Motor up....power down

Oil. If one wished to summarize May's financial market trading in one word, that would be the one. Crude's stunning rise has befuddled many, including regular posters D and Mr. Prop, as well as Macro Man himself. Anatole Kaletsky blames the speculators; unfortunately, the quality of the CFTC data on specs is insufficient to reach an accurate judgment of the matter, as index "investors" show up as commercials. One of Macro Man's favourite analysts, Goldman's Jeff Currie, suggests that oil's been dragged up by the back end of the curve, which has needed to rise to attract appropriate levels of investment into the industry. Perhaps, but that doesn't explain why Dec 2015 oil has risen 34% (!) so far this month; surely the seven-year fundamentals of the industry haven't changed that much in three weeks! And unfortunately for Mr. Kaletsky's theory, volume in this Dec '15 contract, pictured below, hasn't been that much higher than in March, when the contract traded sideways to lower.

Frankly, Macro Man doesn't know what's going on here, and from what he can make out, neither does anyone else. Crude certainly looks to be a bubble at the moment, similar to wheat in February; that Icarus crashed to earth with a resounding "thud." Perhaps oil will trace out the same pattern as wheat, but Macro Man remains wary of Keynes' maxim when it comes to calling the top in a bubble. Perhaps Cassandra's suggestion of higher margin requirements is what's required to stop the madness; at the very least, it would be interesting the impact from an intellectual perspective.

Intriguingly, the Jeff Currie view of the world suggests that oil is already entering a cyclical bear market, buried deep within the secular bull. The chart below shows the percentage difference between 24th Nymex crude contract and the front contract. Observe how how it is moving into contango, with the ratio turning negative. Equally interesting is the fact that on a percentage basis, the backwardation since the 2006 bear market has been very, very modest in comparison with previous secular bulls; perhaps the energy market has been pricing in slower US/world growth, even as the nominal price has risen. Frightening...
Regardless, rather than try to call the top in something with a rocket up its rear end, Macro Man would prefer to direct his attention to the fallout from higher oil prices. The candidates are relatively obvious; US consumers specifically and risk assets generally. As anyone reading this site is probably aware, many major equity indices have broken key uptrends this week, including the S&P 500. As such, Macro Man is looking to spread out his equity shorts as he builds up a position.
Another place to look for weak spots is in FX, targeting those countries reliant on foreign inflows and facing a negative terms of trade shock. Macro Man is generally favourably disposed towards the Turkish lira, for example, because the CBT is reacting to an inflation spike by tightening policy, thereby maintaining a high real interest rate for investors. Compare that with the situation in South Africa, where the SARB offers scant real interest rate cover for the country's high inflation rate; obviously, there are other headwinds facing SA as well. But even the TRY has broken a pretty well-defined uptrend against the buck recently, which offers further support for a "risk off" mentality.
That the Fed has promised to greet near-term economic weakness with stony silence is another reason to look for a bout of risk reduction; like a petulant child, the market has not responded well to threats of taking its toy/liquidity away. Oil may be motoring higher....but it looks like just the thing to force risk assets to power down.
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Anonymous
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May 22, 2008 at 1:12 PM ×

Hi MM,

I’d like to go back to you last week’s post on the issue of endogenous and exogenous inflationary pressures and the potential failure of inflation targeting as a key driver for major CBs’ monetary policies.

Well, a few days ago unleaded gasoline here in Italy almost breached 1.50 euros per litre and diesel fuel is now just a few inches below, after covering the huge gap it once had vs. unleaded gasoline. Now, it’s a well known fact that Italian prices are however strongly distorted by excises and a distribution network which is far from being fully liberalized. Consumers are now paying 1.50 euros for something which is said to have an industrial cost of some 0.30 euros – is it endogenous and exogenous?

Let’s take bread, instead. According to EU stats, flour used for making bread accounts for less than 10.0% than the price actually charged by bakeries and groceries. A few months ago, bread prices were reported to almost have doubled in Milan or in Rome, but flour used is the same as ever – is it endogenous and exogenous?

I fear that a great part of inflationary pressures currently facing ECB and EU authorities come from distortions in the distribution networks in the EU members states, with many retailers, wholesalers and even chain stores benefiting from newsflow on commodity bubbles. If that’s the case, what is the ECB supposed to do other than keep on with its tightening mode? Such questions should be addressed by single Governments and the EU Commission, not by the ECB, which seems to be mainly worried by limiting what you called “second round effects” and could lead to a vicious cycle of higher inflation expectations and wage increases.

Read you later, AT

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Macro Man
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May 22, 2008 at 1:38 PM ×

AT, I think that's exactly what the ECB is thinking about...ensuring that the underlying secular inflation trend in headline goods isn't allowed to permeate society and alter inflation expectations.

