week of seminars on. Like how do you think about how, what term structure really means in the market? Like are people right now, is the market, is the market optimistic that this crisis will be resolved? Or is it just so panicked at the front end that that's why you're seeing the level of backwardation? So, So another way of putting it, is the backwardation a, a, a rabid premium on spot barrels or is it a gradual discount on future dated barrels in your mind? Yeah. Decoding Oil's Term Structure: Storage Theory and Market Signals That's an excellent question. So let's start with, without going into too much, I'll tell you my views more as a trader because I'm sure that your listeners want to hear that. They don't want to hear the theory of storage, which is actually the underpinning this whole thing. But essentially, you know, for those who are really sort of interested in the academic side of things, they should probably just Google and get some books on on the theory of storage and convenient fields and all of that. That really comes originally from the agricultural products and in the and commodities. And actually it's it's really important. I think it's really important to understand why the curve is certain shapes and so on. But as as a trader, let's look at it this way, OK, that we have, we have an unprecedented situation. Oh yeah. Can I just mention one more point, please? You know, those who are saying that, you know, maybe dated or physical cargoes where the divergent from from the futures market. No, just just look at the futures market itself. I mean June deck last week, the spread between June and December delivery was 20 bucks. I can't remember ever being that. So the futures market themselves were in steep backwardation, you know, indicating that the front month early barrels were very, very dire, very scarce. Now what, what, how do I read this as, as as a trader, which is kind of more important to your listeners is, is that the problem has always been Donald Trump and Taco. And I think that's one of the explanations for, for, for the, the, the steepness also of this market is that we all know, I mean we can and he probably have disagreed in the past on, on what the old was supplied market was going to be on the normal circumstances before that this war, whether it's going to be half a million or 2 million barrels, it doesn't matter anymore. But it was well over supplied and that was probably a lucky thing for this market and. Speaker 1 And and the curve was actually tipping into contango on February 27th, immediately before the war started, the front had tipped into contango. Speaker 2 Absolutely. And the back end of the curve was was pretty much flat. So, you know, we're getting into situation and suddenly where there's a there's a war, we all know there's a lot of oil out there. I think the first question is like if tomorrow all these tankers are going to come out of Persian Gulf, I mean, that's a lot of oil that is going to arrive very, very quickly to the, to the, to the marketplace, right? So within four or five weeks that that this steep backwardation, the front end would collapse. It would still stay as a backwardation because this market is backwardated and and it's and it's tight, but it's still baccordation will remain, but it's going to totally collapse and everyone knows that. So why would anyone go out there and put a massive position on say June deck or July deck or or some further spread unnecessarily or just by flat price at the back end of the of the curve. Because they know that if this market with this situation resolved, we will probably now this is debatable, but I would say we would very quickly by the end of the summer see probably $5060 oil. Speaker 1 We'll be back after this short break. The dynamics of the natural resource trade changes every day. Get the full view of the commodity markets every week with Commodity Compass, hosted by me Jennifer Pickerel. From metals to energy to agriculture, we breakdown the key moves, market drivers and macro forces shaping the resource world, all in one sharp, insightful podcast from the Clear Commodity Network. Whether you're a trader, investor or industry pro, Commodity Compass helps you stay grounded and informed. Listen on [email protected]. Clear commodity network digital news on the physical markets. I'm Roy Johnston, host of Oil Ground Up and founder of Commodity Context. If you enjoy how we're all about digging in and providing more context here on the podcast, you'll love my newsletter research service Commodity Context. Subscribers can expect a mix of real time event analysis, data reviews and deeper thematic research, as well as the Oil Context weekly Market Report every Friday. If that sounds like your kind of edge, head to www.commoditycontext.com or find us on Sub Stack to join for free or go deeper with paid. We're offering Oil Ground Up listeners an exclusive 20% discount off their first full year subscription by going to commoditycontext.com/ground Up. That's Commodity Context dot com slash ground up for 20% off your first full year. OPEC Capacity, Geopolitical Shocks, and Policy Volatility And now back to my conversation