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Sometimes readers wonder why so much attention is paid to the weekly oil inventory numbers published by the U.S. Energy Department's statistical service. Truth be told, a lot of trader breath is held awaiting each Wednesday morning release by the Energy Information Administration. The numbers can sometimes be surprising—such as yesterday's unexpected drawdown in crude stocks (see "Oil Inventories Continue To Surprise Everyone")—sometimes not. One week's inventory figure, important as it may seem, doesn't tell oil's whole story. For that you have to pull back to see the larger trend. And you have to keep an eye on another metric we follow in each Wednesday Desktop—the presence and size of the NYMEX contango. Contango represents the premium priced into deferred delivery contracts. As an example, the nearby July contract for West Texas Intermediate crude settled at $74.38 per barrel yesterday. The contract calling for delivery of WTI in October—three months forward of July—was pegged at $77.03. The $2.65 premium in the October contract is typically considered to be a contango. Mostly, the spread's made up of carrying charges—financing costs, storage charges and insurance fees—incurred for "carrying" the oil until delivery. A normal, or carrying charge, oil market exists only when there's enough crude to store for future sale. For oil, contango equals surplus. Historically, though, oil prefers to live in a world of slight backwardation—one in which deferred deliveries trade below nearby prices. The inversion of oil market prices indicates shortage. In a backwardated market, traders anxious to secure supplies immediately bid up nearby prices. There's a distinct and direct relationship between domestic oil inventories and the WTI term structure. Zoom out a little and take a look: U.S. Oil Inventory Vs. NYMEX Futures Spreads 
In the long run, contango rises along with inventories. Backwardation sets in when supplies are tight. We've been in a carrying charge market since June 2008—a month before prices broke dramatically amid the financial crisis. If you're looking for a turnaround in our economy, one of the better indicators is the NYMEX term structure. Increasing demand for petroleum will at one point draw down our supplies to the point that the contango can no longer be sustained. Much as the flip from backwardation to contango in 2008 was a bellwether, the flop in the opposite direction will point to an increase in aggregate demand. We'll, of course, be monitoring the situation in each Wednesday edition of the Desktop. So should you.
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Any discussion about oil demand/prices over the next decade must include an attempt to quantify emerging economy demand as an important driver at the margin. Here is a simple thought experiment using Chinese demand to generate some rough “back of the envelope” forecasts:
- China moves from 3 bbls/person/year to the South Korean per capita consumption level of 17 bbls/person/year over the next 30 years
- No peak in global production
Result: In next 10 years we must find 44 million BOPD - 26 million BOPD to maintain supply and 18 million BOPD to keep up with demand increases.
If you superimpose peak production on top of this demand profile using the following parameters oil prices would increase approximately 250% in real terms over next 10 years – something would have to give far before that price level:
- Oil demand elasticity of -0.3
- Current production 84 million BOPD, current price US$ 80
- Peak production 100 million BOPD
- Post peak decline rate of 3-4%
If you want to try the model for yourself using your own assumptions it can be found at Petrocapita in the “Research” section: www.petrocapita.com/index.php?option=com_content&view=article&id=128&Itemid=86