I have been cautious about chasing the bear market rally in the last few weeks, having turned bullish post the cathartic Bear Stearns move (see post). Specifically, I warned at the end of April that the financials rally was premature in the light of no apparent bottom for US housing and contagion to other credit markets, (see Banks: The end of the beginning... ) and we have now seen most bank indices slide back to their March lows. In fact the rally over the last 8 weeks has seen not only low trading volumes but narrowing breadth, with resources and particularly oil related stocks (now over 15% of the S&P) spiking with the move in crude. The sharp fall from the 200 day moving average last week in US markets is ominous. Belatedly, the euphoric and unsustainable move in energy prices has awakened inflation and earnings fears in the wider market, the trigger for last week's sell-off. Ford, GM and the airlines all declared that they are reeling from the oil price shock, and consumer sectors exposed to the squeeze on discretionary spending all took a hit; short interest in consumer and financial stocks has risen sharply recently. The key driver for all markets from the dollar to bonds over the next few weeks will be where the oil price goes next. Far from worrying about $200 a barrel oil in the foreseeable future, I would stress test my portfolio for sub $100 oil, which is far more likely from these levels. At a time when maybe 50m barrels of oil is simply parked in supertankers offshore with no takers, Peak Oil is not at hand but peak speculation in oil may well be. Given the weight of resource stocks in key global indices (and earnings), it will be interesting to see how markets react to a looming reversal in oil; some pretty brutal sector rotation would certainly result and the dollar would resume its stalled rally (see previous post for analysis of the Peak Oil myth). Germany has now called for a global ban on oil market speculation, echoing hardening sentiment in the less than stunningly perceptive but increasingly furious US Senate (they should be threatening to sue US pension funds, not OPEC). If the market doesn't collapse soon under the weight of its own excess, legislation will surely be enacted within months to choke off the tens of billions in commodity index and ETF funds flooding the market in a self-reinforcing spiral (Lehman calculate they amount to about $240bn now, up from $70bn in early 2006, of which $90bn is new money). Ironically hedge funds are not the real culprits, and many have been in fact short on a fundamental analysis until recent weeks when they have been forced to close their positions, exacerbating the parabolic acceleration in prices. As oil grabs not just headlines but editorials around the world, and retail participation soars via ETFs and spread betting, a lot of bells are sounding the top of this move. Most encouragingly for the bear case, The Economist has decided in its wonderfully pompous way that high prices are here to stay and it's got nothing to do with speculation; this from the guys who forecast $5 long-term oil in 1999. Short of an oil trader getting Man of the Year from Time magazine, as contrary indicators go, it doesn't get much better than that.
- The bubble in oil now exceeds the move in Nasdaq during the tech boom, and matches that of house prices during the credit boom at over 600%. Price are up almost 170% since the trough in January 2007 alone. Current prices in real terms stand at a scary 3 standard deviations above the long term average; the last time oil was this extended was in 1980, and it subsequently collapsed 86% over the next 18 years. Both the Nasdaq and housing bull markets were killed by increasing supply, and the bulls will argue that no such supply response has been forthcoming in oil. Really? Akthough genuine physical tightness was evident in 2007, the market for crude has been creeping into growing surplus for through the Spring. OPEC's monthly report says that demand this quarter will average 85.75 million b/d. Supply was 86.8 million b/d in April. The US Energy Information Agency says non-OPEC supply will edge up by 600,000 b/d over coming months as Brazil, Azerbaijan and the Sudan raise production. Output increases from June by Nigeria, Iraq and Saudi Arabia (800k b/d) plus the 600k b/d from non-OPEC will push the market into unambiguous surplus. OPEC are right is claiming that there is no shortage of supply, in fact the world is running out of storage right now such is the excess of crude available.
- Meanwhile, demand is now falling dramatically in the US (25% of world demand); the number of highway miles driven in the U.S. in March fell for the first time since the 1979 oil crisis according to the DOT; in just the last week we have seen SUV sales collapsing (as are resale values), commercial aircraft being mothballed and the US military (the world's largest single oil consumer) planning a major switch to synthetic fuels. These are major structural shifts which will undermine long term demand growth even if, as I suspect, the oil price slumps to under $100 in coming months.
- The bull case has been that emerging market demand is price insensitive, because gasoline and diesel prices are heavily subsidised across the developing world. But for how much longer? Egypt, Taiwan, Indonesia, Bangladesh, and India are now moving to eliminate government subsidies. The key for global markets is China; local oil stocks soared up to 10% early last week on rumours of a lifting of price controls. Although various officials have denied an imminent move, the government is likely to be very secretive about any plans to change oil prices since this is only likely to encourage hoarding in the short term. Low domestic oil prices (roughly a third the world price) have encouraged horrendously wasteful energy use (Chinese GDP growth is 4x as energy intensive as Japan's) and are now straining the budget at a time when the earthquake damage will require $100bn plus to put right. Hoarding and smuggling are likely to get worse as the serious reconstruction in Szechuan starts. Crucially, the government has seen its moral authority soar given the competent response to the earthquake and associated rise in patriotic sentiment, limiting the risk of any social unrest if gas prices soar; if radical action is to be taken, now looks like a great time to take it and it would devastate the bull case for oil demand. Already Chinese demand growth this year is down to 400k b/d, well of levels of 700-800k b/d seen in recent years on total usage of about 7m b/d or less that a third of US demand.
- Index speculators are benefiting from 16:1 leverage on crude futures contracts given current margin requirements. Michael Masters, a respected hedge fund manager recently testified before the Senate and said this (see relevant chart above): 'It is easy to see now that traditional policy measures will not work to correct the problem created by Index Speculators, whose allocation decisions are made with little regard for the supply and demand fundamentals in the physical commodity markets. If OPEC supplies the markets with more oil, it will have little affect on Index Speculator demand for oil futures. If Americans reduce their demand through conservation measures like carpooling and using public transportation, it will have little affect on Institutional Investor demand for commodities futures. Index Speculators' trading strategies amount to virtual hoarding via the commodities futures markets. Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits.' Let's hope those Senators paid attention because the looming US recession will mutate into something nastier if the energy bubble isn't popped soon. The American model of laissez-faire financial capitalism has been thoroughly discredited by a series of damaging asset bubbles that have erupted in quick succession of which oil is just the latest; its days are surely numbered.
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