“Something structural has changed in current fundamentals” | FT Alphaville

“Something structural has changed in current fundamentals”

John Kemp at Reuters has penned a cracking column on the current peculiarities afflicting the crude markets.

As Kemp notes, ask anyone in the market — specifically the physical market — and they will tell you the market is tight. Not just tight. Really tight. (And most likely that the recent backwardation reflects this tightness.)

He writes:

Hedge funds and other money managers remain convinced oil prices will rise. The ratio of money managers with long positions in WTI-linked futures and options to those running short positions remains 3:1, according to data released by the U.S. Commodity Futures Trading Commission (CFTC). For Brent futures and options, the long/short ratio is 1.77:1, according to Intercontinental Exchange (ICE), lower than earlier in the year but still bullish.

Physical traders are also bullish. “Bullish physical oil traders, who have been warning for months of a tightening market, have so far won the game against bearish macroeconomic hedge funds” as my colleague Javier Blas wrote in the Financial Times on Tuesday (“Swing in WTI price curve leaves oil traders reeling”, Oct 25).

Yet, despite all this bullishness, there is one inescapable fact. Prices have been trending lower:

That’s something that’s very hard to ignore, not least, as Kemp points out, because “sustained downtrends have been remarkably rare since the great upsurge in oil prices started in 2003”.

So what gives?

In Kemp’s opinion it could imply that some kind of structural shift is under way, one which is yet to be understood by the market at large.

As he notes:

It is not necessary to believe in either strong versions of the efficient markets hypothesis (EMH) or the forecasting power of technical analysis to perceive something structural has changed in current fundamentals or expectations about the future.

The downtrend started back in the late spring, long before there was an end in sight to the disruption of Libyan oil supplies, and also before the markets began to fully appreciate risks of a synchronised global slowdown.

Though he does offer some more conventional explanations tool:

The downtrend is probably due to a combination of factors: (a) expected resumption of Libyan oil exports; (b) cuts to projected global growth; (c) downward adjustments in forecast oil consumption; (d) liquidation of the record long positions in oil derivatives taken by money managers in late 2010 and early 2011; and (e) improved confidence in medium-term oil supplies as a result of tight oil and other technologies.

But if there is one indicator of “another” story to be told, we would say it’s this one:

The ratio of long to short position of managed money is still a very bullish 3:1 in light sweet crude, but it’s nowhere near the 10:1 ratio we saw in April/May just before the US debt ceiling debacle shenanigans began in earnest, and before QE came to a chortling end in July.

That peak in the ratio happens to in coincide with when the down trend in crude prices began.

Which is not surprising since it ties with a swift reduction in the length controlled by ‘managed-money’. If that length was the flip side to commercial shorts… and if their view didn’t change quite as quickly, it’s unsurprising that it translated to the choppy volatility we have seen since March and April. Physical wants to sell futures at a higher price than there is demand to supply futures, from managed money. That’s naturally either going to translate into a choppy ride lower on the flat price as futures converge with the physical (if the curve is to remain intact) or see the curve backwardate until the excess supply built up to support that managed money is flushed out.

As Kemp points out in comments here, by definition backwardation is a sign of tightness that is expected to be temporary. “If it was expected to persist, the curve would be in contango.”

The common shorthand that backwardation = tightness, contango = slack, is thus an oversimplification.

(We couldn’t agree more.)

Related links:
Money managers and commodities, the case against
– FT Alphaville
Just when it makes sense to sit in oil futures…
– FT Alphaville
Are index funds the new swing producers? – FT Alphaville
The WTI-Brent anomaly – FT Alphaville