Copper/Crude Oil Spread: Watching For a Reversal

Looking to Reenter

Back on December 1st, the IMC blog entered a short position in the copper/crude oil spread at the equivalent of +$12,870 (premium copper), due to rollovers.

September Copper Crude Oil spread daily

September Copper Crude Oil spread daily

The blog was last holding a May spread.  It was liquidated at the market-on-close on April 20th at +$13,280 (premium copper) because the crude contract was expiring.

We are now stalking the September copper/crude oil spread for a short sale.  The blog did not roll into the September contracts automatically because the spread tested support at the early February low last week and bounced.  The plan is to get into the spread only if it breaks the similar lows from early February and last week.

Copper Crude Oil spread monthly

Copper Crude Oil spread monthly

Currently, it appears that the spread is headed for a test of the contract high that was posted just last month at +$17,882.50.  A breakout to new highs could push it right over the +$20k mark in a heartbeat.  If so, we will revise our short sale criteria.  History shows that this spread has been a good short sale after surpassing the +$20k level.

Trade Strategy:

Place a hypothetical contingency order to sell one September copper contract and simultaneously buy one September crude oil contract if the spread closes below +$10,000 (premium copper).  If filled, liquidate the position on a two-consecutive day close above the contract high that precedes the entry (currently at $17,882.50). 

If the spread closes above +$20,000, change the parameters to enter a short position if the spread closes below +$17,000.  If filled, liquidate the position on a two-consecutive day close above the contract high that precedes the entry. 

 

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Crude/Nat Gas Spread: Catching The Falling Knife

Spreading the Energies

Some of my favorite spreads are in the energy sector.  In particular, I love to trade the crack spreads.  But there’s also another lesser-known energy spread in my bag of tricks: crude oil against natural gas.

A few years ago, the correlation between crude and nat gas broke down.  It lasted for a few years and was not resolved until 2014.  This made for some tough sledding for anyone trying to trade the two markets against each other.  But since the correlation has been back to normal over the last three years, the odds of successfully trading the spread have gone up.  To that end, it looks like a buying opportunity is shaping up right now.

Making Plans for Labor Day?!

Two days ago marked the first day of spring.  Ironically, the trade opportunity that popped up on my radar screen yesterday is for the Labor Day (September) contracts.  I guess that’s why these are called futures contracts, right?

A crude oil futures contract controls 1,000 barrels of crude and a natural gas futures contract controls 10,000 MMBtu (million British thermal units) of nat gas.  To simplify the spread, I plot the difference between the actual values of the contracts.

Over the last couple of years, one September crude oil contract has been worth anywhere from 40% more to a little more than double the value of one September natural gas contract.  Therefore, the blog has been plotting the spread between one crude oil contract and the sum of the value of two natural gas contracts.

Price Parameters

Yesterday the September crude oil/natural gas (x2) spread closed at -$15,930 (premium nat gas).  This was the lowest price it has been in fourteen months.

Notice that this was only the fourth time in the last year that the spread has closed at -$15,500 or lower.  The lowest closing price was the January 20, 2016 low of -$16,170 and the longest that it ever closed at -$15,500 or lower was two consecutive days.

September crude oil natural gas (x2) spread daily

September crude oil natural gas (x2) spread daily

Actually, I fudged on that count just slightly.  The August 2, 2016 close was -$15,430.  That’s only $70 away from the -$15,500 threshold, which is close enough in horseshoes and hand grenades.  So we’ll say it’s close enough for spread trading, too.

Each of the dips to -$15,500 or lower was followed by rebounds that took the September crude oil/natural gas (x2) spread north of -$6,000.  Now interestingly enough, each close above -$6,000 was also a short-lived excursion as well.  Once the spread achieved this level, it soon rolled over and plunged again.  It’s been a perfect trading range for nearly a year and a half.

In light of this, it looks like the trade opportunity here is to buy the spread now and look for a rally above -$6,000 before taking profits.  Also, an ‘add-on’ position could be purchased once the rebound starts.  So that’s exactly how the IMC blog is gonna play it.

Ratio Confirmation

The ratio between the values of a September crude oil contract and a September natural gas contract confirm what we’re seeing in the spread.  The ratio closed at 1.51:1 yesterday.  The last three times it closed at 1.52:1 or lower, a major recovery soon followed.

The biggest challenge for the ratio’s recovery happened in January 2016.  The ratio closed at 1.52:1 on January 12th and didn’t fully recover above this level until two weeks later.  During this time, the contract low of 1.4:1 was established on January 20th.

September crude oil natural gas ratio daily

September crude oil natural gas ratio daily

In the grand scheme of things, though, this extended stay at 1.52:1 or lower was not all that dramatic because the spread only stayed at -$15,500 or lower for two days.  This is why using both the spread and the ratio together is a good idea.

Trade Strategy:

For tracking purposes, the blog will make a hypothetical trade by buying one September 1,000 barrel crude oil contract and simultaneously selling two September 10,000 MMBtu (million British thermal units) natural gas contracts at -$15,500 (premium nat gas) or better.  Initially, the spread will be liquidated on a three-day close below -$16,500.

