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Hussman "The Likelihood of $60 Oil"

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The oil bulls will take offense at Hussman’s contention that high oil prices will break, and probably break pretty seriously. Note we think high oil prices would be desirable if phased in over several years via a carbon tax to discourage use, but as everyone know from direct experience, a sharp runup is destabilizing, and if prices did fall back sharply, that would discourage the push for alternative energy sources (as well as plain old conservation).

Hussman’s market overview is also worthwhile. He thinks a “tradable bear market” as in a bear market rally, is not in the cards until the idea that the economy is in a recession can be argued to be baked into stock prices. He also has an interesting discussion of inflation (he argues that Friedman is only half correct in seeing it as “always and everywhere a monetary phenomenon”).

Here is his section on oil prices:

Any discussion of inflation should begin by noting that the bulk of recent inflation has been restricted to food and energy. Outside of those groups, the year-over-year change in the CRB commodity price index is already negative.

The main factors influencing the outlook for broad inflation are that the U.S. economy is most likely in a recession, consumers are unusually strapped because of both mortgage debt and tight budget constraints, international economies are beginning to weaken, and credit concerns remain endemic. We should not exclude China from the risk of economic weakness, particularly given that the Shanghai index is already down by well over half since last year’s highs. Stock markets typically don’t drop in half without economic repercussions. Meanwhile, U.S. government spending, while still undisciplined, is relatively stable and not expanding rapidly.

Given this context, we have a combination of weakening demand for most goods and services as a result of consumer restraint, accompanied by a generally firm demand for currency and Treasury securities (particularly short-dated bills) as safe havens from credit risk. That combination is disinflationary, and it is likely that we’ll observe further downward pressure on inflation outside of the food and energy groups over the coming quarters.

On the subject of oil prices, it’s clear that elevated gas prices have been a factor in the terrible consumer confidence numbers recently. Still, my view remains that broadening economic weakness and an unwinding of speculative pressures will combine to produce steep declines in commodities prices, most probably by the end of the summer season.

It’s sometimes suggested that hedge funds, commodity pools and speculators don’t actually drive up the price of oil, because they don’t actually take delivery of the physical product – instead rolling their futures contracts over indefinitely or until they close out their positions. From an equilibrium standpoint, however, this argument ignores the zero-sum nature of the futures market. Producers have an interest in selling their output forward to lock in a predictable price. Similarly, bona-fide hedgers (such as transportation and industrial companies) have an interest in buying their oil forward so they can plan without concern about future fluctuations.

To the extent that the speculators begin to take one-sided trend-following positions, their purchase of a futures contract crowds out the purchase that a hedger would otherwise be able to make from a producer.

It doesn’t matter that the speculator has no intent to take delivery. What matters is that if the speculators are unbalanced on one side, the producers will have satisfied their need to pledge future delivery. Moreover, because they can lock in a high price, they will be inclined to sell more for future delivery than they otherwise would. Meanwhile bona-fide hedgers will be inclined to buy less on the forward market than they otherwise would. You can see this combination of effects in the commitments data, as a tendency for commercials as a group to become net short following significant price increases in oil.

When it comes time for the speculators to roll the contracts forward, they have to sell their existing contracts either to someone who is willing to take delivery, or to a producer who sold the oil forward and can now clear that liability without actually producing the stuff. Given relatively high spot demand and tight supply, these rolling transactions have worked fine to this point, without driving prices lower.

In my view, the problem will emerge a few months from now, as a) economic demand softens further, b) planned production hikes actually emerge, and c) weakening price momentum encourages speculators to close long positions instead of rolling them forward. At that point, I expect that net speculative positions will plunge by 10-15% of open interest and we’ll see a sudden glut on the market for spot delivery. It should not be surprising if this speculative unwinding takes the price of crude below $60 a barrel by early next year.

None of this means that prices can’t move even higher over the short term. As I’ve noted repeatedly, once prices go into a vertical spike, very small changes in the date of the final peak imply significant uncertainty about the ultimate high. Still, I continue to believe that the often extreme cyclicality of commodities has not suddenly become a thing of the past.

[Geek's Rule o' Thumb: When you have to fit a sixth-order polynomial to capture price history because exponential growth is too conservative, you're probably close to a peak.]

In over 25 years in the financial markets, starting at the Chicago Board of Trade, I’ve heard a lot of talk about holding onto one asset class or another as a “long-term diversification,” and a lot of reasons why this factor or that has permanently changed the investment landscape (I have a Pets.com sock puppet in the office as a reminder of one of those times). Believe me – nothing shakes people out of their “long-term investments” faster than steeply declining prices. In commodity markets in particular, price trends feed on themselves in both directions, so we see pronounced cyclicality, and much more persistent trends – once set in motion – than we typically do in the equity and bond markets. It may be difficult to identify a peak in oil when it occurs, but most likely, the fallout from that peak will be spectacular.

