Investment Postcards from Cape Town

This post is a guest contribution by Dian Chu*, market analyst, trader and author of the Economic Forecasts and Opinions blog.

Last Friday, US crude oil futures finished above $78, the highest level in a year, surging more than 9% during the past week making it the largest weekly gain since the height of the summer driving season, even though the US continues to sit on ample supply of petroleum.

Given the continued sluggishness of the economy, high unemployment rate and large amounts of excess oil production capacity around the world, analysts said a sudden upward spike was still unlikely, while others are predicting an immanent correction down below $70.

However, if you take a closer look, it is evident that the current crude oil market is almost entirely detached from fundamentals. Furthermore, there are several factors supporting oil rising to new levels, as fundamentals are out the window in the near to medium term.

Technical breakout
Oil has been locked roughly in a band of $65 to $75 a barrel since the start of June as traders weighed optimism over the prospects for a recovery in global demand against a supply glut (see chart below). Typically, the longer it is trading in a sideways pattern, potentially the more powerful a breakout is going to be.

And breakout it did on the first sign of a seemingly positive indication. In addition to dollar weakness, the oil rally last week was sparked also in part by government data that showed surprise inventory drawdowns in domestic gasoline and distillates (mostly due to lower refinery runs at around 81%).

This, coupled with stronger-than-expected China trade data, was enough to send a ripple through the markets midweek boosting market bullish sentiment on global economy recovery hopes along with oil demand.

Now that oil blew past its previous 2009 high of $75, many analysts believe the recent increase is a sign that prices will now trade at a higher range.

US dollar policy … if there is one
The recent rallies in commodities, including crude oil, and even the stock market to some extent, have been driven primarily by the floundering dollar on the lack of fundamental support from the demand side since the recession (see chart below).

The US dollar dropped to a 14-month low against a basket of currencies on speculation the Federal Reserve will keep interest rates low trailing other central banks and the unprecedented levels of government debt. Crude and most commodities are priced in the dollar; therefore, tend to rise when the US currency falls.

Though the correlation between the dollar and oil has not been statistically established, dollar is clearly part of the “causation” of crude movement this year, as investors sold dollars and bought oil as a hedge against inflation and uncertainties in other asset classes.

With a concrete “dollar policy” and “dollar intervention” conspicuously lacking, traders and investors are wondering if US officials merely wanted to slow the rate of decline of the dollar, and that the Administration really does not care if the dollar depreciates, only how fast.

On that note, markets will no doubt keep testing the US dollar resolve, and if government actions do not follow their rhetoric (highly probable from current indications), we could all say good bye to the dollar as it could free fall to no man’s land. And anyone could guess what that would do to the price of oil as well as inflation.

Capital flow & asset rotation
Under normal circumstances, oil prices and stocks typically have an inverse relationship. That is, rising oil prices pressures stocks, and falling stocks push investors into oil.

However, since the recession last year, oil and stocks have been trending in lock step largely due to the huge amounts of easy money freed up by global governments to rebuild their economies and companies.

The stock market is rising with the Dow breaking the 10,000 mark last week, which is an indication that cash in general has come back into the market. In fact, most of the price movement in the crude market is clearly stemming from financial flows based on activities on the NYMEX and ICE.

When there’s so much liquidity in the system, it will have to go somewhere. So, we should still expect crude and stocks to move in tandem, but the rotation of assets has deepened more in hard commodities because of the rising skepticism in equity markets. This means crude oil could outperform equities in the medium term.

Better fundamentals won’t hurt either
Even though fundamentals won’t play a significant part in the oil market for the foreseeable future, any positive data points could further bolster the non-fundamental factors discussed so far.

The International Energy Agency (IEA) did just raise its forecast for global oil demand for the current year and for the next year citing a more optimistic economic prognoses and stronger preliminary data from America and Asia.

Déjà vu year 2008
You may recall the start of the US Federal Reserve’s cycle of interest rate cuts in 2007 spurred the influx of cash into commodities markets. Oil prices surged during the period, peaking at a record $147 a barrel in July 2008 as the money flowed in amid projections of strong global demand driven by emerging markets like China.

Right now, the US Dollar is driving the oil price. In order for the trend to change, the US dollar has to strengthen against other currencies, and that is unlikely to happen without some intervention by the US government relative to its current monetary policy.

The dollar has not collapsed but the trend has been downward this year and fear is the trend could continue with massive and growing national debt and quantitative easing policies by the Fed. Until we get any strong change in fundamentals for the dollar, it will continue to weaken further and everyone will flock to crude as one of the primary hedges (gold being the other).

