Bulls, bears and contango: What’s in store for crude

It’s been a rough year for commodities in general, and crude in particular. What will the new year hold?

Read: Use futures for commodities plays

“We’re very optimistic about commodities long-term,” says Tim Pickering, CEO and lead portfolio manager at Auspice Capital in Calgary. People who worry about commodities tend to focus on China. Pickering says that while China’s economy may be slowing down, in absolute terms, even lower Chinese growth entails a massive appetite for commodities. “A simple example is that, as of April, China is now the largest importer of crude oil.”

So, overall demand for commodities won’t abate any time soon. “It’s going to ebb and flow, but the long-term trajectory is there.”

Crude

The price drop we’ve seen in crude may not be over. There’s plenty of demand, says Pickering; the problem is oversupply.

“But if we think out a few years, oil has a great opportunity to recover given global demand.” He says if you want oil exposure, consider Canadian crude. “The downside in Canadian crude is probably $5; the upside is probably $35 or $40. The downside on WTI is at least $10, maybe more.”

Canadian crude is trading at a discount to WTI, and historically, if oil markets fall, Canadian crude falls less than WTI, Pickering says. And if markets go up? “If [Canadian crude] is at a $15 discount to WTI and both rise by $10, where’s the better return?” In percentage terms, Canadian crude.

Read: How to play energy in a down cycle

Christopher Foster, CEO and portfolio manager at Blackheath Fund Management, is less optimistic, at least for the near term. He rode the better part of the collapse in oil prices through short bets on futures and recently exited his position.

“People thought, when crude [fell below] $70, that shale [production] was going to be completely shut down. Guys loaded up on crude oil; they said, ‘It can’t stay down. Supply is going to be cut off, offshore oil will be curtailed, and exploration budgets are going to be slashed.’ Yet shale production went up. So [they] were in this awful position of holding large long positons in a down-trending market.”

Foster’s looking for a specific signal to trigger a bet: the market’s trending down but people are bullish; or, the market’s trending up and overall sentiment is bearish. “Their sentiment is going in one direction and the price is going in another, and price always wins.” If the market’s dropping and, despite a wave of speculative long bets, continues falling, it’s a signal the commodity’s fundamentals are really bad. “If it can’t rally with all that hot money coming in, there’s something rotten in Denmark.” In this scenario you’d go short.

Read: How politics impact markets

But there are no sure things. “You can put a trade on for the reason I just articulated, and then something happens in Iran, [for example]. […] When the Russian jet got shot down [by Turkey], there was a $2 to $3 rally.” Not what you want to see when you’re short.

“There are so many news events, inventory reports [and] political developments that’ll move the market $2 or $3. But if you’re seeing heavy speculative buying and the price is not responding, it’s a great signal—not just in [the commodities] space, but also in […] regular equity investing.”

Foster says he won’t buy into the current crude market. “The contango is so fierce. Right now [December 8, 2015] we’re at about $38 a barrel. If you want to make a bullish bet on crude oil by June, you would go out and buy June crude oil futures, which are $42.75. That’s $4.75 a barrel higher than the spot price. So, the spot price has to rally 10% for you to break even.

“The carrying charge that we’re seeing in the market right now is a function of there being too much crude and not enough storage. If there was a lot of available storage, people would buy crude in the spot market, sell it forward for June, store it for four months, and then make that $4.75. But there’s no storage available because there’s so much crude sloshing around. So, for a speculator to go in and buy that crude, you’re paying that contango.”

Making a 10% profit is hard enough; needing a 10% price rally just to break even amounts to a major headwind, concludes Foster.

Read: Focus on oil facts