with Addie Imshirovich. Yeah, I'm probably I'm I'm I'm probably less, slightly less bearish in the back end than that. Now I think I think we were pretty aligned on our view in the market, say in January, February, I think we both saw oversupply. We were both labeled bears by the various Twitter constituencies and everything else. I would say I would be surprised to see $50 crude now given that even already we've lost 450 million barrels of Gulf supply that hasn't been produced. That feels like a lot to me. But again, it could be, it could be swallowed by SPR releases. There's lots of ways that we could paper it over. Speaker 2 Well, I think I think that's an excellent point you mentioned. That's actually a great point because that illustrates actually something else that a lot of people understand. I think that the flat price, what we call flat price is the futures would fall dramatically. What will still stay is this backwardation at the front end. Precisely why for the reasons that you just mentioned, because we have a lot of bottlenecks. We have a lot of issues with shipping. We have a lot of issues with, you know, storage facilities in Fujairah and God knows where. We don't even know exactly the extent of some of the damage. So, but, but at the same time, I, I, I think that, you know, let's face it, we can this is arguable. What, what, what the OPEC excess capacity in December 25 was, but it was anywhere between 1 and 1 1/2 and 3,000,000 barrels a day. Yeah, right. So we know that OPEC could very quickly, especially the Saudis could easily just throw a lot of oil into that market more over and above what they would have done otherwise. Speaker 1 And, and in fact, they've actually, while they've been completely cut off, they've actually, OPEC has continued to actually ramp more aggressively. It's it's easing, cut, easing pace than had been previously planned. So it's obviously nothing burger right now because they can't produce, but those will continue to accumulate over the course of the crisis as well. And they'll come out with much higher quotas. Speaker 2 Absolutely. And you know what, I think it's also worth mentioning that, you know, operationally Saudis and UAE have been amazing. I mean, you know, Saudis ramped up, you know, East West pipeline, 7 million barrels. I mean, that's incredible. Speaker 1 It's crazy, yeah. Speaker 2 And, and in spite of Fujairah being on fire and everything, you know, UAE sort of ADNOC had pretty much 1 1/2 plus more than one and a half million barrels. I think it's 1.7 as a number that they were pumping. That's just incredible and and that saved a lot of people's bacon, I think at the end of the day. Speaker 1 Yeah. But so let's let's talk through the current. So right now even with the East West pipeline reroute and Fujairah and even when we were counting some Iranian barrels getting through, which is questionable now because we don't exactly know how firm the blockade is. Like we don't know anything anymore. We have, we, there are all these factors and we're like, well, it's kind of Swiss cheesy, but like maybe this maybe today there will be a tanker, maybe not anyways, but we still have roughly 13 million barrels a day of production shut in the Gulf, which to my knowledge has never happened before. We've never had a supply loss that long. I personally and long time listeners will know I did not expect this to last this long. I don't think anyone did. I don't. I least of all Donald Trump did not expect this to last this long. I think he wants out of this. And I think the question is like, how do you see? Like if let's say you were back on the Trade Desk, if you were in an outer, I'm going to put you in an impossible position. Of course, if you were trying to process this like it's been and, and to the point as well, to your point about like the, you know, the speculative, you know, or, or even like paper contracts and, and this kind of inability to get long or unwillingness to get long. I think additionally to that, there's this behavioral psychology element on top of it that every time we're rallying to let's say one 10115 Brent on prompt, which it felt like both momentum and the fundamentals, all the rest of the upside, Trump would come up with a tweet and we'd be down 15 bucks a barrel in a day, guaranteed. Many, many, many, many people traders have gotten blown out of positions, have likely lost jobs over this crisis from days like that. There is this element of like be, you know, damned what the fundamentals say. Trump is the one that is basically jawboning this price really aggressively. So sure, we'll let physical markets do all of the heavy lifting and clearance. You know, if we on the paper side and if our biggest downside like it's unlikely that we're going to spike vertical $20 a barrel in a day, but we could drop vertical $20 a barrel in a day at any moment. With that kind of backdrop, how does pay, how does the futures market, which is typically meant to reconcile into physical overtime gradually some, you know, somewhere along the line, does that distort the normal relationship between paper and physical markets and to a degree kind of limit their natural