"Fire!"

Someone screamed "Fire!" in the oil theater, and the Hedge Funds headed for the exits.

As predicted, the weight of "pork oil" finally broke the back of Hedge Fund long bets, and some big players were forced to go defensive over the past couple of weeks. According to this piece from SeekingAlpha, Pierre Andurand liquidated much of his long oil position last week, with others followed suit, citing "stop loss" triggers and "risk management requirements." The article states that Andurand's fund is down 15.4% for the year.

As I've mentioned, Hedge Fund long bets in futures peaked at the end of February, and they were slowly declining for the past two months, but the trickle became a flood over the past two weeks. According to this Ft.com article, Managed Money positions fell by 26% the week prior to Tuesday (that's when Andurand closed his position). That scramble continued the rest of the week, leading to volatile price swings; for example, WTI experienced price moves in a 7% range yesterday.

Here's how dramatic the sentiment has changed: according to this Bloomberg.com article, some trader(s?) made a serious bet(s) yesterday (Friday 5/5) that WTI will drop below $40, as 14,000 July puts @$39 were sold, almost 20 times the number of contracts previously outstanding! The price of the option was somewhere between 15 and 20 cents per contract, so that amounts to almost a $3 million wager.

Will it pay off...?  I'll stick with my call here that WTI will stay above $40, as both OPEC and Wall Street banks will try to prevent that from happening. In addition, if the price does approach $40, it will most likely cause the bulls to jump back in, especially since inventories have declined over the past two weeks. Note, that doesn't mean the huge wager won't pay off, as the option premium will increase in value if the price does fall lower.

Now, I could be wrong on that price floor, and the condition for a price collapse is the unraveling of OPEC, which is certainly a possibility given every country's need for oil revenues.  Interesting times...

The Bankers are getting worried

In my February 15th piece Strange Brews in Oil, which looked at the recent phenomenon of a price bump immediately following the EIA's weekly oil inventory announcement (positive builds for the past nine weeks), I suggested the following possible explanation:

I have another theory: Wall Street banks have billions of dollars in loans outstanding with US shale oil producers and prices at $40 or less was pushing many toward bankruptcy.  Between the banks and OPEC, these are two very powerful forces with interest in maintaining higher prices. 

Deep down, I wondered if I was being a bit "conspiratorial?" Recent news gives me more confidence in this position.  First a little contextual reminder of the current oil market situation: with global supply outpacing demand, oil inventories were reaching record highs; (so) OPEC and Russia agreed to reduce output in December; (which led to) record long futures positions held by Hedge Funds at the end of February (they have since been pared down a bit); with prices reaching the mid-$50 range, US shale producers could profitably lock into contracts a year out (they were the sellers to the Hedge Funds buying); and finally, big Wall Street banks have serious loan exposure in the US shale oil market.  Let's start there.

This MSNBC piece from January 2016 provided some detail (from a Goldman Sachs report) on the loan exposure of the banks:

Bank of America leads the list with $21.3 billion. Citigroup is next at $20.5 billion. Wells Fargo is third at $17 billion. JP Morgan Chase is at $13.8 billion. Morgan Stanley is at $4.8 billion, PNC Bank has $2.6 billion and US Bancorp is at $3.1 billion. 

How much is that, as a percentage of the bank's total loans? 

Morgan Stanley leads the way at 5%, followed by Citi at 3.3%, Bank of America at 2.4%, Wells Fargo at 1.9%, JP Morgan Chase at 1.6%, PNC at 1.3%, and US Bancorp at 1.2%.

While the Goldman report didn't list their position, the MSNBC piece quoted Goldman's CFO who said they had $10.6 billion in oil loan exposure. 

So, here's the deal: as recent articles pointed out, OPEC, while previously castigating Hedge Funds for their speculative activity, is now courting them, and they have to because the HF long positions are what's propping up oil prices, at least until last week.

It didn't take a genius to see the situation was untenable: relying on the speculative bets of Hedge Funds to maintain prices is a fool's bet. This brings me to yesterday's piece from Bloomberg.com: Citi tells investors to stop worrying and learn to love oil. Citi analysts came out with a report urging investors to take advantage of the recent price drop because the Saudi's are likely to defend the price. The article also mentioned that Goldman Sachs analysts "called for investors to be patient and said they should go, or stay, long on oil." 

