Crude Oil - Déjà Vu Year 2008, No Fundamentals Required

By Economic Forecasts & Opinions

Last Friday, U.S. 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 U.S. 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.

U.S. 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 U.S. 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 U.S. 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 U.S. 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 U.S. 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 U.S. 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 U.S. dollar has to strengthen against other currencies, and that is unlikely to happen without some intervention by the U.S. 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 inevitable deflate.
 

Economic Forecasts & Opinions

Comments

[Anonymous]

Oil is a fundamental element of our society.

This kind of analysis may be accurate, but it also seems extremely perverse.

Just goes to show how overly powerful and damaging the world of economics/finance has become. The tail isn't wagging the dog, it's thrashing the poor dog against a wall.

Ah well, if we're really this stupid as a society, maybe we deserve what's coming.

[Anonymous]

The Dow Priced in Oil:

http://afantieconomics.blogspot.com/2009/10/bartering-for-dow.html

[Anonymous]

Wow. Oddly nothing but praise from these posters on yet another wrongly bearish zerohedge article. Zero hedge has been consistently wrong and its postings have accomplished nothing but losses for any readers foolish enough to buy the so called analysis. A bull market is a bull market and zero hedge has been fighting it all the way up. What a dis service this blog has been for those looking for insight and guidance. All they get is permabear outlooks.

[walküre]

ROFML

Bull market.. LOL.

Try PUMP and ... DUMP

GS called for $85 oil by year end.

They gotta know. GS shorted oil at $145 last year because they KNEW.

Bull or bear have no meanings when the market is pumped by government dollars and the promoters get a piece of the action.

Business "NEWS" channels are public corps. It is in their best interest to toe the government line and PROMOTE the hell out of the rotten corps that is the Wall Street casino. ANY officer of a pub co. is a shareholder and wants his/her networth restored as much as possible. From the perspective of these officers, the market is always bullish and the sky is always blue.

Buy and hold at your own peril. Trade while you still can.

When the shit hits the fan and the promoters start to DUMP their shares, you'll be last in the Conga line. The DUMP will come and it could take a week or so to drive markets back to March 2009 levels.

[ghostfaceinvestah]

Huh?  The article seems to be saying oil prices will continue to rise due to a falling USD.

Doesn't sound bearish to me, except on the USD, which, when Bernanke is printing $5B a day to buy MBS, seems like a good bet.

[BM (not verified)]

in other words, enjoy cheap oil while you still can, because Bubblenanke is a total idiot. God bless America.

http://gregor.us/crisis/the-alignment-of-asset-reflation-and-a-collapsed...

[Anonymous]

Fundamentals don't matter. Never have and never will in any auction market. It's only about liquidity and the relative position of traders.

It helps if the asset has the support of powerful elites.

[Lionhead]

You sir, are spot on! Long oil, targeting $89 & $91; long gold, primary target hit, secondary intermediate target to $1330.

[Anonymous]

Peak oil...get used to it...who's your daddy?

[Miyagi_san]

 A simple look.....The middle east called for $75 or else...Gs ran it to $70ish then we got the, "We will price oil in non dollars" so here we are at $78. I dont think we got anything in return for the $75 except for inaction on many fronts. Refinery utilization at 80% , I think they will bring gas to $2.50 ... that will be the last straw for demand.  

[Miyagi_san]

I got it: Saudi's stop Russia's arms sale to Iran, while we sell $7 billion to King Abdullah  

[jm]

totemo ii desu yo, Miyagi san...

[Anonymous]

I do see a temporary breakout for oil to 85-100, but then it will resume its downward trend from last years high. Contracting M2 will sink all boats eventually. Maybe the push higher will last long enough to pass Oblamas bogus global warming laws however. Us Minnesotans For Global Warming will all be out there spraying our CFC aerosol cans on Jan 1. Sheesh, it's already 20 degrees below average up here and it's only October!

