Supply dislocations drive Brent market structure into extreme backwardation

Supply disruptions out of Kazakhstan, the North Sea and Libya and dislocations to typical trade flows as the market adapts to the Russia situation have driven the European crude market structure into an extreme backwardation, with buyers being forced to pay hefty premiums for prompt cargoes.

The extreme backwardation -- where prompt cargoes trade higher than forward dated cargoes -- is clearest in weekly Brent contract for difference derivatives. Contracts for the promptest weeks -- June 20-24 and June 27 to July 1 -- were separated by more than $2.30/b, according to broker information June 17.

"I have never seen Dated [Brent] rolls over $2/b before," said one North Sea trader.

In the ICE Brent futures market, front-month versus second-month contracts are now over $3/b apart, highlighting the sentiment for further market tightness.

Traders expect further strengthening at the front-month in paper contracts as the full effects of the EU's embargo on Russian seaborne crude exports is absorbed. One paper trader said a backwardated market structure was set to stay as "only 60%" of the current sanctions against Russian crude were priced in to the current ICE Brent futures price.

Furthermore, firmer paper trading is expected when the full brunt of the new insurance ban on vessels carrying Russian crude comes into force.

In the physical North Sea market, differentials against Dated Brent for key North Sea grades also speak to the tightness in the market. Values have climbed rapidly in recent weeks as the market adjusts to the EU's embargo on Russian seaborne crude by the end of the year and renewed supply disruption in Libya since early June. The Dated Brent differential was last assessed June 16 at plus $4.615/b, an all-time high.

"Baltic refiners are buying the BFOE (North Sea) grades in an effort to substitute the missing Urals," said a Mediterranean based trader.

This was echoed by a third trader saying, "Forties has a strong baseload demand now with less Urals being taken in NWE."

Mediterranean flux

In the Mediterranean sweet crude market, the backwardation has created opposing forces affecting market differentials. Lighter grades are being heavily discounted in order to clear an overhand and avoid the punishing costs of backwardation, while in the medium sweet market supply tightness is pushing up differentials for distillate-rich crudes.

Naphtha-rich CPC Blend was last assessed at a $6.68/b discount to Dated Brent June 16, falling $1.44/b since the longer July program was released June 8.

"The market is oversupplied, many people bought alternatives a long time ago," said a second Mediterranean based trader.

However, cargoes further into July are being bought at higher values in order to guarantee delivery for refineries. "CPC is really feeling the structure," said a third Mediterranean trader, adding that first-half July cargoes were trading at a $3.90/b discount to Dated Brent.

Conversely, in a sign of market tightness in the medium sweet market, protests across Libya have jeopardized crude shipments from key terminals leading to buyers increasing bids for cargoes of distillate-rich Azeri Light.

"Libya's most recent issues have caused a quick return [for Azeri Light]," said the third trader.

Azeri Light was last assessed at a $6.50/b premium to Dated Brent on June 16, up 80 cents/b since the release of the July loading program on June 8.

Despite record-high refinery margins, refiners are noting that the strong backwardation is hurting margins and driving changes in buying activity.

"The market structure is brutal," said a Mediterranean refiner, adding that refiners were looking to buy "partial cargoes" and "running low inventories" in order to avoid the punitive costs of holding crude stocks in a period of strong backwardation.

This is undermining demand and further weakening sentiment across the Mediterranean sweet complex.

WAF suffers

The softening of light sweet crudes out the Mediterranean is also having an impact on longer-haul West African crudes, where the steeply backwardated Dated Brent structure has pressured differentials while advantaging shorter-haul grades from within the continent.

"The strong backwardation in the market is eroding [West African] value fast, $2/b weekly rolls on some inter-week CFDs... ridiculously steep," one Nigerian trader said.

Punishingly high freight rates are compounding difficulties for WAF crudes. The WAF-UKC Suezmax route was last assessed at $17.26/mt, up $3.00/mt since the start of the week.

"Freight to Europe is up and [Dated] structure is eating another 50-60 cents on the backwardation since then," a second Nigerian trader said.

Looking to Asia, things get even more difficult for West Africa. On top of historic backwardation, a strong Brent-Dubai Exchange of Futures for Swaps is further obstructing flows to typical Asian buyers such as India and Indonesia.

The Brent-Dubai EFS was last assessed at $11.12/b, having averaged $9.48/b in May, according to S&P Global data.