utility? Because I think at the end of the day, these are all risk management instruments. They're meant to help manage risk. Are they doing a good job of that right now? Understanding Futures Convergence, Contango, and Backwardation in Oil Right. Let me, yeah, let me just take one slight step back because I think you mentioned a very, very important point, which I was a pain to explain to somebody. And I, I, you know, obviously having been in the market for so many years, to me it comes naturally. And, and, and I think there's really clever friend of mine is a pH D in everything. And he studied the market for a long time and he goes like, oh, only now it makes sense. And I've read this, these books and books and books and it didn't. And I said, look, you know, you're super smart. The problem is that, you know, learning by doing has, you know, is really underappreciated. When you do something day in day out, you know, it just comes naturally. And, and what, what, what the question that I've been asked a lot also lately was and, and Fathi Birol mentioned this and I think confused the hell out of everyone. And I don't know whether he understands it or not. He basically came out and said that well, we'll see the futures market converge with a physical market. Now what the hell does that mean? Now futures markets and physical markets naturally converge because June futures will eventually be loaded in June and will be physical. But then they're not futures anymore. So they do converge. In a good well functioning market like CME and WTI and ICE brand, they do converge and they do converge as you mentioned, the curve is smooth, very smoothly. But that's because futures become physical. But that doesn't mean that dated will not still stay way above the futures because the next month, which is July, takes over. You can. Speaker 1 Just shift forward. Speaker 2 Basically, exactly. The backwardation shifts forward and as long as the situation remains tight, it shifts forward. And even if the market gets really, really bullish about oil situation, longer term, all will happen. The whole curve will just shift upwards. You will still have backwardation, but the whole curve will just shift upwards and at a higher price level. The one what's not going to happen is the futures go up and physical stays unchanged because people still desperately need oil. And that's the whole theory of backwardation or contango, whatever it is that the whole curve shifts and doesn't change unless the fundamentals or supply and demand change. So now in in the process of saying this, I've completely forgot what your question was. Well. Speaker 1 Here I'm going to restart my question, but I'm also just going to quickly touch on this kind of inventory or or storage theory of, of, of term structure basically. And, and, and let me know because I think, I think for a lot of people, contango makes sense, right? If you have an oversupplied market, you need to bid those barrel prices down so you can effectively pay for storage. But that makes sense. Backwardation is weirder because it's not a direct payment for storage. I typically explain it as one, it removes any financial, financial incentive to store the barrel. So you've lost that. And then it effectively creates an opportunity cost to not release those barrels to the market because again, when when WTI was $15, you know, prompt time spread between May and June. If you held a physical barrel in Cushing and you didn't need it that month for refining or whatever, you could have sold that barrel into, into the May contract, bought the same barrel back in June and you'd basically be whole with $15 extra in your pocket. So it's basically that as long as we have the largest supply deficit in history, you're likely going to have the largest backwardation in history. Is that the? Speaker 2 Can I just say 11 really simple and basic thing, please, because I'm sure not all of your listeners, you know, are, are, are too technical. I always laugh about this because I have my my view as as put together in the books and everything else. And, and I didn't make it up. It comes from a lot of other smarter people than me is that contango is a natural state of the market. Backwardation is, as the word says, backward. It's the wrong way round. It's the wrong way round, and that's why it's called backwardation. Speaker 1 One day I'm going to have you and and Ilia on. Speaker 2 Ilia is a good friend I'm sure. Please. Speaker 1 And you have both. I remember having you on the podcast relatively close to each other and you I think made the argument that contango is natural state, which I think is a very, let's say, agriculturally kind of anchored view, which is like the original theory of storage. Whereas Ilia argues typically that backwardation is natural state because producer hedgers have more producers are more interested in hedging down the curve than than others. So he has a paper barrel, A paper barrel. SD view. Speaker 2 And a very Keynesian Keynesian view as well. I can have you. Speaker 1 On for a debate sometime. Speaker 2 Very, very, you know, Elia is a good friend. He's got a great book, He's an excellent teacher. I'd