Copper/Crude Spread: Switching Bets From Red to Black

The Correlation

Copper and crude oil prices are strongly correlated.  You can look at the last three decades of price history and see that this is the case.  This makes is a great pairing for potential spread trades.

Fundamentally, this correlation works because of the demand side of things.  The two markets are connected to economic growth.  When the economy is doing well, consumption of both commodities increases.  Conversely, consumption of both copper and oil slumps when the economy slows down.

copper-crude-oil-overaly-nearest-futures-weekly

Copper Crude Oil overlay (nearest-futures) weekly

Thanks to the big difference in the supply side, however, there can occasionally be big divergences between copper and crude.  A mine strike in South America will move copper immediately and have no effect on oil prices.  Likewise, a change in OPEC policy immediately impacts oil prices but the copper market may not respond at all.

The demand side connection and the supply side disconnection create ebb and flow between these two markets that can generate spread trading opportunities.

Historical Boundaries

As readers know, the blog is interested in spread trade opportunities whenever an intermarket spread reaches or breaks the historical price boundaries.  This is because commodities are mean-reverting.  Whenever they reach the upper limits of the historical price range, it’s just a matter of time until it snaps back in the other direction.

Looking at the last three decades, it appears that the spread between the value of one 25,000 lb. copper futures contract and one 1,000 barrel crude oil futures contract reaches unsustainable levels when the nearest-futures spread gets to $17,000 (premium copper) or higher.

Sometimes the copper/crude spread has peaked within weeks of reaching the $17,000 price level.  Other times, it has taken several months to eventually turn over.  But every time it has reached $17,000 and beyond, a major bear market has followed.

copper-crude-oil-spread-nearest-futures-weekly

Copper Crude Oil spread (nearest-futures) weekly

The bear markets have been doozies, too!  They carried on until the spread inverted and crude had a premium of at least $10,000 over the copper.  At that point, the bear market had swung the pendulum all the way to the other extreme where the copper/crude spread became a trade candidate on the long side.

As traders, that’s perfectly fine with us.  As a matter of fact, it’s preferable.  This means we can ride the spread back and forth, hopefully banking profits in both bull markets and bear markets.

Current Setup

Exactly three weeks ago, the nearest-futures copper/crude spread hit $17,000 (premium copper) for the first time in months.  It appeared to be on the way to reaching the February top near $24,000.  We were actually cheering for it.  Based on the current price action, however, it is quite possible that the Black Friday (November 25th) high marked the end of the run.

The March 2017 copper/crude spread previously peaked in Q1 of this year between the January 20th high of $13,605 and the March 4th high of $13,642.50.  This left a double top pattern in place and represented a major resistance level.

Once the spread broke through the double top on November 9th the price resistance immediately became price support for the spread.  This is a well-established charting rule.

The spread pulled back just below this support zone on November 21st when it closed at $13,367.50.  It immediately bounced the next day and raced to new highs by the end of the week.  This reaction validated the support level.

march-2017-copper-crude-oil-spread-daily

March 2017 copper crude oil spread daily

But as we start the new month today the spread is currently trading below both the Q1 double top and the November 21st reaction low.  A close below this level would signal that the November breakout has failed.  If so, it would warrant a short sale in the March 2017 copper/crude spread.

Trade Strategy:

Place a hypothetical contingency order to sell one March copper contract and simultaneously buy one March crude oil contract if the spread closes below $13,367.50 (premium copper).  If filled, liquidate the position on a two-consecutive day close above the contract high that precedes the entry (currently at $19,137.50). 

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