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What Is Backwardation, And Why Could It Mean $60 Oil?

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What Is Backwardation, And Why Could It Mean $60 Oil?

While the S&P 500 has rallied 8.9 percent in 2017, oil and energy investors have been left in the dust. The Energy Select Sector SPDR (ETF) (NYSE: XLE) is down 13.3 percent and the United States Oil Fund LP (ETF) (NYSE: USO) is down 16.8 percent on the year as WTI crude oil prices have once again dipped below $48/bbl.

After rallying in the weeks following a historic OPEC production cut deal in November, oil prices have slumped again in 2017 as it appears the OPEC cuts aren’t doing as good a job as anticipated at alleviating the massive global supply glut that led to a crash in oil prices in 2014.

WTI prices drifted mostly sideways in the opening months of the year before crashing below the $50 mark in recent weeks as OPEC opted not to announce even deeper cuts for the rest of the year.

Things are certainly looking down for oil investors, but Fundstrat analyst Thomas Lee sees one bullish indicator in the oil market that suggests WTI could be headed above $60/bbl in the near future.

A Contrarian Indicator

In an appearance on CNBC, Lee pointed out that oil futures contracts are on the brink of transitioning into backwardation. Futures contracts typically trade at higher prices the further the expiration date is into the future. However, backwardation is a scenario in which futures contracts that expire at later dates are trading at lower prices than those expiring sooner.

“We’re approaching a flip into backwardation meaning the spot price is approaching and may soon exceed the 24-month contract,” Lee said.

Related Link: OPEC Cuts Aren't Cutting It

While this situation may seem bearish for oil investors, Lee said it has historically been a contrarian buy indicator.

“Our investors and clients are overly pessimistic on oil. The market is coming into balance,” he said.

History As A Guide

What could it mean for oil prices if Lee’s contrarian thesis comes true? The last four times the oil futures market slipped into backwardation oil prices rallied between 25 percent and 72 percent over the next nine months.

Using $47/bbl as a starting point, those types of returns would be equivalent to oil prices of $59 to $81 per barrel by February of 2018.

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