Newsom on the Market

By Darin Newsom
DTN Senior Analyst

By now I'm sure there are some who are saying (in their best Mr. Peabody voice), "Quiet you, that's enough about lines." But I, doing my Vizzini (from "The Princess Bride") impersonation, respond, "Not remotely!"

Last time we were together, I talked about the connection, correlation and between-the-lines connection found in closing weekly futures prices, and lines that reflect changes in noncommercial net-futures positions, located in Commodity Futures Trading Commission weekly Commitments of Traders reports. But what if I were to now tell you that we can also use technical analysis (the study of trends, or price direction over time) to better understand real market fundamentals?

That sounds impossible, right? Like proving a certain lite beer is less filling BECAUSE it tastes better.

Keep in mind how I phrased that sentence, particularly the part about "real fundamentals". In many commodity markets there are two sets of fundamentals working at any given time. The first is the known fundamentals, or those that the U.S. government (USDA, EIA, etc.), tell world traders what it thinks supply and demand is at any given time. Into this category falls weekly EIA energy stocks, USDA monthly Cattle-on-Feed, USDA Quarterly Stocks, and many others including monthly Crop Production and Supply and Demand reports (the next edition of these are set for release later this week).

Fundamental analysts love these reports as it gives them numbers; though they may be imaginary be because they are nothing more than projections, to analyze and argue about until the next set is released the following month, or week, or quarter, or whatever.

But if you want to know what the real fundamentals of a market are, based on the opinion of real commercial traders of a commodity (involved in the trade of the cash commodity), then we need to study the trends of futures spreads (the price difference between futures contracts of a specific commodity), forward curves (price of futures contracts plotted along a line from nearest contract to furthest deferred), and basis (the difference between a commodity's cash price and its futures price).

These can be charted using lines to connect daily, weekly, monthly, etc. changes over time. Follow the trends.

Let's start with futures spreads. Those of you familiar with my analysis know the importance I put on spreads. I believe the price difference between contracts of a specific commodity tells us more about what the commercial side of a market believes real supply and demand to be than any report from a government agency.

I've been analyzing commodity markets for almost 30 years, and a couple of examples of the power of spreads stands out to me.

First is the 2008 crude oil market. You remember that year, don't you? Crude oil had extended a decade-old major (long-term) uptrend on its monthly chart to $143.67 per barrel by June 2008, closing the month (recall the importance of the closing price from earlier) at $140.00. Fundamental analysts calling for $150 and $200 crude oil were as thick as ants as a picnic, all over television and print media, because the United States was going to run out of crude oil, according to government reports and private analysis.

However, the nearby (first two futures contracts) futures spread was telling a different story.

Before we go on, let's talk a little about some terms in futures spreads. If the deferred contract is higher priced than the nearby contract, the spread is said to be in carry (or contango if you happen to be trading a New York market). The stronger the carry/contango is, the more bearish the commercial outlook of the market. If the nearby contract is priced higher than the deferred contract, a spread is said to be inverted (in backwardation to New Yorkers) and as you have likely surmised, the stronger the inverse/backwardation, the more bullish commercial traders believe real fundamentals of a market to be.

Back to our crude oil story: By June 2008 crude oil's nearby futures spread had trended down from an inverse/backwardation of $1.26 at the end of October 2007 to a carry/contango of 58 cents, an obvious increasingly bearish supply and demand situation. Yet, as June turned to July, the bullish screeching grew louder, until it was no longer heard. By the end of July, the futures market had fallen to a low of $120.42, closing at $124.08. The month of December 2008 saw the nearby futures contract bottom out at $32.40. As January 2009 came to a close, the nearby futures spread was sitting at a carry/contango of $4.45. Yes, $4.45. We weren't going to run out of crude oil after all.

And it could have all been read by anyone choosing to connect the dots of monthly closes for crude oil's nearby futures spread, creating the line between supply and demand.

Next time, we'll discuss one of my favorite examples of futures spreads: The 2013-2014 soybean market. Until then, enjoy USDA's monthly reports. Just don't mistake them for a read on real fundamentals.

Darin Newsom can be reached at darin.newsom@dtn.com

Follow Darin Newsom on Twitter @DarinNewsom

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