Oil Bears Celebrating Prematurely

by: Marc Gerstein

Oil's sharp correction off its recent peak has raised eyebrows, and one can easily find advocates of both bullish and bearish views of future price direction. The latest wrinkle was a slight upward move based upon the realization that the Iran situation is not yet truly resolved. On the other hand, the potential for high prices to inhibit economic activity, and hence oil demand, remains ever present. In the middle of this debate is the futures market, where the level of uncertainty diminishes as we stretch our time horizon.

Table A shows how prices of various oil futures have moved on the New York Mercantile Exchange.

The high levels we see at June 30 are familiar to observers. Less discussed is the context surrounding the subsequent downturn.

Consider the nearest futures expiration, the October 2006 contract. Although the magnitude of price decline was steep — nearly 15 percent in a little less than three months — it's really hard to argue that oil has shifted into a bear market. The Sept. 13 closing price is about where it was in late-2005.

Looking further out along the "curve," we see a different picture. The December '06 contract, one that's so close at hand you can almost touch it, was still up since late last year. The December '07 contract closed yesterday 10.4 percent above where it was nearly a year ago. That hardly seems like a bear market.

Commodities futures are especially interesting measures of the pulse of the market. Clearly, investors are present in these markets. But there also exists a separate class of participants; commercial traders who need the commodity in order to run their businesses.

Undoubtedly, commercial users would rather buy low. But if prices are high, they buy anyway and either pass their increased costs on to their own customers or accept lower margins. (At this point, it's too early to tell whether we're in one of those extreme situations where oil prices have risen to the point where commercial buyers question whether they can use the commodity profitably in their business — a classic economic phenomenon of high prices depressing demand and possibly leading to a cyclical slowdown).

In this context, if we are experiencing here-and-now shortages, commercial buyers who want to stay in business will bid prices up to whatever level is needed to secure necessary supplies. Assuming the shortage is perceived to be temporary, they'll have no reason to pay up for longer-term deliveries. That leads to a down-trending futures curve, a condition known as "backwardation." The opposite, scenarios where supplies are perceived to be in line now but where there are concerns about future shortages, lead to "contango," wherein longer-dated futures trade higher.

Table B shows the how the trend in oil futures has evolved over the past year. These are not strict contango-backwardation calculations, which compare futures prices to fair values calculated by adjusting spot prices based on estimated carrying costs. The table, which compares longer-dated contracts to nearer instruments, is a broad approximation that, nonetheless, paints a similar picture of market sentiment.

While the trends are not perfectly smooth, it appears that for much of the past year, the market perceived a general balance between supply and demand, both in the present, at least through December 2007. The deviation occurs in the most recent period, the post-spring correction. Prices came down all along the maturity curve, but the decline in the near-contract, the one that most closely approximates the spot market, was most severe. The December '07 contract was less sharp, and it now trades at a significant premium to the October '06 delivery.

Table C presents another view of the latest price move.

It is hard to articulate the relative roles played by the two different groups of market participants, commercial traders and investors. But the overall results do raise at least some inference that the latest oil decline may have been overdone; i.e., motivated more by emotion than objective assessment of supply-demand considerations.

To add perspective to the oil situation, we can compare it with copper, the other "hot" commodity and the one that is usually paired with oil when observers discuss new paradigms, bubbles, and so forth.

Table D shows the trend in copper futures prices over the past year.

Here, we see a completely different picture. As we move out in time, copper futures trade at increasingly wide discounts to near-term delivery dates.

Demand for and prices of both commodities are influenced by the economy, but the segment that more heavily influences copper, housing, is perceived to be more at risk. Meanwhile, there are divergent views of supply: copper is impacted by production and labor issues that are expected to diminish over time while no imminent long-term easing is envisioned for oil supplies.

The copper-oil comparison is apt insofar as it demonstrates the way futures curves can sort out different sets of fundamentals. Nothing is conclusive — commercial traders are as capable as anyone else of being wrong. But for now, the data provides food for thought for those who argue that oil has passed a long-term peak and is now in the early stages of a sustainable bear market.

At the time of publication, Marc H. Gerstein did not own oil or copper futures or shares of any of any producer companies. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.