Backwardation and contango

Ever since the Trump inflation inspired global equities market rally, the trading community has now fallen into two camps.

Oil
Source: Bloomberg

The first camp believe this equities and commodities rally is just getting underway, which is highlighted by the trading and hedge fund investment houses being net long everything from equities to property and commodities.

The second camp is the group that are waiting in angst for the potential correction or significant pull back for an entry point, but instead are watching the markets march higher every trading day.

In the past few days, the oil futures market has moved into an event called backwardation, which is where the front spot price is higher than longer futures settlement price. This suggests the market is concerned about an immediate shortage and are taking delivery. This often happens in the soft commodity market when there is a weather event or crop damage that can create a shortage, making future delivery questionable.

It is important to remember that the difference in the futures market quote and the current spot price will eventually be closed as expiry nears. In the oil market, this can play out two ways: the future demand will fall (unlikely) or the spot price will fall to meet the then futures price.

To maintain delivery, oil buyers will have to eventually move to the futures price to ensure delivery in a falling production, rising consumption market. Oil only has one direction: higher. Once again, the market will be in contango, where the futures price is higher than the current spot price.

In late overnight trading, the spot price of oil has again traded higher though the $54.00 resistance level in place for the past nine weeks. At $55.65 a breakout signal will occur, forcing a short cover rally with the potential for a move back to the June 2016 highs of $61.00 and on its way to the OPEC-inspired $65.00/lb.

Coming back to our two groups of market participants, for markets to continue higher, all of the players must be of one mind: bullish.

The Dow moved higher again, however the transports sector came off a full one percent or 100 points and the Nasdaq fell by half a percent at 5835. This is often the warning shot across the bow that price weakness may be coming and may offer an entry point to those left behind. Commodities metals also took some heat with iron ore falling three percent and copper moving lower by three percent to $2.65 and under a key support level at $2.70.

Our SPI futures are down one point and showing no direction for the open today. We will see a large volume day after an ASX options expiry yesterday. The BHP ADR at $25.32, shows a lower valuation from yesterday’s close at $25.84. Financials look to be the drawcard today with the CBA ADR pricing in at $84.12 - a 0.64 cent gain from yesterday. The AUD has rallied back over the key 0.77 level overnight.

Finally, companies reporting today include Automotive Holdings, Billabong, Charter Hall and Hello World.

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