Trade Strategy for ‘Add-On’ Position:

For tracking purposes, the blog will make a hypothetical trade by buying one September 1,000 barrel crude oil contract and simultaneously selling two September 10,000 MMBtu (million British thermal units) natural gas contracts on a close at -$13,000 (premium nat gas) or higher.  Initially, this ‘add-on’ spread will be liquidated on a two-day close below -$15,500.

Copper/Crude Spread: Rollover Update

Overdue Update  

The IMC blog entered a short position in the March copper/crude oil spread at +$13,265 (premium copper) on December 1st.  We rolled to the May contracts at the market-on-close last Friday (February 17th) because Monday was the Last Trading Day for the crude contract.

Alas, I had a blog post all queued up for the rollover last Friday and forgot to send it!  If you have a decent broker, however, they should have given you notice that the March crude contract needed to be liquidated or rolled.

On February 17th, the March copper/crude oil spread closed at +$14,275 and the May copper/crude oil spread closed at +$13,880.  Therefore, the discounted price would put us in the May spread at the equivalent of +$12,870.

may-copper-crude-oil-spread-daily

May Copper Crude Oil spread daily

As a reminder to why the blog initiated a short position, it is because the nearest-futures copper/crude oil spread signaled a bearish trend change after peaking out at +$20,640 in late November.  Historically, prior runs to +$17,000 or higher have been followed by major bear markets that hammered the copper/crude oil spread down to where crude oil had a premium of $10,000 or more over the copper.  Therefore, this could be just the start of a major decline.  We will be watching for setups to add to the short position along the way.

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). 

Crude/Nat Gas Spread: Book the Rest of the Profits

End of the Road

The IMC blog entered a long position in the December crude oil/natural gas (x2) spread at -$20,000 (premium nat gas) on August 5th.  The December crude oil contract expires today, so we’re just going to book the profits, sit on the sidelines, and enjoy our Thanksgiving turkey.

december-crude-oil-natural-gas-x2-spread-daily

December Crude Oil Natural Gas (x2) spread daily

However, being on the sidelines does not mean that we are not monitoring the crude oil/natural gas (x2) spread.  We are now focusing our attention on the June 2017 contracts.  That spread is currently priced around -$10,650.  A return to the double bottom between the January and August lows of -$15,960 and -$15,820 would have us watching for a setup to get back in on the long side.  Until then, enjoy your Thanksgiving holiday!

Trade Strategy:

On the long December crude oil/natural gas (x2) spreads entered at -$20,000, take profits here at -$11,600 or better to liquidate the trade with a profit of +$8,400.

Crude/Nat Gas Spread: Take Some Money Off the Table

Best of Both Worlds

The IMC blog entered a long position in the December crude oil/natural gas (x2) spread at -$20,000 (premium nat gas) on August 5th, purchased a second spread at -$15,310 on August 11th, and purchased a third position was entered at -$13,690 on August 15th.

The spread recently soared to the highest level since May, but it is now turning over.  Is this just a temporary pullback after the explosive rally?  Or is it over?

december-crude-oil-natural-gas-x2-spread-daily

December Crude Oil Natural Gas (x2) spread daily

The more important question is do we cash out or hang on?!

The nice thing about having multiple positions is that we can take partial profits.  It’s not a binary “in-or-out” decision.  It really is the best of both worlds.  So that’s what we’re gonna do here.

Trade Strategy:

On the long December crude oil/natural gas (x2) spreads entered at -$15,310 and -$13,690, take profits at -$12,000 or better.

 

Crude Oil/Nat Gas Spread: We Bought ‘Em Near the Bottom

A Wicked Reversal

At the beginning of the month, the IMC blog took a hit on a position on the long side of the December crude oil/natural gas (x2) spread when it smashed prior price support to smithereens.  However, the fact that the spread looked overdone and the fact that the December crude/nat gas ratio appeared to be establishing a double bottom lured us back in.

Not only did we go back in, but we went in aggressively.  The trade strategy was to get back into a long position with an initial exit signal if the ratio broke the double bottom.  Then we’d add more once the spread close back above the “ice level” of -$17k.  Finally, a third purchase would be made if the December crude oil/natural gas (x2) spread could clear the July high and close above -$14k.

This took place over the last week and a half.

December Crude Oil Natural Gas (x2) spread daily

December Crude Oil Natural Gas (x2) spread daily

The blog entered a long position in the December crude oil/natural gas (x2) spread at -$20,000 (premium nat gas) on August 5th, the blog purchased a second spread at -$15,310 on August 11th, and a third position was entered at -$13,690 on August 15th.

We are now loaded up.  Initially, we are looking for the spread to reach a resistance zone between the March 7th high of -$6,840 and the May 18th high of -$5,730.  Once the spread gets into this area, we will monitor the price behavior closely to determine our next course of action.

If the December crude oil/natural gas (x2) spread starts to flounder in the resistance zone, we may take partial or all profits on the trade.

