Wednesday, September 27, 2006

OZ, OZ, OZ ... Oil, Oil, Oil

Received a well written reply on my post on oil prices, my comments in blue.

investequities said...
Hi Dali, nice write-up on the energy sector. However there are a few points that are quite confusing. Hopefully you can clarify further. Thanks. You have mentioned that oil price should not drop too much too fast as that could easily ignite good-feelings among consumers (especially in the US where their housing starts and activity depends largely on sentiment and liquidity). Too fast a drop may cause housing figures in the US to spike up and may leave the Fed with no choice but to raise rates again come the next round. If I remember correctly, the FED's have to raise interest rate 17 times this year to control inflation which is mainly due to the spike in oil prices. As such,it would be safe to say that,with the current downtrend in the oil price inflation should moderate and this renders further increase in rates by Fed's unjustifiable. The Fed's are concern about the housing market too but it is not the only indicator that they look for to determine the interest rate directions. My take is that,if the housing market growth is good and yet inflation is within limits, the Fed's will not increase rates further as it will impede economic growth.

(Your views are correct. However, we may be assuming that the Fed incorporated too much weightage on oil in their rate hike decisions. If you postulate correctly, 17 times straight - the first 10 times had nothing to do with oil as oil only starting behaving bullishly over the last 2 years. Inherently, the US economy was supported by the strong domestic consumerism especially in housing. Many peopl question why the US can allow such heavy deficits and yet many governments keep buying their Treasuries. It boils down to 3 main pillars - military supremacy (leader of the free world, it has more implied economic leadership); US consumption supported because investors are willing to buy US assets, be it Treasuries, stocks, real estate, etc... the whole system is underpinned by US superiority in technology and business productivity (especially in finance, medical stuff and retail); thirdly, the whiole world thinks that normal US citizen has very low savings rate compared to the rest of the developed / developing world, that's because most did not incorporate housing as a form of savings, in fact ask any American, the bulk of their assets are tied in housing. Hence I view housing as a very important factor in the eyes of the Fed. Strong housing prices also acts as a refinancing tool for further consumerism, which is what the Fed fears the most. That will eat away at "savings" and raise their average debt financing levels. Hence, when you take away the oil factor, the wait and see attitude by many may turn into an avalanche in housing starts. Bears watching closely.)

Amaranth hedge funds,as its name implies, its a hedge fund. My question is,why are they not hedge in their investment portfolio? Too much are invested in the energy sector which resulted in significant losses in its funds.
(Yes, hedge funds are supposed to be hedged in some way or another, but it is not imperative unless written into their charter or code of conduct / discipline when asking for investors to invest. Most in fact are pure long or short, even when they have long and short, they are not properly hedged in the same sector or currency. Generally, those trading with quant models may be closer to being called a hedge fund. Hence to most, hedge funds are simply labeled a such to reward performance with a 20% cut on gains and promote secrecy.)

You have mentioned that you expect oil price to be in the range of USD62 - USD64 for the rest of the year. However, I would like to point out that most oil analyst report or articles that I have read predicts a lower range of about USD50 - USD60. Some of the reasons cited are : 1) More funds are expected to suffer losses and this will cause many funds to reduce or pull out completely their investment in the energy sector thus causing the price to plummet further. 2) IEA predicts a lower demand for energy consuption next year. 3) Probe on BP for price manipulation by the US authorities. 4) A large amount of speculative premium are not there any more. 5) New energy discoveries. 6) Increase in usage of alternative energy source such as biodiesel,ethanol,solar and etc. 7) Calmer geopolitical enviroment.Iran is willing to negotiate now.Less riots in Nigeria. 8) Opec is not cutting production now.Cutting production by the oil cartel might backfire according to some analyst.Part of the premium in the oil price is due to the market perception that there are no or limited extra capacity currently. By cutting production this fear premium is removed. Predicting oil price is highly debatable and your guess is as good as mine. However its a relieve that price had fallen and we look forward that the government will not increase our petrol price next year.
( If you remember just 3-4 months back, we read tons of article on why "oil prices will stay above US$80 and have a likelihood to challange for US$100 within 12 months" - who hasn't come across dozens of these articles. Unfortunately, when we are bearish, we whip ourselves into a frenzy and everything is half-empty. And we do the opposite when the sun is shining and the bulls are dancing gaily in the fields. We have to balance with realism, terrorism is not over, OPEC can easily reduce output, there are still pockets of violence in oil producing countries especially in Africa ... so blue skies are hurricanes which has been given some botox... it ain't pretty when the medicine runs out...)

1 comment:

khlim said...

Hi Dali, I just want to clarify that Amaranth's biggest losing stake was spread bets on natural gas futures for mar07 and apr07 and not pure long or short as a lot of readers would assumed. Again, over leveraged on trades made with similar strategy is the culprit here, little to do with the strategy itself whether its convergence, mean reversion etc. Another perfect case study under "Fooled By Randomness".