By Don Dawson, Online Trading Academy Commodity Futures Instructor

Has anyone seen all of those oil tankers anchored offshore recently?  Well there is a reason for it.  No, they are not just empty extra tankers with no delivery schedules.  These are tankers filled to capacity with oil that is being stored at sea.  Everybody remembers not too long ago when oil was at $142 per barrel and we could not get the tankers in here fast enough and unload them.  Now that the world economy has fallen into a recession, the demand for oil has fallen considerably.  With prices now down in the low $40 range, we see a different kind of oil market.

Remember that Futures contracts trade in different delivery months far out into the future.  The Front Month, usually the first contract month traded in the series of months is known as the “Spot” contract.  The proceeding months are for future delivery of a Commodity.  Since the Commodity markets are priced on Supply & Demand each delivery month usually has a different price.  Currently in the oil markets we have a pricing structure of these delivery months known as a “Contango”.

• Contango – When the distant prices are above the spot price.  Because the distant prices must converge on the future spot price, Contango implies that Futures prices are falling over time as supply brings them into line with the expected future spot price at expiration. 

Let’s look at the price structure of the Crude Oil market as of today:

The Crude Oil market is in Contango at this time.  Notice the last price starting in the Feb09 contract and how the price increases out to the Sep09 contract. 

Commodities that are stored for future delivery have cost associated with holding them until delivery.  Some of the cost may be for the storage facility, insurance on the storage facility, interest on the money borrowed to pay for stored Commodity, employees to maintain the Commodity, transportation, inspection of the Commodity for delivery etc…  These cost are sometimes called “Cost to Carry”.   There is also some risk in price changes so the holder of the Commodity may demand a higher price to assume the risk of holding the Commodity in storage. 

Back to our oil tankers anchored off the coast.  Since the price of crude is dropping as each Spot month expires, the owners of this physical oil on the tankers are finding it more profitable to sell the distant oil Futures contracts and making their profit as the price declines on the Futures.  By doing this they stand to profit in two ways:

• They profit from the Futures position.  If the Futures position should turn against them the price of oil will be going up.  They would then use the physical oil they have on the tankers to offset their Futures position losses. 
• What happens when there is less supply of oil?  It creates more demand, forcing prices higher.  At which time the tankers engines are started up and the owners of the oil are more than happy to unload the oil off their rigs.  This is a way of artificially taking oil off the market by storing it at sea.

The other type of market price structure we can have is the “Inverted Market”.

• Inverted Market – When the Futures price is below the expected future spot price.  This is an ideal time to be long this Commodity because the price is expected to increase.  An Inverted Market causes demand to increase for the Commodity in the immediate future more than in the distant Futures.

This is where there is excessive immediate demand for a Commodity.  This can happen when there is a perceived shortage of a Commodity in the very near term.  Since it takes large volumes of money to move markets around we can assume that when these markets trade with an “Inverted Market” pricing that the Commercial traders are the ones causing this.  The Commercials are considered the “smart money” in the Futures markets.  If they are climbing all over each other to get this Commodity in their hands we as traders should be paying attention to this.  We want to trade with the smart money. 

Currently a market that has Inverted Market pricing is Cocoa.  Let’s look at the pricing structure of this market:

Notice how the Last price is “decreasing” as we go out the price ladder.  You can see there is becoming some excessive demand for Cocoa right now.  The Commercials are willing to bid prices up in the Spot market due to a perceived shortage of Cocoa.  They are not willing to wait until the future contracts expire because they need the Commodity “NOW”.   Commercial traders are very patient traders normally, however you can see that when they need a Commodity immediately how they can run prices up.  Another event that happens as word gets out that a bull market is underway is that most all brokers and advisors of public money get their clients into the market by buying the contract with the most liquidity.  That contract typically is the Spot or Front month of the Commodity.  Thereby causing even more demand in a market with a perceived shortage.   

We can now see how watching the price structure of a Commodity can tell if there is excessive Supply or Demand in the market.  This is a great tool to alert traders to a substantial upcoming market move.  However, one cannot use this tool as a timing tool.  You must incorporate technical analysis to help time your entry.  The Futures markets have too much leverage to just use the “buy and hold” strategy.  Once you spot a market like Cocoa with this type of Inverted Market structure you could be looking for key Support levels for the market to pull back to for an entry point.  As always make sure you use good risk management.  Even the best trades don’t work all the time. 

Good trading,

Don Dawson

DISCLAIMER:
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results.

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