The Swift and Violent Rise of Oil

Why are oil prices lying?

Prices communicate information. The NYMEX February oil contract fell over 5% today in New York trading to $34.40. This suggests oil is falling in value, at least in the short term. And maybe that’s not totally a lie.

After all, the current oil price results from two factors. First, the absence of leverage from the oil futures market leaves prices reflecting immediate supply and demand. With inventories full, the market seems well supplied (so much so that OPEC is cutting production). Second, the reality that oil demand will be flat or slightly fall this year because of the worldwide financial pandemic.

Adequate supply plus stagnant demand equals $35 oil. So why is the December 2010 oil contract trading nearly 80% higher at $61.80? What could possibly happen between now and December 2010 that would cause oil to go up 80%?

Well, for one thing you might be in the early stages of an economic recovery by then. Demand would have recovered. Shares could be higher. Everything could be fine.

But we can think of at least three reasons why the current oil price is headed much higher this year (not in 2010). First, the lower oil price is actually going to lead to lower oil production later this year and next. Oil production is declining to begin with. But the crash in prices has put the kibosh on exploration and production.

Second, as Diggers and Drillers contributor Mike Graham explains in a January article on the subject, the clear trend within the oil market is that historical exporters are exporting less oil. There are several reasons for this, which Mike gets into in his story.

One is that oil exporters are hoarding it now and waiting for higher prices later. Another is that oil exporters are consuming more of their own production, leaving less for export. And still a third reason is that the world’s largest oil exporters face declining production trends thanks to…you guessed it…Peak Oil.

Yes. Peak Oil has not gone away. It’s been sent to the corner while the Credit Depression hogs the stage. But Goldman Sachs oil analyst Jeffrey Currie issued a report yesterday predicting a, “swift and violent rise” in oil prices in the second half of 2009.

Currie told a conference in London that, “”Thirty dollar oil reflects the same imbalances that got us to $147 oil. The problems haven’t gone away. We still believe the day of reckoning is to come.” What problems?

There are still major infrastructure bottlenecks in the global oil network. Currie says that despite the big fall off in demand, “This is not 1982-1983 all over again. The supply picture’s radically different…the demand picture’s radically different. The key difference is that today there are no large-scale next generation projects that are going to save the world. Commodity demand is exponentially higher than it was.”

This brings us to the third reason oil prices should rise later this year: the oil trade is back on. Sure, credit may still be a scarce commodity. But if you judge traders by their actions, you can see the market is setting up for a big oil back draft. As evidence, Bloomberg reports that, “Morgan Stanley hired a super tanker to store crude oil in the Gulf of Mexico, joining Citigroup Inc. and Royal Dutch Shell Plc in trying to profit from higher prices later in the year, two shipbrokers said.”

Our friend Dan Amoss back in America calls this the oil arbitrage trade, where supply is stockpiled offshore, and thus withheld from refiners, allowing existing gasoline inventories to be worked down. Then in six to twelve months time, when crude prices have moved higher, you simply park your ship at the terminal and cash in on the difference between what you paid six months ago (today) and the new market price.

It is normal for the oil futures to be in contango, where spot prices are lower than futures prices. What’s less normal is the amount of oil being stockpiled offshore. “Frontline Ltd., the world’s biggest owner of supertankers, said Jan. 14 about 80 million barrels of crude oil are being stored in tankers, the most in 20 years,” Bloomberg ads.

We also suspect that oil as an inflation hedge will come back into vogue later this year, which might be adding to the appeal of buying today at bargain basement prices. What’s more, you can never discount (although you can never fully quantify) the geopolitical aspect of oil prices. A good general rule of thumb is the more war there is in the Middle East, the more likely oil is to go higher.

Next is a massive topic we are reluctant to introduce today. But we have to. There is no other way around it. It begins with a question: how much air is left in the credit bubble?

Actually, the question comes via Howard Ruff and Steve Hochberg. Let’s start with Hochberg.

He’s the lead analyst at Elliot Wave International. Bob Prechter’s folks have been forecasting for years that the collapse of the credit bubble would lead to a general and massive deflation, including much lower gold prices. In his latest analysis, courtesy of a DR Reader, Hochberg explains:

“The systemic build up of total market credit is so large, currently about $52 trillion, that its implosion will swamp the Fed’s attempts to inflate. And as Conquer the Crash discusses, the remaining dollars that are not extinguished through bankruptcy, restructuring and write-offs, will increase in value. The thirst for cash will be insatiable relative to all other assets.

“Initially, the Fed’s attempt to inflate was akin to using a garden hose to refill Lake Mead after the Hoover Dam collapsed. Over the past five months the chart shows that the Fed has graduated to a fire hose. But creating just over $2 trillion in the face of a contracting pool of $52 trillion in total credit market debt is just not going to get the job done, and the only thing getting hosed right now is us.”

