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Backwardation in the oil market, explained

ELISSA NADWORNY, HOST:

There are a lot of factors behind high oil prices right now - soaring demand for energy, natural gas shortages, the threat of conflict between Russia and Ukraine. But there's another explanation for this tightness in the oil market. That is when there's lots of demand, but not enough supply. Stacey Vanek Smith and Paddy Hirsch from NPR's daily economics podcast The Indicator explain a phenomenon known as backwardation.

PADDY HIRSCH, BYLINE: Oil is basically priced in two ways, right? There's the spot price, which is what it costs to buy a barrel of oil right now today.

STACEY VANEK SMITH, BYLINE: Like, on the spot.

HIRSCH: Right on the spot - thank you. And then there's the future price, which is what a barrel of oil will cost you at some point in the future if you lock in the price today. Now, without getting all technical about this, the future price is what oil traders expects oil prices to be months or even years from now.

VANEK SMITH: And when the global economy is expanding, like it is right now, those future prices are usually higher than the spot price, which you would expect - right? - because more growth means more future demand. Helima Croft from RBC Capital Markets says in a market that is as tight as this one, prices should rise in the future.

HELIMA CROFT: People are back on the road. You know, they're getting on airplanes. And there are not enough barrels out there to potentially meet this demand as it is expected to grow.

HIRSCH: But right now, prices are not higher in the future. Right now, you can strike a deal to buy oil in six months for less than it will cost you to buy it on the spot today.

VANEK SMITH: Paddy, that seems backwards.

HIRSCH: (Laughter) The market is in backwardation. Prices are expected to fall in the future, not rise. And there are a couple of reasons for this. The first is that there were a lot of people who bought oil during the pandemic when it was super cheap, and they stored it. And now, with prices rising, they are cashing out.

But as oil heads towards 100 bucks a barrel and more sellers emerge, there is now the possibility of a glut on the market, added to which, Helima says, the speculation that some Middle Eastern countries may start pumping more as well.

VANEK SMITH: And if there is more oil for sale but demand is about the same, then the prices are going to fall. And so they mark those future prices as lower.

HIRSCH: And you might say, big deal - traders are making bets that oil prices are going to fall. So what?

VANEK SMITH: Traders going to trade.

HIRSCH: Yes. But it's not just oil traders who are watching those futures. Oil producers and investors are as well. And right now, they're looking at that backwardation - that expectation that oil prices will fall in future - and they're worrying that if they spend a lot of money on building rigs that take a year or more to come online, oil prices are not going to be high enough at that point to make that investment worthwhile.

VANEK SMITH: So that reluctance to put money in the ground - to invest in drilling rigs and extraction pumps - is a big reason why the U.S. has so little control over oil prices right now. We don't have enough infrastructure online. That means we do not have the ability to just flip a switch and turn on an oil spigot and bring the price of oil down.

HIRSCH: Helima says oil companies are slowly bringing more capacity online, but it'll take a while before we see the effects of that increase - maybe not till the end of the year.

VANEK SMITH: And even if we do get back to pumping like we were before the pandemic, Helima says it probably will not do much to take the edge off high prices. She expects global demand to rise by 4.3 million barrels a day by the end of the year.

(SOUNDBITE OF ERNEST RANGLIN'S "KING TUBBY MEETS THE ROCKERS")

HIRSCH: Paddy Hirsch.

VANEK SMITH: Stacey Vanek Smith, NPR News.

(SOUNDBITE OF ERNEST RANGLIN'S "KING TUBBY MEETS THE ROCKERS") Transcript provided by NPR, Copyright NPR.