Oil Gusher
I’m still in the process of getting a handle on everything that has happened since last Wednesday and I hope to post quite a bit over the next couple of days.?I will start by covering crude oil not because it is the most important, but simply?because it is the most recent, development.
As you may already know, crude oil prices exploded today in a crazy short covering rally that at one point had the expiring spot month October 2008 contract hitting $130 for a rise of $25/barrel in one day! In the meantime, the forward crude oil contracts (November 2008 and beyond) rose strongly as well, settling near $110 (the high) after a $6+ rally for the day. The result was massive backwardation to the tune of almost $20/barrel at one point on Monday, and the day still ended with a backwardation of over $10/barrel. What this means is that there were way more buyers of the expiring October crude oil contract than there were sellers. Indeed, those who were short October crude needed to get out of their positions?in a bad way (probably because they did not have the physical oil needed to deliver under the contract). This episode in crude oil?carries some lessons.
First, this was a very good example of how “shortages” are resolved via the futures markets: prices rise (spot month prices in this instance) until there is a balance between buyers and sellers. If there is a big imbalance, prices will?rise by a big amount, as they did in crude oil today. When prices are high enough, some?of the longs will start to “peel off”. It’s simple greed.?Here it?helps to realize that (most) traders aren’t trying to create a default, they are trying to earn a profit. And $10,000-$20,000?per contract is pretty darn inviting. This reminds me of the recent episode in the Indian silver market where, according to “Sunil” as reported to David Morgan, the expiring silver contracts were settled for cash at a premium to spot prices because physical metal was not available for delivery. Apparently the premium was established arbitrarily by the market officials instead of letting the market itself make that determination (as?in NYMEX crude oil today). Say what you want about the U.S. futures markets, but they are still more “free” and “efficient” than many of their offshore counterparts.
Second, a trader?is wishing for suicide if?he/she?holds a?spread into expiration?with the?short leg?in the spot month and the long leg in a forward month. Such a spread in crude oil would have cost more than $10,000 per contract today with a maximum loss (a possibility if a margin call resulted in a forced sale) of $20,000 per contract. Ouch!
Third,?an advocate of Ted Butler has been suggesting in the comment section of some of?my previous?posts that a long-side manipulation?can be effectively carried out by putting in place a spread consisting of the short leg in the spot month and the long leg in a forward month. He then claims that buying to close out the short leg in the spot month will pressure prices higher, thus creating profits in the long forward month position. The foolishness of such a (nonexistent) strategy has been demonstrated yet again today, as?if the?episode earlier this year in?spring wheat weren’t enough. Similarly, short-side manipulation is not done by going long the spot month, short the forward month, and then unwinding such?”uneconomic”?spread?by selling the long spot month position in order to drive down prices to the benefit of the short forward month position. That is utter nonsense. Simply put, spot prices cannot be driven into extreme contango near contract expiration, but they can be driven into extreme backwardation.?Even traders who are?hell-bent on?manipulating the market aren’t going to do it by swimming against the current. I’ve been meaning to write an article on this subject for several weeks and may perhaps get around to it in the next few days. In particular, I’m talking about addressing the article Jon Nadler proves Precious Metals manipulation (no really, he does?) By: C. Loeb.
Fourth, the basis DOES clearly matter in trading despite the protestations of my (and the Professor’s) detractors. Today, the basis mattered to the tune of $10,000-$20,000 per contract in crude oil. The margin required to hold a spread crude oil position? About $400 per contract. Confusing the short and long legs, because “it doesn’t matter”, could be the difference between retiring in Aruba or under a bridge.
Fifth,?spreads can be an appropriate way to trade the basis in gold and silver as I have suggested in the past. Just don’t ever be short in the spot month!?One day gold (and silver) will do something very similar?as spring wheat and crude oil have done this year but it will be even more extreme. The current margin on COMEX gold and silver spreads: about $100 per contract.?If you are getting some ideas about October COMEX gold (which goes into expiration at the end of this week), I would point out that?open interest in that contract is?probably not sufficient to generate a lot of short covering. But in this crazy market,?who really knows?
