Trader’s Narrative

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?

The CFTC plans to hold hearings into revoking the exemptions they had previously give to investment firms which removed limits on the amount of assets they could hold in physical commodity markets. This exemption, called ‘Bona Fide Hedging’, circumvented a 1936 law which protected price discovery by limiting the involvement of speculators. It allowed true hedgers, producers and speculators to participate in the same market without anyone bullying the others.

Before the Great Crash of 1929 the US financial market was largely unregulated. You could say that compared to today’s market it was the wild wild west. As a consequence of the crash a lot of sensible regulations and government oversight was instituted. But most of those sensible and necessary rules were removed as the power of absolute free markets took hold. The pendulum is now swinging towards more regulation. All we can do is hope that it doesn’t swing too much and the regulations that are put in place are useful.

The danger is that politicians will make hedge funds or any speculator to be a scapegoat to score cheap points. If the limits are too restrictive, then it will reduce liquidity. But as long as we can go back to the simple rules that worked for 50+ years, I think we’ll be fine.

I don’t think that anyone can look at the underlying supply of crude oil, which has been plentiful and without interruption and then look at the demand side, which has been waning and find any justification for the kind of price swings that we have seen recently. In less than two years, we’ve seen a barrel reach $145, then crash to $33 and then rise 50% to $70! All the while, no fundamental change whatsoever has occurred in either the demand side or the supply side.

Although I believe we should let markets work, when you have speculators controlling more oil than all the commercial oil held in storage in the US combined with the US government’s Strategic Petroleum Reserve… then things are clearly out of whack. The only reason this was allowed was because the CFTC gave exemptions to OTC swap dealers who needed to hedge their own exposure through the futures markets. Due to the size and amount of their OTC transactions, the needed to take mammoth positions.

It isn’t entirely clear what the CFTC will do but the hearings coming up will provide an answer. As usual, expect the FIA to push for less regulation. One possible solution would be more transparency. The CFTC will improve the detail in its weekly CoT report by reporting swap dealers positions separately.

The result will probably be less volatility, which is not that great if you’re a trader. But if the consequence is having a sane and healthy commodity market which will provide a foundation for a stable economy, then I’m all for it.

Finally, there was a rogue trader from PVM who pushed the futures price higher by an extra $2 recently and caused a $10 million loss. But that is not even chump change compared to the size of the oil market. If there was a ‘Nick Leeson’ type trader out there who was responsible for the run up in crude oil, it would let Goldman Sachs and other investment banks off the hook.

A recent article shows the chart to the left which demonstrates the correlation between crude oil prices and the size of the passive long-only institutional investor.

This is a topic that I’ve been harping on ever since last year, as a barrel went for $135: What is really going on with the price of crude oil?

It also confirms the previous chart showing the stampede of hedge funds and other large speculators to the long side of oil. Back then I couldn’t prove what was going on but the inflation adjusted price of oil certainly looked like a bubble.

There wouldn’t be a problem of course if these powerful market participants were taking both or either sides in legitimate speculation or hedging. But there is a problem for everyone, including these same institutions, when they pile into only one side, continuously going long the crude oil futures.

According to the article:

Passive investors increased their crude-oil holdings to the equivalent of more than 600 million barrels in June, up more than 30% from the end of last year…

So what is going on? How can these behemoth institutional players treat the crude oil market like their very own ponzi scheme? Last year the effects on the world economy were devastating. Wealthy economies stalled into a recession and poor economies were thrown into chaos as staple food prices soared.

Isn’t there a regulation to prevent the manipulative “walking up” of prices in commodities? Yes, yes there is. Or more accurately there was.

Matt Taibbi’s scorching article on Goldman Sachs (GS) in the most recent edition of Rolling Stone magazine explains. There was a 1936 government regulation which had successfully stopped this type of shenanigan. In effect it did not allow large speculators to lean on any commodity market and crowd out real producers and consumers. Until 1991. That’s when Goldman Sachs’ (GS) commodities subsidiary, J. Aron, request an exemption based on the flimsiest justification.

