Trader’s Narrative

If oil shares and anything related to oil to get a pop this morning, this may explain it:

There is a report from the Guardian that a “whistleblower” from the IEA claims that that organization has been, for years, over-reporting the estimates of oil reserves around the world under pressure from the US government. This revelation is timed well as the ‘World Energy Outlook’ is being released tomorrow. Now it is under a shadow of suspicion. As is the OPEC calculated spare capacity.

The IEA in 2005 was predicting oil supplies could rise as high as 120m barrels a day by 2030 although it was forced to reduce this gradually to 116m and then 105m last year

I can just picture the peak oil theorists dancing in the streets right now. But before I join them, I’d prefer to see some sort of evidence to support this. I know that is a tall order but considering what is at stake, it isn’t too much to ask that we rely on more than just the word of an anonymous source.

Source: Key oil figures were distorted by US pressure

Don’t get me wrong, this is definitely within the realm of possibility. After all, what better way to prevent panic than by pretending there is nothing to panic about?

Unfortunately, getting to the bottom of this is simply impossible. There are too many different agendas over too many international boundary lines. Just think, if we can’t get to the bottom of the manipulated oil futures markets in the US, what hope do we have of policing the books of oil producing countries and making sure that they are stating their reserves accurately?

This news is great marketing for a new documentary style film featuring Michael Ruppert, called “Collapse”. As the name suggests it is about the imminent collapse of our modern world due to dwindling oil reserves - the main source of energy for almost everything that we rely on.

Here is a short clip from “Collapse”:

I had read about the problems with US Oil Fund (USO) but it wasn’t until I plotted a simple graph comparing it to crude oil futures contract that I understood just how little badly it has performed:

The chart shows the ratio of USL to the crude oil futures contract (West Texas intermediate) since the ETF’s founding on April 10th 2006. Here are the four variables that influence the difference in the performance of the USO ETF vs. the crude oil futures which they are supposed to mimic:

• contango/backwardation
• MER (0.45%)
• rollover impact
• interest earned (on 90% of fund assets)

The MER is too low to account for the enormous valuation drift. So too is the (positive) effect provided by the interest earned on the majority of the ETF’s assets. Right now interest is so low that we can assume these two cancel each other out. Therefore, the other two variables are the key.

Contango occurs when later futures contract prices are more expensive than current contract prices. Backwardation is the opposite. We’ve been experiencing contango for about two years now. Right now the current NYMEX contract (November) is $70/barrel. Meanwhile the March 2010 is $72/barrel. This has meant that USO has had to buy slightly more expensive contracts every month, in effect, shaving a little off their asset valuation little by little.

As well, due to the gigantic size of the fund, the impact of rollover exacerbates the already existing difference between expiring and forward month contracts. As USO sells their holdings, they push down prices and as they buy, their demand increases prices. Of course, other market participants can count on their rollover to front run their obligatory monthly cycle.

All this means that the fund has done an abysmal job in tracking the crude oil market. From the start of the year until now, crude oil futures have gone up about 50%. But if you tried to replicate that by buying USO instead, you would have been out of luck as the ETF has gained less than 5% for the year.

To mitigate these concerns, a new fund was created: the United States 12 Month Oil Fund LP (USL). As the name implies, it holds 12 months worth of contracts so that each month only 1/12th of the fund is rolled over. While we have much less data for this ETF, as you can see by the chart below, the same valuation drift is at play:

Year to date, USL has returned about 16% while crude oil futures have increased in price by about 50%. A little better than USO’s horrendous under performance but still, not even close to tracking their underlying commodity.

The conclusion is that you shouldn’t simply assume that an ETF will do what it is supposed to do. Almost all ETFs and for that matter any retail structured product is created to “feed the ducks” when they’re quacking.

USO and USL are imperfect products when we use an intermediate to long term time horizon. They are appropriate for intra-day trading or swing trading but holding them as a proxy for the futures contract is self-defeating due to the valuation drift. If you want long term exposure to oil, buy the futures contract. Otherwise, buy small to medium size oil companies or explorers like Anadarko Petroleum (APC).

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For the complete list, follow the graphic link below to news.tradersnarrative.com:

And remember to check back regularly since there are interesting links added throughout the week.

Europe’s Week Ahead

While the crude oil market has sharply corrected from its bubble heights, there is reason to believe that it still does not truly reflect the underlying demand and supply equation at the heart of price discovery.

Here’s a chart showing OPEC’s spare capacity in millions of barrels over the past 8+ years:

Source: Bloomberg

We are right back to where we were at the beginning of the year in 2000 and 2002. Since this isn’t relative (to total production or demand) it is difficult to look at this data series over time. But assuming that 9 years isn’t that long, it is still valuable.

Of course, there are many variables that go into determining the price of a barrel: total capacity of production, how much oil is flowing from OPEC, how much demand there is from the global economy, as well as the demand from institutions not for use but for investment.

This last rationale has been the driving force in recent years as ‘animal spirits’ have taken hold. While last year’s crude oil bubble returned to normalcy, it looks like it is reflating right back up again. And the same basic script is being used as large institutions and hedge funds plow money back into this market.

Considering the extreme economic downturn, crude oil should have fallen to $20 - previous support from 2002. That’s just my own guess. Or it could have not gone up so much in the first place. Instead of acting as a ballast to rescue the global economy when it most needs it, it has instead been acting like an anchor, dragging it down further.

Here’s a chart of crude oil futures for the same time period showing each time that spare capacity reached above 6 million barrels:

Looking at these two charts together makes one wonder if the crude oil market is ignoring the excess spare capacity or whether it successfully discounts it. For example, most recently by falling from $147 in 2008 to less than $40 in early 2009 as spare capacity shot up to multi-year highs.

It is impossible to speak on behalf of a collective such as the market but my hunch is that, for the past few years, the oil market has been driven by tectonic shifts in asset allocation more than that which can be explained by fundamental analysis (such as supply and demand variables).

While we’re at this discussion, here’s an intriguing thought experiment. Imagine if instead of crude oil, we had to rely on a cartel such as OPEC in setting the price of a ubiquitous commodity like say, water. How would the price of water be set? would we just go along? or would we simply refuse to allow a cabal to dictate the price of water by turning their spigots on or off?

For economic and market news and to see what you may have missed last week, check out the list below. It is a small sample, to see it all go to news.tradersnarrative.com:

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For the complete list, follow the graphic below:

And remember to check back regularly since there are interesting links added throughout the week.

Week Ahead: