Friday, January 22, 2016

Last Contango in Paris (and everywhere else): When Will Oil Market Bottom Out?

When Oil Will Bottom: The Most Important Column I've Ever Written 

by Inside Investor with Dan Dicker -

Everyone’s now pretty well convinced that the collapse in oil prices is a disaster for stocks, something I’ve been trying to convince people of since late in 2014. So, nothing is more important for investors than figuring when oil might bottom out, but even more, when it might turn constructive again.

I think I can tell you that now – making this possibly the most important column on oil I’ve ever written. But I’m warning you: It’s a wonky column, so proceed at your own risk.

As an oil trader engaged in this market since 1983, what’s struck me about the recent action in oil has been the parallels to other oil ‘silly seasons’ – much of the action downwards today looks almost exactly like the action I saw to the upside during 2007 and into the Spring of 2008. 
There are also several parallels to the downward move the oil market experienced from July of 08 to March of 09. In both cases, there is the same disconnection from fundamentals, the same massive movements of capital both into and then out of oil, the same overwhelming speculative positions driving prices – and the same parabolic price action. What does 2008 and 2009 tell us about when all of that stops?

From a fundamental side, I’ve maintained that constructive oil prices only return when real production cuts are realized – so far, those cuts have been mostly on paper with few measurable drops in supply. But fundamentals have limited impact on the oil market when it goes parabolic like this anyway.

From a financial side, something more telling will signal a real bottom in oil is appearing, because it also emerged following the spike in ‘08 and the crash in ‘09: the changing shape of the crude curve.


Oil is traded in monthly deliveries – with each month having it’s own price that moves. The relationship of those monthly prices is called the ‘curve’. If prices generally move downwards as you move out in time along the curve, that’s known as ‘backwardated’, and is a rare event. If they move upwards, the market is in ‘contango’.

Contango, because of costs for storage and other reasons, is the normal state for most commodity curves, and is the way the oil market is today; Oil for delivery two years from now is more than $12 more expensive than it is trading in the spot month – February 2016 – on Wednesday:

A very weak contango, or even a market that has gone into rare backwardation, is a sure sign of a very bullish market – as happened in 2008. A very deep contango, however, how a market looks that has gone parabolic to the downside. One of the biggest money makers during the crash in oil in 2009 was Koch oil, and they did that by buying front futures contracts and storing them for delivery 12 months in the future: at the depths of oil near $30 then, the 12-month contango was near $15 – and a big, “free money” opportunity for oil producers with storage.

That kind of carry trade opportunity won’t happen again today, for lots of reasons – but here’s what happened back in ’09 that foretold that the move down was over: That contango began to deflate, or using the terms of spread watchers, the oil curve began to flatten.

It makes intuitive sense as well that a flattening curve would be the guidepost for a change in market conditions: For one, the ‘carry trade’ opportunity needs to be destroyed before oil production can be truly squashed – In 2009, Koch was joined by Royal Dutch Shell and others and filled every available storage unit and floating tanker before prices truly turned. We know how tight storage is today, with the gluts we’ve been experiencing. 
Second, the hedging ‘safeguards’ of premium oil prices far into the future need to be equally removed in order to deliver production discipline going forward. One of the fears of recovering oil being sustainable is in the resumed production, and continuing gluts, that will come of it. But a flat curve delivers no hedging ‘freebies’ and the easy capitalization that comes from it. A flat curve tends to prevent very strong production growth.

It’s what happened in 2009 – and it’s what must happen again before oil begins a sustainable march upwards again.

For me, I’ve taken up another third of my screens watching – and charting – the spread market in WTI and Brent crude oil, and looking for the signs of a change in the action and shape of the curve. Have a look again at the daily settlement chart I posted above – it shows a deep dive in prices in the front months on Wednesday, and a relatively small drop in prices in the months further back. This is a perfect example of a market still in parabolic decline, and not yet near ready to turn.

What will a day look like of a market ready to go upwards again steadily? One kind of day I’m looking for will be when the bounce upwards is tested back down again. On this day, instead of the spot month getting crushed compared to the backs, there will be a more equal move in both.

A week or two of action like that, and I’ll be convinced we’ve reached bottom for good.

It’s what I’m solely watching right now to try and find a bottom in oil, and, considering the panic in oil and stocks, making this perhaps the most important column on oil I’ve ever written.

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