Central Bankers Aren't Capable of Evolving With Actual Data

Central Bankers Aren't Capable of Evolving With Actual Data
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For commodity investors, a roll yield opportunity can be everything. By rolling over a short-term contract into a longer dated one, speculators can profit off the futures curve regardless of short-term movements in the spot price. It helps police the curve, an arbitrage that aids good function. But only so long as the futures curve remains in backwardation.

Curve shapes are one of the most important parts in assessing the state of markets and therefore a whole lot more beyond them. Futures markets are often deep enough and liquid, meaning that in a “big data” sense they give us less noisy signals. Since commodity futures are pegged to physical deliveries, there is an almost purity in the price. Put up or shut up means something.

This is not to say that these markets are perfectly efficient; none is or ever will be. For diagramming and diagnosing real conditions, however, this may be as good as it gets.

A futures curve will always have a distinct shape. Even one that is a straight line lacking any curve at all gives us an important profile. If the price of each contract out into the future is lower than the one preceding it, this is backwardation. In some commodities, such as gold, backwardation might indicate a shortage of physical metal for delivery demand.

In others such as crude oil, backwardation is the natural shape; perhaps. There is actually some intense debate about the topic, given that by pure reason this should be so but in practice it hasn’t always worked out that way. Ever since futures markets developed and attained sufficient robustness, in oil the curve has been split almost evenly between backwardation and its opposite.

If the price of each contract out into the future is higher than the one preceding it, this is contango. In gold, contango gives off a carry trade often highly efficient. In crude, it’s an entirely different matter.

Should short-dated futures prices fall below longer-dated contracts, the market is discounting crude available today so that futures investors will have a sufficient spread to make storage economical. They can buy up that discounted spot oil and immediately sell it in the futures market for later delivery. So long as that difference in price, contango, is large enough they can easily and profitably absorb the costs of finding and maintaining storage.

Included within those expenses is more than just the physical tank and pipeline transportation freight, there are also financial costs, as well. Most of the time this kind of transaction is leveraged, meaning interest and liquidity costs and risks. There needs to be reasonable compensation for everything.

Unlike storing gold, storing oil is a different prospect for investors as well as the market as a whole. Gold is meant to be stored; crude is meant to be used. This is the theoretical modification in the “natural” state of each futures curve, or why we should expect gold to be backwardated only rarely while crude out of it gets our attention.

What does it say about the world economy if commodity investors are, for example, steadfastly discounting current product so as to entice contango? This financial encouragement toward future rather than current delivery and use can be as foreboding as it sounds, but only in certain cases.

There are several reasons oil contango might arise. If producers suddenly produce for reasons of real-world production idiosyncrasies or even mistakes and imbalances in the futures market and the curve (again, not efficient), a supply “glut” might develop where given current demand there ends up being too much crude available for current disposal. It has to go into storage and there has to be some economic incentive for someone to take it there and leave it until conditions equalize.

On November 20, 2014, the WTI futures curve, that is the old NYMEX market benchmark futures contracts for West Texas Intermediate (WTI) crude, the US standard price, shifted out of backwardation and into contango at the crucial six-month calendar spread. The spot price of oil had fallen sharply by then, but as the curve first flattened and then shifted the roll yield disappeared and positive storage carry developed.

To most people, especially Economists who view the price of oil from an economic perspective, supposedly, this was certainly the organic result of the shale boom in the United States. Domestic production had skyrocketed as a result of prior years when the oil price worldwide seemed steady above $100. That made more expensive and intensive exploration and recovery profitable for the first time.

As US production soared, demand just couldn’t keep up. Contango, the financial incentive to store more and more crude, was inevitable. Or so they said. It had to be supply because their forecasts for the US and world economy was only varying colors of strong and robust.

But November 2014 was a curious moment for every other reason beside US production. It was only a little more than a month past October 15, 2014, and the sudden, disruptive “buying panic” in US Treasuries. It was also several months into a quite unexpected, by central bankers, “rising dollar.”

The latter actually related to the former in that the one, dollar, suggested very intense, severe problems in the global monetary system whereas the other, UST panic, a prominent symptom in terms of the disrupted collateral flow such tightness usually leads toward. A mere few weeks after the WTI curve jumped to contango, UST yields would drop quickly again, the Russian ruble was in crisis, high yield markets were cratered, and the Chinese yuan and Chinese economy started to capture global notice.

A month after those, the Swiss National Bank was forced to abandon its pegged franc to the euro because of eurodollar funding stress on Swiss banks (an artificial constraint that wouldn’t have mattered if the eurodollar system had been healing itself).

Things would only get worse from there, this “overseas” turmoil which would develop not overseas but everywhere. Even the United States economy fell into a downturn despite all mainstream expectations for substantial acceleration; rather than forecast recovery a manufacturing recession and near-recession overall. In other places around the world, it was far, far worse.

Those views for a 2015 US boom were predicated in large part on dismissing the oil crash as a “supply glut.” But contango in the curve need not be a product of too much additional product.

Contango can show up, obviously, if demand subtracts. Should the local or global economy weaken, the same situation in the futures market would arise. Producers would have to discount the short-term futures contracts relative to longer ones so as to begin the incentivization toward more storage. If you aren’t going to be able to use what’s available today, it has to go into a tank or pipeline somewhere until demand returns.

This process can be amplified if liquidity or funding becomes difficult. If you can’t finance your end of contango easily, you have to discount even more to get out of current obligations.

As that happens, this abhorrent futures curve shape tells producers they better cut back. The more they continue to pump out of the ground, the greater they will have to discount it in the spot market (as well as increase their own hedging costs while they do this).

