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Trading crude oil? Use seasonality to your advantage

23 April, 2015 1:15 PM
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Trading crude oil? Use seasonality to your advantage

Seasonality often plays a part in determining prices for commodities in regular cycles throughout the year. Normal increases and decreases in supply and demand for particular commodities seem to occur every year in fairly consistent patterns.

By definition, a seasonal price tendency is the propensity for a given market to move in a given direction at certain times of the year. One can support his investment decision in markets using knowledge of seasonality trends along with other analysis before entering into a particular trade. Most commodities have strong seasonal tendencies every year.

Commodities usually trade in two markets one is the physical or spot market and the futures market wherein buyers and sellers agree on the price of commodities for delivery at future dates. In the futures market the prices are set by speculators and producers also known as hedgers, the price represents their expectation of the value of the underlying commodity.

The movement of commodity prices though unpredictable, is dependent on a host of fundamental factors, giving rise to “contango” or “backwardation” in the commodity markets. A market is said to be in “contango” when the far- month futures prices trade above the near-month prices. The opposite of “contango” is “backwardation” whereby near-month future prices trade higher than far-month contracts. Contango situation reflects spot prices plus cost of carry which is the general market condition whereas Backwardation indicates tightness in supply in the immediate/near term.

Factors such as current spot price, inventory levels, supply and demand balance determine whether market is in backwardation or contango. Seasonality of price spreads provides useful information in predicting market will trade in backwardation (discount) or contango (premium).

A historic price analysis of crude oil reveals that October month price of oil generally peaks and December month is where the price generally makes a bottom. Please refer chart below for reference.

Factors such as current spot price, inventory levels, supply and demand balance determine whether market is in backwardation or contango. Seasonality of price spreads provides useful information in predicting market will trade in backwardation (discount) or contango (premium).

We analyzed spreads between October and November month for a period 8 years and derived that due to the cyclic nature of crude oil which tends to peak in October month due to reduced demand on account of US winter season. The spreads widen between October and November months and on an average are positive 25 basis points. Please refer chart below.

Generally spreads remain in contango in normal market conditions. The maximum spread as per chart above has been 100 in October month every year. The minimum spread as per chart above has been -60 in October month every year and the average spread as per chart above has been 25 in October month every year.

Ideally one can watch the calendar spreads on MCX crude oil contracts (October, November expiry) from September month onwards, the opportunity to initiate the spread trade can be explored if the spread is below historical averages or trading at a discount for the contracts to eventually trade at a premium. One can long the far month contract (November expiry) and Short the near month contract (October expiry).

As the above analysis is based on past trends of price spreads it is not necessary that there cannot be a deviation to the historical trend as there can be exceptional fundamental events like war or excessive supply due to economic slowdown or new oil discovery which enhances supply that can trigger reaction in the prices. Hence one must always enter any trade by keeping stop losses keeping in mind the historic price spread averages.

Source: moneycontrol.com

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