The fall and winter of 2019-20 looked like easy money for investors in the oil market. Then the coronavirus hit.
Beyond the virus’s human toll, with hundreds dying in China and thousands sickened there and elsewhere, the global response to the health crisis has rippled through financial markets. Volatility returned to the U.S. stock market after months of relative calm, while bond yields have fallen and commodity prices have seesawed.
In oil markets, the conditions that had made the crude-oil trade so lucrative suddenly dried up. On Monday, Brent-crude futures that expire this month closed below the price of contracts that expire in March for the first time in almost a year—a situation known as contango.
That shift was driven by efforts to contain the contagion, which led traders to anticipate an immediate fall in Chinese energy demand and pushed near-term oil prices lower relative to future months.
For the past couple of years, traders have made rich profits from selling oil futures closing in on expiration and reinvesting the proceeds in later-dated contracts that carry lower prices. This strategy proliferated in recent years among exchange-traded and momentum-tracking funds seeking to exploit the market condition known as backwardation.
Backwardation takes place when futures prices rise the closer the contracts are to expiration.
This market pattern helped investors in Brent-crude futures earn a total return of 38% in 2019, according to the S&P Goldman Sachs Brent Crude index, well above the 23% rise in spot Brent prices. Returns on Brent surpassed the 31% return that stock-market investors earned from the S&P 500 index, as well as the 17% rise in broader commodity prices tracked by the S&P Goldman Sachs Commodity index, which includes raw materials like copper and grains.
This tailwind all but disappeared as the outbreak of coronavirus hammered short-term oil prices this week. Brent has generated 16% losses in 2020, only marginally better than the 17% drop in spot prices.
“It’s definitely a reaction around the demand destruction in China,” said Frank Monkam, a crude-oil trader at Gunvor Group.
A week ago, U.S. Commodity Funds LLC had almost reached the limit of what it is able to invest in energy futures and was enjoying the easy money to be made from backwardation.
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It was a “much better environment for commodity investing than it was a few years ago,” said the firm’s Chief Investment Officer Kevin Baum, because the firm was able to earn a steady profit from rolling into cheaper later-dated contracts.
The outbreak of coronavirus has forced a change of approach. As oil markets moved into contango, Mr. Baum’s firm slashed the share of its main fund invested in energy from just below 35% to 21%, buying livestock, agriculture and precious-metal futures instead.
While contango punishes investors, it also presents an opportunity for physical traders who ship barrels of oil around the world.
“Traders can look for storage opportunities when it becomes entertainable—depending on storage costs—to technically hold barrels in tanks and sell them later and potentially make money,” said Mr. Monkam.
The number of confirmed cases of coronavirus, which originated in the central Chinese city of Wuhan, has climbed above 24,000, and the death toll has surpassed 490 people. Beijing extended the Lunar New Year holiday, imposed travel restrictions and placed several manufacturing centers under quarantine. Businesses, stores and restaurants have also closed in parts of the country to allow employees to stay at home and avoid person-to-person infections.
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In the West Texas Intermediate market, the futures contract that expires in February cost $51.04 a barrel Wednesday, 17 cents a barrel less than the contract that expires in March.
Before coronavirus struck, oil markets had mostly been in backwardation since August 2017.
This was because output cuts by the Organization of the Petroleum Exporting Countries and its allies had drained a global glut of oil, putting a premium on crude that was available sooner rather than later. The world’s biggest oil-exporters are once again considering steeper production cuts, The Wall Street Journal reported this week, which may swing the market yet again.
Several other factors are also squeezing oil supplies, including disruption to exports from Libya, slowing production growth in the U.S., sanctions on oil-exporting Venezuela and broader geopolitical concerns in the Middle East.
Brent futures remain in backwardation beyond April, suggesting that traders aren’t pricing in a long-lasting fall in Chinese demand. Longer-term trends have also made the oil market more inclined to be in backwardation.
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Financially stressed U.S. shale producers are hedging more of their sales in the futures market, seeking to prove to lenders that they have guaranteed cash flows, said Marwan Younes, founder of Massar Capital Management. This is weighing on the price of long-dated crude contracts because there aren’t many investors competing to buy them, a result of the demise of several commodity-focused hedge funds.
For now, however, Mr. Younes said he is wary of betting on a speedy recovery in Chinese oil demand as authorities grapple with the fast-spreading coronavirus.
“You can’t hope to contain it without taking fairly drastic measures, and that has to transfer into a hit to consumption, a hit to consumer sentiment,” Mr. Younes said.
— Anna Hirtenstein and Pat Minczeski contributed to this article.
Write to Joe Wallace at Joe.Wallace@wsj.com
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