Oil Dances the Contango Around the Basis

Is it 'speculators' or Peak Oil?  Take a look at this chart, and read Tim Woods trenchant analysis, and you will be convinced that this is a classic parabolic bubble, an oil mania driven by a piling on of speculation driven by fear (greed being a type of fear, fear of falling behind).  It will end badly, with a linear drop to below when the mania started, which here looks like $49.50 in early 2007.

How can this be, pundits argue, when the oil must be delivered?  Won't the price eventually hit the level which balances supply and demand?  Read on, below the fold, to learn how to dance CONTANGO with your partner, the BASIS.

Oil traders don't trade the price but the BASIS - simplified, the difference between the current price and the next delivery price.  If the BASIS is in CONTANGO, meaning the future price is higher than the current, the trader can buy current and sell future, and pocket the spread - the BASIS - less any costs. Even if the price goes up and up, if we remain in CONTANGO, the traders make money playing the BASIS spread.  This doesn't end until something pops the bubble and the future prices drop below current.  Then we sell the current and buy the future (at the lower price), locking in the BASIS the other way - driving the price down relentlessly faster than it went up, as traders panic to reverse positions. 

Normally this doesn't happen, although oil has always been relatively volatile, since unlike most commodities like corn, it isn't perishable.  Normally most traders in oil have commercial interests: refineries, distribution, oil companies, downstream oil processing/plastics.  They try to manage oil price volatility in the futures markets.  Speculators join in and provide increased liquidity. 

But we are not in normal times.  The current oil dance is a phenom is driven by a "perfect storm" of three causes, all financial in nature: (a) Dollar weakness, (b) de-leveraging from the subprime mess, and (c) a huge increase in speculative interest from 30% to 70% of the oil market, which most likely accounts for the parabolic curve.   

a) Oil stayed relatively flat from 2001 until 2004, and then it began to rise, spiking up in 2006 momentarily.  In parallel, the Dollar has been falling, and had a brief recovery in 2004-5 before falling again.  It is now down from 120 to just above 70 in the Dollar Index, almost halving. 

b) Matters accelerated after the credit crunch hit last July, and charts of commodities show all rising fast since Oct07 as if they were linked.  This is unusual historically.  It likely reflects the de-leveraging from subprime and similar debt instruments.  With the Dollar falling during the crisis, commodities and in particular oil provide a hedge.  Since 1973, the Dollar has been on an oil standard, and oil tends to rise faster than the Dollar falls, and vice versus. 

c) Funds that de-leverage can take advantage of the so-called Enron loophole (see below), and appear to have done so - it is estimated (remember the data is obscured) that speculative interest in oil has increased from 30% to 70%, a huge increase, largely on the long side.  The funds buy with high margin through investment bankers who sell the future contract and pocket the basis; when their deliveries come due, the funds simply offset against the future contract and roll over to the next period. A continuous increase in the long side is the result. 

(The Enron loophole: At the end of the Clinton era, a loophole was created to benefit Enron, to allow speculators to trade through investment banks and still be considered commercial interests, not speculators, obscuring how much speculation is in the market and potentially giving better margin levels.  In 2006 the CFTC, which regulates oil trading, allowed electronic trading to extend to London under the Enron loophole, bringing in a much larger potential volume of speculation.)

The bubble may be extending due to pernicious but tediously predictable manipulation by oil States, particularly Saudi Arabia.  Normally you wouldn't hoard oil when prices are high, but when prices are rising and the markets stay in CONTANGO, a clever oil producer can govern production to maintain the aura of scarcity , and ride prices up.  The Saudis have enough swing capacity (or so they claim) that they can be the final player at the margin, and do their own COTANGO dance until the music stops.

When will this end?  It may burn itself out.  The wave structure suggests an end somewhere between $160 and $189/bbl.  It may be popped by strengthening the Dollar, closing the Enron loophole, and jawboning.  Most likely it ends when credible new sources come on line, such as the US *really* getting serious about drilling again and building new refineries.  The markets do not need the drilling to occur or the new oil to flood the market; just the change in mindset about the up up and away price of oil.  Or it could end when demand is clearly going to slacken, especially demand from China and India.  It doesn't have to actually moderate, just be expected to reverse. 

If I had to speculate, I would place to top sometime shortly after the Beijing Olympics, probably in September.  The Chinese will keep their engine running flat out through the Olympics, and then will need to deal with huge distortions that are already straining their economy.  Keeping their currency low to the Dollar has imported a fairly high inflation.  Labor rates are rising, and many Chinese goods with heavy labor content are becoming too pricey.  We might see a retrenchment of flat-out growth and a more rapid float of the RMB.  In parallel, India is suffering similar distortions (inflation, slowdown in growth, etc.).  Chinese and Indian markets may already be anticipating slower growth, as they have essentially crashed over the past nine months - the Shanghai stock market is down 50% off its all time high, after its own parabolic rise. 

