By Eric J. Fry (dailyreckoning.com)
To some investors, the chart below might seem to portray
nothing more than an unintelligible squiggle. Perhaps
that's all it is. But we think we see a sign in this
squiggle that the current oil rally will take a
breather...very soon.
We think we see the painful short-squeeze of traders who
had been buying long-dated crude futures and simultaneously
selling short near-term crude futures. In fact, the
"adjustment" pictured on the right hand side of the chart
has occurred so swiftly that we think we can almost hear
the agonized screams of speculators who are finding
themselves on the wrong side of a very big move.
For most of the last two years, the December 2007 futures
contract for crude oil sold for several dollars less than
the July 2005 contract. That's a fairly ordinary
configuration known as "backwardation." However, as the
rally in crude oil gathered steam late last year – raising
the prospect that $50 crude oil might not be a "temporary"
condition – oil traders began to "bid up" the prices of
long-dated crude futures.
As the chart above illustrates, the spread between December
2007 crude and July 2005 narrowed from "$9.00 under" in
mid-March to nearly $2.00 OVER last week.
At first, the narrowing of spreads between long-dated crude
futures and near-month contracts caught many "seasoned" oil
traders off guard. But eventually, they embraced the
spread-narrowing trend as a relatively "low-risk"
opportunity.
For a while, traders minted money by buying long-dated oil
and selling short near-month contracts. But this trend of
this spread reversed with a vengeance early last week.
Specifically, the price of July 2005 crude oil jumped $4 in
a few days while the price of December 2007 oil actually
FELL.
In other words, the final $3 to $5 of last week's crude oil
rally may have had more to do with the unwinding of ill-
fated hedge trades than with any real-world demand for
crude oil.
Our theory might seem a little complex to novice investors,
but suffice to say that we distrust the last few dollars of
the recent oil rally. We still love the black gooey stuff
as a long-term investment. But we are wary for the moment
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