Borrowing An Indicator

Among our favorite types of data to follow are the unique sentiment insights we get from the weekly Commitment of Traders (COT) Report.  We highlight key pieces of that information every Friday in our Daily Edition.

The basic idea is to look at the net position held by the "commercial" traders of the various contracts, because those traders are the big money, and thus presumably the smart money.  But not every futures contract in the COT Report offers us useful insights.

This week's chart is a great case in point.  It shows the commercial traders' net position in crude oil futures.  Ideally, you would like to see this indicator get up to a high reading (large net short position) at important price tops, and a deep negative reading (large net long position) at price bottoms.  But it just does not work that way, at least not very well.

One of the problems with looking at the COT data for crude oil is that some of the "commercial" traders are actually oil producers, who are using the futures market to lock in pricing for their future production.  Other entities like airlines and rail carriers use the futures markets to hedge their fuel costs, so it is not so much of a matter of the smart money versus the dumb money.

There are times when this indicator gives us great indications of a top or a bottom for crude oil prices.  And then there are other times when listening to it would be a horrible idea.  It is just not consistent enough to be reliable.  So what should we do to get an insight about where crude oil prices are headed?

The answer is to borrow a related indicator from another market.  Below is the same indicator for the Canadian dollar futures.  It is well known that the exchange rate of Canadian dollars versus US dollars is very closely correlated to oil prices.  And so if you could know where the Canadian dollar was going, then presumably you would have a pretty good idea about where the price of crude oil was going.  



The COT Report data for Canadian dollar futures offers us a much more reliable indication for both that currency, and for oil prices.  One reason for the greater reliability is that there are no "producers" of Canadian dollars like there are oil producers.  So it is a much purer bet on the direction of exchange rates.  Interestingly, the Mexican peso also correlates very well to crude oil prices, and so I find that its COT data also makes a nice surrogate indicator for oil prices.

Right now, in November 2011, commercial traders of Canadian dollar futures are back to being net long, after having shown us a big net short position earlier in 2011 when oil prices and the Canadian dollar were topping.  The message from this net long position is that crude oil prices should be expected to head upward from here.  How long they head upward is something that this indicator does not tell us now, but we will be watching and reporting on it in future issues of our Daily Edition as more data come in.