be more than happy to discuss it. But anyway, that's where we are. So essentially the, the reason I mean, these structures, it's it's let me also say this, I think it's kind of educational for a lot of people. Why do these structures exist? A really good example was 197073. I think first all shock and it was Nixon administration, what they did, they they, they, it, it was the Arab embargo and and Nixon administration froze prices not not just of oil and products, but pretty much everything. Yeah. So the problem with that is that is that oil products are highly seasonal. In those days where heating oils was used primarily for burning, was even more seasonal. So in the summer you have gasoline and jet demand, and in the winter you have heating oil. It's highly seasonal. What happens when you freeze these prices? You kill the seasonality and nobody has any incentive to actually store gasoline for the summer. So if you freeze prices in February, nobody's going to put that those that that gasoline into into storage for the summer because storage is expensive. You have to book tanks, you have to insure them, you have to do all sorts of other things. You have losses and blah, blah, blah. So what happened? Naturally we had shortages because refineries can't just swing their production between heating oil, IE distillates and gasoline overnight and suddenly produce 30% of this more and 30% of that more. So storage is absolutely essential. That's why it comes from agricultural industry. You know, not, not that I'm huge in agriculture, but it comes because a lot of agricultural products need to be stored like wheat and so on. And, and the, the, the theory of storage is absolutely instrumental. So any of your viewers or listeners who who are really keen on on trading commodities which they should definitely read up on on the various storage and. Financialization, Interest Rates, and Volatility in Oil Prices It's interesting too, I think that again, there's always this debate and we've seen, for instance, Kevin Hassett, you know, in the US talking about how, oh, the, you know, the futures curve says that Brent will be or the oil price will be down to $70 a barrel by what, summer, next summer or whatever like that. And I've always been of the of the view that the the fuse curve is not a forecast, is not a flat price forecast. But I think what your point here around the, the forward structure of highly seasonal products like gasoline or natural gas, but it has a very predictable seasonal pattern of storage. It's not about the forward curve necessarily predicting or forecasting the flat price of those, but it is implicitly baking in the necessary seasonal storage incentives that this market needs to naturally carry over inventory and supply from one season to the next. Is that is that right? Speaker 2 Absolutely, I would. What I would say just is that that that that curve gives you absolutely essential information correct on which we act. And now let me, since I'm saying this, let me throw another kind of a big thing that even the PhD analysts get it, in my opinion, totally wrong, as you probably know people that the flat price, the flat price of oil is usually modeled based on storage. The more storage you have, the lower price you expect, OK? But actually, if you think about it, it's really as a trader, it's, it's actually the store, it's actually the, the, the, the storage curves, I'm sorry, the price curve, the time structure that tells me how much oil to store. It's actually the price of oil that gets me to store oil or not. It's the other way around. So essentially the only reason we are using storage to predict futures prices is because we haven't got anything else out there. And that storage is, is essentially an indirect indicator of the supply and demand balances. Yeah. So if the market is oversupplied, price should go down and it does. And, and, and basically what people do when when it goes down sufficiently, they put oil into storage. Yeah. And then but but by reading that there's a lot of oil in storage, therefore price should go down is the wrong way around. Having said that, it it's more complicated than that because dynamic process because anything in storage now is future supply. So that there's that argument as well. So anyway, it's not straightforward. But anyway, I just want to highlight that that, that it is a little bit. People do use slightly wrong things to actually calculate things that we think are set in in in stone. Speaker 1 Well, so let me let me play something off you then, because and this is going to be like a like a student giving the professor kind of his homework and seeing if if this checks out in your mind. So this is the way I typically approach the because again, everyone has that inventory price chart, right? Like that's like one of the cliche things. It's, you know, inverted chart, Bing bang, boom. I've always found it a little simplistic. It's kind of like revealed. But sure, there's more to it than that. And I think it doesn't tell you that much interesting about what's currently happening in the market. So I've split it in half. And one of the things I noticed that's very interesting is