Oil Stocks Find Option Bulls As Crude Finds Backwardation

Oil Stock Unusual Option Activity Report

If you follow the oil market, there is so much to digest right now. Between stimulus, draconian COVID measures, and the possibility that a more virulent version of COVID is muddying the waters.

If you’ve read the blog, I’ve been pretty bullish on oil and energy stocks since early October. However, the huge inventory build two weeks ago had my expectation of a return to normalcy for crude in jeopardy. With crude oil futures testing backwardation, that appears to be changing the game as option bulls are coming back.

Oil Supplies

Last week, there was a small draw in crude of 3.1 million barrels. However, that still placed oil supplies well outside of the 5-year supply range. My whole bullish thesis was based on oil re-entering its historical supply range and the reduced production placing pricing pressure if demand picks up in the spring. The big build two weeks ago made a detour and the news of more COVID closures only placed the return to normalcy in even more doubt. The EIA chart below shows the trend in crude oil inventories.

Oil Backwardation

The concept of backwardation or contango in the futures market isn’t something that a lot of casual watchers of the oil futures market follow. However, I think it is one of the most important things to watch. Backwardation is a condition where the price of the active contract rises above the contracts with more time to expiration.

Backwardation happens when there is a positive net cost of carry. That means the cost of financing and storing the oil is offset by the lease rate. This condition assumes there is an existing or expected shortage of oil. Given the current supply conditions for oil, this seems ludicrous. However, stimulus spending and a ready Federal Reserve may be rekindling the appetite for speculation in the oil market. The appearance of backwardation reflects that bullish interest.

In the chart below, you’ll see how the prices of the various crude oil contracts have changed over the last month. The red line is today’s prices, and each successively lower line is another week further back in time. As you compare the red line for today, the line falls from the January to February expiration before rising. This represents a slight bullish backwardation.

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