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Trader's Corner

This week’s Trader’s Corner looks at the importance of understanding speculative trader positions.

We all know there is a lot of speculative trading in energy markets, especially crude. Following how speculative traders are positioned in crude futures and how their positions can affect future crude market activity is important.

It is so important, in fact, that every Monday we report to our daily readers the positions held by speculative crude players. Speculation is a growing influence on markets, even though commercial activity makes up the majority of trading.

Commercial activity is the trading of crude by oil companies, refiners and other entities that are influenced by the price of the commodity. In fact, some propane companies trade crude because they understand the relationship between crude and propane.

Much of the commercial activity is hedging. For example, a refiner buys or sells crude futures to lock in margins and manage volatility. It is no different than when propane retailers buy pre-buys or swaps to manage their supply costs. To a large degree, a commercial player is not trying to predict the direction of prices when they own both the commodity and the financial hedge. If they lose on one side, they gain on the other. That is the whole point for a commercial player, to use futures to take the unknown out of supply costs, which helps refiners, processors and other commercial players to manage their business better.

In contrast, a speculative trader is not a producer, refiner, processor or some other type of commercial player. He has no offsetting commodity to his financial position. He is usually not hedging a position, rather is making a pure bet on market direction.

If a speculative player is not correct on his assumptions about the market, he will lose money. These speculative traders can be in and out of the market quickly. Following what speculative traders as a group are doing can give us insight into the market.

The Commodities Futures Trading Commission collects data each Tuesday on the positions of speculative traders, then submits a report on Friday afternoons on where traders stand. On Monday, our readers get a summary of that data. Let’s take a look at some of the charts and tables we put in the report. Click to enlarge.

The chart above shows the net speculative position along with the price of crude. When the blue bars are above zero, it means more trades are long than short. We will discuss this a little more, but the bottom line is that more believe the price of crude is going up than believe it is going down. Let’s look at the table below to help us understand the net position.

The last column in the table above, labeled “Difference,” is the net difference between the total number of long and short contracts held by traders. A contract is 1,000 barrels.

Let’s run through the data for Feb. 19. Open interest in crude was at 1.65 million contracts, which includes speculators, commercial players and spread plays. Speculators held 502,792 contracts, including long and short positions. Of that, 380,355 were long positions and 122,437 short positions. The difference was 257,918 contracts. Since the number of longs is more than the shorts, speculators are said to be net long by that amount. If the short positions outnumbered the longs, the speculators would be net short crude.

When a trader is long, he is making a bet that crude prices are going higher. When a trader is short, he is betting on the market going lower. The net long position lets us know traders are bullish crude – expecting prices to go higher. Therefore, they have bought a crude contract for delivery in the future. They expect prices to go higher so they can sell the future they hold into a higher-priced market and make a profit.

In contrast, a trader short is expecting prices to go lower. The short player agrees to sell crude at a certain price in the future, but does not yet buy the crude he will need to make good on that commitment. His bet is that prices are going lower. When they do, he will buy the crude for less than he committed to sell it for and make a profit.

Of course, knowing the predominant “bet” that speculators are making on crude helps us, but that is not all these numbers can tell us. As mentioned, crude players are net long by 257,918 contracts. On average since 2004, the market has been net long by about 75,000 contracts. Based on history, the market would be considered very net long.

A player that is long must sell his position to make a profit or minimize a loss. When more sellers enter the market, it can drive the price lower. When the price goes lower, more traders holding long positions may be pressured into selling. It is easy to see how the selling can begin to feed on itself fairly quickly, causing extreme price movement in the market.

The more the market is long the more selling pressure is building. What might seem like relative minor bearish news can cause extreme downward price movement. Look at the net or difference column in the table above for the week of Feb. 12. Traders were even more net long, at 272,875 contracts. In one week, 11,547 long positions were sold. Now let’s look at crude price movement during the week this selling was taking place and what happened through last Friday.

This chart is a good example of how selling to close long positions can cause rather dramatic movement in crude’s value.

When we are in a bullish pricing environment, speculators are generally going to become more long the commodity they trade. However, the more long the market the greater the potential downward movement in prices.

During those times when propane is following crude fairly closely, it becomes increasingly more risky to buy propane when crude traders are extremely long. Conversely, when traders are short crude, they must buy to cover their positions, so their activity can drive prices higher. That means it becomes less risky to buy propane when crude traders are only modestly long (the market is normally long) or have become net short crude.

So the positions tell us a lot about how traders are viewing the market. But their overall positions help us identify the potential degree of volatility in the market when the market view changes.

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Crude fell off sharply to close the week and could have more downside coming.

Propane held up well, with weather in support.

The weather should remain in support of propane for a couple of more weeks, but the current inventory picture remains bearish. We began the week with a bearish outlook.

Monday: Markets closed for Presidents Day.

Tuesday: Propane prices started the week higher as cold weather became more supportive of prices. While it is a battle line between the last vestiges of winter versus the end of colder weather, forecasts became more supportive. Crude closed up 80 cents a barrel at $96.66 with only one day of trade left in the March contract.

Wednesday: Crude posted a loss of $2.20 on hedge fund concerns and supply issues. Both Belvieu and Conway held up well, considering the large drop for crude. Belvieu posted a half-cent loss and Conway posted a three-eights-cent loss.

Thursday: Propane tracked closer to crude on Thursday after the Energy Information Administration released some bearish data. Crude oil posted a build of 4.143 million barrels, leading to a drop of 2.5 percent on the day. Belvieu lost 2.3 percent of its value and Conway was down 1.3 percent.

Friday: Propane prices were stronger to close the week after two straight days of losses. Crude posted a small gain after hitting a six-week low on Thursday.

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Cost Management Solutions LLC (CMS) is a firm dedicated to the analysis of the energy markets for the propane marketplace. Since we are not a supplier of propane, you can be assured our focus is to provide an unbiased analysis.

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