Date: 05/09/22
Author: Kent Moors, Ph.D.
In times like these, in which geopolitical events have disproportionate impact, I usually find myself reverting to what was a primary analytical niche not too long ago.
Energy.
And here, that oil figure emerging in the corner of your TV screen (the “bug” as it is known in the trade) may not be telling you the real story. The bug may be a well-known element for investors. But it is becoming a more suspect base for analysis.
At close Friday, WTI (West Texas Intermediate, the standard for futures contracts cut in New York) had advanced 1.34 percent for the day, 4.58 percent for the current rolling week daily average (adding the most recent closing value, deleting the earliest), 14.22 percent for the month, and 44.47 percent year to date (YTD). Brent (the most often used international yardstick set daily in London) posted results of 1.25, 4.64, 11.69, and 42.47 percent, respectively.
Both remain above $100 a barrel (in each case with the bug providing the next month’s price) with the pronounced swing in investor attitude to holding long rather than short positions. That translates into the prevailing opinion holding higher prices will remain.
But is there a genuinely strong ground for that position? And even if there were, the return for the average retail investor is hardly what the main insider traders are making. After all, considering the YTD figures mentioned above, good but hardly great returns for more than five months, a normal investment into any exchange traded fund (ETF) or exchange traded note (ETN) following either benchmark crude rate would have realized a return of even less since the beginning of the year.
The WTI and Brent benchmarks are also not telling you what the “wet barrel” (actual oil in physical trade) market is telling us. Both WTI and Brent are sweeter (containing less sulfur) than over 70 percent of the trades made each day. Most global transactions are settled at some discount to one or the other. Of the two benchmarks, WTI is a slightly better grade. However, Brent is used more often as the base of international contracts and is priced higher. Yet WTI remains the more liquid of the two when it comes to trading volume.
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Both are now signaling the recent run up in prices is drawing to a close. Much of this movement has resulted from a disproportionate over reaction by those arbitraging “paper barrels” (futures contracts) with the oil genuinely exchanging hands (i.e., the wet barrels). They have little choice, given that international concerns over supply will require those cutting futures contracts peg to the expected most expensive price of the next available barrel, using options to hedge those prices.
Over the past several trading days, a narrowing has emerged. Some of the has to do with the uncertainty over what will emerge from Moscow today (May 9 being the major Russian holiday commemorating victory against Germany in 1945) and the widespread belief that Vladimir Putin will announce some major new initiative in the invasion of Ukraine. However, this is colliding with the clear signals coming from marker fundamentals that the supply/demand balance is tilting toward a situation that would require a decline in price during more normal times.
A reversal has been indicated for a while. First, as I have noted previously, my proprietary Effective Crude Price (ECP) has signaled the quoted crude price as being inflated when compared to actual underlying market conditions for at least the last month. ECP calculates the actual market price of crude oil once shorts, derivatives, artificial supply moves, and other outliers are removed.
As of this weekend, ECP is providing a WTI per barrel price of $87.75; $89.25 for Brent. Those are 20.13 and 20.52 percent, respectively, below closing prices on Friday. Even given the fact that a pure ECP figure is not going to emerge on any given day (for a number of statistical and other reasons), this divergence is still remarkable. They are the greatest discrepancies observed in the almost five years since ECP was created.
Second, and perhaps of even greater interest, is oil prices as portrayed by the NYMEX Strip. This is regarded by insiders as the most accurate price for crude oil futures contracts struck in New York. While the near month (i.e., next month) price is given when the WTI appears as a bug on your TV screen, futures contracts are traded for months further out stretching out several years.
Trading volume is generally the greatest for contracts representing closer expiration dates. Nonetheless, merely referring to the price 30 days from now (i.e., the bug) is not usually the most accurate in determining where oil is heading.
That’s where the strip becomes valuable. The most used (and most traded) is the 12-month strip. This tells us at any point during the trading day what the average price is for contracts bought at the same time for each of the next 12 months.
The strip has been telling us for the past week or so that the more effective price for WTI is about $6.13 below the next-month price given for WTI when compared to the delivery price for September consignments. Over time, moving out the strip quotation a quarter is the more accurate way of judging market sentiment.
The reason for this is something called backwardation. This is the situation in which the current price is at premium to those trading for future months.
Currently, the backwardation extends out through at least May of next year. This means the undergirding of the WTI pricing range is weakening even as the spot price may appear to be holding. As I have noted on several occasions, it is the floor of the range rather than the ceiling that tells us what is really going on with oil.
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A similar backwardation situation emerges with a Brent strip. This is why comparing the strips is important. For the past month, the spread between WTI and Brent has been narrowing. This indicates that the two main yardsticks for oil sales are converging. The spread is the difference between near-month WTI and Brent (the figures you see reported each day). The more accurate way to gauge this difference is as a percentage of the WTI price since Brent trades at a premium to WTI.
Brent is also more sensitive to global supply/demand balance flows. It picks up the signals faster than WTI, owing to its more frequent usage in trades worldwide and its greater vulnerability to geopolitical events – especially the war in Ukraine and the EU move to cut oil imports from Russia.
Well, the situation is even more pronounced now. The spread has narrowed below 4 percent for the past five consecutive trading sessions and 9 of the last 10. The movement here has been for Brent to move down to approach WTI rather than the reverse. That is a rising indication that the “Russian invasion premium” may be reaching its end.
When these matters converge, there will be a marked decline in oil prices.
On the other hand, the energy play emerging is with natural gas. This is a matter I have noted for some time and will be accentuated by the longer-term readjustments away from imported gas from Russia. Even with the current high crude oil prices and despite a rather pronounced decline on Friday (as much energy investors’ taking a breather more than anything else), natural gas continues to be the better play.
Henry Hub (the benchmark rate for US natural gas) declined 8.38 percent for the day. However, it still comes in at 7.18 percent for the week, 26.34 percent for the month, and a hefty 110.38 percent YTD (as compared to 44.47 percent for WTI and 42.47 percent for Brent, as noted earlier). As oil begins a decline, there will be plenty of room on the upside for natural gas.
Dr. Kent Moors
This is an installment of Classified Intelligence Brief, your guide to what’s really happening behind the headlines… and how to profit from it. Dr. Kent Moors served the United States for 30 years as one of the most highly decorated intelligence operatives alive today (including THREE Presidential commendations).
After moving through the inner circles of royalty, oligarchs, billionaires, and the uber-rich, he discovered some of the most important secrets regarding finance, geo-politics, and business. As a result, he built one of the most impressive rolodexes in the world. His insights and network of contacts took him from a Vietnam veteran to becoming one of the globe’s most sought after consultants, with clients including six of the largest energy companies and the United States government.
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