Howard Simons was an economist in the government affairs department of a major oil company during the second oil shock of the 1970’s. He wrote a piece in Real Money that is hard to understand, except for the last line below:
We can summarize the shape of a forward curve in the singular measure of “convenience yield.” This can be thought of as the insurance costs buyers are willing to pay to avoid running out of physical inventories; it is also the price increase required to justify holding those inventories. The higher the convenience yield, the more anxious buyers are about the sustainability of a price trend. If convenience yields turn negative, a riskless cash-and-carry arbitrage is possible.
If we map the convenience yields between July and succeeding months of crude oil after the current leg of the rally began on April 2, we see a steady decline from April 25 down to last Wednesday — May 21 — marked with the green line. This indicated much of the rally was being propelled not by just-in-time buyers of the front month, but rather by buyers in the deferred months.
On the surface, this is extremely bullish, as it indicates acceptance of the rally. But if we map the ratio of implied volatility to actual high-low-close volatility, or excess volatility, against the price of West Texas Intermediate crude oil plotted on a semilogarithmic scale — yes, we have come to this — we see how this excess volatility, which had been falling between August 2007 and February 2008 as price rose (marked with green trend lines), is now rising. The April 25 and May 23 values of excess volatility are marked with magenta and black columns, respectively.
This sort of increase in excess volatility often signals an imminent short-term trend reversal. Given the extended technical state of the crude oil market, that reversal could be quite violent, if only temporary. Those old enough to remember the October 1987 stock market crash may wish to use it as an analogy.
That’s not all that is of interest in this piece. Oil trading would appear to moving to markets with limited regulation and transparency, a subject we discussed the other day. More of Simons:
If Congress or the CFTC moves to restrict the index funds, they will simply move their activities to ICE or to other non-U.S. exchanges outside of the U.S. reporting system. The net result will be even less transparency than we have today. This may be happening already. How else can we explain the combination of the absurdity of last week’s Commitments of Traders report [“a decline of more than 20,000 contracts in non-commercial traders’ net long position”], the observed changes in crude oil’s forward curve and the reversal of a long-standing relationship between excess volatility and the price trend? This is a movie I haven’t seen yet, and it has my full and complete attention.
Some day we’ll figure out what all the technical talk means, but it is surely a warning sign when traders appear to have moved to perhaps further mask their activities as prices continue their parabolic arc. Our simple minded view is that, absent some dominant special factors, oil is a commodity that has a lot in common with other necessary commodities. When it conspicuously trades in a pattern that is totally out of synch with almost all other commodities, as it has done over the past few months, something is likely not quite right. A public flogging of the offenders can’t come too soon.