Friday, July 18, 2008

Is the bubble done?

I have speculated for about 2 years that the oil rally would eventually end at a fibonacci number, $89 or $144 as it has appeared for the past couple of years. For one, I had an idea that the rally had fallen short in 2006 and that the low 80's figure was going to be the high. That was until the financial crisis left huge amounts of money unattached worldwide and the market ran past $89 to about $100. That too was a potential top, but once oil ran past $110, it was clear it was going to the $144 area, where for the time being it has stopped.

In such a market, the high of $147 or whatever it was interday was about as close to $144 as one could expect. The next move, if we do in fact go higher will be $233.

I have become attached to these fib numbers due to my knowledge of the movement of oil over time. For a long time it was $3 a barrel, even when $3 was a lot of money. In the 1970's, it moved first to $5, then to $8, then to $13 where it stayed for about 5 years. When the Iranian revolution broke out, oil then moved to $21 and then in a 2 price system to $28 and $34, with the Saudi's maintaining the lower price. When oil broke, it always settled in the $13 range before rallying back to $21 for about 2 decades, with some runs to $34 during times like the first Gulf War and early in the 2000's. Thus we saw moves to $5, $8, $13, $21 and $34, making 5 total moves. This time we saw moves to $21, $34, $55, $89 and $144 for 5 moves. Does this mean we are done? I think there is a real good chance we are, as there is coming something that few will understand, the fact that inflation causes deflation.

Here is what I believe and I will maybe change this, but for now I am going to stick to what I believe is happening. For one, the bust in the CDO market created a situation where $400 billion wasn't recycled to from one account to another and instead was funded by the banks writing what amounted to hot checks, leaving the money to circulate. Of course, the Fed had no alternative but to cover these checks, as word got out in the Fed funds market that maybe lending to XYZ bank might be a bad idea. Everyone knew about banks like Citi, which clearly had worldwide influence as was probably too big to fail, but much of this is still out there. There was the run on Northern Rock and the implosion of hedge funds, including some run by Bear Stearns, but this was lost money. The bank of England covered the funds drawn from NR with $100 billion. All this money was left to follow the only game left, commodities.

What has happened in the last year is quite interesting. For one thing, much of the $400 billion has been absorbed by deflation. I will elaborate here to the point that hopefully you can follow what I am talking about instead of reading the headline inflation numbers, primarily because inflation and deflation are lagging and not forward. First, much of this extra money went to buy oil because the demand for oil was burgeoning and it was something that would clearly store and play down the road. Second, much of this money ended up or was already in SWF (sovereign wealth funds) and much of this money went to recapitalize many of the weak financials. In this case, money kind of disappears. They say we have written off $400 billion worldwide, so that pretty much accounts for the $400 billion that didn't get recycled.

We are now seeing a pretty violent reaction on the oil price run up. The bulls think this is good news, but oil is a huge market. If this is indeed a speculator driven price hike, then it is clear that there are some huge speculators stuck in positions. There is only one way that speculators could have driven this market higher for this long and that is to roll their own contracts. In order to get out of the current months contracts, they would have had to have taken delivery or rolled sufficient enough long positions forward to entice the hedgers to move their short positions forward instead of making delivery at a loss, thus both moving their liabilities forward. Now that the shorts might have the upper hand here, it is quite possible they are going to force delivery of product the longs aren't prepared to take. I don't know where this oil may be hidden, but I woudn't be surprised to see it suddenly appear in inventory either here in the US or overseas. The point is that if speculators are indeed responsible for this bubble, then there is oil somewhere unaccounted for and if it is hidden by the longs, then it is financed and it and the borrowed money must be liquidated. This is a financial disaster awaiting the hedge funds and you can bet that OPEC itself has forward shorts in this market.

Amaranth supposedly lost $6 billion on their failed gas corner. To understand the size of their position, one must realize that gas declined about $8 from peak to bottom and that Amaranth probably paid around $10 for most of it on average. Realizing they got out at between $6 and $8 and that 1 trillion feet of gas sells for $1 billion a dollar then one might realize how huge their position was. Figuring they lost $3 per MCF, they had 2 trillion of the roughly 3 trillion in storage. I was wondering for some time how gas was staying as high as it was in light of how large the supplies in storage were. There just isn't a lot of places you can hide natural gas. This may not be true for oil, as I suspect there are storage facilities around the world that could hold a billion barrels or more and it not be inventoried. Imagine if there were 1 billion barrels of oil out there that suddenly needed to be liquidated? Even if the figure were 200 million barrels, we would be looking at the US supply of crude sitting out there somewhere. The large exporting countries have to have massive storage facilities for no other reason than to be able to manage production and demand over time. Countries like Indonesia where there used to be sizable exports could have large storage facilities that they could rent to allow the hiding of oil. The Japanese trader who ran the copper corner in the 1990's supposedly had copper in warehouses in LA and other areas that was bought on the LME.

In any case, the market could actually have been true rather than rigged as I suppose and there isn't a hidden surplus. I find that highly doubtful, having watched the oil market for decades. But, it has to be either a rolled contract game or an actual taken delivery and hidden game where continued pressure is put on the market by very sizable excess contracts being taken to delivery points over and over again. If a corner has enough long contracts over what could be provided to the market, they can always exercise a few deliveries and the shorts have to buy their way out of the rest of them. This gives the appearance of making a huge profit, which is really nothing more than postponement of a liquidation of long positions. All buyers have to become sellers in speculation and visa versa.

Where I part company with the bulls is I believe this to be highly deflationary. For one, the bulls think the consumer game will go back to normal while I believe that those that could still spend kept spending while those that couldn't used the rest of their credit just to survive this oil price run up. Thus, they won't be spending any time soon, if forever. Thus we have had a forced inflation in the short run out of this speculation which will cease and now the world will run without the credit inputs of high oil prices. You can consume for as long as you have room on your credit card, which could be as long as they keep raising the limit or the payments exceed income.

I am watching the money supply figures and they have weakened over the past 90 days. Not a decline in M-2, but a very weak growth, which in light of $160 billion in stimulous checks and the extra money that has been injected into some account by the credit used to buy gasoline is pretty sorry. Where would we stand without the stimulous checks? Bernanke was making light of this situation and the bulls seemed to take it as a signal of the bottom. I take it as the first true recognition that we are in recession and that we went into recession with Santa Claus gifts from Uncle Sam, huge booms in exports and 2% interest rates.

What I see now is maybe another huge short opportunity for the financials. There are again statements to the effect that the bottom is in on housing. It is going to be a damn flat bottom if that is the case. Suddenly Europe is slowing down and China is clearly going to be next, as it is paying massive premiums on everything it imports and its exports are losing traction with its customers economies on the slide. I sense the financials get a good month of reprive and then are back in the dumps again, just as we saw back in March. In fact, we really got to June before the financials started getting the truth out once more. First time it was C getting new capital, then it was Bear being bailed out along with MBIA and Ambac and now it is the implicit being made explicit in regard to FNMA and FHLMC paper. This won't in any way fix the problem.

I would watch the money supply figures going into the fall. I have to believe that we are going to see poor retail results as the stimulous money dries up and the price of oil dries up credit card spending. If inflation indeed turns to deflation, the entire world game is up.


Rick said...

Thanks for linking to this blog from Prubear. I tried to get on that board around the time Tice and Assoxiates decided to cash out, and have never gotten a response.

I greatly enjoy the thrust and parry between the inflationist and deflationsit scenarios, and hope that you can appreciate how very many more of us are looking in from the outside on a daily basis as the global financial system works its way toward its true net worth.

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