US$139. Asset prices don’t rise indefinitely — but oil is surely testing that hypothesis. US$139, thats the second short squeeze in a couple of weeks. That, to me, is a sure sign of over-speculation on the long side. Thus, it makes brilliant mid term trading to take a 6 month dated put option on oil at US$139. The interplay suggests a peaking of buying frenzy. Just imagine the number of long positions taken up over the last few weeks. Now imagine who will be taking over these positions when these long players take their profits. A brief pullback to around US$122 a barrel early in the week fooled a few investors into thinking perhaps oil’s peak had passed.
But oil exploded on Thursday and Friday, gaining a ridiculous 13% on the New York Mercantile Exchange in two days to trade at US$137.08. Every bubble in history had a good story.According to the IEA: Economic slowdown and high oil prices have continued to depress demand - global consumption forecast cut again by about 400,000 b/d from April report, bringing total cut to 1.2m since December to 86.8 mb/d. This is still up from the average level of 86 mb/d recorded in 2007. April global oil supply fell to 86.8 mb/d from 87.3 mb/d in March, led by lower supplies from OPEC, North Sea and non-OPEC Africa. 2008 non-OPEC supply projected to reach 50.6 mb/d. Non-OPEC output growth in 2008 is now seen averaging 680 kb/d, compared with 550 kb/d in 2007.
Oil demand fell in the first quarter, which supports the idea that prices should drop. On the other hand, the trade is being dominated by investment flows.
According to OPEC: Recent high volatility in oil prices due to short-lived, non-fundamental factors. Although fundamental factors such as cold weather and refinery difficulties have had some impact, prices have mainly been driven by non-fundamentals, in particular financial market turmoil, US dollar depreciation, and worsening US economic outlook. Moreover, the influx of financial investments into commodities has helped to repeatedly push crude oil prices higher, amid occasional periods of profit-taking.
The biggest culprits are the long-only commodity index funds and ETFs. They simply buy baskets of commodities at whatever the price is, speculating on the rise in the price of the overall commodity market. It is a one-way trade. But there are limits to how much exposure speculators can buy, because the CFTC will allow a speculator to only buy so much of any given market, to keep large players from getting a corner on the market and driving up prices, a la the Hunt brothers and silver in 1980. These limits are known as "position limits."
There are no position limits for commercials who are hedging. They are in theory hedging their physical exposure to a given commodity they are selling or buying. The CFTC created a loophole when they allowed investment banks to be classified as commercial investors. So, when a long-only commodity index fund wants to buy a million barrels of oil, they can go to the investment bank, who will sell them a "swap" on the price of oil, and then immediately hedge their exposure in the futures market.
To be sure, the long-only index fund can now create positions far in excess of the position limits that are enforced upon normal speculators. These funds can grow to be huge - multi-tens of billions of dollars. Even though they are speculators, they are not included in the data as speculators. Because they get their exposure from an investment bank, they are ultimately listed as a commercial. In total, they represent an enormous part of the commodities markets. But they are providing liquidity, so what's the problem? They are not actually hoarding the commodities. The price is still set at the spot price. From the rumblings in Washington and I am sure among many big central bankers, I would bet on some "new rules" to be introduced very very soon to limit these so-called commercials from having "excessive position limits" - these so called long positions matched by swaps can easily be curtailed by new "rulings". Because seriously, even I have to agree with AAB that he is probably right that speculators have driven up oil price to pretty excessive levels. Forcing many countries to abandon subsidy on oil is a clear sign that central bankers are almost at the end of their patience with the "free markets".
You can see from the media frenzy that all seem to be focused on supply constraints only. None appears to be giving much weight to the demand destruction given the explosion in oil price. Economies are being rein in, the US looks like edging towards higher unemployment and their oil consumption habits have changed dramatically owing to the last few hikes in price of fuel, oil subsidies in emerging economies have be slashed which should curtail demand substantially - all these demand destruction seems to mean nothing to the speculators.
Hence my SHORT call is based on: quick successions of two major short squeeze; rampant open long interest and subsequent rollovers plus momentum players in this bubble run; players ignoring the fact that many countries have reduced their subsidy on oil which pulls back substantial demand for oil and changes consumption patterns dramatically; higher inflationary rates globally as economies try to rein in their economies by raising interest rates; overall demand destruction owing to price explosion; and finally look for legislative rulings and "new regulations" which would severely curtail some of these "commercials" in curtailing their inexhaustible "position limits". Watch your steps on falling bodies when the profit takers stampede out of their long positions.
The good news from all this is that its looking very much like a bubble now for the price of oil, and a correction will be pretty good and severe. If the price of oil falls back to a more manageable US$105, the impact will be very good for global equities. So just get ready.
p/s photos: Tangmo Pattarathida