Hmmm....with $30 billion in loan exposure (though I'm sure they've reduced positions some since last year), do you think there might be a little conflict of interest for Goldman and Citi? Interestingly, according to this piece by William Engdahl, banks also "support" the trading of Hedge Funds: 

Goldman Sachs and Morgan Stanley today are the two leading energy trading firms in the United States. Citigroup and JP Morgan Chase are major players and fund numerous hedge funds as well who speculate.

According to the data above, these four banks had a combined $50 billion loan exposure to the US oil industry last year.  This is more than enough incentive for the major players to "rig" the market. However, the Hedge Funds are getting antsy, and have started to pare down their long positions. Given their herding propensity, there is a very good chance of a market rout, which is why the big banks are now publicly urging them to "hang in there." 

The current oil market situation is akin to the prisoners dilemma of Game Theory: it's in the best interest of all to collaborate and maintain higher prices (HFs benefit because falling prices will cause significant losses on their long bets); however, individual HFs may view their best option is to run for the exits (to minimize their losses) before an expected crash.  I'm thinking the exit run is going to win out...

Quick update on yesterday's post

An article on Bloomberg.com this morning highlights most of the issues I discussed in yesterday's post: Hedge Funds with historic levels of long positions; OPEC's attempt to rein in supply; prices stuck in a range of $53 +/- $2--something's got to give!

The hope of the speculative long positions is that the production cuts will balance current supply with current demand; however, if supply is not curtailed significantly enough to start a draw down on the glut of inventory, then the overhang will persist, keeping a lid on prices for the next year.  And, even if prices are pushed up higher, US producers will jump in quick, adding new rigs and simultaneously selling futures to hedge production for the next year.  There simply isn't a sufficient basis of support for the bulls in the short run.

Steady Price of Crude

As I mentioned in my last post, I don't see oil prices moving to either extreme price predicted by two forecasters a couple months ago.  An article in Bloomberg here provides some support for my view. From the article:

All but one of 15 senior oil traders and executives interviewed this week at the annual Asia-Pacific Petroleum Conference in Singapore expect crude to remain between $40 and $60 a barrel over the next 12 months. Brent crude has traded in that range for the past five months.

The issue, as I've stated, is that commodity markets dominated by investors do not allow prices to fall low enough to generate the shake out needed to balance the market. Prices also tend to rise quickly enticing new production. So-called "savvy" investors are looking to time the bottom and ride the price rise up.  As one trader stated, the issue is that prices go up too fast, and this happens because of the herd mentality of Wall Street.

The current commodity deflation is a consequence of the bubble Wall Street promoted from 2002 to 2012, and most prices will be depressed for a long time because of the over-investment that occurred as a reaction to that bubble.  We consumers are getting some needed relief...

Is it $80 or $10?

I've been meaning to write this particular post for awhile, but other priorities have taken up much of my time--finishing up some formal articles--publish or perish!

About a month ago two very different oil price forecasts came out within days of each other.  First, a report by Raymond James financial advisers forecast oil at $80 in 2017, and shortly after that publication Gary Shilling came out with a forecast of $10-$20.  The RJ forecast is based on projections of a "tightening in supply and demand dynamics" over the next year, though more so on supply issues, and you can read a bit more about their forecast in this Bloomberg article.

Shilling's projection is based on a combination of factors: high inventories; producers pumping oil to generate cash flow in order to survive the shakeout, and the Saudis pumping oil to drive them out; a slowing global economy; and the impact from a rise in the value of the dollar as a safe haven in uncertain times.  Shilling's views can be found in his Bloomberg piece here.

It's quite possible that both forecasts are right!  Shilling does not provide a time frame, though it appears he is describing a near term crash in prices, whereas Raymond James' forecast is for sometime in 2017.  Futures prices suggest some movement higher over the next year, as the price of a July 2017 contract is currently $47.07.  However, while the current futures oil price curve is in contango, it is not steep enough to support the oil storage trade.  In his piece, Shilling provides some estimates of storage costs: floating storage is about $1.13/month, rail storage 40 cents, and Cushing oil tanks cost 25 cents/month.  Given the current contango structure, alternative storage facilities (rail and sea) are no longer profitable, so, as contracts mature from trades that were previously profitable, those traders will have to dump oil into the market, putting downward pressure on prices in the short term.