If strength persists, however, we may just sit back and let it ride.  It is possible that the spread could be on its way up to challenge the 2015 high of -$1,540.

Crude Oil/Nat Gas Spread: Aggressive Recovery Strategy

This Energy Spread Tanked

The blog entered a long position in the December crude oil/natural gas (x2) spread at -$17,000 (premium nat gas) on July 22nd and exited at -$22,410 (premium nat gas) on August 3rd after spending  five consecutive days below -$20k.

Broken Spread Pattern

We initially bought the spread because it has exhibited a pattern of making sizable recoveries after closes below -$17k.  This pattern may now be broken since the spread has been below -$17k for two consecutive weeks.

Now that the -$17k level has been broken, it turns into an overhead resistance level.  A great analogy that Peter Brandt uses is that of being out on a frozen lake.  When you are on the lake, the ice acts as support.  But if you fall through, the ice is suddenly a resistance barrier that you must get back above.

December Crude Oil Natural Gas (x2) spread daily

December Crude Oil Natural Gas (x2) spread daily

In the event that the December crude oil/natural gas (x2) spread can climb out of the water and get back above the “ice” at –$17k, it might make sense to get long again.  In addition, a close back above –$17k could indicate that the breakdown was a trap.

The Ratio

Now here’s a twist: While the spread broke down, the ratio may be establishing a double bottom.  This means that the fat lady hasn’t sung yet.

December Crude Oil Natural Gas ratio daily

December Crude Oil Natural Gas ratio daily

The December crude/nat gas ratio closed at a contract low of 12.95:1 on January 20th and rallied to nearly 18:1 by mid-May.  It closed at 13.1:1 on August 2nd and is starting to bounce again.  This has the potential to be a double bottom right around the Lucky Thirteen mark.

Power Play

Here’s an aggressive way to play the current setup.

First, go long in the spread right here and risk a break below the double bottom on the ratio chart.

Second, add another spread on a close back above the “ice level” at -$17k.  This would also place the December crude oil/natural gas (x2) spread closes above the declining 30-day Moving Average for the first time since early June.

Third, add a third position once the December crude oil/natural gas (x2) spread closes above –$14k.  At that point, the spread would be above last month’s high and the first two purchases would have nice open profits.

Trade Strategy:

Place a hypothetical order to buy one December 1,000 barrel crude oil contract and simultaneously sell two December 10,000 MMBtu (million British thermal units) natural gas contracts at -$20,000 (premium nat gas) or better.  Exit if the December crude/nat gas ratio makes a two-day close below 12.5:1.

  First ‘Add-On’ Trade Strategy:

Place a hypothetical ‘add-on’ order to buy one December 1,000 barrel crude oil contract and simultaneously sell two December 10,000 MMBtu (million British thermal units) natural gas contracts on a close above -$17,000 (premium nat gas).  Initially, this ‘add-on’ spread will be liquidated on a two-day close below -$20,000.

 Second ‘Add-On’ Trade Strategy:

Place a hypothetical ‘add-on’ order to buy one December 1,000 barrel crude oil contract and simultaneously sell two December 10,000 MMBtu (million British thermal units) natural gas contracts on a close above -$14,000 (premium nat gas).  Initially, this ‘add-on’ spread will be liquidated on a two-day close below -$17,000.

ULSD/Crude Spread: The Next Leg Down

About to Tank

On July 29th the December ULSD/crude spread closed below the 100-day Moving Average for the first time since early May.  This triggered and entry signal for the blog, so a hypothetical short position was entered at $13.84 (premium ULSD).  Initially, we are risking to a two-consecutive day close above $15.94.

December ULSD Crude Oil spread daily (200-day MA)Recall that this is happening after the spread briefly pushed above the 200-day Moving Average and rolled over.  When this happened last year, the spread continued to decline for several months and dropped over fifteen dollars per spread.  Just in case this is a replay of2015, we will be watching for setups to pyramid the position.

Gold/Crude Spread: Verbatim Replay of 2015

Short-covered

The IMC blog reentered a hypothetical short position in the December gold/crude (x3) spread at -$14,430 (premium crude) on July 13th.  The position was then liquidated at -$2,620 (premium crude) on July 26th.

The mid-July short sale was made after the spread neared a Fibonacci .618 retracement, briefly closed above the 100-day Moving Average, and then rolled over.  The idea was that this should be the end of a bear market rally.

The position was liquidated because the spread broke out above the early July price peak.  This put back on track for a continuation of the bull market.

Right now, it appears that we are watching a rerun from last year.  Recall that the spread peaked in January 2015, closed below the 100-day MA in mid-April for the first time in several months, and closed back above the 100-day MA in early July.  This was followed by a continued bull run and new contract highs.

This year the spread peaked in January (again!), closed below the 100-day MA in mid-April for the first time in several months (again!), and closed back above the 100-day MA in early July (again!).

December Gold Crude Oil (x3) spread dailyIf the analog continues, we should be looking at new contract highs soon, an autumn pause, and then more upside right at the end of the year.  Until the 2016 pattern shows a divergence from the 2015 pattern, we are going to hang back on the sidelines.