[I am the mole]

The "inside money" for lack of a better term need to isolate one asset bubble after another in order to sell as everyone else - i.e. the "outside (read: unsuspecting/public/dumb - enter yourr own term) money" - buys, and then capitalize on the way down too when the buying demand diminishes - fundamentals be damned until too late.  Indeed, Yankee, the more things change the more they stay the same - I couldn't agree more.

[Yankee]

The Bard would have loved you Taoists - Much Ado About Nothing - these prices don't mean shit, everything is hedged and hyped - next stop for all overpriced markets is 50% of current price.

The more things change the more they stay the same.

I'm sorry I just looked back at thought on foreclosures, folks in foreclosure have more money to spend - they are living rent free.  But most don't buy oil futures too often

[Anonymous]

most of the recent change in oil price is due to dollar depreciation.....

kitco has an interesting table of gold price where it isolates the change in gold price due to dollar fluctuations vs. demand.....a similar breakout on oil would be intersting....

this is not to deny non-fundamental factors or fundamental factors but we need understand that the dollar is in a serious decline and thus oil prices should increase all other things being equal...

[Anonymous]

RAY CHARLES COULD SEE THESE MARKETS ARE MANIPULATED. BECAUSE OIL AND BY PRODUCTS ARE HYPER- CRITICAL TO ALL HUMANITY THESE COLD BLOODED MATTOID CRIMINAL GENIUSES SHOULD BE BANNED FROM TRADING IN OPTIONS OR FUTURES.
LET THE LEGITIMATE REFINERS BUY IN THE OPEN MARKETS,NOT THE PAPER MARKETS. AND LET NOT THE COMMERCIAL BANKS BUY REFINERIES.
BRAVO 7

Did Goldman Goose Oil?
Christopher Helman and Liz Moyer 04.13.09, 12:00 AM ET
How Goldman Sachs was at the center of the oil trading fiasco that bankrupted pipeline giant Semgroup.

When oil prices spiked last summer to $147 a barrel, the biggest corporate casualty was oil pipeline giant Semgroup Holdings, a $14 billion (sales) private firm in Tulsa, Okla. It had racked up $2.4 billion in trading losses betting that oil prices would go down, including $290 million in accounts personally managed by then chief executive Thomas Kivisto. Its short positions amounted to the equivalent of 20% of the nation's crude oil inventories. With the credit crunch eliminating any hope of meeting a $500 million margin call, Semgroup filed for bankruptcy on July 22.

But now some of the people involved in cleaning up the financial mess are suggesting that Semgroup's collapse was more than just bad judgment and worse timing. There is evidence of a malevolent hand at work: oil price manipulation by traders orchestrating a short squeeze to push up the price of West Texas Intermediate crude to the point that it would generate fatal losses in Semgroup's accounts.

"What transpired at Semgroup was no less than a $500 billion fraud on the people of the world," says John Catsimatidis, the billionaire grocer turned oil refiner who is attempting to reorganize Semgroup in bankruptcy court. The $500 billion is how much the world would have overpaid for crude had a successful scam pushed up oil prices by $50 a barrel for 100 days.

What's the evidence of this? Much is circumstantial. Proving oil-trading manipulation is difficult. But numerous people familiar with the events insist that Citibank, Merrill Lynch and especially Goldman Sachs had knowledge about Semgroup's trading positions from their vetting of an ill-fated $1.5 billion private placement deal last spring. "Nothing's been proven, but if somebody has your book and knows every trade, it would not be difficult to bet against that book and put the company into a tremendous liquidity squeeze," says John Tucker, who is representing Kivisto.

What's known for sure is that Goldman Sachs, through J. Aron & Co., its commodities trading arm, was in prime position to use such data--and profited handsomely from Semgroup's fall. J. Aron was Semgroup's biggest counterparty, trading both physical oil flowing through pipelines and paper oil, in the form of options and futures.

When crude oil peaked in July, Semgroup ran out of cash to meet margin requirements on options contracts it had with Aron, contracts on which it had paper losses of $350 million. Desperate to survive, Semgroup asked Aron to pony up $430 million it owed on physical oil. Aron said no, declared Semgroup in default on its contracts and demanded immediate payment of losses.