Therefore, my view is somewhere in the middle.  The current market has too much excess crude AND too much excess refined products, as recent reports indicate.  While the fundamentals dictate near term crude weakness, it's difficult to see oil falling to $20 or less because investor/speculators (and they dominate trading in futures markets) will be looking for the bottom and an opportunity to start buying again.   This is what also puts a lid on future prices of crude: since investors dominate price discovery in futures markets, prices will continue to seesaw and make it impossible for producers to adjust to real forces; that is, prices most likely will not reach a low enough price to create the shake out necessary for stronger future prices.

My best guess is prices will not fall below $30 in the short term, and they will not exceed $70 in 2017, assuming no major supply shock event.  Then again, in this topsy turvy world, who would've predicted a guy like Donald Trump would have a shot at becoming president of the United States....

Brexit and Oil Prices

I was going to write a piece to update recent issues with oil prices, and came across this article which essentially includes the point I wanted to make: despite no change in the global physical markets for oil, prices are declining, which is the result of the strengthening US dollar caused by Brexit.  The relevant parts:

Moreover, price movements are also largely dictated by the interaction between global currencies. Since oil is priced in U.S. dollars, any strengthening of the dollar relative to other currencies makes crude more expensive, cutting into demand and pushing prices down. The crash of the British pound over the past two trading days is having this effect. The pound is now down 10 percent from the pre-Bexit vote last week; the euro is down 3 percent. The U.S. dollar index, which measures the currency’s strength against a basket of six major currencies, is up. The dollar jumped by another 1 percent on Monday, to a three-month high.It is no coincidence that oil prices plunged at the same time as the dollar surged. “We all got it wrong,” Michael Lynch, president of Strategic Energy & Economic Research, said in an interview with Bloomberg. “This is strengthening the dollar, which is bad for commodities."

 As I've argued in several pieces, I believe the reasoning that explains the decline is hogwash! A change in the dollar does not cause a rapid change in oil demand; the explanation is that the dollar-oil trade is a favorite of hedge funds and other global investors.

A Dollar-driving rally in oil?

Despite the negative news on the attempt to freeze output among the major suppliers, the quick drop in oil has been reversed, and it's (WTI) heading over $40 again.  Is this irrational behavior?

The main driver in the news today is the drop in the dollar.  Analysts discuss this relationship as if it's  "natural"--as the dollar falls, commodities priced in dollars rise because they are cheaper in terms of other currencies.  However, this negative correlation was non-existent until commodity markets became financialized, formally through deregulation in 2000 (the Commodity Futures Modernization Act).  Prior to 2000, the simple correlation in oil prices and the dollar was near zero, and there were even periods of positive correlation.  Since 2000, the simple correlation between prices has been about -0.8, the perceived natural relationship.

In my view, now that hedge funds and other investors dominate trading in commodity markets--especially oil, they have incorporated this "trade" into computerized models.  So, we end up with what appears to be a conundrum: despite the lack of agreement on supply and continued growth in oil inventory, the dollar-oil trade fuels a nice price rise.

Ahhh...the difficulty of predicting short run price movements....

A little validation

From Bloomberg.com this morning, Barclay analyst Kevin Norrish stated that oil and copper are at risk of a steep pull-back in prices :

"Given that recent price appreciation does not seem to be very well founded in improving fundamentals, and that upward trends may prove difficult to sustain, the risk is growing that any setback will result in a rush for the exits that could again lead commodity prices to overshoot to the downside."

It's always risky trying to call turns in the market and to what extent prices will move, but it is pretty clear that speculators are the main force behind price movements.

Another piece published the day before on Bloomberg provided interesting evidence on the underlying cause--it was not that investors were making bets on higher prices, rather, as the article stated, the recent price uptick was a consequence of investors with bets on lower prices, fearing the bottom had been reached, needing to close out their positions:

"The rally has come from shorts getting scared out of their positions, and you’re not seeing a lot of money coming in on the long side," said John Kilduff, partner at Again Capital LLC, a New York hedge fund focused on energy. "It really calls into question the fortitude and staying power of the rally."

Investor-speculators who make bets using futures contracts have to close their positions by taking what's known as an "offsetting position." If they don't do this, then oil contracts held to maturity must either deliver oil if you're holding a contract to sell oil (short position), or you must take delivery if you're holding a contract to buy oil (long position). For example, if one bets on falling prices, one "sells" a futures contract on WTI oil, and to close the position--to take profits or minimize losses, the trader must "buy" an equivalent contract.

