In the past, priests used to divine omens from the steaming entrails of sacrificed animals. While things have thankfully improved since then, we can still divine useful information by looking at the different working parts of the financial markets. Take crude oil for example, it recently broke up out of a long consolidation phase, but promptly fell back and now looks as if it might be breaking down out of that same consolidation area. Was the bullish break just a false alarm (See Fig: 1), or will we find the ‘real’ story if we dig deeper into the entrails of the oil market?
The Arc of Instability – Eastern Europe, the Middle East and North Africa – has surprised the energy market with the consistency of its supply (Russian natural gas, Iraq & Libyan oil). The turnaround of the USA, from the world’s biggest energy importer to one of the world’s big three energy exporters, has also created unexpected additional global supply. These positive supply surprises have dampened price movements in the market, but is it enough to justify the oil markets’ apparent complacency?
This is where delving into the arcane world of the forward curve of the crude oil futures market can be helpful. (See Fig: 2) The forward curve is not a predictor of future spot prices, but a curve on a chart representing the prices at which the market is currently willing to transact business for settlement over a series of future dates. It is important because it provides guidance on market expectation of the supply and demand for crude oil, not just for the near term, but for a whole range of periods right out beyond 2020. What is also very helpful, is to look at the changes in the levels and shape of the curve as new information becomes available. The two lines on the chart illustrate how the market expectations of future changes in the oil price have changed recently.
Over the last month the crude oil forward curve has ‘flattened’ i.e. the near-dated futures are lower than they were a month ago, reflecting the complacency that was referred to above.
However, the longer dated contracts – say for 2014 to 2016 – are higher than they were in relation to the near contracts a month ago. This tells us that the market is only complacent about the oil supply/demand dynamics in the very near term. Over the longer term there is definitely some anxiety creeping into the market.
This is simply another example of that old lesson of not taking things at face (spot price) value. You need to pay attention to the story beneath the surface too. Forward curves provide very useful information on the nature of market expectations at any specific point time. That’s why it is important to watch them as well as the spot market.