Friday, July 27, 2007

We like Matt Chambers on Oil

I've never been good at trading a market in backwardation so I usually stay away.

For the last week though I've had a nagging suspicion that oil was lulling the bulls into a false sense of security, sucking in the hedgies (who aren't), come on in the water's fine. And silliness like this:

For the past few years, a vicious contango in the energy markets has made investing in commodity futures mostly a losing game. Investors in the new and popular commodity-focused exchange-traded funds, such as the iShares S&P GSCI Commodity-Index ETF (AMEX: GSG), have watched in consternation as their investments lost money despite the surging bull market in spot commodity prices.

The reason, still poorly understood by many investors, is that the primary driver of the value of a commodity futures investment is not the spot price of the commodity. Rather, commodity futures investments are driven by three factors.

1) Changes in the spot price

2) Interest income: You only have to put up a small fraction of your money to buy futures, and the rest can be invested in Treasuries.

3) The roll yield: Futures contracts expire each month, and you must sell the expiring contract and buy the next month's contract when that occurs. If the next month contract is priced higher, you lose money: that's contango. If it's priced lower, you make money: that's backwardation.

Historically, the roll yield has been the most important factor in long-term commodity returns. For the past few years, it has been viciously negative. That's the reason the United States Oil Fund (AMEX: USO) has lost 16.4% of its value since launching in April 2006, despite record oil prices. Similarly, the aforementioned GSG is down 10.6% despite a raging bull market for a broad range of commodities.

So why get excited now? Because the vicious contango(!) appears to be abating.

When I think I know what's going on I have to consciously remind myself of General Custer's comment as he rode into the valley of the Little Big Horn, variously reported, here's Time's version:
"Hurrah, boys, we've got them! We'll finish them up and then go home."

DJ's Matt Chambers wrote for the wire:

...“Anyone who bought in at this price last year got absolutely slaughtered,” said Walter Zimmerman, vice president of United Energy in Jersey City, N.J. “The market is remembering what happened a year ago” when prices crashed in early August as a severe hurricane season that was predicted failed to emerge.

...While that might seem a positive factor, to cancel the bet or lock in profits, traders need to take a short position, essentially a bet that prices are likely to fall. Many analysts are concerned that once selling starts, the funds will cancel bets quickly, exacerbating the decline. The ability of the crude market to fall from its lofty levels was shown early last August, when prices fell $20 a barrel, or 25%, from near-record levels in a little more than a month.

Speculators with long bets “need a hurricane or some other supply problem” to keep prices going higher, Zimmerman said. “If that doesn’t happen, there is the potential for a reversal” as traders sell to close out long positions, he said.

We like Matt Chambers, here's today's WSJ Online uptick update.

Vanna, I'd like to buy a clue please.

Update: I see that as I was noodling, the WSJ's Energy Roundup posted a note from Mr. Chambers on today's action.
I'd still like to buy a clue.