Oil and copper are key industrial commodities. Oil powers the world, and copper is used in everything from computers to construction. Many traders watch these as indicators of global industrial sentiment. At the moment, they're telling different stories.

20150108 cop vs oil

The dive in prices represents the third leg of the commodities cycle peak - two years ago, there was a peak in commodity prices. This saw investment in future production peak about a year ago. Now, the peak in production is driving prices to multi-year lows.

A point for reflection is the the current downturn is NOT driven by falling demand, but rather increase in supply. this is "good" price deflation - bad news for miners and drillers but a positive for industry and consumers, and (well-balanced) economies generally. In broad terms, they mean the overall cost of production of goods and services has fallen substantially. Many share markets are yet to reflect this improvement in conditions.

Looking ahead, commodity markets now enter a new phase. If prices remain subdued, there will be a supply side response. Diggers and drillers will start to shut down unprofitable mines and wells. As this response deepens, prices will tend to stabilise, and then head higher, ultimately starting the cycle all over again.

In general terms, the steeper the price fall, the quicker the shutdowns begin. The current divergence in crude and copper prices offers a potential pairs trade.

Buying crude oil and selling copper simultaneously leads to a long/short commodity position - largely insulated from fluctuations in global industrial sentiment. Taking this sort of pairs trade is about the gap between the two commodities, regardless of whether they travel up, down or sideways. If oil producers such as high-cost US shale frackers start closing, the gap may narrow rapidly as markets start to price the future. And the surprise drop in US oil inventories reported last night may be a signal this process is under way.

20150108 cop vs oil tkts

Note there are no stop loss orders on this position. Putting on this trade means tracking the relative value of the two, rather than being concerned with the profit/loss on either leg of the trade, and requires careful watching (the dollar values of the bought and sold positions are roughly equal at current prices). However, the lower risk nature of long/short positions makes some traders comfortable with the approach.