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Mr. Market Gets It Wrong Again

Dave Cohen
dave.aspo@gmail.com
May 29th, 2009

Now do you want to hear some real bullishness? Crude has fallen so far, so fast, that we could see a snap-back rally drive it to $62 … $77 … heck, even $90 is possible!
— Sean Brodrick, from How You Can Trade the Current Volatile Oil Market (March 25, 2009)

Once again the price of oil is in La La Land. Today the price of NYMEX light sweet crude surged past $62/barrel. My best guess based on the supply & demand fundamentals is that crude should not be trading a penny over $35 per barrel right now. In a justified fit of pique last December I wrote The Price Is Not Right, which attempted to get to the bottom of why oil prices move up or down. Today’s essay is Not Right, Part II.

I now believe oil has not been priced “correctly” for the last 34 months going back to about July, 2006. Exceptions to the new rule crop up because even a broken clock tells the right time twice a day. Why does Mr. Market get it wrong over and over again?

Green Shoots Raise the Oil Price?

GDP in the European Union shrank 2.5% in 2009:Q1. It was down 4.6% year-over-year. Recent Wall Street Journal reports included these observations.

Investors helped drive up oil prices in recent weeks, pulling their money out of cash and putting it into hard assets such as crude oil as they anticipated imminent economic recovery and a weaker dollar — and were willing to stomach more risk. Oil futures briefly topped $60 a barrel in trading Tuesday on the New York Mercantile Exchange for the first time since November, before falling back to close at $58.85, up 35 cents. Oil prices are up 73% since bottoming out at just under $34 in February.

The [EU GDP] data followed on from fresh downward revisions to global oil demand from three agencies this week, with the latest from the International Energy Agency Thursday warning that oil demand recovery will be sluggish and remains some way off.

“I think realization is starting to hit home that everything isn’t all right,” a London-based crude oil trader said. “The recession is still on”.

[My note: It's starting to hit home that something's Not Right? What was your first clue?]

Oil demand strength can be viewed as following from economic conditions. However, due to its tight correlation with GDP, demand also serves as an indicator of those conditions. World oil demand is way down. Japan, where GDP shrank 15.2% in 2009:Q1, consumed 3.57 million barrels-per-day in March, down 1.45 million barrels compared with previous year. For the week ending May 8th, demand in the United States was 18.194 million barrels-per-day, down 1.56 million barrels (-7.9%) compared with the same week in 2008. That’s 3 million barrels-per-day right there, and I’ve only listed 2 countries.

According to Platts, China consumed 6.69 million barrels-per-day in the 2009:Q1, down 4.5% over the previous year. The lone “bright spot” was India, which was up 4.8% averaged over the entire year 2008-2009 ending March 31st (2.65 million barrels-per-day).

The sagging demand picture is clear enough. Although some of the quoted data is behind current conditions, key indicators say the global economy has not improved. So-called “green shoots” refer to a slowing of the rate of various declines. In a CNBC interview, economists Nouriel Roubini and Harvard economist Ken Rogoff explain why even a weak economic recovery is still months away. Roubini issued his standard warning—

“People talk about a bottom of the recession in June, but I see it more like six to nine months from now,” Roubini said. “The green shoots everyone talks about are more like yellow weeds to me.”

[My note: Nouriel, my friend, you're behind the times! Budget director Peter Orszag now says "the analogy is there are some glimmers of sun shining through the trees, but we're not out of the woods yet."]

Howard Davidowitz tells Yahoo’s Tech Ticker why the worst is yet to come. Davidowitz provides a realistic assessment of wealth lost and debt de-leveraging that will take many years to achieve.

Given the dismal demand numbers, why has the the price of crude been going up lately? The Wall Street Journal’s Liam Denning weighed in on the problem. Figure 1 shows the correlation between the oil price and movements in the S&P 500 along with the current inventory data from the EIA.

Oil prices used to pay heed to stocks — of crude, that is. These days, they track stocks of a different kind. Over time, supply and demand set the oil price. That is why it has little, or negative, correlation with equity markets over the long term. So far this quarter, however, correlation between the moves in the S&P 500 and crude-oil prices has leapt to 70%. This week, oil markets essentially ignored both a surprise, and bullish, fall in U.S. crude inventories and a bearish report from the International Energy Agency.

Crude oil has bounced since February to almost $60 a barrel despite worsening fundamental data. Commercial inventories are overflowing, having risen in the first quarter, a period when they usually drop. Moreover, as oil prices have risen, OPEC’s discipline has started cracking, with the organization raising output last month for the first time since August…

Oil is really floating on cheap money. Quantitative easing is, as intended, pushing investors toward riskier asset classes such as equities, high-yield debt — and crude. Investors in oil funds push up futures prices, making it profitable for others to store crude and sell it forward; another reason inventories are high.

[My note: In Rotterdam, Europe's largest oil terminus, they are running out of room to store the stuff.]

Figure 1 — The correlation with the S&P 500 (left) from the WSJ. Current inventories (crude stocks, right) from the EIA. Prices have risen as inventories remain far outside their 5-year average range. Note the slight downturn lately.

