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Oil Selloff Looks Different

The current downdraft has made it difficult to use oil as a gauge to buy oil and stocks.

Oil's been a fantastic metric for the health not just of oil stocks, but also for the market at large.

I've spoken at length about the correlation between oil and stocks, which has been incredibly strong during this latest downturn . Oil is down more than $8, while the

S&P 500

is off almost 75 points in the last two weeks.

But oil's latest downdraft is not looking precisely like selloffs we've seen in the past -- selloffs that I confidently predicted as interim lows and used as an indicator to buying oil and buying stocks.

I'm less confident that oil has reached that interim bottom at $71.50 a barrel, or that the markets have found their lowest levels as the S&P index hovers around 1,050.

Let me tell you why this selloff looks different and what it should look like when oil has more likely reached a tradable bottom.

One of the best indicators for finding a strong rallying point in oil has been by finding a deep differential between trading months going six to 10 months out in the curve. Remember, the mechanism for pricing oil is with futures contracts, which have separate months of delivery that trade individually. The differentials between the trading prices between months are called spreads, and the matrix of spreads moving along the calendar make up what we call the curve of prices.

This curve can be indicative of many things, but the one thing that I've used it for is for the relative investment interest in oil as an asset class. It has been my thesis for three years now that investor interest in oil has been the primary driver of prices, while supply and demand fundamentals have sunk deeper down the list of influences.

When investors want to "bet" on the price of the crude barrel, they overwhelmingly do it through commodity index funds and ETF's on oil. And, to be very brief, these investments have the effect of skewing the curve of oil prices -- more investment tends to push premiums on price further and more deeply back on the curve. What happens, is that prompt, front-month prices become significantly discounted to prices that are trading six to 10 months into the future.

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Particularly on sell-offs, this front-month premium, known as a "contango," can reach upwards of $10 for a six-month differential. In one very dislocated moment in 2009, it actually pushed out to $15, an incredible, historic spread.

When that happens, physical traders of oil no longer have much incentive, if any, to sell stockpiles into the futures markets, preferring to store what they can and take advantage of the sharply higher prices in the future. No selling from legitimate physical hedgers leads naturally to an interim bottom and strong rally in price.

But this time, with this selloff, prices have not reached a $10 contango, or even a $5 contango, the minimum I have looked for to guess at a buying opportunity. The October/March spread in crude oil is hovering at $3.50 or thereabouts, clueing me into the possibility that this downdraft probably still has more to go.

It's getting there, however. Even today, the spreads are "blowing out" (getting wider). The oil market is down today pretty sharply: On my screens, October is down about $1.50, while March has lost $1.10.

A few more days of this kind of action could give us that $5 threshold I'm looking for -- but it might also bring a lower crude price with it, maybe even threatening the interim lows of $67 we saw in late May. And with the possibility of oil dropping further, we also visit the possibility that the equity markets may do little good until after Labor Day.

The oil curve has been a worthwhile indicator to watch of general market health. And right now, it's not delivering much encouragement. But keep a close eye on oil. This summer has proven that we're working with range-bound markets, both in oil and in stocks -- and the curve is telling us we're getting closer to one extreme.

Dan Dicker has been a floor trader at the New York Mercantile Exchange with more than 20 years' experience. He is a licensed commodities trade adviser. Dan's recognized energy market expertise includes active trading in crude oil, natural gas, unleaded gasoline and heating oil futures contracts; fundamental analysis including supply and demand statistics (DOE, EIA), CFTC trade reportage, volume and open interest; technical analysis including trend analysis, stochastics, Bollinger Bands, Elliot Wave theory, bar and tick charting and Japanese candlesticks; and trading expertise in outright, intermarket and intramarket spreads and cracks.

Dan also designed and supervised the introduction of the new Nymex PJM electricity futures contract, launched in April 2003, which cleared more than 600,000 contracts last year alone. Its launch has been the basis of Nymex's resurgence in the clearing of power market contracts over the last three years.

Dan Dicker has appeared as an energy analyst since 2002 with all the major financial news networks. He has lent his expertise in hundreds of live radio and television broadcasts as an analyst of the oil markets on CNBC, Bloomberg US and UK and CNNfn. Dan is the author of many energy articles published in Nymex and other trade journals.

Dan obtained a bachelor of arts degree from the State University of New York at Stony Brook in 1982.