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Anonymous
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May 22, 2008 at 1:52 PM ×

I went to a 'Macro Economists' presentation on commodities 4 years ago and the thesis was that based on the supply/demand the rise in commodity priced was difficult to explain. Indeed hedgefunds were blame for a big part of the move. At the time India and China were only slightly catching a buzz in the press. Now that the CRB has gone from 190 to 435 since 2001....its up for debate again. Over speculation is heavily argued. Didn't we hear the same with the Housing years ago? What about a structural shift? People are still spending a much higher pct of their disposable income on housing, shouldn't we expect to pay more for food and fuel? Its just time to go back to work, cuz you are need the cash. Greenspan's fault innit?
Macrofan.

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Anonymous
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May 22, 2008 at 3:06 PM ×

Look, have you guys ever heard of fundamentals?

Oil started to go into a trading range on April 23. Saudi Arabia was bringing on 300,000 barrels a day, and the price would have stabilized for a couple of months.

What happened is that we had strikes in the UK and Nigeria that took roughly 380,000 barrels a day out of May supply. To make matters worse, this lack of supply was not spread smoothly through the month. It was bunched up into a couple of weeks, and the effect of those weeks just started to hit. Traders had to pull off shorts and the price zoomed up.

Also, it turned out that Saudi Arabia had lied about when those extra 300,000 barrels a day were coming online. They had announced to the press that production had started the third week of April. Now it looks like the new production really didn't come online for another 2-3 weeks (if then).

Prices would normally come down in a few weeks as this production started returning to the inventory reports. But you can kiss that good-bye because we have a special situation right now--China and India have been holding off on purchases, and a flood of new demand will be hitting when they get their act together in the next week or two. India: http://timesofindia.indiatimes.com/BPCL_starts_rationing_fuel_supplies/articleshow/3061069.cms. China: http://in.reuters.com/article/asiaCompanyAndMarkets/idINPEK15115620080521.

This has been China's normal cycle for at least the past year. Foot-dragging then massive buying when the diesel runs out. And now they are burning diesel in power plants to make up for a lack of coal related to the earthquake.

Meanwhile, Russia's exports are off 3.3% from last year, and existing production has a decline rate somewhere between 4.5% and 8% (and rising).

So, the price has been rising unusually fast, but it's been due to unusual conditions. There is very little extra production capacity about, inventories have been kept tight and it's not easy to raise supply when exceptional conditions arise.

Moe Gamble

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Anonymous
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May 22, 2008 at 3:53 PM ×

My question about oil prices, related to what the last anonymous said about disruptions is the following:

Where are the shortages in oil? Oh there are none.. There's plenty of oil. Unlike rice, where there WAS a shortage in some places.

So how does oil price at $130 when there's no shortage?

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Macro Man
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May 22, 2008 at 4:33 PM ×

Also pursuant to Moe's comment: fair point about the strikes and temporary disruptions, but what's that got to do with the price seven years' hence, which rose 34% in 3 weeks?

Moreover, as I understand it the problem with Chinese distillates is refining capacity; there is no more capacity to refine, so it's hard to see how that translates into demand.

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Anonymous
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May 22, 2008 at 4:53 PM ×

Moe Gamble,

you're perfectly right as far as fundametals are concerned, but the point is that crude oil and refining costs only account for a small fraction of the industrial costs that consumers as a whole pay in the journey from crude oil to unleaded gasoline: the rest - and it's an awful rest, indeed - is made up of excises. Now different EU member countries might have different taxation levels, but taken as a whole differences are not that huge. I fear that a great part of recent spikes in EU HICP and to a lesser degree in EU PPI come from distortions in the distribution sector, which is profiting from the commodity bubble to round up prices, and it's not up to the ECB to fix such a matter. Try and ask the bakery at the corner what part of its costs come from flour and what part from employees compensation... If that's the case, most of inflationary pressures in the EU are somewhat "endogenous" in nature and inflation targeting - aimed at avoiding a vicious spiral the kind of 1970s - is still a reasonable approach. Choosing the proper target (HICP, core HICP or what else) is a different matter...

AT

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Anonymous
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May 22, 2008 at 5:49 PM ×

It’s a pretty interesting dichotomy in sentiment here. Nobody except the guys buying/holding up here at $130 believes that it can be sustained.
I mean, S&P @ 1400 +/- certainly doesn’t buy it. Holding equity right here is the same to me as buying a put in oil.
Is the backup in treasuries here a wink to the price of oil? Maybe a little.
I wonder if capitulation in other markets while crude still levitates isn’t what is needed to get the price down.
RJ

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Anonymous
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May 22, 2008 at 6:26 PM ×

MM,

I have been reading this blog for sometime now and have appreciated the posts - even though I don't always understand the terms and trades put forth. The oil price discussion has been particularly interesting of late and I am wondering whether the problem in understanding the basis for the forward and spot price run up is just a popping of a currency bubble. Since noone can understand why people would bid up a physical commodity when there is enough current supply and demand is not spiking, then maybe it is just a dollar issue. However, it is hard to ignore the expected demand growth and reserve decline when looking out 5 or so years.

