Oil Rally: Another Head Fake?

Includes: OIL, USO
by: Hard Assets Investor

By Brad Zigler

Oil bulls have had their fair share of disappointments this year. Rallies in 2010 have been fragile, as they've taken place against a backdrop of rising inventories. Traders had a hard time taking their eyes off the mounting stash of crude whenever they pushed their "buy" buttons. They were quick to hover over their "sell" buttons, too, as each weekly inventory report was issued.

Until recently. Despite a 1-million-barrel build in the last report, the market's showing a telltale sign that the current rally (over $89 in the nearby WTI contract) is something different. Something that may indeed have legs.

Let me spell it out for you: C-O-N-T-A-N-G-O. It's shrinking.

Contango describes a positive slope in the futures curve where each successive delivery month is higher-priced. The spread between the delivery months represents the finance charges, storage fees and insurance costs necessary to carry inventory into the future. Thus, contango implies more-than-adequate supply. After all, there has to be something to carry to justify those costs.

WTI crude's been in contango since June 2008, yielding an average $3-a-barrel cost for a three-month roll. Holders of exchange-traded oil products like the United States Oil Fund (NYSEARCA:USO) are all too familiar with contango for its deleterious effect upon their gains.

Over the past three trading sessions, though, rolls costs have shrunk — and stayed — below the $1 mark. Dips below a buck have been rare. They've been only head fakes, occurring on only six days since June 2008. Five of those were just one-day excursions. One lasted but two days. And none of them was as deep as the current dint. We're down to 73 cents a barrel now, after ratcheting down from 96 cents through 83 cents.

The spread can flatten further. It can, in fact, go negative. Stasis for crude oil is actually a slight backwardation. Backwardation, or inversion, denotes a negative slope in the futures curve where nearby prices are higher than those of later deliveries. The condition reflects shortage in supplies. Think of it this way: In an inverted market, everybody wants their oil now, so spot and nearby prices are bid up; the lower prices for back-month deliveries tell you that little, if any supply is carried.

Crude Oil's Recent Contango

Crude Oil’s Recent Contango

(Click to enlarge)

The thing about contango and backwardation is that the onset of these conditions is predictive. Think back a couple of years to 2008. The oil market flipped from backwardation to contango a month before crude peaked over the Independence Day weekend.

Crude oil prices have broken to the upside of a six-month congestion area and are pointing to a potential target price of $105. There's a much greater likelihood of that target being reached if we see contract spreads shrink further and flip to backwardation.

Disclosure: No positions