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
HDR Price at posting:
0.0¢ Sentiment: None Disclosure: Not Held