Anyway, my real question had to do with the effort in the U.S. Congress to go after OPEC countries by denying them sovereign immunity under the U.S. anti-trust laws. While this seems silly to me on many levels, the flailing of Congress at the situation might actually cause it to pass. If so, I would expect OPEC countries could do a number of things, but one of them could be to require contracts in euros rather than dollars. Could such a shift like this really happen (i.e. can the exchanges physically handle it). Also, I think I know this, but what would happen to the dollar? Why would anyone (including China) want to hold them? Thanks again for all the good insights.

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D
admin
May 22, 2008 at 6:37 PM ×

My short term equity signal flipped buy in the sell-off yesterday. Average signal round trip is 6 days, with a low of 2 and the fattail was april with 19 days.

When crude gets moving the brokers will hike house call requirements to "manage" their risk and to help out their proprietary desk of course!

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Macro Man
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May 22, 2008 at 7:08 PM ×

Anon,

If the US Congress were really serious about getting the oil price lower, they would be taking steps to reduce US consumption, both via Pigovian taxes and the promotion of alternative energy. While neither is a cure all by any stretch, and any move away from the current US oil intensity of GDP will necessarily entail pain, both are preferable to the current situation. However, the ludicrous ethanol policy is a pretty good indication that the Congress isn't interested in making optimal policy.


As for OPEC, Iran already claims to not accept $ for its oil. In extremis, sure, an all out economic war could result in a wholesale rubbishing of the dollar. However, such an outcome is in the best interest of neither party, so I am pretty sure it won't happen in a way too much more aggressive than the subtle way that it's already occurring.

D, your model is a bit too short-term even for me, who gets accused of hyperactivity by some true long-term types (but sloth from some of my short-term friends.)

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Anonymous
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May 22, 2008 at 7:31 PM ×

Regarding anonymous 3:53 p.m.'s post: Oil inventories in the U.S. are a little below the 5-year average, despite the big run-up in price, and despite the fact that refineries have been running sharply below capacity.

Gasoline as now fallen below the 5-year average, as we head into peak driving season.

And diesel and propane are far below the 5-year average. Since the run-up in prices hasn't led to excess inventory, the prices are about right--i.e. they've killed off exactly the right amount of demand. If prices were $120, we'd be seeing shortages.

MM, regarding Chinese distillates, the problem is not at all a lack of refining capacity--it's a Chinese oil company strike against refining product at a loss. Product prices are set too low for producers to recoup the price of crude inputs, so producers aren't buying oil or product until the Chinese gov't either ups the product price or the subsidies they're providing for buying oil.

Regarding the price 7 years hence, the increase is due to the simple fact that nobody wants to take the other side of the trade. Oil companies know they're having trouble replacing reserves. The IEA let it out in the past few days that they're redoing their supply forecasts in some kind of attempt to stop looking like complete idiots, as their projections have been off by multiple millions of barrels per day for several years now, and are looking worse, not better.

When the price rises to $130, Saudi Arabia comes on and promises an extra 300k barrels per day in June; unfortunately it's the exact same extra 300k (Khursaniyah) that they already told us about in April, thus blowing what little credibility they had left as swing suppliers.

The UAE and Dubai are using diesel for electricity and desalination because they're so short on natural gas. China's exports (and consumption) continue to grow (see Brad Setzer's blog). Russia's consumption continues to grow. The Gulf States' consumption continues to grow.

Who the f*** wants to take the other side of that trade? Since the oil producers don't want to, how about you RJ? Time to load up on 2016 shorts?

It's possible that some inflation pressure is coming from the distribution sector--I have no data on that. If you have some data, AT, I'd like to see it.

Regarding belief in the sustainability of oil prices, the only reason the S&P is at 1400 is because of investors' belief in oil prices. It's Exxon and Conoco that are holding the whole market up.

Moe Gamble

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Gregor
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May 22, 2008 at 7:35 PM ×

As I just wrote to you in an email, the emergence of a full-length contango is not surprising if one has been anticipating it for several years. Nor would it seem sudden. In fact, the flips between backwardation and contango have taken place in "relatively" short amounts of time--or what "feels like" short amounts of time.

Actually, this is not the first full-length contango of this cycle. We had one briefly in January of 2007, when the front part of the curve was pulled down hard, during a warm-weather event. (heating oil inventories piled up very quickly).

Finally, what's poetic about futures curves is that they are both a reflection of behaviour--but then also they induce behavior. This move to contango is, and will be, no different in that regard. Bottom line: a full length contango is not easy to sustain. But, if it can be sustained, uhhmn, well, that will eventually be understood be all.