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30 comments

  1. Anonymous

    Yves, quite frankly I am utterly confused at the various arguments around the speculators/take delivery aspect of this whole thing. Every time someone writes on the subject, they stray a little bit away from what someone else was discussing, not to mention terminology differences. Perhaps I’ll get around to compiling everything together but it would be nice if one of us would finally lay out the structure of (i) futures markets (ii) how they usually work (iii) how they work in a bubble environment of incremental increased buying (iv) how they work in a world where futures market eclipses cash market.

  2. Michael McKinlay

    The likely hood of $60 oil ? Next to nil …

    The demand destruction that has so far taken place is mostly of the first order, that is voluntary and involuntary substitution and conservation. Real, permanent demand destruction has not taken place on a massive scale.

    Once the price of oil falls demand will once again pick up quickly.

    If indeed oil falls to $60 it would be due to a worldwide depression and a very large long term demand destruction.

  3. RK

    What if producers with a very low marginal cost per
    barrel simply decided to stop selling production forward and take the spot price? What if they decided not to limit their upside, but simply protect
    against a fall with a put (or equivalent). If that resulted in a lack of sellers in the oil futures forward market, what would be the result?

  4. Scott

    Hussman’s explanation is the best I have seen of how futures can affect spot prices; I feel that he is 100% correct. The crowd-out factor is the key point since producers have a finite amount they can produce for any contract period. Thanks for the pointer!

  5. matt

    “If indeed oil falls to $60 it would be due to a worldwide depression and a very large long term demand destruction.”

    A few years ago I read that if oil ever got above $100 a barrel (which it wouldn’t!!!) then we’d immediately enter a depression.

    So it seems that the sweet spot, or non-depression range, for oil is somewhere between $60 and $100.

  6. DownSouth

    michael mckinlay,

    I’m with you. The only thing that would bring oil down to $60 would be a prolonged, worldwide depression.

    $100 oil is certainly within reach. This I believe Boone Pickens acknowleged today. But as Pickens said in an earlier interview, if prices take a nosedive, at some point OPEC will intervene and cut production. He didn’t know where that point would be, but he felt we’re talking something like $90 or $100.

    The other price support for oil is the cost of production. Canadian oil sands need something like $105 per barrel to bring on new production, assuming a reasonable return on investment. This can be gleaned from Suncor’s 1Q08 financial report:

    http://www.suncor.com/data/1/rec_docs/1694_Suncor%20Q108.PDF

    Capital cost here:
    “Plans to further increase production capacity from 350,000 bpd to 550,000 bpd in 2012 were confirmed in January when the company’s Board of Directors approved the $20.6 billion Voyageur expansion. Approximately
    $3.3 billion has already been invested in the project, which
    includes constructing a third upgrader and increasing
    bitumen supply through further expansion of in-situ operations.”

    and current operating cost (on page 21) of $56 per barrel.

    New conventional oil is a tad cheaper, but not much:

    “ConocoPhillips said Thursday that rising exploration and production expenses are increasing the cost of adding crude output to $100 per barrel.

    “A weak dollar, rising prices for commodities needed to build oil infrastructure and fewer resources to search for new deposits are to blame, John Lowe, executive vice president for exploration and production at Houston-based ConocoPhillips said.”

    ” ‘You add all those factors up, and you get an incremental cost of supply somewhere in that $90 to $100. And I think it’s moving higher, not lower,’ Lowe said.”

    (Houston Chronicle, May 30, 2008)

  7. Nick

    “What if producers with a very low marginal cost per
    barrel simply decided to stop selling production forward and take the spot price?”

    My understanding is – and someone please correct me if I’m wrong – that the oil futures markets are “unique” in that the producers DO NOT hedge their production forward. For instance, I’m fairly certain that Exxon does not do so. Can anyone confirm for the industry at large?

    My theory is that they realize that if they do sell forward, the liquidity won’t be there, and an extreme backwardation will result. They’d rather pump as much as they can now at a bid-up spot rather than take a chance destroying the overall game in the futures markets.

    I agree that oil is going to go down to at least $60 – maybe even $30. There’s $80-100 oil in the ground all over the place and the producers don’t seem willing at all to go for it, so I suspect they lean in the same direction.

  8. Anonymous

    Based on similar reasoning about the role of momentum in commodity markets, a few weeks ago Hussman substituted foreign currency for gold in his total return fund. I wonder if food price escalation would respond the same way, or if biofuel gimmicks make it an exception.

  9. Anonymous

    An original thinker. People should pay more attention to Hussman. He’s right on disinflation.

