Tuesday, September 26, 2006

Slippery When On A Slide

sopskysalat said: One issue in everyone's mind, "is the oil dropping too fast and too much?"

I did mention before that we needed the oil price not to 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. That is the danger. However, when we look at the down trend in oil price, it looks too fast and smooth. The massive losses suffered by the hedge fund Amaranth could cause some of the hedge funds to also unwind their positions. Just how big is hedge funds? Amaranth lost a US$6 billion bet in natural gas and there are 7,000 hedge funds, so its anybody's guess as to how much big bets are placed on oil and gas futures. We have to remember that oil and gas futures have been on a sharp uptrend for the last 2 years, a trend is your friend, and with the Israel/Lebanon thing this year, one can asume most funds better on higher prices. If you mark the correction in oil and gas prices, it only started a few weeks back, and hence we haven't seen the last of the blood-letting in some hegde funds. We can expect a few more hedge funds to report bloodied returns.

Locally, the sharply lower oil prices now questions the viability of biodiesel. According to some estimates, the processing and logistics cost combined means the oil would have to stay above US$55 for biodiesel to remain competitive. That is on an open market, but we have to remember that given the choice, certain countries, in particular, Europe and US would choose to favour biofuels. That will come in the way of lower taxes, duties or even incentives. Thus it could push the cost-competitive price of oil down to US$50 and still be viable for biodiesel. Like I said before, the company jumping in early into biodiesel may be a bit riskier. The smarter old dogs like PPB, IOI, KL Kepong have all stayed away, because the rationale is there will not be "supernormal profits" with producing biodiesel. The delivery logistics and consumer acceptance are not certain. To me, biodiesel is just another arm of downstream for palm oil, nothing spectacular. Yes, it may add 10%-15% to new consumption a year, and that will be reflected in CPO prices, which benefits all producers, not just biodiesel producers.

Why is oil prices falling? Beside the hedge fund effect, the main thing boosting prices for the past 6 months have been fear. Especially fear of Iran imposing sanctions or disrupting supplies should the Lebanon and Israel conflict escalate. Some have even factored in the possibility that the hurricane damage to the US gulf coast refineries may exacerbate the problem. Both turn out to be wet-fuses. Fundamentally, US Energy Department figures released showed that crude oil inventories were 5% higher than a year ago, and diesel and heating oil inventories were 11% higher.

Psychologically, the oil price rally have faded somewhat. The bull rally in oil lasted almost 2-3 years, and within that time, traders and hedge funds played among themselves, like a pack of wolves with a carcass, they can whip themselves into a frenzy, now that the dust has settled, they realise that its still just one carcass. Due to the prolong period of the bull phase, it forced a lot of government and private sector initiatives to come up with solutions to high oil prices. Biofuels and wind farms ventures were rushed out with many private equity funds launched to promote new renewable energy ventures. Like it or not, a trend has started, it may take some time before any of these new energy sources replaces fuel, but just 5% in 2 years time will take a lot of pressure off oil prices. Its a cumulative thing.

Of course, all that also depends on how OPEC reacts, so far when oil reached US$61, Saudi Arabia said that the current oil price was reasonable. Hence we may only see OPEC coming out with real cuts in supply should it fall below US$55 or thereabouts.

To answer the question: yes, oil is dropping too fast; but it has probably overshot on the downside, I see oil stabilising around US$62-64 for the rest of the year. Oil at the current price brings more benefits than the negatives, i.e. potentially higher rates by Fed.


swifz said...

Oil ran up because of speculative play. Down because of speculation gone wrong. The rich cause misery to the poor. Even if the rich lose 60% of their money, they are not really affected. Only the poor.

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.

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.

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.Lastly,I would like to say that I enjoy reading your post and do keep up the good work.Cheers!!!!



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