Or, it might come after the US election in November.  Like the Chinese, the Bush administration is doing whatever it can to keep the econmomy chugging along: low interest rates, tax rebates, weak Dollar to encourage exports to make up for the drop in home construction. 

Ironically, those very policies have also helped spark the Oil Bubble, and high gas prices may undermine all the efforts to sustain growth. Three of the last four US recessions (1991, 1980-1, 1974) were driven by oil spikes.  Nixon, Carter, HW Bush, and W never learned how to dance the CONTANGO. 

Comments

[George Soros]

I almost went broke shorting crude and natural gas!

[Percy]

All Tim's invitations are "trolling for suckers" oh I meant subscribers. All his statements ever say is he is watching his, take his word for it, "precious indicators". If anyone needed him to tell them the oil price is parabolic, please sit on the stool in the corner of the class. Tim doesn't say buy oil, Tim doesn't say sell oil, he says pay for my letter and I'll tell you what my indicators say. He implies here, but doesn't say it, that he saw, through his indicators a tradeable November top, but all he has actually done since November is watch his indicators and look for a 4 year cycle bottom, which after 5 years he is still watching for. Try to trade on Tim's indicators if you don't like money and want to be told after a loss that "I didn't say that". I have not been one of his suck.. er subscribers but have followed the good ole boy from afar, very afar. I recommend all do the same.

[Eventhorizon]

Thanks for this interesting post, Yelnick.

I have read several essays in recent months discussing the "speculative bubble" vs "weak dollar" vs "peak oil" hypotheses. I find each argument to have its merits.

To me, it "feels" like a bubble when I look at the chart, but I find this to be the weakest argument from a market mechanics point of view. I can't seem to get my head around this spot vs futures and contango vs backwardation thing.

It's all in your third para above. Here's my confusion, I hope you can help me understand the mechanism of this contango trade: If we are in contango as a speculator I buy spot and sell futures and pocket the cash spread. But what do I do with the oil I now own? Do I take delivery and store it? I can see that I only need to store one month's worth of this trade since from that point on I simply roll contracts (my short future becomes short spot next month which I cover and then short futures once again pocketing the spread). Ultimately I sell what I have in storage once the market gets into backwardation.

IF I have this correct then anytime this trade is increased there is a concommitant increase in oil inventoried somewhere (either in a tank farm, in VLCC, or ... ?). Where would this show up (official inventories, as high VLCC rates / tanker shortages, somewhere else?)?

Am I on the right tack?

[yelnick]

Event, let me explain as best I understand it in a new post.

[TObject]

Here's interesting commentary on FSN this week - Institutional Investors reducing exposure to oil - skip to 36th minute from the start
http://www.netcastdaily.com/broadcast/fsn2008-0705-1.mp3

Percy, agree with you 100% on Tim's "magic indicators" :)
He never says what those indicatora are telling him right now.
But he does have free radio commentary each week
http://www.cyclesman.com/Articles.htm

Puplava clan at FSN bugs me too. I listen FSN for years but all they talk about is oil and gold and especially their favorite Gold Juniors and how we're all doomed. Puplava loves to make huge profits (like 300%) in Gold Juniors yet when comeone is shorting his favorite penny stock he's mad. Puplava invited Eric King who screams at you "You have toi buy juniors!". This sector so volatile and so thinly traded they need suckers to make money. Recently Puplava gona completelly mad - he asked his listeners to call FBI because someone shorted his favorite gold junior. Although I agree Naked shorting should be delt with. Yet solution is simple - don't play in the sector if you know you can lose a lot. But Puplava clan not only continues to play there, they suck listeners as well.

[I.Sosceles]

Yelnick,

A logarithmic chart, please. Does it matter? Yes.

[TObject]

Here ya go, log scale :)
http://picasaweb.google.com/Slash850/TACharts/photo#5219568287028740706

[pawel]

this is hiperbolic buble

[patrick neid]

My guess for legislative action, should there be any, will be closing the "trading limits" loophole window that Goldman and Morgan have been crawling through placing all those "buy only" positions for the swaps they have been writing.

It may even end up looking like the "sell only" rule the CFTC instituted to crush Bunker Hunt's silver escapade back in 1980 leading to the silver futures trading lock limit down for 21 days.

[JP]

@George Soros

He went short just after the top in May and said: every turn to the upside must be a counter trend move until the trading cycle low, (which is due in..... only for subscribers)

Tim is doing a great job.

[drilling rigs]

i am not sure what to think about this.

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[Penny Stocks]

Thanks for the information on topics.I was excited for this post. Thank you again.

[Penny Stocks]

Smart post!from now on i will try those tips, very informative thanks for sharing.