Crude oil futures curve, or the forward curve is one of the mostly common terms you will hear about. As an oil trader who has exposure to crude oil futures, understanding what the crude oil futures curve is all about is important. There are many misconceptions about the forward curve or the futures curve for crude oil. In this article, I will explain in simple terms what the oil futures curve is all about.
By the end of this article, hopefully you will be a bit more knowledgeable when it comes to the crude oil futures curve or the crude oil forward curve. So let’s get started with the absolute essentials.
What is the crude oil futures curve?
Many people think that the crude oil futures curve forecasts the future prices of crude oil. This is absolutely wrong!
The crude oil futures curve, is simply the term structure of the various oil futures contracts and their respective prices. These oil futures contracts are set up one after the other. On the left side, you would start with the spot price, and then use the immediate or the active oil futures contract to build up the curve.
Therefore, unlike a regular oil futures price chart, where you have time on the x-axis and oil price on the y-axis, a crude oil futures chart has the monthly contracts on the x-axis and their respective price on the y-axis.
If you are unsure, read about what are crude oil futures contracts to get an understanding of the futures market.
How to plot the oil futures forward curve?
The best way to understand what crude oil futures curves are all about, let’s work with an example and dig our way through.
The first step is to collect the end of day prices starting from the spot oil price, all the way through to the next year. We will make use of the EOD oil price from Barchart.com.
From this, our table would look like the below.
|CLN21 (Jul ’21)||66.07||05-25-2021|
|CLQ21 (Aug ’21)||65.79||05-25-2021|
|CLU21 (Sep ’21)||65.32||05-25-2021|
|CLV21 (Oct ’21)||64.78||05-25-2021|
|CLX21 (Nov ’21)||64.25||05-25-2021|
|CLZ21 (Dec ’21)||63.72||05-25-2021|
|CLF22 (Jan ’22)||63.22||05-25-2021|
|CLG22 (Feb ’22)||62.74||05-25-2021|
|CLH22 (Mar ’22)||62.29||05-25-2021|
|CLJ22 (Apr ’22)||61.88||05-25-2021|
|CLK22 (May ’22)||61.51||05-25-2021|
|CLM22 (Jun ’22)||61.16||05-25-2021|
|CLN22 (Jul ’22)||60.78||05-25-2021|
|CLQ22 (Aug ’22)||60.42||05-25-2021|
|CLU22 (Sep ’22)||60.09||05-25-2021|
|CLV22 (Oct ’22)||59.77||05-25-2021|
|CLX22 (Nov ’22)||59.48||05-25-2021|
|CLZ22 (Dec ’22)||59.22||05-25-2021|
The next step is to use MS Excel to create the futures forward curve for our crude oil data. You can click on the chart below to view it in full screen.
As you can see from this little exercise, we simply created a crude oil futures forward curve. From this, we can now form a definition of the crude oil futures forward curve.
The crude oil futures curve, or the forward curve, is a graph showing the oil prices in the weeks and months to come. In other words, the forward curve is simply the term structure of the various futures contracts in the crude oil futures chain.
What is the crude oil futures chain?
The crude oil futures chain, as the name suggests is a chain of all immediate futures contracts. The futures chain shows the ticker of the futures contracts, their expiry and their prices. When you club together, the futures contracts in an order (starting from the active contract, all the way into the future), you get the crude oil futures chain.
It is from this futures chain that one is able to plot the futures forward curve.
Below is an example from the Refinitiv Eikon terminal showing the crude oil futures chain.
As you can see in this futures chain, the most immediate oil futures contract is the one expiring in July 2021. If you look at the chain, you will see that starting from the active contract, you have the next contracts in the chain. The further out you go into the future, the liquidity starts to dry up. This is evident after the June 2022 oil futures contract. If you look to the column title Op. Int, which is short for Open Interest, you can see that it beings to decline as well.
What does the crude oil futures curve tell you?
So far we know what are crude oil futures and also explained with a simple and quick exercise on how to draw you own oil futures forward curve. Now comes the obvious question of what does the forward curve tell you.
If you pause for a minute and think, you might find the answer yourself!
When you line up all the oil contracts and their respective prices, it tells you how the demand and supply looks like for the commodity over a period of time. Below is another example of the crude oil futures chart from Bloomberg.
This more up to date WTI futures forward curve shows that the prices are high on the extreme left, comparing to the prices on the right. In other words, there is a lot of demand for crude oil currently and in the preceding months rather than a year from now. But of course, this is how the futures curve looks like today. It might change tomorrow, the week after and so on.
The most important point to note is that this oil futures forward curve does not predict oil price. Therefore, do not misinterpret the chart by thinking that oil prices will fall a year from now.
This is one of the most classic mistakes every beginner to crude oil trading makes. The forward curve gives the oil trader a generic overview of how the futures market looks like.
However, note that the curve doesn’t always have to look the same. In other words, there is a good chance that the curve might shift. Below is a comparison between the oil futures chart, a year ago (in red) to how it looks today (orange).
You can see how significant the oil futures curve has shifted over a span of a year. This should serve as an important reminder that the forward curve should not be used as a means to predict oil prices.
Backwardation and Contango in the futures market
In the above curve, you might notice that the direction of the slope has shifted dramatically. This is nothing but a market phenomenon.
When the futures curve slope upward, it indicates that there is less demand for oil currently and in the short term, while there is higher demand for oil in the medium or long term. This creates the upward sloping futures curve (in red). This phenomenon is called Backwardation.
Likewise, when the futures curve slopes downward, it indicates that there is high demand for crude oil now, comparing to the longer dated contracts, or in the future. You can see this on the above chart, in orange. This phenomenon is called Contango.
Backwardation and contango are two important aspects of the futures forward curve. Whether you are looking at the oil markets, or other commodities, the concept remains the same. In short, backwardation and contango are simply terms referring to how the supply and demand looks like.
What does the futures forward curve signify?
If the forward curve or the oil price forward curve does not predict price, you might be wondering, what is it used for.
Well, the forward price curve is useful in a lot of ways and this where, things get a bit more advanced. To begin with, the forward curve can show you characteristics such as the cost of delivery, seasonal demands and so on. When the forward curve is in backwardation, it means that demand for storage is lower.
On the contrary, when the forward curve is in contango, it shows that demand for storage is higher.
Storage is an important concept in the futures markets. You can read more about the cost of storage in this article.
Because of the backwardation and contango phenomena, commercial traders are able to manage their inventory accordingly. Obviously, when demand for storage is lower, the cost of storage also falls. Thus, as an inventory manager, you might want to take advantage of this lower cost for storage when the market is in contango.
Seasoned oil traders can also create trading strategies using the oil futures forward curve.
As an appetizer, if you see that the futures curve is in Contango, you know that the cost of storage is lower.
You can bring in the futures spread into the equation. Thus, in a contango market, you could ideally stay long on the current contract and also stay short on the next active contract. Because the cost of storage is cheaper, you can wait for both contracts to expire and pocket the difference from the storage.
Besides this simple example, there are many other trading strategies that one could devise using the oil futures curve.
Futures Forward Curve for Oil – Summary
To summarize, the futures forward curve is a curve used in the futures markets, or in our context, crude oil markets. It is simply a plot of all the futures contracts prices in the oil futures chain. By looking at the futures curve, one can get a brief idea of how the supply and demand for the commodity looks like.
Speculators can devise crude oil trading strategies using the forward curve, in the futures market. Similarly, commercial players in the oil futures business can also get an idea of whether it is cheaper to buy crude oil for future delivery or whether to buy outright.