Regards,

Gregor

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Macro Man
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May 22, 2008 at 7:46 PM ×

Moe, my information on distillates in China comes from the Barclays oil analyst, who I believe is regarded as one of the best on the street. My understanding is that refiners were already at high capacity (a legacy of the snowstorms which knocked out some coal-fired power plants), and then a few went offline as a result of the earthquake, leaving the country's effective refining capU at 100%. I've not verified this for myself, but the guy does have credibility.

Your points on inventories are well made, and I suspect that you follow this market more closely than me. So my question is this: what has possibly changed in the last three weeks to cause buyers to be willing to pay so much more for long dated oil? was there a seller there that buggered off, and buyers are forced to buy with a gun to the head? (I did hear one story that back end demand was the result of a curve trade gone badly wrong.) The absence of supply isn't a sufficient reason for these kinds of moves, particularly at the back end; there has to be some sort of demand. And the fact that the curve has moved into contango in this little run suggests that the factors that you cite aren't really what's driving the price.

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Anonymous
admin
May 22, 2008 at 7:46 PM ×

Here's a link on the conundrum for Chinese refined product producers: http://www.chinadaily.com.cn/china/2008-05/13/content_6681648.htm

It's not the best for data, but it's convenient. The product shortages have gotten worse since this article.

Moe

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Anonymous
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May 22, 2008 at 8:03 PM ×

MM, the pattern with Chinese product supply has been going on for at least a year now. Oil prices go up, Chinese refiners can only produce at a loss, they go on strike until the gov't either raises prices or subsidies, and then they go on a buying binge for millions of tons of oil or diesel and drive the price of oil up $7-$10 in a day. It's been happening like clockwork every 2-3 months, since long before the earthquake.

But the earthquake will lead to further Chinese diesel purchases in and of itself: http://www.lloyds.com/dj/DowJonesArticle.aspx?id=392194

I don't have as high an opinion as you of the Barclays oil analyst. I'm sure he's a fine person, though.

The best info I have is that the curve was indeed a seller buggering off, and you can see the excess coming out already. Nonetheless, I agree with Goldman that there is a kind of fundamental rethinking of the price just getting started.

Moe

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D
admin
May 22, 2008 at 8:09 PM ×

The one thing we know is demand is not static. It can go up, and it can go down.

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Anonymous
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May 22, 2008 at 8:25 PM ×

Not for me Moe.
I was actually trying to intone you and your brethren could be much more right then most can possibly believe; the skepticism around $130 oil is just thick, thick, thick.
I though do not believe that profit expectations and valuations of equities outside of energy are in accord with this price of crude, nor treasuries. I don’t think that the energy sector can Atlas the S&P, it punishes too many of its colleagues.
If crude stays elevated here, and we finally get a stagflationary response from equities and treasuries, and crude holds it’s own, I just wonder if it wouldn’t be then that demand would fall quite fast, and the price wouldn’t respond immediately b/c then the sentiment would have shifted to acceptance of your structural argument.
RJ

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Anonymous
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May 22, 2008 at 8:34 PM ×

First, errata: I believe the correct term (in my last post) would be: "got buggered off", as opposed to "buggering off." UK is not my first language.

RJ, I agree that equities outside of energy (and, in fact, inside of energy) are overpriced.

D and RJ, I agree demand will fall. It has already been falling outside the oil-exporting countries. But it's falling incredibly slowly. A colleague suggests that the easy demand destruction has already taken place, and that the remaining users have a lot of money to bid.

Moe

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Macro Man
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May 22, 2008 at 8:52 PM ×

OK, I thought the subsidies covered the gap between world prices and the fixed onshore price on a more real-time basis; I wasn't aware that they would wait and then all come to market at once when the subsidies or onshore price were raised.

As for the Barclays guy, people who know a lot more about energy than me rate him very highly, and that was good enough for me, an admitted tourist in this market.

But really, I know that I don't know this market that well (addressing the point you raised in your email, Gregor), only that the swift price rise is what one usually sees in the context of a bubble; one of the benefits of writing a blog is you can throw something you don't really get out for discussion and see what it leads to.

And thus my conclusion to focus on the collateral impact of high oil; frankly, I'm a bit stumped there, as well. Yes, recently-layered equity shrots have worked, though not today. What's really puzzling, however, is that the large cap indices that contain the big oils are badly underperforming the smalls caps, which have a more domestic, more energy-vulnerable focus. I've gotten my ass handed to me on my large cap/small cap trade, despite what would appear to be an ideal scenario for it to be coining money.

Then again, I look at short ends around the world, and it seems quite clear that fundamentals are not necessarily what is driving markets at the moment.

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theroxylandr
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May 25, 2008 at 3:45 AM ×

Backlink to your post:

http://yellowroad.wallstreetexaminer.com/blogs/2008/05/24/the-last-bubble-in-the-investment-desert/

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