Some answers may emerge in late March when former FBI director Louis Freeh releases a report on the trading surrounding Semgroup's demise. He was hired by Semgroup and given subpoena power by the bankruptcy court judge in Delaware. Meanwhile the Securities & Exchange Commission is investigating, and lawyers involved in the bankruptcy say that Manhattan District Attorney Robert Morgenthau's office is looking into the actions of New York firms in the collapse. His office declines to comment.

Goldman says only that any allegations of oil price manipulation are "without foundation." Merrill and Citi declined comment.

Goldman and Aron (where Goldman Chief Executive Lloyd Blankfein got his start) have had a deep connection with Semgroup. In 2004 two former Goldman bankers bought a 30% stake in Semgroup for $75 million through their New York private equity firm, Riverstone. Both men, Pierre Lapeyre and David Leuschen, had helped form Goldman's commodity trading business, and Leuschen had been a director at Aron.

In late 2007 Semgroup entered into an oil-trading agreement with Aron. The companies began trading both oil futures and physical crude. Aron sent much of the oil it bought from Semgroup to a Coffeyville, Kans. refinery in which Goldman owns a 30% stake.

Semgroup's troubles mounted in the first quarter of 2008, when it had to post $2 billion in margin to cover losses. Goldman offered to underwrite a $1.5 billion private placement. Kivisto's attorney Tucker and others believe that it was in the Wall Street research for this offering that Semgroup's trading bets became fatally exposed. In April the banks (Merrill Lynch and Citibank were co-underwriters) required that Semgroup submit its trading positions to a stress test, a process one source describes as a "proctology exam." Goldman ended up abandoning the placement as investors balked at braving the liquidity crunch.

Meanwhile the futures markets had gotten wacky. On June 5, with no news catalysts, oil futures spiked $5 a barrel, the biggest one-day jump since the outbreak of the first Gulf war. The next day, on no news, the price jumped another $10 to $138. Traders say that in the days leading up to the $147 peak on July 12 there was the smell of blood in the water. "We just kept bidding the market higher," one trader says.

According to a trading summary submitted with court documents, Semgroup had entered into some terribly costly trades with Aron. In February 2008 Semgroup sold Aron call options on 500,000 barrels of oil for July delivery with a strike price of $96 per barrel. That meant that at the peak Semgroup's loss on each of those barrels was $51, or $25.5 million on that trade. Goldman says it "can't comment on the trading positions of counterparties."

Shortly before it filed for bankruptcy, Semgroup sold its trading book to Barclays Capital. Barclays' bold bet was that the price of crude would fall, erasing the losses. It is believed that 30 days later Barclays was sitting on a $1 billion gain as oil indeed fell, to $114 a barrel. Barclays wouldn't comment other than to confirm it still owns the book. That prices plunged after Semgroup failed is more evidence of manipulation, says Catsimatidis: "With the portfolio in Barclays' hands they could not squeeze the shorts anymore. The jig was up, and oil collapsed."

Since the bankruptcy, Aron has agreed to pay Semgroup only $90 million to settle up accounts. That's not enough for the dozens of oil producers who still haven't been paid for $430 million in oil that Semgroup delivered to Aron. "We sued J. Aron because Semgroup didn't do it," says Phillip Tholen, chief financial officer of oil company Samson Resources. "I can't fathom why they wouldn't file against J. Aron for those monies."

One possible answer: the Goldman connection. Going after Aron's cash would complicate matters with Riverstone, which still wields sway over the board. The creditors have reason to keep Riverstone and Goldman happy; the duo has teamed up to buy myriad energy assets in recent years, most notably a $22 billion leveraged buyout of pipeline king Kinder Morgan. They are likely to team up again to buy choice Semgroup assets out of bankruptcy.

[jm]

Nice macro analysis.  One Taoist to another, I have a couple of questions.

It seems that the consumer credit contraction, and higher foreclosure rates haven't crested yet.  Is there a big risk of demand implosion?

Is crude, gasoline, or TOO the better play here?