Sixth, this move in crude oil wasn’t just a completely unpredictable twist of fate. The basis gave some clear warning signs to those who were looking carefully. These people made a lot of money while those who?believe the basis is irrelevant sat?on their hands and watched in awe. What were some of the things the former group?was seeing? Try?this on for size:
9/12? ?-0.07
9/15?? ? 0.02
9/16??? ?0.13
9/17???? 0.20
9/18?? ? 0.34
9/19??? ?1.80
9/22?? 11.55
I’d call that a pretty simple progression. It is the basis?between the October and November 2008 NYMEX crude oil futures contract using daily closing prices. The trick would have been to recognize what was going on as of September 18 because “buying the basis” at a backwardation of 1.80 ($1,800 per contract) on September 19 would have been pretty difficult.?Equally tricky would have been to actually?hold the position until September 22 even though September 19 offered a tremendous profit already (remember, the margin on this spread is under $400). To do that, one could have sold half on September 19 and held the rest into the trading session on September 22.
Okay, you say, that’s crude oil and not gold or silver! You ask, do you have any examples where basis?might have been a useful tool for trading the monetary metals? Well, here is what I said on September 16, the very day before gold and silver embarked on their monster tear:
Speaking of which, the basis has shrunk substantially in the past couple of days. Most noticeably, the 12-month forward rate of gold as quoted by the LBMA has declined from 3% at the end of July to under 2% today with most of that coming in the past two days. That is quite a change and speaks to the possibility that there is at least a shred of truth to what I have discussed above. As far as what to make of this shrinking basis, I will just say for now that it is positive. I will have much more to say at GSUL 5 in Canberra (assuming I can get just a few more of you to join me) and once The Metal Augmentor has been launched.
Well, the results were quick and obvious and now only the retroactive explanation remains. But don’t fret, there will be plenty of future?opportunities involving the gold and silver basis.
And now congress in the US is going to use this episode to try to curb speculators in commodities, although, correct me if I am wrong, but this was a gift to consumers. I believe that the long speculators were blown out by the shorts and commercials not wanting to buy when it was in the 140s, then when it dropped below 100 via shorts and liquidation, the commercial users jumped in to buy for actual delivery. Unfortunately, the shorts in oil weren’t producers but speculators, and the users didn’t want paper oil but the physical stuff to run their refineries etc. So as the price rose and rose, the commercials wouldn’t sell because they actually needed their physical. That left only a few very smart speculative longs that held out, knowing that they were the only game in town.
I am starting to feel like Don Corleone. To paraphrase him, just when I feel like I am getting out, you draw me back in with some idiocy that demands a response.
First, I have never argued that there is a ‘long-side’ manipulation going on. I have only argued that there is a clear short side manipulative mechanism available by straddling the visible market with a short leg, and the OTC market with a long leg. The long leg provides the gullible and trusting CFTC, Nadler et al with the appearance of a hedge. Piling the short leg on, the price eventually collapses and profits are made in short covering. If the price explodes, no problemo, the long leg also becomes profitable with any uncovered shorts neutralized by the OTC long.
Second, we know the current manipulative gambit has involved just what you write is not feasible - clearly short in the Comex, and presumably long OTC, unless you want to argue the COMEX short is naked. As the CFTC data tells us, a very large and apparently new short position existed just prior to the price collapse. The large short position moved the price down (big surprise), short contracts were covered, and contracts continue to be covered as we speak. Given the basis of the initial position in gold and silver, hundreds of millions of $ have been realized by the manipulators. What happened in crude is hardly relevant here, unless you wish to make the point that it is dangerous to carry a short position into first delivery day. If so, point granted, but that is not what is, or has been happening in Au and Ag. Frankly, I am not sure what point you are making, and I am not sure you are either.