Two kinds of “green” have pushed the oil price up to heights it should never have attained lately: 1) a bogus perception of green shoots in our staggering economy; and 2) an influx of money into both equities (e.g. stocks) and crude oil. These factors explain the price differential between today’s $62 and my guestimate of the “correct” price (~$35 per barrel). The difference is necessarily unrelated to supply & demand fundamentals.

This kind of oil market distortion has been going on for quite some time now, but with different causes at different times.

Ignorance Is Not Bliss

Ponder the following two graphs and their captions.

Figure 2 — World liquids supply & demand annual numbers for 2001-2008. Demand exceeds supply in 2006. The gap widens in 2007. Source data from the EIA (supply and demand).

Figure 3 — Nominal WTI average monthly prices (NYMEX) 1990-present. The circled price series demonstrates unwarranted volatility (i.e. crazy price swings) after 2006:Q2. The gray line is my smoothed best guess of how the price should have moved during this period. Like a broken clock, the nominal line meets the gray line on occasion.

What set the oil price adrift after 2006:Q2? Before turning to causes, let’s examine Mr. Market’s erratic history between then and now.

The first outrage, which I documented in ANWR Is Not The Answer, saw the oil price fall to $54.57 in January, 2007. Based in part on the over-hyped Jack #2 discovery, oil traders decided for no good reason that oil was plentiful again despite the fact that global demand had exceeded supply during that year (Figure 2). Then traders spent almost all of 2007 playing catch-up to get the price back to where it should have been (Figure 3) as the supply & demand gap widened (Figure 2). Unsatisfied with this brief moment of accuracy at the beginning of 2008, traders on crystal meth bid up the price without restraint until June & July, 2008, when the average price hit $133 and change. When the drugs wore off in August, 2008, our manic-depressive traders took the price all the way down to $41.02 in December when I wrote Not Right, Part I. It was another case of overcompensation—the worsening fundamentals did not yet justify a price that low. The price bottomed-out at $39.16 in February of this year, but has now climbed over $62/barrel despite the fact that the fundamentals of the economy and oil markets are certainly worse now than they were 3 months ago.

All of these events followed the collapse of the Housing Bubble in 2006:Q2.

Let me take a moment to explain why oil prices reflecting actual market conditions might be important to us. Regardless of whether we are in the Peak Oil Era—we probably are—in 2009, we would like to know at all times what the relative abundance of the Elixir of Life—with respect to demand for it—of Industrial Civilizations is. Oil is important mainly because of our need to move people and stuff around. And please do not tell me about the latest biofuels & electric cars fantasy.

The price signal is the traditional Way of Knowledge for gauging oil’s relative abundance measured in barrels produced daily to meet our needs. An accurate price signal helps us set priorities and plan for the future in almost all areas of life. But if Mr. Market is stoned, we do not know where we stand. Ignorance Is Bliss does not apply when it comes to oil’s availability and price.

Index Fund Traders Bet On Oil

The Wall Street Journal’s Liam Denning believes the “oil [price] is really floating on cheap money” as investors in oil funds push up futures prices. This is the only reasonable interpretation of what’s going on. Reuters’ John Kemp supports Denning’s view.

Retail investors betting on a price rise in oil via exchange-traded funds and institutions using commodity indices are paying a steep price for going long too early. The cost of rolling positions forward in a contango market is wiping out any gains they are likely to make if prices eventually rally later this year or early 2010.

Contango is the term used to describe the situation in a futures market where prices for immediate or nearer delivery trade at a discount to those for future delivery.

Figure 4 — A recent snapshot of the current market contango. Today’s front-month contract price just surpassed the futures prices out to October, 2009. If oil is more expensive in July than it is in June, rolling your contracts over to the next month costs you money.

In the meantime, the main beneficiaries are investment banks taking the opposite side of the trade to their customers, and physical traders able to store increasing amounts of crude and finance it by running a short position in the futures markets.

In effect, retail investors and pension funds are paying the bills for the record quantity of crude oil being stored in tank farms around the world and in vessels offshore, via the losses they make when they roll their positions forward every month.

I want to frame these observations in terms of supply & demand. Speculators betting on a long-term price rise by purchasing near-term contracts and rolling them forward, or physical traders buying oil now and storing it in tankers, are creating artificial demand for oil. This has everything to do with futures prices (the contango) and little to do with end-user demand (refiners). It has still less to do with inventory levels, which have actually gone down lately (Figure 1) because oil stored on tankers does not go into crude stocks.

Thus the oil price goes up as the glut on the world market grows. Mr. Market is said to be behaving “correctly.”

The contango is waning as the market “self-corrects”—the once steep differential between future and front month prices flattens out as current spot prices catch up with futures prices (Bloomberg, May 5, 2009). After the correction it is no longer advantageous to buy oil now and store it on tankers. Already Bloomberg reports that Shell failed to sell a load of North Forties crude.

