Do Oil Prices Predict An Economic Recovery?

June 29, 2010 | By More

Ever pay attention to the oil future prices you see every day on CNBC?  If you don’t, you might want to start taking a closer look.  They can tell you a lot about the health of the economy.  In fact, you may be able to see a shift in the economy before the crowd sees it.

More importantly, you might catch some great trading opportunities other investors are missing.

Look, I realize there are a ton of economic indicators out there.  Some of the most common are unemployment rates, durable goods, GDP, interest rates, and CPI.  It can be pretty tough to digest all the data.  Professional investors regularly use many of these statistics to gauge the condition of the economy.

Don’t kid yourself, these numbers are widely followed.  Everyone watches them so closely, they no longer give you any real edge…

More often than not, the markets already priced in the information.

Ever wonder how the government uses all the economic data?

Alan Greenspan, the famous Federal Reserve Chairman, made some very significant contributions.  One contribution was changing the way the Fed measured economic activity.  Greenspan and his team introduced the concept of taking a very complex set of data and turning it into an equation measuring the economy’s health.

Reportedly, Greenspan would use the price of scrap metal to help determine interest rate policy.

While I don’t recommend digging up scrap metal prices, other common statistics can be plenty helpful to traders.

They can prepare you for possible market shifts before they occur. All you have to do is look to the futures market for some great info.

But first, you need to know some lingo.

Commodity futures trade in monthly contracts.  Each contract has a delivery date at some point in the future (hence the name “futures”).  The month with the nearest delivery date is called the front month.  It’s also usually the most actively traded contract.  Later months can also be traded, even several years out.

Listing the price of oil by month gives you what’s called the term structure.

Take a look at this example of a term structure for a commodity…

The August contract is trading at $50 – this is the front month.
The October contract trades for $52.
And, the December contract is trading around $55.

As you can see, August prices are lower than October and December prices.  This is called contango.  And it’s normal for the commodity markets to be priced this way.

Contango occurs because of carrying charges.  Think of it this way, later month contracts include things like storage fees, financing costs, and insurance costs.  These extra costs make further out contracts more expensive.  It also shows there is a surplus of a particular commodity.  If a product has enough supply to fill warehouses, then it must have a surplus.

The opposite of contango is backwardation.  This occurs when the front month is priced higher than subsequent months.

Backwardation occurs when buyers need a product now more than in the future.  Something like this might happen in times of shortage.

For example, imagine if most of this year’s entire wheat crop gets ruined by a massive flood.  Bread makers would demand as much wheat today as possible.  Front month prices would jump faster than those further out – meaning backwardation.

So what commodity do I like to look at?

Oil of course… and right now we’re seeing contango in the oil futures market.

August oil futures are trading around $78 a barrel.
October futures are trading near $79.50 a barrel.
And, December futures are trading at roughly $80.50 a barrel.

An excellent indicator of a turnaround in the economy is when oil goes from contango to backwardation.

It’s a great sign of economic strength because often demand for oil increases before companies start ramping up hiring or announcing higher earnings.  The term structure of oil will change before other indicators such as GDP or the unemployment rate improve.

In June of 2008, oil was in backwardation.  The economy was still chugging along.  Then the oil term structure shifted from backwardation to contango.  One month later, the financial crisis hit.  And the markets collapsed!

Shifts in the oil term structure can precede a market turn.  This is true from contango to backwardation or vice versa.

I’m keeping an eye on oil future prices and so should you.  Watch for a change in the term structure.  You may be able to profit by recognizing the economy is heating up well before everyone else does.  Once the economy gets hot again, stocks often run higher!

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Category: Commodities

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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