Finally, your comment on the value of using the ‘basis’ (however you and Fekete are currently calculating it) to profitably trade is a howler, even by your standards, Tom. Please check my math on this, but if I read your prescient post on September 16th and fell over myself to trade the ’shrinking basis’, I would have gone long December silver (after all, only a fool goes short the front month) and short March silver. So, frantically trying to take advantage of your news bulletin, I would have purchased SI Z8 for $10.65 at precisely 11 am on the 16th, and sold SI H9 at precisely the same time for $10.72. And, having jumped at this opportunity, my gain as of 11 am today on this trade would be (drumroll please….) A LOSS of $475.00 per spread. As you said, the results were quick and obvious, and now only the ‘retroactive explanation remains.’ Do I have to travel all the way to Canberra to learn how to trade like this, or can I just set fire to a pile of 100 $ bills in the interest of saving time?
Limpet Mine:
First, yes you did absolutely argue that Vitol was manipulating the oil market from the long side by using spreads with the short leg in the spot month and the long leg in the outer month, and then you stated that silver could be manipulated in the exact opposite manner with the long leg in the spot month and the short leg in the outer month. After I pointed out how futile that would be, you changed the song by claiming the “spread” involves the long leg in OTC and the short leg in COMEX, which despite being a completely normal and expected dealer/swap transaction, you still think is just the “appearance of a hedge”. Well, it is a hedge! What a riot!!! This is what you claim is a clear sign of manipulation? Are you sure your thinking isn’t influenced by all that nitrous oxide you have ready access to in your line of work?
Second, you are still making completely unfounded statements like the “large short position moved the price down” despite the fact that the COMEX short position was “in place” before the price made its largest and most dramatic decline. So what if the contracts are being covered? DUHH!!! Assuming the OTC longs are still in place, the covering of the short COMEX position did not result in any profits. Just watch, next you’ll claim that the intended effect of the covering itself is to make the price rise so the “manipulators” can make a lot of money on their “naked” OTC long positions. The problem with that is they still need to SELL those OTC “naked” (fantasy) long positions to actually book any profits. Were the alleged manipulators to do so, of course, the price would drop back down again and they wouldn’t really be making all those “hundreds of million of $” as you claim. As for crude oil, my point was that the basis does matter. And that there are economic reasons for spreads. Despite you not being sure what point I was making, I’d be willing to bet that most of my readers without preconceived notions and know-it-all attitudes do understand what I was trying to say. That’s besides the fact most of them (I hope) are not under the constant influence of laughing gas.
Finally, you are so lost on the topic of the basis that it isn’t even funny. Why would you have gone long a spread in December silver and short March silver when the gold basis as measured by the London forward rate was falling??? Where did I give you that advice? In fact, I didn’t provide any trading advice. I simply stated that the basis provided an advance indication, as it did in crude oil leading up to expiration. The “quick and obvious” results were gold rallying about $150 in a couple of days. Why don’t you stop being so smart for a second and actually listen to what other people are actually saying? (That is, people other than your fiction-writing hero Ted Butler.)
Why would I have gone long December and short March? Well, I wouldn’t, but if I was following your post and took your opinions seriously I might have. After all, you said “a trader is wishing for suicide if he/she holds a spread into expiration with the short leg in the spot month and the long leg in a forward month.” Not being suicidal, one would then conclude that long the front month and short the forward month would be the ticket if one cared about spreads. And since you said “spreads can be an appropriate way to trade the basis in gold and silver as I have suggested in the past”, one might be forgiven for thinking that you were saying you thought spreads can be an appropriate way to trade the basis. Put that together with your prescient observation on 9/16 that the “basis” (whatever the heck that is) “has shrunk substantially in the past couple of days” and presaged the “tear” in prices, it sure sounded like you were supporting the idea of a spread to take advantage of this SIGNIFICANT change in the “basis” (whatever the heck that is.)
After all, you are “one of a few big mouths in the silver market who actually makes calls like this (instead of the typical wishy-washy stuff that can be interpreted 1,001 ways to Sunday)” so I just thought I would see where you advice led. Or perhaps you were saying something exactly the opposite of what you wrote, or perhaps you were saying nothing at all, which increasingly appears to be the explanation.
Limpet Mine: Thanks at least for admitting you know nothing about the basis.