Re: Oil-Forward Curves & Holy Grails (or Lack Thereof).

Been having many discussions on Twitter about the forward curve/time-spreads of Oil, so I wanted to collate my thoughts into a coherent thread here.

First, let me dispel the notion that there is an easy, tried-and-true leading indicator/model for predicting price movements of Oil, or for that matter ANYTHING. Ridiculous notions of “stock-to-flow/halving models” for $BTC come to mind.

Second, let me dispel once and for all the notion that CURRENT FORWARD prices in the curve reliably predict FUTURE SPOT prices. It’s unbelievable to me how many otherwise financially savvy people in the media assume that this is the case. SIMPLY NOT TRUE.

That all said, I believe that there IS a decent heuristic that can be derived from CHANGES in the SHAPE of the forward curve; however, there is a PATH DEPENDENCY that limits the signal quality to only one direction.

Last February, I wrote this thread to explain the significance of Contango-to-Backwardation (C2B) flips in the forward curve:

A qualitative explanation for why this initial flip has significant signal content is that it is a FIRST sign that demand is starting to outstrip supply: when a SPOT buyer is willing to pay a “CONVENIENCE YIELD” over and above the carrying/storage cost of the commodity over time.

Certainly, this last C2B flip DID precede a SIGNIFICANT rally in spot 1 year later. The last C2B Flip happened around YE’20 with spot WTI in the mid-$40’s, and 1 year later at YE’21, spot WTI was in the mid-$70’s.

But even this heuristic only worked 64% of the time since 1988. Note the times that the heuristic FAILED and WHY – 50% of the failures were from EXOGENOUS DOWNWARD DEMAND SHOCKS.

The natural follow-on question is: once the forward curve is already backwardated, is there any more PREDICTIVE signal content in the forward curve? My view is NO.

I think it is a dangerous fallacy to assume that CURRENTLY steep backwardation/tight time-spreads will automatically lead to higher prices. Many in FinTwit seem befuddled by the steep price declines despite “tight physical markets.”

If you rely on this indicator alone, you may find your head on a platter by the time the time spreads reflect demand weakness.

PauloMacro illustrates the coincident quality of these spreads. Not much help if you’ve already gotten kicked in the nuts based on “tight physical markets” a couple weeks ago!

Btw, OPEC+ is more than happy to jawbone the market to buy into this “paper-to-physical discrepancy.” I’m not entirely convinced that 1) it is entirely real, 2) that it even matters.

Why wouldn’t it matter? Because, here’s the rub: TIGHT SUPPLY IS IRRELEVANT IF DEMAND DROPS.

In fact, SUPPLY INELASTICITY EXACERBATES DOWNWARD PRICE ACTION IF DEMAND DROPS. People forget that the SWORD OF INELASTIC SUPPLY CUTS BOTH WAYS.

anasalhajji has produced a great visual to show you how useless the shape of the forward curve was in predicting STEEP DECLINES. In particular, note the backwardated curves in 2008 and 2011 – right before DEMAND SHOCKS drove prices off a cliff.

To understand why this makes perfect economic sense, please read this treatise I wrote on what happens when a DOWNWARD DEMAND SHOCK HITS AN INELASTIC SUPPLY CURVE as it pertains to $BTC. Oil is NOT exempt.

Re: $BTC/Crypto: The Beginning of the End of the Liquidity Lottery.

If anything, I have worried that the recent SUPER-BACKWARDATION encountered when WTI hit almost $140 on fears of Russian shut-ins create exactly the conditions for such a downward demand shock. Wrote this in June:

We have gotten some relief in recent days given the declines in Oil prices, but the USD Wrecking Ball has muted these effects for MOST OTHER COUNTRIES:

You know what would produce the Mother of All Downward Demand Shocks? Asian Contagion 2.0. In the ST, I think this is a distinct possibility.

Wrote this 2 weeks ago:

Re: Inflation/Macro-Asian Contagion 2.0?

What about the OPEC+ Put? OPEC+ recently jawboned about this, but I don’t realistically think they can strike it at $90 Oil because of this reason:

I think the real OPEC+ Put is more likely to be in the $60-$70 region, because at least then the world will have a fighting chance at a less hawkish Fed and therefore a softened USD Wrecking Ball.

So the unfortunate reality for those looking for a Holy Grail to predict Oil prices: this C2B Flip Indicator only works in ONE direction and only 64% of the time in an admittedly small sample size.

Making money is HARD in every asset class, and THERE IS NO HOLY GRAIL.

In the ST, I am VERY cautious for Oil as I see far more headwinds than tailwinds to DEMAND.

That all said, I REMAIN A LT OIL BULL FOR STRUCTURAL REASONS. We are not at this STRUCTURAL SUPPLY/DEMAND SINGULARITY scenario below yet, but we are getting closer:

What is unknowable is how/when this inevitable Structural Supply/Demand Singularity will impact the Fed’s ability to fight inflation. Right now, Oil has taken a breather, but Rent/OER strength precludes a Fed Pivot.

But when Rent/OER strength finally wanes, we might just be on the doorstep of the STRUCTURAL SUPPLY/DEMAND SINGULARITY for Oil! It's like Tag Team WWF!

I don’t know what happens next, but this is yet another reason why I think the Hopium of an imminent Fed Pivot will be completely eviscerated in the coming months. Have a great weekend.

END OF ORIGINAL THREAD.

Some additions:

Good pushback from WarrenPies. Think we both agreed on RV on the value of C2B Flips/lessened drawdowns during backwardation. My main issue: the curve can't predict downward demand shocks.

By the way, I tried to find the interview that WarrenPies and I did on RealVision in July '21 but I think the link is dead now. Is there an archive?

https://www.realvision.com/why-oil-is-about-to-enter-a-supercycle?utm_source=contributor&utm_medium=referral&utm_campaign=20210804_MKWP_JB_CONT_W1_LINK