Even though there are ample supplies of petroleum products due to the recession and there is little chance of a shortage in the near term, based on the technical and dollar indicators, it is likely that the next technical breakout would move crude oil to the $85 level. While some option bets of $100 crude by the end of 2009 seem overly aggressive; nevertheless, crude could trade above $100 within 12 months based purely on non-fundamental factors.

Bubbles will deflate
Investors should expect crude oil to be much higher during the heat of 2010’s summer driving seasonal run-up, with the peak price probably well above $110 at this pace sometime by next July, before the Fed is pressured to curb high commodity prices by raising rates.

The Administration will face a considerable dilemma with both a high unemployment rate and sky high gas prices at the pump from the oil run-up due to a weak dollar policy. The unemployment will not be magically solved by itself, the easier solution would be to raise rates to curb commodity inflation.  But by the time the public is up in arms about high gas prices, it is too late, the inflationary damage is done.

So once again, we have managed to create yet another bubble in asset prices. Until we have a longer term view for monetary policy, expect asset bubbles to continue, and invest accordingly to prepare for the eventual and inevitable deflate.

Source: Dian Chu, Economic Forecasts & Opinions, October 18, 2009.

* Dian Chu is a market analyst, trader and financial writer for Zero Hedge, Seeking Alpha and Daily Markets. Her articles are also syndicated to Reuters, USA Today and BusinessWeek. Professional credentials include M.B.A., C.P.M. and Chartered Economist with extensive professional experience in market segment forecasting and strategies. She is currently working in the US in the energy sector.

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A huge debate is raging at the moment about the outlook for crude oil, influencing the formulation of investment strategy in a significant way. Discussions range from excessive speculation to geopolitical factors to increased demand meeting inelastic supply.

A report from Rob Fraim (Mid-Atlantic Securities, Inc) has just arrived in my inbox and is worth perusing for two reasons: (1) Rob’s good track record in this sphere, and (2) his common-sense approach and findings with which I mostly concur. The paragraphs below are extracts from his excellent report.

I have for quite a lengthy period of time – going back several years – been bullish on energy markets and energy-related stocks. And fortunately this has been a decent call.

So now what? Last week a $10+ jump in the price of crude in one day. Visions of $200 oil dancing in their heads. Articles in the media about $15 gasoline, outcries about speculators driving up the price of oil, and the inevitable somewhat late-to-the-party recommendations to pile into the energy sector now.

Spoiler Alert: I’m going to suggest lightening up positions a bit in the energy sector. Sorry for ruining the suspense, but you’re busy, I’m wordy, and you were probably going to skip to the end anyway.

I’m not suggesting a complete exit – since I still believe that we will have reasonably high energy prices for the foreseeable future and that energy companies will be strong and profitable. However, I also believe that the oil market in particular has gotten a little goofy and frothy and that we are due for a meaningful pullback in crude – which is likely to impact the psychology and pricing for other energy markets as well. We all know how it is when the “hot money” gets out of a sector and how much volatility that can create.

Do I think that oil is going to $50? Not a chance? Not $50, not $60, not $80. But I do think that there is a better than average chance that we are going to revisit $100-ish and stabilize there for a while.

This being the case I am suggesting that reaping some profits and reducing energy positions a bit might be a wise move – at least on a trading basis. Keep a core holding for the long-term, but lighten up. Sell some stuff. Write some covered calls. Hedge a bit. Maintain the core but trade with part of your energy investments. Do something other than get whipsawed.

Why? A combination of fundamental, anecdotal, and emotional factors actually. (I might also throw in technical, psychological, sociological, zoological, anatomical, and astrological if I get really cranked up.)

Here are a few of the reasons why I am reaching this conclusion.

There are some indications that demand is actually beginning to fall – somewhat in the same way that it did in 1979 and 1980 when gas pump pain reduced gasoline use by 5% and 6% respectively.

Miles traveled in the US are down – off 4.3% in March. In the last week of May – with Memorial Day weekend – gas buying was down 3.9% from the previous year. Why the declines?

Consumers are adjusting their driving and consumption habits. There is a real switch toward smaller, more energy-efficient cars and away from trucks and SUVs. In May of this year 4-cylinder cars made up 45% of sales versus just 30% in 2005.

Anecdotally, transportation companies are adjusting as well. We had a conversation with a trucking company recently and they spoke of measures that they have put in place to reduce fuel consumption. They are using monitoring and tracking systems and technology to enforce the 55 mph limit on their drivers – instead of the “unofficial” 65 mph or so that was the norm before. They are very serious about this and have enacted real driver penalties for non-compliance. Different studies have shown different results, but roughly speaking the difference between 55 mph and 65 mph is about a 10% improvement in fuel economy.