“Eventually credit will contract to the point whereby the income generated from economic production will be able to sustain it and at that point, yes, the U.S. dollar should indeed collapse of the weight of all the Fed’s machinations and gold should soar. But before the market arrives at that point, deflation must run its course. In our opinion, there is still a long way to go.”

But how far? A lot depends on the composition of that $52 trillion in credit. It can’t all just vanish can it? But how much of it is securitised by relatively stable assets? And how much of it could potentially melt away under the intense heat of deflation?

This is not an easy question to answer. But it begins with knowing what you’re dealing with. Specifically, you have to know who owes how much, and who owns how much. Those are two different questions. Let’s deal with the first one. And we promise we’ll make this as painless as possible. If you want to review this data yourself, by the way, you can find it here.

Keep in mind this data deals just with the U.S. And keep in mind it is government data. But the general question is this: how much deflation is left in the credit bubble and who stands the most to lose from it?

The Fed breaks up the total credit market debt outstanding into three categories: Domestic Nonfinancial Sectors (households, farms, nonfinancial corporations, state and local governments, and the Federal government), Financial Sectors (commercial banking, REITs, broker dealers, savings institutions, Government sponsored enterprise, Agency and GSE pools, and issuers of asset backed securities), and finally, the rest of the world.

What we find is that $32.9 trillion in credit market debt outstanding, as of the third quarter in 2008, was owed by the domestic non-financial sector. That’s 63% of the $52 trillion total. Households are on the hook for most of that, with $13.9 trillion owed (or 26% of all credit market debt outstanding). That would mostly be home mortgages we reckon.

Next within the financial sector are non-financial corporate businesses with $7 trillion, non-farm corporate businesses at $3.7 trillion, state and local governments at $2.2 trillion, and the United States Federal government at $5.5 trillion.

So what does it tell us? Well it tells us that if U.S. house prices continue to fall, there is a lot of room left to deflate in the credit bubble, at least several trillion dollars. It’s not hard to see this happening, given the rise in foreclosures, the prospect of even less federal funding for refinancing of mortgages, and the sudden collapse of America’s banking model.

But the lack of credit for refinancing and the looming wave of Alt-A recasts this year and next is, in some sense, already old news. What also keeps us up at night is the $16 trillion in credit owed by the financial sectors. How much of that is at risk to further deflation?

You can get an idea by looking at the L2 table on page 59 of the Flow of Funds report. There is $6 trillion in corporate bonds outstanding. Nearly $5 trillion in Agency and GSE-backed securitised mortgage pools are on the books, and another $3.1 trillion in GSE debt itself. This does not include $1 trillion in “other loans and advances” which may or may not include home equity lines of credit.

We’re sure you get the picture by now. There is still at least $8 trillion housing related assets owed by the financial sector. That might be kind of tough to pay off, given the falling value of the assets which securitise that debt. So who stands the most to lose if households can’t pay their mortgages, corporations default on their bonds, and housing-related assets held by financial corporations continue to fall?

The financial sector combined holds $37 trillion in credit market “assets.” It owns $37 trillion in other people’s promises to pay. Those promises, all $37 trillion of them, are on the books at face value. What’s more, U.S.-chartered commercial banks (Citibank, Bank of America for example) own $8.2 trillion in credit market “assets.” Life insurance companies own another $2.9 trillion. Money market mutual funds own $2.1 trillion in credit market assets, while mutual funds own $2.3 trillion.

Do you see what we’re getting at? The institutions that have the most to lose from a fall in the value of their credit market “assets” also have large obligations to shareholders and pensioners. Those institutions are counting on those assets to meet their own future liabilities (which do not fluctuate in value). And households are relying on those assets to retire, or in some cases, to live month-to-month on a fixed income.

Someone is going to lose, somehow. Or everyone will.

Households win if the value of the credit they owe (their mortgage) is written down or managed lower by some new law. But investors counting on that asset (often the household itself through a pension or life insurance) don’t win if the amount they are owed is arbitrarily reduced.

Either way, Prechter’s group is probably right. There is more deflation ahead. A lot of it. And not just in housing.

The corporate bond market would be another place to look. Corporate defaults haven’t begun to rise noticeably yet. But faced with a much slower economy and much higher borrowing costs, it’s going to be tough for highly indebted firms to roll over their debt, much less take on anything new. Dividends are already being slashed here in Australia.

And where does the deflation of the $52 trillion credit bubble leave us? Well Howard Ruff reckons we get a period of serious deflation, punctuated by a period of hyperinflation. Over at Kitco, he writes that, “First, we will continue to plunge into a major deflation period which will be characterized as a ‘recession,’ and later in the year as a ‘depression.’ Deflation and inflation are always monetary phenomena.”

“Second, deflation will evolve into a run-away-hyper-inflationary depression because of what government will do to try to prevent deflation, which is synonymous with depression and has overtones of the 1930s.”
How will government accomplish that? Stay tuned…

Dan Denning

January 26, 2009

The Daily Reckoning