In January I wrote what I called my “most important column” describing how the curve of oil futures, then in deep contango, needed to flatten in order for the oil market to show me that it had bottomed.
We’ve had that flattening of the curve, and with it what I think is a long-term bottom in crude prices. So, what happens when the crude curve flattens and why can you be a bit more confident in buying oil stocks when it does?
The reasons are mostly financial, and not fundamental at all – something that the vast majority of analysts discount, or at least rarely discuss. In understanding the macro motion of the curve, let’s take a quick look at the financial inputs that have dominated crude oil recently.
Fundamental global gluts of crude oil can be reasonably ‘blamed’ for the collapse of prices below $80 a barrel or even $50 a barrel – legitimate panic hedging from producers certainly added to the one-sided move we saw, but the fundamentally unsustainable pricing that we’ve seen for much of 2016, particularly after the 2nd failed OPEC meeting, has been much more dependent upon speculative short positions in the market, particularly from algorithmic momentum funds. We could track the speculative short positions against the price of crude almost exactly as prices dropped below $40 the first time, with long positions decreasing to their lowest levels in five years as crude dropped under $30 a barrel.
In these types of markets, fundamentals get thrown out the window. In 2008, when financial inputs again dominated the oil market, we saw a liquidity vacuum and capital contraction send prices down to the $30’s – the cause was not a fundamental increase in production or lack of demand.
Here’s another important point to futures market operation: Financial players, whether funds, traders, indexes, black boxes or ETF’s almost exclusively “play” oil using front month contracts, and ‘roll them over’ as they expire to maintain positions. In 2008-9 as in 2015-16, front month collapses left large gaps in the back months and deepened the contango to historic levels – in 2008, the 12-month contango reached above $15, at the lows this year, we got an almost equally crazy $9 gap.
Ok, so oil prices lose much of their fundamental moorings when financial inputs take prices to unsustainable levels – whether those levels are very high as in 2007, or very low, as we had in 2009 and today. Prices get wilder in the front months as well. What changes are required to begin to restore “correct” fundamentally based pricing?
Let’s look again at our players one by one, and see what can halt the one-sided flow: Momentum algos have no brain or regard for price – if markets are moving down or up, they will continue to sell or buy forever with few limits. Something has to ‘break’ this avalanche of one-sided orders and god knows, it’s hard to tell what that can be when the market’s collapsing or streaking higher. I will speculate that the avalanche of algorithmic selling this year really ended when the jawboning of a production ‘freeze’ began.
Now, let’s look at our legitimate hedgers, our producers – they have been the waiting sellers on every rally, and the contango has been actually helping them sell during this wild ride. Remember that forwards contracts were at a massive premium to prompt prices. Therefore, even small rallies could be met with an avalanche of producer selling in the back months, again setting the momentum players in motion in the front months. But break that contango and much of that selling goes quiet. With the deep contango we had, $38 prices today are almost equivalent to $30 prices we saw in February, at least if you’re in the market trying to hedge forward production.
Physical players have a great reason to support a wide contango – and their carry trade opportunity only disappears when storage becomes scarce or too expensive. Have a look at the Baltic Dry index over the last two months and you’ll see why their bearish glutting of storage with excess barrels has begun to cease.
Finally, we have the traders and hedge funds – wise guys like me, looking for a play on oil. Of course, we’ve been looking to find a bottom to buy, but how to safely do it in the face of all of this trend selling? News-driven as these markets are, we want to be buying oil with as deep a safety net to hold for as long as we possibly can. Historically, we know the contango has to ease before oil can again rise – so we bank on the curve flattening by buying front months while selling back months.
This is the financial turnaround that’s toughest to map - even the Commitment of Traders reports (COT) only note changes in overall speculative positions but cannot break it down by monthly delivery. When hedge funds and traders sell spreads in size, the COT report is powerless to recognize it, as every long contract is offset by a short contract.
Now that we’ve taken a macro look at each of the futures players, we can see why the flattening of the curve is a mostly financial, instead of a fundamental move – except for a physical change in either access to or costs of storage, all of the other inputs have no connection to fundamental changes of supply or demand in the market.
In short, it’s nearly impossible to get a retest of low oil prices with the curve in backwardation – as it is approaching today – and is therefore a great opportunity to buy loved oil stocks for the long-term.
And the reason it can begin to rally instead? Well, because it has to – for the simple reason that much of the financially driven selling has gone.