A potentially strengthening US dollar can have a big effect. While we tend to focus on supply-and-demand metrics and speculative forces when talking about oil prices, the simple fact is that a lot of the rise in oil prices has been not about oil inflation, but rather dollar deflation. The greenback has been in a downward spiral for months – courtesy of the credit crisis, problems in the US economy, and the long series of interest rate cuts. Now that rates have likely bottomed and as the US economy comes out of panic/fear mode the odds favor somewhat of a rebound in the dollar.

Jeffrey Saut at Raymond James – a strategist for whom I have the utmost respect – has adopted a more bullish stance on the dollar after years of warning about dollar weakness. If he is right – as I suspect he is – dollar appreciation will bring down crude oil pricing – as the need is also lessened for oil producers to keep prices high on crude, which is their primary greenback denominated export.

Back to the supply and demand issues, we know that real (or perceived) energy consumption in the emerging economies in China and India has taken up all the supply “at the margin”. And it is those last few incremental percentage points of usage data that make the difference between tight markets (rising prices) and looser ones (stable to lower prices.) While the China and India growth stories are real – and will be a continuing factor – there are certain things that speak to a modest lessening of demand.

When government subsidies in many Asian nations disappear by year’s end, demand should slacken. And China, stockpiling supplies for the coming Olympics, will likely shift gears and cut back on its energy purchases by August according to some. Now, today’s report regarding potential demand from China speaks otherwise, but then again I could find another item that would again talk about demand leveling off. It’s always a tug of war of course, but I am getting the feeling that the picture is not nearly as one-sided as has been reported.

Furthermore a slackening economy here in the US should also take a little pressure off of the demand side of the equation.

While not the end-all of supply problems, there has been some modest production growth – largely from Russia. So all in all the supply and demand balance seems to be tipping back in a more favorable direction – at least for now – with some estimates and reports indicating that we have moved from a deficit of 900,000 barrels a day that had to be made up by dipping into reserves, to a global “cushion” of 600,000 barrels a day.

I also wonder at what point political ideologies and environmental concerns will crumble to voter dissatisfaction over painful energy prices – possibly opening up drilling in previously “off-limits” areas.

“There is no justification for the current rise in prices,” said Saudi Oil Minister Ali al-Naimi on June 9, 2008, calling for an energy summit between producing and consuming nations. Now to be sure, we can take anything from OPEC nations with a grain of salt, but ultimately it serves the interests of the oil producers for oil prices not to skyrocket too far – since this would encourage serious conservation measures and bring about further political pressure. While excess supply capacity is not huge, Saudi Arabia itself has about 2,000,000 barrels per day in potential production expansion capability.

So with all of that in mind, do I think that we’re going to return to the days of cheap energy and a huge energy price decline – as occurred after the 1980 spike? Hardly. It was easier to increase production back then since oil fields were less mature and exploited. Also there were a lot more energy inefficiencies (in cars, appliances, building materials and techniques) back then than there are now – areas that could be markedly improved easily enough.

No, not cheap energy – just maybe cheaper by a bit. It would not surprise me to see $100 to $105 oil by the end of the year. That probably equates to gasoline in the $3.50-ish area.

Of course the unknown and unknowable regarding crude oil is the geopolitical picture. What if Israel bombs Iran and the Straits of Hormuz are blocked? What about Nigeria? And Hugo Chavez down in Venezuela? And Iraq? Terrorists! Floods! Plagues! Locusts! Well, as we saw last Friday those types of concerns (absent the locusts) have been moving the energy markets. Did anything really happen on Friday – something other than rhetoric – that fundamentally impacted the picture? Not really. It was a speculation and fear-driven spike.

Now I’m not one of these folks who vilifies speculators and blames them for high prices. It’s a free market and speculators actually serve a purpose. But blame it or not, speculation does enter into the pricing picture as speculators vie with actual users of the commodity for a relatively limited pool of sellers. But like ’em or hate ’em, speculators give us our market timing opportunities – to buy when people are selling or sell when most are buying. It just seems to me that more than a little of today’s $136/barrel price tag on oil price has geopolitics/fear/speculation written on it.

Last week I wrote about the (in my view) somewhat silly finger-pointing and ranting about the role of speculators in having driven up the price or energy and noted that ultimately speculators aren’t bigger than the markets and that supply-and-demand always wins out. Speculative moves can last longer and go further than we expect – and no one, me especially, can hope to “top-tick” the market by selling at the very peak. That’s why my recommendation is not a 100% all-or-none exit from energy positions, but instead an attempt to be level-headed and proactive by taking advantage of speculative fever and “ringing the register” on portions of energy exposure.

Source: Rob Fraim, Mid-Atlantic Securities, Inc, June 10, 2008.

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