In June 2014, the futures curve was in steep backwardation just as the deflationary wave swept up. The front month price was about $106, August 2014 delivery, whereas one year down the curve the contract price was about $96. That meant a calendar spread of -$10, or pretty steep backwardation. So far so good for Yellen’s optimism.

On January 14, 2015, the day before the Swiss National Bank shock, the WTI curve had totally flipped. Not only was the spot price down huge, the curve itself was massively contango. The front month, February 2015 delivery, priced at around $48. The February 2016 contract was about $55.50. The calendar spread, therefore, was +$7.50.

During the worst of it in early February 2016, the trough of the global downturn, the 1-year calendar spread would balloon to the mesmerizingly awful +$11.40.

Contango was an economic warning. But it wasn’t just one by itself, it was an important threat that should have promoted concern and attention even if it had been. Alarm bells were blaring particularly in the monetary realm (deflation, contango being one type of it in the commodity space) all throughout that period. They would only escalate further each time.

WTI contango went unheeded like all the others because central bankers needed it that way. The mainstream was only too eager to oblige.

It would take almost three years for it to return to backwardation again. Not only had US production been cut along the way, OPEC scrambled to deal with the mess in its usual haphazard, inefficient fashion. Ultimately supply cuts were reluctantly introduced and for once adhered to. Exactly one year ago yesterday, contango was finally expunged from the WTI futures curve. Backwardation had returned, the roll yield with it.

Part of the reason for that rebalancing wasn’t a delayed US economic boom finally showing up last year, it was the removal of export restrictions which allowed domestic oil to be shipped overseas.

According to estimates provided by the US Energy Information Administration, US producers had exported on average between 400 and 600 thousand barrels per day (bpd) in 2016. By early November 2017, the average was about 1.2 million bpd. The last week in October, the one just before backwardation reappeared, American firms exported 2.1 million bpd.

Over the several years since the last time the dollar rose, the US crude market has become even more tightly linked to global factors of both supply and demand.

In 2018, central bankers need even more for everything to go right. And yet, everything continues to go wrong. The litany of monetary, financial, and now economic offenses is too long to list here. I’ll just add a few of the more recent of them: European GDP was +0.16% more in Q3 2018 than Q2, meaning there was practically no economic growth whatsoever in Europe during those three months; Chinese GDP was the lowest since 2009 and both its official Purchasing Managers Indices for October pointed to sharper deceleration just ahead; US retail sales over a four-month period through September (the latest data) had dropped off to a 3% annual growth rate more consistent with domestic recession than this supposed boom.

In short, quite a bit of economic weakness permeating the entire world economy especially among its major constituents. Demand, so to speak.

There have been all sorts of warnings about this for well over a year now. I’ve been attempting to catalog and explain them along the way. May 29, another huge collateral call very similar in type to October 15, 2014, was a big one. The dollar is, obviously, rising again only now officials in EM economies are starting to really complain as they sink deeper into the quagmire. Another warning showed up on October 3 (related to India, I believe, a story I’ve related in other forums).

Since that day, oil prices have dropped. Crude has been volatile for most of this year, especially since May and the “rising dollar.” Still, with Jay Powell’s outwardly hawkish stance, one echoed consistently by Mario Draghi, WTI had reached $76.40 on October 3. As of this writing, it was less than $63.50 for a loss of about 17%.

Again, this sort of price reduction hasn’t been totally abnormal. In late June, the domestic benchmark had surged to $77.40 only to fall back to about $65 by mid-August.

There is one key difference, though, between this one and that prior decline. You can probably guess by now what it is. Whereas during the summer oil rout the futures curve maintained backwardation, since October 3 it has morphed menacingly back into contango.

It isn’t huge at this stage but it needn’t be large. That it has happened at all, and that the contango is spreading and deepening, is what matters. It is, perhaps more than any, a huge economic warning about which way the world economy is really heading. The eurodollar tightening we’ve been following since last September is like 2014 registering in the physical world.

And like four years ago, there are already those talking about OPEC and shale, a second supply glut if you can believe it. Central bankers cannot afford, not now, another downturn.

They put all their chips on 2017. The 2015-16 interruption was called, laughably, “transitory factors” the oil crash primary among those. The recovery was just delayed, they would claim over and over. Four years is already pushing it.

In March 2017, PIMCO’s Global Advisory Board had aided in the firms’ glowing economic outlook which they characterized as:

“Putting it all together, we are now more confident in our baseline view that the nearly eight-year-old global economic expansion will be strengthening and broadening over our cyclical horizon.”

The advisory board was chaired by none other than former Federal Reserve Chairman Ben Bernanke, including also Gordon Brown and former ECB chief Jean-Claude Trichet.

Globally synchronized growth, or at least the idea of it, was supposed to be the happy ending for central bankers and politicians, perhaps more so former central bankers and politicians. They had been foiled only temporarily for nearly a decade, but given enough time and patience it was for them a foregone conclusion. The world would rediscover its economic footing in 2017 in large part because of their genius and perseverance.

If the oil futures curve is right, like it was four years ago, then what to them seemed like genius and perseverance to everyone else can be conclusively characterized as ineptitude and ideological stubbornness – to the point of criminality. The entire global economy has been held hostage by dereliction, so as to now be facing a fourth “unexpected” global downturn in a connected series of them.

Jay Powell is still hawkish, but the computerized commodity pits in taking away the speculator roll yield should more than anything else to this point make him rethink his position. He won’t. None of them will. Not only has the economy failed to materially change out of its wretched eurodollar-driven baseline, central bankers have shown time and again they aren’t capable of evolving with actual data.

The warnings about this possibility have been growing and expanding for a long time. Officials especially at the Federal Reserve have become adept at one thing and only that one thing: tuning them out and keeping them from the mainstream economic message. The oil curve contango is a big one. A very big one. And it isn’t in any way unexpected. 

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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