Black gold rising to the top? (page 1 of 2)

When the conflict ended and peace returned, the oil price was starting to drift lower. Following that peak, the WTI August contract began to descend sharply touching a bottom of around $55 at the beginning of the year. Since my column of May 29, WTI has now rallied by about 6% to reach the barrier of $70.

As I mentioned in my last column, the Dubai Mercantile Exchange took the initiative to open its doors to the oil trading business on June 1. Although the characteristics between Oman Crude Oil, WTI and the European Brent Crude are slightly different, the prices are to a certain extent correlated to each other. The same fundamentals apply to these commodities. Political tension in the world, hurricanes and strikes in oil producing countries will put pressure on all oil prices.

To hedge or not to hedge

Oil futures contracts can be traded around the world, and around the clock, from Dubai to New York and London. Nowadays, it is as easy for you to do shopping in a supermarket next door as to buy a barrel of oil. There are several ways to profit from developments on the oil market. One way is to take a directional position: long or short.

Being long, one is speculating on rising prices. Being short, one is betting prices will fall and that the contract sold can be bought cheaper in the future. Nothing is more difficult than to predict stock prices and, moreover, commodities prices are being influenced by many fundamental developments. Unexpected developments in the world, for instance, a coup in Venezuela, a strike in Nigeria or increased tension in the Middle East can have a severe impact on oil prices. Just last week, oil prices spiked 3% after Nigerian labour unions began strikes to protest against an increase in domestic fuel prices. This then led to a disruption of oil production and Nigeria is one of the largest exporters to the US.

It is advisable not to have SEC overnight positions in the futures markets, unless your wallet is deep enough to bear some draw downs. A possibility is to hedge a long position in, for example, Oman Crude Oil with a short position in Brent or WTI. Since the correlation is not always 100%, depending also on the liquidity of both contracts, it is not guaranteed that the position is perfectly hedged.

Since there are several contract months listed on the futures exchanges, another strategy can be initiated: a calendar spread. For instance, a WTI August Long and a WTI September Short. At this moment, WTI August is traded at $69.2 and the WTI September at $69.9. Hence the spread is $0.7. It is interesting to see that the August/September spread was traded at $0.4 in March and rose to $1.1 in May. As you can see, to be in a spread position, does not mean that your position is flat and cannot move against you.

Front months and back months

Under normal circumstances, in oil, the front months are cheaper than the back months. That is called a contango market. The reversed situation is called backwardation. In this case front months are traded at higher prices than the back months. It is also possible that, due to hurricanes, the shorter term futures like WTI August are rising more sharply than September, October or even December futures. In the commodities markets, balance of supply and demand in the underlying commodities are extremely important aspects to monitor. Recently, in the US, due to bad weather, the soya bean crop has been largely destroyed. This resulted in a sharp rise in the shorter contracts. This could also happen in the oil market when a big hurricane the size of Katrina visits the US again.