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Trading Lessons

Peak Bull Crap - How Oil Futures Curve Have Little Predictive Value

Commodities / Crude Oil Jan 12, 2016 - 06:05 PM GMT

By: EconMatters

Commodities

The oil market is the hot market right now from a news generation standpoint. But there are a lot of people writing and even trading in the oil market that frankly don`t have any clue what they are talking about. I have read some real rubbish the last few months regarding the oil market, and with the recent fall in prices, the last few days have been characterized by peak bull crap. Maybe if anything else this is an indication of the bottoming process in oil. Sort of like all those do it yourself Gold Mining shows hitting the reality television scene pretty much nailing the near term top in the gold market.

Long History of Studying Oil Markets

Remember we have been doing this a long time, just read some of our older stuff where we break down the huge drop in U.S. Imports of oil from a finance and numbers analysis with our conclusion that the oil market was long overdue for a major pullback just based upon the US Domestic Oil production pushing down External Imports of oil to such a degree that that there was no way a slowing China could possibly eat up this difference because the numbers were so huge. That the oil had to go somewhere, and frankly we were surprised that it took the rest of the market so long to get it.

Financial Hacks

There are a lot of stupid people in the world, and the financial markets industry is filled with an abundance of hacks even at the professional level. But you now have people who have never followed the oil markets all the sudden giving their hack analysis of the commodity. And it is time to call bullshit on this stuff!

Oil Futures Curve

The oil futures curve used to be more relevant with Contango and Backwardation analysis and to some extent it becomes self-fulfilling and pretty useless as an indicator of market strength or weakness that is already known in the market. Thus anybody today who routinely starts referring to these two terms for their price predictions for the oil market, is only getting the derivative cause for the price movements in the market. Someone who knows what they are talking about will just stick to the primary cause.

Peak Stupidity

Now onto something that really is completely false, this idea that the futures forward curve tells you anything about the future direction of the oil market. This is about as bad as you can get in any oil analysis. It basically screams to any trader who has long term experience in the oil market that this person is a novice hack, and basically has no clue, and doesn`t even know that they have no clue what they are talking about. The forward curve is completely bullshit as any indicator of anything other than a reflection of current market sentiment. It has no predictive value in the market. In fact, it probably is more of a contra indicator than anything else.

Background Info

I will give an example to make this point clear. When oil traded between $80 and $115 for that era we had many moves up on Middle East tension events. Well the front months went up on the curve, and so did the back months where contracts actually traded.

Keep in mind another point there isn`t actually a lot of trading volume on forward months and years of the oil futures curve. More money actually used for hedging and forward bets on the oil market is done with swaps and other OTC derivative plays that aren`t on any exchange whatsoever, and not on the transparent oil futures curve of let us say the WTI and Brent contracts that are on exchanges.

In short, the futures contracts for oil have ridiculously low taking delivery percentages, less than 1% of 1% of all contracts trading is a kind figure regarding anyone taking physical delivery in the marketplace. These are basically trading vehicles, and now mostly done via computer algos like games of poker at a casino. Place your short term bets, make lots of money, and cash out for the next market moves or hands to be dealt by the dealer. In fact most oil trades are held between 20 minutes and two hours for an average trade holding time depending upon the firm strategy.

Another factor is that most actual spot oil is transacted with contracts and prices much lower than the futures contracts depending upon refinery relationships, logistics, and several other factors that I will avoid covering here.

Curve Example

Back to the example after covering some background issues, so when the front month oil contracts spiked on Middle East events they would bring all the other forward months on the curve up with them. Like this latest Middle East tension event would stop the flow of oil, so you would have the front month futures contract trading at $115, the next month at $114, then $113, $112, $112, $111.50….and so on. But all those forward prices on those futures contracts were just a reflection - and moving off the front month trading activity - and current market sentiment at that moment in time.

In fact if you bet against all those other futures months you made a fortune as these spikes were goldmines or false positives every time oil spiked on some Middle East tension event as oil inevitably traded back below $100, and made its way down many times below $90 a barrel, and the game started all over again with the next up move in this trading casino. The market routinely made 20 dollar up and down moves and was a huge profit center for many longer time duration position traders in the market – they loved these roundtrip trades.

Yes the contract was in slight Backwardation, but that tells you nothing from a predictive value for what is going to happen in the future. As all it would take is an actual physical shortage issue event and that entire future curve could in a day go into major Contango if actual oil fields were taken offline. And if/when it did occur this fact would have no future predictive value regarding price or market direction because two weeks or two days or two hours later news could come out showing that there was no long term damage to the oil fields and they will come back online shortly.

Poor Predictive Value of Future Price

Just because five months out on the curve come in as oil sentiment at the moment (in the midst of a January slow time in the market and oil is being slammed down) is poor has about as much long term predictive power or indication about where futures prices will be when that contract rolls over as a person holding a water finding stick trying to get water because they are thirsty. Just look at the trading volume and open interest out on the oil futures curve and this tells you all you need to know about the significance of the futures curve. There are some bets placed around the December contracts at the end of years two years out, mainly 2016 and 2017. And in between there isn`t much of anything going on except computers trading against an occasional computer for an arb play.

nth
Volume
Deliveries
Open Interest
Venue Detail
Trade Type Detail
At Close
Change
Globex
Open Outcry
PNT / ClearPort
Total Volume
Block Trades
EFP
EFR
EFS
TAS
·         About This Report
FEB 16
619,523
0
29,117
648,640
5,923
252
0
0
37,618
0
283,331
-54,372
MAR 16
277,063
51
26,652
303,766
3,267
62
0
0
32,441
0
445,688
55,320
APR 16
69,587
0
2,478
72,065
2,475
3
0
0
1,676
0
139,971
-1,866
MAY 16
34,422
0
971
35,393
968
3
0
0
252
0
85,166
-16
JUN 16
53,913
0
4,001
57,914
3,997
4
0
0
0
0
150,991
1,955
JUL 16
16,357
0
793
17,150
790
3
0
0
0
0
44,055

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