Monday, July 22, 2013

Oil Looks Extended: "Huge Backwardation In Crude Oil" (and what it means for equities)

Major caveat:
On March 31, 2012 we posted "Lumber Says This Is A Top For Housing Stocks" (ITB; XHB) because we agreed with the premise.
As can be seen in this comparison of the iShares Homebuilder ETF, the SPDR Homebuilders and the S&P500 that was an awful call:
Chart foriShares Dow Jones US Home Construction (ITB)
The link was to McClellen Financial (yes, he of the oscillator).

It was so bad that two months later we posted "Our Worst Call of the Year and How Tight Stops Can Save the Day (XHB, ITB)":
Embrace your losses. Booking your losses should be a joyful thing. The first loss is the screw it. 
The worst call post goes on to look at one of the masters of the Chicago pits and his thoughts on taking losses, swung by London to see  HOW THE RICHEST ECONOMIST IN HISTORY GOT THAT WAY and ended up back at the homebuilders.
Quite a romp.

With all that in mind we return to McClellen Financial for the first time since that March 2012 post:
Chart In Focus
July 19, 2013 ...Actually, not all oil prices are zooming.  The near month futures contract for light sweet crude oil right now is the August 2013 contract, which settled on July 18 at $108.22 per barrel.  But looking out 11 months into the future to the July 2014 contract, we find that it closed at just $95.56.  That is a huge difference, and it says that oil futures traders are not willing to bet on the current month's high price continuing into the future.  In other words, it is a temporary anomaly.

Such anomalies can contain important information.  This week's chart looks at the raw price spread between the near month contract and the contract that is 11 months out.  When the near month contract is priced lower than the out months, that condition is known as "contango".  In commodities like gold and silver, contango is the norm since the available supply consists of not just the mining production but also all of the bullion sitting in warehouses and safes around the world.

But because oil is so much more expensive to store than gold is, there is not the same sort of standing inventory available to remediate temporary supply-demand disruptions.  So oil prices can move to very large conditions of contango, or to the opposite condition known as "backwardation" like we are seeing right now....MORE
Read on for the oil equity correlation.
$107.03 at pixel time.
HT to Attain Capital Management who write:
...This spike higher in the spread between front and back month contracts in Crude Oil is causing difficulties for many of the spread trading CTAs we follow, but those traders are also saying this is a dramatic spike in the front months which can’t last for much longer. McClellan’s piece agrees on this front, saying [emphasis ours]...

....One item not included in the piece is the structural anomalies surrounding Cushing, Oklahoma and all of the problems getting the shale oil production out of the middle of the US.  The following chart shows that we’re well on our way to fixing that problem, with the amount of oil being sent down to the Gulf Coast from Cushing set to triple by this time next year. That is likely keeping a lid on further out Oil contracts as well.
Chart Courtesy: Reuters
(Disclaimer: Past performance is not necessarily indicative to future results.)
What’s it all mean for managed futures? Well, one well known Crude oil spread trader sure wants to see that Backwardation spike reverse course to the benefit of his short Oil spreads. After that, your run of the mill CTA doing trend following might be overpaying in the front month contract if he’s looking for a several month’s long trend upwards. This costs them some profitability if Crude continues to rise, and causes larger than expected losses should the up trend stall out and the backwardation spike revert to the mean some....MORE