As the article notes, since February 2nd long positions of investors fell by 971 contracts, but short positions were reduced by over 130,000. In other words, those betting on lower prices, in order to lock in their profits before prices increased, had to close out their short sell positions with buy orders, and those offsetting buy orders are what drove prices higher. This is the problem when speculators dominate markets: if they heavily bet on one side of the market, when they close their positions--so they don't have to deliver or take delivery, it creates an equal and opposite reaction on prices.

That's the kicker: the market is now set up for an equal, opposite reaction--what Barclay's Norrish is predicting, and what I've been predicting. Speculative positions are now seriously net long--there are about 65,000 bets on falling prices and 300,000 bets on rising prices, so their net positions are long by 235,000 contracts. With the continued glut of supply in the real market for oil, the only way these paper bets can be maintained is if more rubes join the bet on higher prices. If this doesn't happen, and prices start to weaken, there could be a run for the exit! That is, as prices start to weaken--as they have in the past two days, in order to prevent further losses on their long positions, speculators will have to sell contracts to close them out. And, just as buying to close their short positions is what raised prices, selling to close their long positions will cause prices to fall further. Look out below!

I'm sure it all sounds confusing; however, there is a very important point here: this behavior will continue--price volatility and bubbles--as long as speculators are allowed to dominate trading in futures markets. Deregulation in 2000 allowed speculators to take over the markets, and it's safe to say that markets are less efficient, not more. It's time to bring back stricter position limits on speculators.

A quick commodity update

We are seeing the burst up in prices caused by investors hoping for a price floor and looking to make a quick buck.  I think the market is getting jittery regarding whether or not the price of WTI will hold near $40?  US inventory data from Wednesday showed an increase in crude stocks of 3.9 million barrels, another new high.  Prices will not hold until those inventories start to decline.

It's currently a game by "smart money" investors related to "when to take profits"?  Ride the quick wave up, take your profits, then wait for the next opportunity to jump in.

Finally, here's a good piece on the debt issues in the commodity sector, focused on mining and energy.  Still no news from the farming sector....yet....

The Yin-Yang of Oil Prices

We are about to get a first test of the hypothesis I outlined in "The Oil Bubble and Bust":

"Assuming no unforeseen changes in markets (like a serious Middle East “event”), the glut in global markets will keep a lid on prices well into 2017, but volatility will reign because there’s no other way to make a quick buck when interest rates are zero and heading negative.  “Smart” investors--those who think they can time markets—will jump back in at the slightest indication of “good news.”  For example, if central banks announce another attempt to save the markets or a group of producers attempt to curtail production, there will be a quick jump back up in prices, only to be brought down by the reality of “pork oil”—the glut in global inventory and supply."

The price of WTI crude has increased by about 15% since then, currently sitting near $35/barrel. There was an interesting piece by Liam Denning on Bloomberg.com yesterday which puts numbers and data to my view: The Spring Oil Rally Redux

The important takeaways:

1. Despite the rise in price, the inventory build (in oil and gasoline) continues in the US and Europe.
2. While demand is rising somewhat, it is still insufficient to draw down inventories.
3. The key point: there has been a spike in the bets on higher prices by hedge funds and other investors in the futures markets (last graph).

I expect the "smart" investors will take their profits this coming week...but the yin-yang will continue.

On the Yin side, noted investor Jim Rogers has stated there is a 100% chance of a recession within the next year. While Rogers doesn't state what will cause the recession, certainly the oil sector is one of the keys, and the pain continues build.  Bloomberg.com posted a great graphic of the rise and fall of oil rigs over the past five years HERE.  And the pain will continue because, as Leonard Brecken at Oil.com shows, imports continue to grow as domestic production falls--the Saudis want to kill the shale competition.

On the Yang side, the most recent jobs report was positive, and much of the growth came from services related to consumer spending.  The savings at the pump are helping, BUT consumer confidence just registered its lowest level for the year.  Oops! This was supposed to be the positive paragraph...

So, my view hasn't changed.  I believe the Yin wins out, and the debt-deflationary forces overwhelm the boost on consumer spending from lower gas prices.  Stay tuned....