The Oil Disconnect

Today, we want to present readers with some insight into the forces that drive the commodities markets and how cases of divergences may present traders and speculators with opportunities.

Returning to a market which have been fairly well acquainted with, readers will understand the differences between the spot physical markets, and the futures markets. A good deal of price discovery has taken place since we last penned our note on March 19 calling for an inflection point in prices, and especially so after our first long trade on oil nailed the initial bottom back in January.

For the record, we still feel higher oil prices should be expected. We favor upside at or slightly under current prices - $57.50 on WTI, and $62.30 on Brent - and see the most recent decline as an opportunity to initiate long positions. The fundamentals of the U.S. oil market have changed rathe significantly in the last 2 months; and this has lagged prices, something that we find interesting.

We will probably pen a separate piece on this. But for now, here is some good commentary about the schism that has developed in the oil markets.

Via Peter Sainsbury:

Oil Futures Prices Divorced From Physical Markets For Now

"Like pushing a rock up a hill"
That’s how some trader’s view the current disconnect between the physical market for crude oil and the futures market with speculators pushing futures prices higher while the physical market remains moribund.
Before continuing, it’s important to make the distinction between the physical market for crude and the crude futures market.
  • Physical (also known as cash) market prices are determined by the supply and demand for physical crude. Here traders buy oil from the producer and sell it to the refiner, for immediate delivery. Physical buyers and sellers have a direct pulse on the market and may feel immediately when it is well supplied, or not.
     
  • Futures prices, on the other hand, are determined by the supply and demand for crude futures positions. Futures markets provide a means for trading the probability of where crude prices will be at certain points in the future; this allows physical market participants a means by which they can hedge their position and so reduce risk.
The physical crude market tends to show weakness (i.e. too much crude swashing about) when the premium for the best crude grades weakens against the benchmark Brent. One of the most favoured grades in Europe is Azeri Light due to its high quality.
Over the past couple of months physical crude traders have noted the weak premiums for Azeri Light versus Brent as other cargoes, particularly from West Africa compete to supply crude into an already oversupplied Atlantic Basin market.
This apparent disconnect between the futures and the physical market appears eerily similar to mid-2014, just prior to crude prices collapsing. So is the current weakness in the physical crude market a precursor to an imminent weakening in crude futures prices?
Don’t bet on it - at least not based solely on what the physical market is doing.
Market positioning for WTI crude oil futures as reported by the CFTC in their weekly CoT report shows how speculators have once again loaded up in longs while commercials (hedgers) have increased their short exposures by almost a commensurate magnitude. Traditionally, extreme positioning in both categories have signaled major turns in the market as illustrated by the record longs speculators were exposed to in 2Q14, when oil prices topped. Note that positioning data is 2 weeks "delayed" - data that was compiled a week ago is released one week later. Commentary by Business Of Finance, chart courtesy of Zero Hedge

Market positioning for WTI crude oil futures as reported by the CFTC in their weekly CoT report shows how speculators have once again loaded up in longs while commercials (hedgers) have increased their short exposures by almost a commensurate magnitude. Traditionally, extreme positioning in both categories have signaled major turns in the market as illustrated by the record longs speculators were exposed to in 2Q14, when oil prices topped.

Note that positioning data is 2 weeks "delayed" - data that was compiled a week ago is released one week later.

Commentary by Business Of Finance, chart courtesy of Zero Hedge

While the physical fundamentals of supply and demand prevail eventually, the physical market may not always be able to anchor futures prices for days, months or even years.
If commodity futures prices rise too much, perhaps as a result of speculative interest, as there is now, physical supplies will start to be delivered against short positions (a manufacturer looking to hedge its inventory of raw materials might have this kind of position).
In practice, there is never enough physical material readily available to deliver against all the short positions, so rising futures prices can only be offset by buying back crude futures contracts rather than making physical delivery. It takes time to divert and accumulate sufficient physical crude supplies to meet a rise in futures prices driven by speculative rather than fundamental factors.
To get an idea of the extent to which this process is occurring take a to look at the net contract short position for commercial hedgers from the US CFTC weekly Commitments of Traders report. Back in mid-2014 the net short position amongst commercial hedgers (actual producers and users of crude) rose to around 500,000, a record level. This position has since fallen to just over 300,000, but it is still high on an historical basis.
As we know from the months leading up to the oil market crash that began in the middle of 2014, oil futures prices can divorce themselves from the physical fundamentals for a long time.
The price of crude, as with any other commodity is only worth what someone is prepared to pay for it. The market’s perception of scarcity in mid-2015 is such that participants in crude futures markets are now willing to pay less than half what they were paying just one year ago.
While theory suggests crude futures markets are anchored to the physical market as contracts expire, in reality the link is a lot more tenuous. As with the myth of Sisyphus the rock will eventually start to roll back. Timing when that will take place, and the catalyst involved, is a whole different matter.