Friday, January 23, 2009

Oil Contango - Fed Funds Again

Another view on comparing the oil contango with Fed Funds path - how the market is pricing the Fed Funds change which will have equivalency to the market expectations for nominal GDP growth change. Think that all would agree oil shares much the same expectations - or it should.
The oil contango shows that the market feels strongly that growth will clearly be re-instated and that a completely successful reflation will occur as shown how future prices defy the cost of carry and trade steadily upwards. Given the obvious inventory of oil in both transport and also documented such as IEA PADD II etc etc, the contango can be read as only the most adamant and enthusiastic bullish future expectations of USA nominal GDP growth.
The CL contract in 12 months netted against the front CL contract:
But there is a diametrically opposed expectations in the Fed Funds market expectations. Fed Funds will over time have equivalency to nominal GDP. While there is a lot of noise in the first year at the market some robust insight can be had by looking at the future for Fed Funds one year forward versus the front Fed Funds contract. That difference will reflect the market expectations on change of nominal GDP. Looking at that chart, we can see how the crisis gobsmacked the market and expectations were for no growth for a year. Though noisy, some expectations of future growth expansion improved to the end of Oct , but then "something happened" and we have steadily deteriorated market expectations for the chance of reflation to this day.

The two schedules above both share that the most important factor is nominal growth in USA GDP. One is completely out of synch with the other. So one must ask which market is more efficient - most liquid and effective in relaying expectations. Obviously that is Fed Funds. Therefore the difference between the two markets expectations has to be inefficiencies in the less liquid oil markets - or put another way, oil is a manipulated inefficient market. The extreme moves in the contango around key settlements indicates that likely efficiency is about to return to the oil market and to force it inline with the macro USA key factors.

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