London, 21 April 2010

The abrupt widening of the contango in crude oil this month has wrong-footed a large number of traders, if the big spike in NYMEX volumes is anything to go by. Daily turnover in crude oil futures on both NYMEX and ICE has been trending upwards since the start of 2009, as activity recovers from the price collapse and the seizing up of liquidity across a wide range of markets in H2 2008.

But trading volumes have surged over the last month to an unprecedented level. In the weeks to April 16, combined turnover in nearby contracts (months 1-12) on the two exchanges averaged 1.27 million lots per day (Chart 1 - download below).

Average turnover was 23 percent higher than in the previous record month of January 2010 (when it averaged 1.03 million lots) and a massive 41 percent higher than in May 2008 when prices were spiking (when it averaged 0.9 million lots).

Volume at nearby NYMEX

Some crucial qualifications are in order:

* Rocketing volumes have been concentrated on NYMEX. ICE Brent has also seen record average volumes, but the spike has been much smaller. NYMEX volumes jumped 53 percent compared with March. ICE volumes were up only 7 percent (Charts 2 and 3).

* Surging volumes on just 4 trading days around Easter (Apr 9 and Apr 12-14) account for almost all the surge on NYMEX (Chart 4).

* Unusually high volumes on those days are concentrated in the first seven or eight months of the strip (contracts expiring between May and December 2010).

Breakdown in Price Trend

What caused this surge in trading nearby NYMEX crude contracts? To some extent it may have been the breakdown in the previous rally in flat prices. But the sudden reversal of the previous trend in the spread was probably more important.

The sustained rally which had seen spot prices rise steadily from around $72 per barrel at the start of February to peak on April 6 at almost $87 began to break down. The consistent rise in prices, and increasingly bullish prognosis, almost certainly drew in a large number of trendfollowing technical traders in size, hoping to ride a sustained rally.

The subsequent breakdown of the rally would probably have triggered downside stops set to lock in profits on the trade (Chart 5). But the daily price changes were relatively small. In fact volatility was falling to some of the lowest levels witnessed in the past decade during this period.

Unless stops were being placed unusually close to the market (signifying nervousness among the trend traders) or the technical funds were present in the market in unusual size, they could not account for so much concentrated turnover on such a small price move.

Massacre in the Spreads

But while movements in the flat price were small, movements in the spread were much bigger, certainly big enough to flush out any fundamental traders or technical traders who were gambling on further convergence.

The spread between nearby prices such as May 2010 and forward prices such as Dec 2010 had been progressively narrowing since the start of the year. The May-Dec spread has shrunk from $3.87 in late January to just $1.75 on March 31.

Many traders probably expected the spread to shrink further or turn negative. Leading analysts had predicted the market would flip from contango into backwardation as a result of a tightening supply-demand balance and the continued drawdown in stocks.

Instead, the spread flared out -- rapidly and massively. In just seven trading days, the spread widened from $1.75 to $4.55 per barrel.

While volatility in both the outright and the forward prices was low, the correlation between them abruptly reversed, and the volatility in the spread surged. As the massacre of the spread positions accelerated, turnover of contracts within the May-Dec strip soared as traders sought to reduce their exposure to the curve trade (Chart 6).

The breakdown of the spread trade coincided with the biggest build of inventories around the NYMEX delivery point at Cushing for three months. Cushing inventories rose just over 1 million barrels in the week ending Fri April 9. Crucially it was the fourth successive weekly gain in Cushing inventories, and the largest so far, confirming the previous drawdown trend was over.

While these inventories were not publicly reported until the middle of the following week, industry insiders and physical traders would have been well aware of the turnaround in the stocks trend earlier.

As the NYMEX delivery point began to attract bigger deliveries, sophisticated traders seem to have started bailing out of the spread convergence trade, forcing the trend followers out with them.

Ends --

John Kemp is a Reuters market analyst - for Commodities Now. The views expressed are his own.

Download charts (1-7) here:

Attachments:

4DAYS4.pdf	5 Kb
CURVE-TRADING6.pdf	15 Kb
CUSH7.pdf	4 Kb
FLAT-PRICE5.pdf	15 Kb
ICE3.pdf	10 Kb
NYM+ICE1.pdf	28 Kb
NYM2.pdf	6 Kb