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”:

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?

Crude oil is down more than 50% from its high of $147 a barrel. Where are the peak oil believers? the breathless analysts and cheerleaders of the commodity that warned of a Mad Max armageddon?

Physical peak oil, which I have no reason to accept as a valid statement either on theoretical, scientific or ideological grounds, would be insensitive to prices. …In fact the whole hypothesis of peak oil – which is that there is a certain amount of oil in the ground, consumed at a certain rate, and then it’s finished – does not react to anything…. (Climate change) is likely to be more of a natural limit than all these peak oil theories combined. … Peak oil has been predicted for 150 years. It has never happened, and it will stay this way.
Dr. Rühl, chief economist of BP

Last Friday, for the first time in two years, OPEC supposedly cut their production by 1.5 million barrels a day. I say supposedly because these agreements don’t mean much when the member countries are facing the same financial crisis. OPEC members are notorious for cheating on their quotes. So it is difficult to give them the benefit of the doubt today when they are in desperate need of cash from the only thing propping up their economy.

Here is an interesting chart showing the history of OPEC changes in supply. In recessions, when there is less demand for oil, price cuts or better put, announced price cuts, don’t have the same effect.

A walk down contrarian lane brings us to the The Economist cover from March 6, 1999 (see above). At the time oil was trading around $14 and thought by many to only be able to go lower. What we saw recently sentiment wise was the opposite of this where “peak oil” came to be bandied about incessantly in the media and taken as gospel to imply that oil could only go up.

Oily Bubble
Crude oil’s bubble like march higher was rationalized by two main proponents, Goldman Sach’s Arjun Murti and Mathew Simmons. Simmons argued for 150 year old peak oil rationale for a spike while Murti made headlines in May 2006 by predicting a “super spike” taking us to $200 a barrel oil.

Murti has since cut his targets repeatedly as oil has crashed through them. First $140, then $110, then $75 and most recently in a bold attempt to get ahead of the price, $50 a barrel.

Although Murti may not have intended his analysis to get so much publicity, it did and a lot of people came to believe that oil was somehow destined to continue higher. Thus proving once again that listening to “experts” can be dangerous to your financial health.

The charts however were telling another tale to anyone who cared to listen to their whisperings. Crude oil had all the characteristics of a bubble and it has imploded like one too. Looking a long term chart, you can see that it has easily sliced through long term up trend line.

If we are going to go through a deflationary period, then OPEC countries are in for a world of hurt because the demand curve has shifted. If they lower production, they hurt themselves, if they don’t and keep it steady or cheat by increasing it, they will flood the market with supply.

From a technical point of view, there is strong long term support for crude oil in the $40 area. I have no idea if we will indeed go that low. But if we do, I’d suspect oil to find strong footing in that area.

Here’s a historical chart showing the previous OPEC changes in production:

Source: Wall Street Journal

Yesterday Bill asked me to take a look at the crude oil market. So here is a quick overview of what I think is going on.

Here is a long term chart of the price of crude oil along with its distance from the 200 day moving average:

OPEC Tax
The price of oil, above a certain point, becomes a tax on western economies. The higher it goes, the less will be consumed and the less economic growth we’ll have. One of the reasons we had an amazingly powerful economy between 1998-2000 was that oil fell to single digits. So there is a built in mechanism in place to moderate price but due to structural reasons it doesn’t work with instantaneous or perfect regularity.

Indexing Fever
The recent parabolic rise may be explained by something other than a supply demand imbalance. In the past few years we’ve seen a trend towards commodity index funds which creates a positive feedback loop. The better the performance of commodity markets, the more funds are allocated to it by pension funds, hedge funds, and other institutions.

And we’re talking about billions and billions of money. And it is flowing to long only strategies. Just buy, and buy some more! It is somewhat similar to the hyper indexing phenomena we saw happening in the tech bubble years. As the Nasdaq 100 index went sky high, it attracted a lot of hot money who would buy ETFs or index mutual funds to chase performance. This would then propel the index higher as these funds would create new baskets to put this money to work in the market. So a positive feedback loop legitimized itself through self-created performance:

Source: It Takes Crude To Contango by Howard Simons at thestreet.com

The problem with a scenario like this is that it becomes increasingly difficult to call an exhaustion point. You can easily be steamrolled flat by the tremendously robust trend. Believe me, many very smart and well capitalized traders were flattened trying to short the internet bubble stocks. The trend will last until it doesn’t. That’s about as lucid an explanation as you can get.

Contango
The normal situation when the price of oil is rising is for future prices to be lower than spot prices. This is called backwardation. But right now the oil market is in contango - where future prices are higher. This is a rare occurrence which creates incentives for speculators to purchase oil, take it off the market, store it and then sell it at some point in the future to gain arbitrage profits.

So now we have speculators who are piggybacking on the commodity indexing trend, pushing it even further, as well as buying contracts in an attempt to “front run” the inevitable buy orders coming down the pipeline.

Flying Turkeys
All of this is happening in the derivatives markets and it is rather complicated for most people to wrap their minds around. Here’s a simple sign of froth in the oil market which most people can identify much easier. We are seeing small, extremely speculative stocks in the energy sector fly off into the stratosphere. For a quick example, take a look at the charts for Pyramid Oil Corp. (PDO) and MEXCO Energy Corp. (MXC).

Most of the stock spam is now pumping oil, gas and energy related over the counter penny stocks. This is the last stage of a parabolic blow-off. When the lamest and sickest of turkeys start to fly as if they were hawks. But good luck in actually pin pointing the top.

Last summer, on June 2007, to be precise, I wrote that the caution was warranted for energy sector. Let’s take a look to see how I did and what lies ahead for this area of the market.

The energy sector managed to push a little bit higher in July 2007 but it then succumbed to the general market weakness. So since I wrote about my apprehension it didn’t go anywhere really for the next two months:

The strength of this sector was undeniable in 2007. In fact, last year it bucked negative seasonality to deliver one of the best sector returns. Usually, from the beginning of June to the beginning of December energy stumbles. In fact, in the past decade only 3 years have bucked this negative seasonality. On the other hand, once December rolls around, things do tend to rock and roll.

Seasonality
The logic behind the seasonal influence is the seasonal weakness in the commodities themselves. Natural gas and oil are weakest in the summer (May to July) and strongest in winter. So right now we are just about to enter the worst time of the year to be long oil and gas stocks.

On top of that 82% of stocks in the Energy Select SPDR (XLE) are trading above their 100 day moving average. That’s not the maximum but it is high. As well, the bullish percent for the sector is a bit “toppy”, hovering below 80%:

The smart thing to do was buy in January and March 2008 when the bullish percent spiked down to 20% (and less). But you already knew that because you know how to time the market using bullish percent charts, don’t you?

On Wall Street it depends who you listen to. Goldman Sachs is hyper-bullish on oil awaiting $150-200 a barrel oil while Lehman Bros. thinks that prices will fall to $83 a barrel in 2009 and $70 by 2010.

What about Peak Oil?
I don’t buy into “Peak Oil”. We will either discover more oil, better extraction methods for existing reserves or move to alternative energy sources. Take new discoveries for example: Thanks to the Tupi discovery, Brazil will become a major oil player - probably joining OPEC as a result. But that is years in the future, assuming all goes according to plan. Petrobras will have to drill more than 16,000 feet under the seabed, itself under 10,000 feet of water. The reward though is tantalizing: 5-8 billion barrels of oil and natural gas.