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Trading Tips

Taking the Piss Out of Goldman

My British and Aussie/New Zealand readers will understand the above headline, as will those who have spent any time (as I have) with friends or colleagues from there. The rest of you will figure it out quickly enough as you read on. No, it isn’t about urine! 🙂

Actually, I’m not talking about the whole of Goldman Sachs here. It’s just one analyst based in London (I believe), but does demonstrate that not everyone who works for the company is brilliant.

A colleague of mine sent along this story

Goldman’s Currie Says Oil Drives Dollar Down, Not Vice Versa

2009-11-04 11:19:12.989 GMT
 By Juan Pablo Spinetto and Alexander Kwiatkowski

     Nov. 4 (Bloomberg) — Crude oil, which has risen 80 percent this year, is causing the U.S. dollar to weaken, driving metals and other commodities higher, according to Jeffrey Currie, head of commodity research at Goldman Sachs Group Inc.
     While oil has risen, the U.S. currency has weakened, leading to speculation that the dollar’s depreciation is driving investors to buy oil as an inflation hedge, thereby pushing up the price of crude.
     “I would argue the other way,” Currie said in an interview yesterday in London. “I would argue that higher oil prices drive the dollar down and then the weaker dollar drives the metals and soft commodities up.”
     The U.S. currency dropped to the lowest in more than a year against the euro on Oct. 26, while the dollar index, an indication of the international value of the currency, has lost 6.4 percent this year. Gold for immediate delivery has climbed 24 percent to a record this year while sugar is up 70 percent.
     “Oil represents 40 to 50 percent of the U.S. current account deficit, so a higher oil price represents an outflow of dollars that pushes the currency lower,” Currie said in the interview, after attending a Chatham House conference on food security.
     Goldman Sachs estimates that oil will reach $85 a barrel by the end of the year on Chinese demand for diesel, and $95 within 12 months time. Crude oil for December delivery traded at $80.35 a barrel, up 0.9 percent, on the New York Mercantile Exchange at 10:48 a.m. London time.

The immediate thing that jumped out at me was the “Oil represents 40 to 50 percent of the U.S. current account deficit…” bit. This is a really poor statistical analysis. I hesitate to even given it that much credit. You can say oil is X% of the total outflows. That would be fine. You cannot, however, state that one thing or another is X% of a deficit. A deficit comes about because outflows in total exceed inflows. It doesn’t mean some components are placed in the part of the equation that balances while others are placed in the deficit portion.

Be careful what kind of stats you accept – even from the so-called experts (and especially from politicians!) – as sometimes folks just don’t look at things the right way and in other cases they only present the information which supports their position (intentionally or otherwise). And watch out for making the same errors in your own analysis. They are insidious little buggers that can do real damage.

The said thing is this guy probably makes a lot more money than me. Maybe I should put in for a job at Goldman. 🙂

OK. Got that rant out of my system.

Here’s the real issue with what this Currie bloke is claiming in regards to the Dollar/Oil relationship. Oil prices can change without there being any change in currency exchange rates. It just becomes more or less expensive in all currency terms. This is what you would expect if prices are being driven mainly by supply/demand considerations. In other words, a rise in oil prices does not have to result in a decline in the exchange rate of the dollar.

On the flip side, though, a broad change in the value of the dollar against the other world currencies MUST result in a change in the dollar price of oil, holding the previously noted oil market supply/demand element equal.

Take a look of this chart of the correlation between EUR/USD and Oil prices.

Rolling 1-Month Oil vs EUR/USD Correlation

The chart above shows the rolling 1-month correlation between the EUR/USD exchange rate and Oil prices. That means each point on the chart shows the correlation between the two markets for the prior roughly 22 trading days. It shows that while most of the time the two have moved in the same direction (oil up, dollar down), there have been times when there’s been either little or no link, and at one point it the relationship was quite inverted. If oil was the main driving force in the dollar’s moves we would expect to see a more sustained positive correlation (though not necessarily always near 100%), not one that’s all over the place.

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Reader Questions Answered

Futures vs. ETFs Performance Differences

Here’s an interesting, but somewhat complex question about oil trading I had come in by email. Well, at least the answer is complex.

Hi John,

While checking a performance comparison for the last 200 days between USO and the WTI Continuous Contract, I noticed that they had very similar performance up to the end of 2008, and from the start of 2009 they began diverging, with the ETF significantly underperforming the futures contract. What happened around new year’s time that suddenly caused this divergence? And what other ETF can I choose that better mimics the price action of WTI if I would rather avoid trading the futures contract?

Thank you

Rod

I’m not an oil trader or analyst (though back in the day I would cover the energy markets on a fill-in basis from time to time), so the really market-specific stuff is beyond my knowledge. I’ll do my best, though, to explain what I suspect is contributing to the difference in performance between the USO and the front month futures, which is basically what the continuous contract tracks.

US Oil Fund (USO) ETF
First of all, we need to look at what makes up the holdings of the USO. According to the fund website, the objective of the fund is:

… for the changes in percentage terms of its units’ net asset value (“NAV”) to reflect the changes in percentage terms of the spot price of light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the changes in the price of the futures contract for light, sweet crude oil traded on the New York Mercantile Exchange (the “NYMEX”), less USO’s expenses.

At this writing the fund is indicated to be long about 45,000 contracts in the July futures, a position with a value of about $2.79 billion as of the May 20 closing price. The fund also shows nearly as much in cash ($2.76 billion). In and of itself, that sort of positioning would be a very good reason why USO is under-performing the front month futures contract. The ETF isn’t fully exposed to it so they cannot possibly match the gains.

I don’t know how those relative weightings have changed over time, though, so I cannot go beyond the current observation to specifically say that’s the entire reason. There may be other factors involved as well (see below). The big cash position definitely stands out, though.

Other Oil ETFs
There are a handful of other oil-focused ETFs out there. Here’s a list:

  • iPath S&P GSCI Oil Total Return ETN (OIL)
  • PowerShares DB Oil Fund (DBO)
  • United States 12 Month Oil Fund (USL)
  • PowerShares DB Crude Oil Long ETN (OLO)
  • United States Heating Oil Fund (UHN)

Some of the ETFs take an approach similar to USO in which they focus their holdings on front month futures to try to track nearby prices. Others, though, such as USL, actually use a spread of futures contracts across an array of months. That creates an interesting dynamic when it comes to comparing performance vs. the front month futures.

Contango and Backwardation
In normal circumstances prices of futures further into the future are priced cheaper than those in the front month. That’s a situation known as backwardation. The price of oil in the ground is less than the price of one in a barrel. Sometimes, though, things flip around into contango, which is when foward prices are higher than current ones.  That can come when near-term demand drops or there’s a glut of supply.

Now, if things hold in either contango or backwardation one would generally not expect to see much difference between the performance of front month oil and that of an ETF which includes holdings of several different month futures. When the situation flips, though, one of the two is going to outperform, potentially by a large margin. For example, if the market goes from backwardation to contango (means forward contracts go from priced less than front month to being price higher) an ETF holding forward months is going to outperform the front month futures (and vice versa in a contango to backwardation switch).

So the bottom line in all this is that you should make sure you know what the ETF you’re trading or investing in is holding so you can know what to expect.