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Oil bulls are putting their faith in an old man and a little boy. They hope the former, septuagenarian Saudi Oil Minister Ali Naimi, is right in saying there has been "a fundamental change" in the oil market. They hope the latter, the weather pattern called El Niño, "the boy," will go easy on them.

Mr. Naimi, speaking ahead of last week's summit for the Organization of Petroleum Exporting Countries, was trying to draw attention from extraordinarily high oil inventories, emphasizing instead that the global economy is recovering.

Mr. Naimi's language, with shades of a "new paradigm," should unnerve bulls. So should market data.

It is true that oil prices kept climbing even as inventories rose, which is odd. Fears of "peak oil," the impact of Chinese demand and inflation helped fuel interest in futures contracts, pushing up forward prices. The resulting contango, in which near-term contracts are cheaper than contracts for delivery in the future, made it extraordinarily profitable to buy crude, store it and sell it forward. Assuming 80% leverage, a 3% cost of debt, and 50 cents a barrel per month in storage costs, buying physical crude and selling it 12 months forward netted returns above 50% as recently as April.

The danger comes when, as now, the forward curve flattens. The contango has narrowed by roughly half since late July, with the 12-month contract now trading about $5 above front-month oil. Using the assumptions above, the trade now generates a loss of 18%. Sure enough, inventories in the U.S., which uses a quarter of all oil, have fallen since early August, although they remain high.

Absent a "V-shaped" economic recovery, therefore, the risk is of a glut of inventories being liquidated. Certainly, the strength of crude prices isn't translating into better refining margins, which have weakened around the world, a sign that final demand is lacking. Valero Energy, America's largest independent refiner by capacity, last week announced more shutdowns.

A big worry, now that summer is almost over, is the overhang in distillates, primarily diesel and fuel oil. U.S. refiners usually switch output to distillate from gasoline as winter approaches. But with distillate inventories almost a quarter higher than the five-year average, there is little incentive to run refineries all out. That means less demand for crude.

El Niño, which can mean mild winters in North America, could exacerbate this. The Climate Prediction Center last week said that El Niño would strengthen through fall and winter.

OPEC may well have to revisit its optimistic view on inventories. Yet OPEC's compliance with earlier production cuts has dropped to 66% in July from 83% in March. The cartel's willingness to forgo more revenue by cutting output could be all that stands in front of a big move downward in oil prices this winter.

Write to Liam Denning at

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