Amazingly enough it got it. And over the years the CFTC handed out 14 other similar exemptions. Goldman and its ilk were busy with a few other schemes and it wasn’t for a while that they started to really take advantage of the loophole they had gained. What followed was nothing short of astonishing. For example:

Between 2003 and 2008, the amount of speculative money in commodities grew from $13 billion to $317 billion, an increase of 2,300 percent.

What makes this even more astonishing is that last year’s oil spike (or bubble) happened when the world was awash in oil supply and faced a drastically reduced oil demand!

…according to the US Energy Information Administration, the world oil supply rose from 85.24 million barrels a day to 85.72 million. Over the same period, world oil demand dropped from 86.82 million barrels a day to 86.07 million.

By the summer of 2008, in fact, commodities speculators had bought and stockpiled enough oil futures to fill 1.1 billion barrels of crude, which meant that speculators owned more future oil on paper than there was real, physical oil stored in all of the country’s commercial storage tanks and the Strategic Petroleum Reserve combined.

This whole bear market has been a massive lesson in the validity and value of smart government regulations. As Ritholtz counts off in his book “Bailout Nation”, over a number of years and even decades, the threads of regulation where one by one removed. As the regulatory framework deteriorated in tatters, things started to go wrong.

Of course, as you may recall, that explanation was not the one offered when we were in the thick of things last year. The old and tired theory of “Peak Oil” was on everyone’s lips and many actually believed it.

The problem with that is, in the market when something is obvious to everyone, it is obviously false. And as I’ve said before many times, while no one disputes that the supply of oil is finite, it is a non sequitur to posit that as this resource is exhausted, the price of oil will spike.

If you believe otherwise, then get into your time machine, go back to the 1800’s and corner the whale blubber market.

According to the difference between 10 year nominal treasury bonds and TIPS (Treasury Inflation-Protected Securities) we were headed for a major, even catastrophic deflationary scenario. Although the jury is still officially ruminating, looking at the market price of copper, it seems that the massive monetary and fiscal measures taken by the US and other major countries around the world have removed much of the risk.

As one of the most important industrial commodities, copper has a Ph.D. in economics. Since it is freely traded in a market, its price is decided upon by the wisdom of the “invisible hand”. Copper can even predict recessions! Right now, it is offering the first glimmer of hope within a very dark and gloomy economic outlook:

The lower window pane in the above chart shows momentum or more specifically, the annual rate of change. When it drops below zero, the economy tends to sputter. Right now, copper momentum is still mired in the negative. And to bring it back to zero, copper futures have to, at least, recover to $325. Which is a very tall order.

Obviously we aren’t there yet, but the rapid ascent which started late last year has already taken the industrial metal +50% from its low. So we if it continues in the same torrid pace, we’ll get there in no time. But no market is that simple, nor direct. Copper futures have jolted higher so within a shorter term time span, it will need to work that out before continuing.

But if we are truly in the first stages of a recovery, then copper is the commodity to watch. If the worst is actually over, then the price trend in copper will be the first to know. Way ahead of, and with much more accuracy than, any talking head on TV.

Copper is famously said to have a Ph.D. in economics. So let’s see what Dr. Copper says:

By now you’re hard pressed to find anyone who won’t be bracing themselves for an economic slowdown. And that is reflected in the historic low of American’s satisfaction levels.

Interestingly enough, when the annual rate of change of copper futures goes into the negative, it signals a recession.

Of course, the National Bureau of Economic Research conveniently labels them after the fact. So we know that officially there was a global slowdown in 1998. And one that lasted from 2001-2003. Notice that this time though the rate of change is much deeper into the red.

Stock market investors and traders who are looking for a bull market may be mollified to know that the market is a forward discounting mechanism. So somewhere between 6-8 months before we are going to see an improvement in the economy, unemployment, real estate, etc. the stock market will shake off the bear market.