Weakening Demand Cycle and Potential Contango Structure
June 21, 2024
Economic activity was surprisingly resilient during the 2022–23 period despite elevated levels of global inflation. As inflation converges toward target levels and central banks pivot toward policy easing, a tightening of fiscal policies aimed at curbing high government debt levels, alongside higher taxes and lower government spending, is expected to weigh on growth. With major commodities priced in US dollars, the rallying dollar we have seen over the past few years has made commodity prices more expensive for buyers around the world and puts downward pressure on demand. The subsequent fall in headline inflation since 2022 reflects a combination of fading energy price shocks (Russia), as well as a reduction in core inflation as factors such as Covid stimulus begin to wane. This ultimately brings the Federal Reserve closer to beginning its interest rate cutting cycle, which should contribute to a retreat in dollar strength.
Weaker economic output along with limited additional room for supply side management can pressure the front-end of the oil pricing curve, while interest rates cuts from the US Federal Reserve (and a weaker US $) would support the back-end of the pricing curve, effectively shifting the forward curve from backwardation to contango (future deliveries more expensive further out than the current spot pricing). Looking at a historical view, we can visualize the relationship trend of US Dollar weakening (shown as the exchange rate between Japanese Yen and US $1) and the strong upward trend in the price of Brent crude, with the exception of the sharp drop during the 2008 period resulting from the Global Financial Crisis. As a result, the crude contango structure is expected to emerge in 2025, introducing significant upside support to tanker demand, as restocking pushes transportation demand above the level for actual oil demand.
Figure 1: Global CPI Forecasts Figure 2: US $ Spot Exchange Rate vs. Brent Price
Source: World Bank, St. Louis Fed
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