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”:

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.

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

Sprott, a young Canadian asset management firm, is going public next week. This might be a market tell. Or it may be nothing.

The reason why I bring it up is not because of Sprott’s size or significance to the market. It is after all tiny, managing only $7 Billion - in the world of asset management that doesn’t even register as a blip on the radar.

Rather, it is that Sprott has been at the forefront of the commodity boom, riding the rise of oil, gas, and even obscure natural resources like molybdenum to earn management fees. The owner and main portfolio manager, Eric Sprott, is an unapologetic believer in “peak oil” and a huge gold bug.

What makes me question the IPO is its potential significance as a market tell for the whole commodity boom. There is no question that Sprott is an astute manager and market timer. The track record of his various funds attests to that. The natural corollary is then, why is he selling now?

If he thought that the commodity boom would be continuing or even accelerating, wouldn’t he want to keep as much of the company and the profits for himself?

The only logical reason to sell is if the commodity boom is about to come to an end.

Consider these other examples:

Sam Zell, probably the keenest real estate investor today, sold Equity Office Properties in February 2007 to Blackstone after a protracted bidding war between the winner and Vornado REIT. You get one guess on when the REITs in the US topped out.

Or take the June 2007 IPO of Blackstone Group (BX), one of the largest private capital managers in the US. Timing when to take companies public, when to take them private, and valuation is their bread and butter. Do you think they might know something you don’t?

Blackstone’s IPO marked not only its own share price but also the top for private equity deals:

For more examples, check out: Don’t buy what Wall St. sells

Of course that doesn’t mean that by default all IPOs are to be shunned. But in the case of Sprott there is a more fundamental reason. It is extremely expensive! The IPO values Sprott Asset Management at $1.5 Billion - twice as much as other Canadian boutique asset managers. Finally, Sprott is selling right at the top. The TSX is at a triple high above 14,500 and the energy sector is rather stretched to the upside as well.

Given the cyclical nature of the natural resource sector, my hunch is that sooner rather than later this sector will revert to the mean. Peak oil is a meaningless concept that has been bandied about for the past 50 years. Every time oil prices go up it finds a new following and every time oil prices return to earth the peak oilers somehow melt into the scenery quietly. The reason why Hubbert’s theory has been proven wrong again and again is that new advances in science and engineering processes move the line in the sand. In effect making it an anachronism.

In any case, for those interested, watch for Sprott’s IPO on May 15th. It will trade under the symbol SII on the Toronto Stock Exchange.