Oil Carry Trade: All About Contango - TheStreet

You see it every day, the crude oil market running in lockstep with the stock market. Even Tuesday I was staring at a screen where the

Dow

was up 100 points and the

S&P

was up 11. Oil? Up $3! There's an argument about which asset class is pulling which -- is the stock market moving upwards on oil's back? Or is it the other way around?

I've written countless articles on what I have dubbed the "endless bid," the connection between investment interest in oil as another asset class that ignores for the most part the fundamentals of that market. But no matter how you slice it, the new interconnectedness of the oil and stock markets can't be ignored.

Wouldn't it be great if you could look at the oil futures market and be able to see when oil has at least the potential for a big move up, ready to transfer some of that power to the stock market?

That's why I'm here.

If you're watching

CNBC

talking about Tuesday's big $3 move, they're talking about the Chinese markets being closed, light volume and a "technical rally" -- they just don't get it.

Tuesday's big oil move was all about the oil carry trade, which

no one

is talking about or seems to understand -- except me and other guys daily engaged in oil trade.

The oil carry trade is all about the contango, where the curve of prices in oil get more and more expensive, the further along in time you go.

This is a frankly ridiculous outgrowth of the "endless bid," where investor money continues to get passed down the timeline, keeping futures moving higher and higher as you move further along the curve.

But the real physical players in the crude market have their say in these conditions. If the contango and the curve gets too steep, the participants in the futures markets with real physical assets can make more money by

not

delivering product and putting it into storage, attempting to take advantage of higher prices further out in the future.

In essence, the number of sellers, legitimate sellers, begins to dry up and disappear.

And you get a monster rally.

We saw the most outrageous contango of close to $15 when the oil market hit its interim lows in early 2009, and witnessed oil rally from $32 to close to $85 in less than eight months. It is also, coincidentally, the precise carry-trade opportunity that Andrew Hall used to infamously collect a $100 million dollar bonus from Citibank.

Such an enormous carry opportunity hasn't returned, but a deep-enough contango has come and gone intermittently to make the sellers disappear, like in the past week when the six-month contango got over $5.

This signaled a strong return of the carry trade, and that the potential existed for oil to rally very strongly and very quickly.

And it has.

The price curve has continued to be a key indicator for oil prices -- and therefore the correlated potential of stock prices, too. Keep an eye on the curve of prices -- and particularly these six- and 12-month price differentials. When they move to these very deep premiums, you are being tipped that the markets could be preparing to go the other way.

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.