“Oil should soon start to return to the market as contango structures appear to be narrowing, especially in the U.S.,” Vienna-based JBC said in an e-mailed research note today. JBC estimates that as of end-April, 40 million barrels were being stored in the U.S. Gulf Coast while as many as 24 million barrels were anchored off the U.K. and West Africa.

Shell, Europe’s largest oil company, sought to sell a cargo of North Sea Forties oil on May 1 which it has been storing in a supertanker off the coast of the U.K. since November. Shell said it failed to attract a buyer for the crude which is on board the 2-million-barrel Leander.

Traders are storing 100 million barrels of oil at sea, enough to supply Europe for five days, Frontline Ltd., the world’s largest supertanker operator, said April 23. Provided they can secure storage and financing for less than the difference between near-term and future prices, they can lock in a profit by buying prompt oil and selling it forward.

Physical traders storing oil will start dumping it back on the market. They will need to dump it all or pile up losses leasing supertankers. The ensuing snowball will cause the oil price to crash. Oil may fall below its February low as today’s distorted $62 price becomes tomorrow’s distorted $25 price. I could be wrong of course. Mr. Market may experience another drug-induced mood swing which reflates the oil price. Naturally it is hard to predict Mr. Market’s future emotional state.

How would you like to be an small independent oil exploration & production company trying to plan new drilling projects under these circumstances?

There’s also the bandwagon problem I discussed in Not Right, Part I. We have all these “retail” investors who have no idea what they’re doing making the same mistakes together. Inexpert investors move in herds. I believe they’re about to lose their shirts, which will only make the price outlook worse when they head for the hills. Jump on in! The water’s fine! (said the sharks…)

Why has the oil market become the playground of index fund traders? Why does the oil market follow the S & P 500? When my friends ask me (”the expert”) why the price of gas is going up during a recession, what I am supposed to tell them? I should tell them the allure of easy money broke the oil market and it has not been repaired. Perhaps the market is FUBAR and can’t be repaired.

And Then There’s Stupidity

A bunch of smart people got together at the EIA’s 2009 annual conference to figure out what pushed prices upward in the first half of 2008. The cause of 2008’s crude price surge remains elusive according to conference participants (Oil & Gas Journal, April 9, 2009, subscription required).

Nine months after crude oil prices reached record levels, experts agreed at the US Energy Information Administration’s 2009 annual conference on Apr. 7 that speculators shouldn’t be blamed. They also could not say definitively what pushed prices upward during 2008’s first half…

“The answers haven’t been palatable to politicians or to us. We haven’t been able to point at one particular type of trader and hold them responsible for running oil prices up to $140/bbl last summer. We have not been able to find the smoking gun,” Jeffrey Harris, the CFTC’s chief economist, said…

[CFTC = Commodity Futures Trading Commission]

The CFTC is the single government agency which identifies hedge funds in commodity markets, but it has found that index fund traders could not be found as easily, he said. “Index funds can come to the market through commodity pools or banks. Many come through swap dealers,” he said.

Well, Jeffrey, if you think the market is functioning normally now, as you probably do, then I guess you won’t find any smoking guns. Generally speaking, if a person can’t see a hand being waved in front of his face, he’s going to miss a lot of things. All defenders of Mr. Market—they are legion—have the same eyesight problem.

Robert F. McCullough Jr., managing partner at McCullough Research in Portland, Oregon, argued that the CFTC data is incomplete and uses “outmoded classifications that do not reflect the current make-up of the commodities market.” Harris responded that “the commission actually has begun to receive fairly good data from over-the-counter markets, especially about index funds, to supplement its own findings.” (Good to know!) Everybody agreed that supply & demand fundamentals were not to blame (see Figure 3). Everybody agreed the 2008:H1 price spike was inexplicable.

Conference participants occasionally wandered into territory which (perhaps accidentally) overlaps reality.

Finally, said Adam E. Sieminski, Deutsche Bank’s chief energy economist, “stupidity can drive decisions. That’s the best explanation for somebody buying a crude oil contract at $147/bbl and expect the price to go up. Governments can’t regulate against this“…

Robert J. Weiner, an international business professor at George Washington University, said traders adopting a herd mentality, where they made decisions by copying other market participants instead of examining fundamental influences, is a likelier force [promoting volatility]. “If lots of people try to get into or out of a position at the same time, volatility can result,” he said.

[My note: you can't fix stupid ...volatility can result. We've all learned something today!]

I can already hear the protests. I have defamed the sacred market. The market does what the market does. The price of oil is the price of oil. The market can’t make mistakes by definition.

My answer is Figure 3. Stare at this graph. Think really hard about it. Do those price movements since 2006:Q2 look right to you? The oil market is broken. Today’s $62 price makes no fundamental sense. As a friend told me, there’s trillions of dollars floating around out there and it’s got to go somewhere. Some of this moolah distorts the oil price. The explanatory burden falls on people who think Mr. Market is OK. Or the ones who think he’s a little woozy but can’t figure out why. Unless we get Mr. Market into rehab pretty damn quick, we are all going to pay the consequences.

Contact the author at dave.aspo@gmail.com

dave.aspo@gmail.com
May 29th, 2009