that in that classic, you know, you know, regression between prompt prices or kind of spot prices and inventories or, and inventories, it's actually the back of the curve. So I'm modeling that as like the 36th Sprint month or whatever that actually correlates better with the overall inventory level in the inverse way. So I split out that as one piece that the inventory level as a perception of scarcity or, or or revealed scarcity sets the rough curve level. But then to your point, we still need the theory of storage in there. So then structure based on the spread between let's say the front month and the 36th month or whatever else is the thing that's driven by fundamentally supply demand imbalances of the moment that then drives structure and then structure then drives those inventory increases or decreases. So I'll send you my, I'll change you my chart after. But like how else would you think about that? Like if you wanted to add more to that, how would you round that at all? Speaker 2 Well, I mean, you put it on the spot. It's the, the, the, the reason, the the reason. I know you, there's nothing more to it in terms of theory of storage. You, you've, you've got the whole thing there. And I think the important part where you've said is that you've got it right way round rather than wrong way around. It's just that, you know, the, the, the way where the complication is, and I mentioned that earlier, is that imagine, and I've done this before, many, many moons ago, when you actually start writing a model in terms of equations, it's a basically it's self feeding system or loop system where suddenly your oil in storage becomes supply in the future. So you have to work out depending on the cost of storage and depending on the rate of interest and value of money, where that story is going to be used. But most people in practice, you know, they book their storage about six months forward. So you can actually make some really good assumptions there as well. But other than that, I think you've got it. You know, the, the, the devil is in the detail where that's why it's, I think it's virtually impossible to model oil market. And I've done it myself as well, is because these days with financialization, oil has, has had so many other drivers. Because oil is used as a hedge against inflation, is used as a, as a risk on trade risk on risk of trade. It's it's basically used in, in a number of ways by funds that don't trade out outright price, but they use a spread trades, You know, I don't know, people can be long crude, short cotton or God knows what. So there are a lot of other trades. But then also you have lately I've done, I've seen some literature looking at volatility is obviously very, very important. We haven't even touched the subject, but we can probably do it separately or you can do it with Ilya as well, because that's his cup of tea because he loves option trading anyway. So what what, what happens is that the this is where Donald Trump comes in because the volatility of the economic policy, volatility of, of, of monetary policy becomes a really big, big issue because the traders the trade absolute price level on, on oil. They are clearly looking at interest rates because interest rate is a cost for storing oil. And I always say repeat for younger customer, younger listeners. Oil does not give you a dividend like other commodities don't as well. Gold is the same. You don't get a dividend. So the only thing you have is capital gains. Everything else is cost. So the higher the cost of storage, the higher cost of of of of time value of money, the lower the oil price by definition. And volatility in terms of monetary policy doesn't doesn't vote very well for price of oil either. Bridging Academic Theory with Real-World Oil Trading Insights So there are a number of other factors. Speaker 1 Well, Addy, thank you so much for joining the podcast today. I always truly enjoy these conversations. I love anyone that can really dig into like the nitty gritty and I think also brooch. Well, my favorite thing about you speaking is you're broaching the kind of, you know, participant trader side with the academic side. Because I, as someone who basically wishes I did a PhD myself, I always want to kind of bridge those worlds. And I have neither APHD nor do I trade physical barrels. So I just kind of pretend in the middle. But it's very, very lovely to chat with you as always. Speaker 2 Now it's this pleasure to be here and you're, you're young, you can do your PhD entry some barrels in the meantime. Speaker 1 Oh, I like the vote of confidence. So let's hope. Let's hope after the war maybe. Speaker 2 Yep, if it ever ends. Speaker 1 If it ever ends, and if not, we'll have to have you back on again. Speaker 2 Yeah, pleasure. Always pleasure chatting with you guys. Take care. Bye. Speaker 1 The information presented should not be considered investment advice. The Clear Command Network and its affiliates are not responsible for any loss arising from any investment decision in connection with material presented herein. Please do your own research and speak with a licensed financial representative before making any investment decisions.