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Oil futures in New York fell as much as 2.1 per cent on Wednesday after the Energy Information Administration reported U.S. crude inventories increased by a more-than-expected 1.6 million barrels last week. After this surprise jump in supply, it’s time to revisit the oil futures curve to see what comes next for inventories and the price of crude.

Continuing production curbs by the Organization of the Petroleum Exporting Countries (OPEC) has the effect of increasing short-term crude prices by limiting global supply. This short-term scarcity is artificial in that OPEC countries have the ability to export more oil, but are just deciding not to. This raises the odds of excess supply in the future, which depresses longer-term futures prices. The result is an oil-futures curve that points downward – “backwardation” is the trading term – with longer-term prices lower than spot and short-term commodity levels.

The futures curve is a vital determinant of inventories because of forward selling by producers. In March of 2015, for instance, the price of the 12-month West Texas intermediate crude futures contract was US$56.33 a barrel. (A producing company could contract to deliver oil to a refiner in a year’s time, March, 2016, and the refiner would pay US$56.33.)

The one-month crude future was trading at $44.84 in March, 2015, about $11.50 lower than the 12-month price. The producer in this case was motivated to sell at the higher forward price. Month over month, the increased forward selling led to higher physical oil inventory levels. The oil was produced, but not deliverable until a future date.

Backwardation has caused the reverse effect, acting as an incentive for oil producers to sell oil at spot and shorter-term prices.

In the first chart below, the grey line represents the difference between the 12-month and one-month oil futures price. A rising line indicates that the price for oil for delivery in 12 months is rising relative to one-month prices. The purple line shows total U.S. oil inventories.

The two lines move roughly together, although often with a time lag. The difference between the 12-month and one-month futures price began a sharp slide in early November, 2016, steadily increasing the producer incentives to sell oil at shorter-term prices.

The effects of this became clear in late March, 2017, as U.S. crude inventory levels began falling rapidly as more oil was delivered instead of stored for sale at a later date. Despite the recent uptick in inventories, the history of the chart implies further declines in the amount of U.S. oil in storage. (The curve is still in backwardation, by about US$5.)

The second chart merely reiterates the law of supply and demand. The WTI commodity price tends to move in the opposite direction of inventory levels. Recent trends have seen inventories drop 99.9 million barrels, or 18.9 per cent, since March of 2017. Starting in June, 2017, (that lag effect again) the commodity price has rallied 47.1 per cent or US$21.09 a barrel.

OPEC‘s strategy has succeeded in reducing global oil inventories but it has also raised the commodity price to the point that U.S. drillers have increased production. This rising supply is a hurdle for the commodity price, but as long as the futures curve is in backwardation and inventory levels are falling, it should remain a supportive environment for investors in the sector.

I’m not suggesting that futures prices and inventories are the sole drivers of the commodity price – geopolitical risk has certainly played a role in recent days. However, the futures curve does provide a measurable gauge of fundamental supply and demand expectation, and investors looking ahead for a guide on the oil price should follow its changes.