  10. Anonymous

    Hussman is a good analyst but he is constantly changing his portfolio as if one could trade week after week avoiding downs and hitting ups. This time is different? Cyclicality in commodities is no news but nowadays the demand is not derived from developed countries and there is certainly a supply concern( oil production from rigs of cantarell, ghawar, north sea and so on are declining so the new price of equilibrium is much higher. I dont know how much of the price is speculative, but 60 dollars makes no sense. Besides this time opec countries have 500 trillions of treasuries so they can reduce their output if a bad scenario shows up.

  11. mxq

    Imo, the Hussman argument basically implies that producers and refiners get leveled by their hedging activities, while spec longs reap the profits directly (zero sum).

    Refiners have little choice and why wouldn’t producers oblige specs?

    The marginal cost of production is, likely half (maybe less?) of current BWAVE prices.

    So producers could really care less if their hedging book looks like roadkill…as production margins more than make up for this (for example: see page 6 & 7 for Apache’s hedgebook)

    So why hedge at all?

    Because producers arbitrarily use BWAVE as their spot price benmark. Higher futures = higher spot.

  12. Doc Holiday

    I love Hussman and he does a great job of calling future trends and questioning fundamental weakness and thus seeing flaws in the games!

    Re: once prices go into a vertical spike, very small changes in the date of the final peak imply significant uncertainty about the ultimate high. Still, I continue to believe that the often extreme cyclicality of commodities has not suddenly become a thing of the past.

    [Geek's Rule o' Thumb: When you have to fit a sixth-order polynomial to capture price history because exponential growth is too conservative, you're probably close to a peak.]

    Love that!

  13. Doc Holiday

    Ooopps,

    One last thought or a question to Yves or anyone in the house:

    Re: Given this context, we have a combination of weakening demand for most goods and services as a result of consumer restraint, accompanied by a generally firm demand for currency and Treasury securities (particularly short-dated bills) as safe havens from credit risk. That combination is disinflationary, and it is likely that we’ll observe further downward pressure on inflation outside of the food and energy groups over the coming quarters.

    >> Hence, if we heading into a disinflationary period, how will that impact the subprime housing trend? Is it possible, disinflation will result in lower mortgage rates and thus contribute to laying a foundation for a bottom in housing? This is like the perfect storm at the bottom of a cycle, where housing prices will be reduced back to realistic levels, mortgage rates will moderate, inflation will slow down, the dollar may gain value, gold will fall, service jobs will remain untouched, foreclosures will slow, Bush will be out of office, taxes will go up….errr, wait a second, what about increased infrastructure costs and increased property taxes and increased “social taxes? with Obama and the increasing health care costs?

    Some components of the economy will recover, but with the trillions in damage and more pain to come, I don’t see any fast fixes, but more like a bottom for housing, less GDP growth and a greater divide between rich and poor.

  14. Anonymous

    Monday view: Commodity crash flashes warning for world growth
    http://www.telegraph.co.uk/money…08/ ccview08.xml

    >> The culprits behind the mid-2006 commodity slide are well-known. Seventeen rate rises by the Federal Reserve squeezed credit. US property went over a cliff. By November, house starts had fallen 35pc from January. The average home gobbles up 439lb of copper.

    The annual rate of home equity withdrawal dropped to $350bn in late 2006 from $780bn a year earlier. Car sales skidded, falling below 17m for the first year since 1998. US economic growth cooled from 5.6pc in the Spring to 2pc by the third quarter

  15. Fullcarry

    So let me get this straight the dollar peggers will turn out to be the best traders as the purchasing power of the dollar sky rockets!

  16. Michael McKinlay

    matt said…

    “if oil ever got above $100 a barrel (which it wouldn’t!!!) then we’d immediately enter a depression.”

    Well Matt, that looks to be the way the world is heading, towards a depression. Immediately in business cycle terms would be months, and remember that oil has only been over $100 for about 6 months.

    What I think will happen is that oil will fall then business will pick up and oil will skyrocket once again. This cycle will repeat itself over and over with lower peaks in GDP and higher peaks in oil. Once we have actually peaked the cycles will be faster and harder but headed down, down, down.

  17. Doc Holiday

    They used to say that small changes in the discount rate and dividend growth can cause large variations in valuations.

    V = D/(R – G)

    We have been here before and thus investors as a collective will demand higher future returns from the other side of the coin. Oil will pop in a downdraft and the dollar will rocket! This explosion will evaporate speculation and leave many speculators with less cashflow, which is the idea, i.e, take the excess inefficiencies out of the market!

  18. Anonymous

    Funny how some folks can’t wrap they minds around sixty-dollah oil.

    Just seven years ago, crude bottomed out under twenty dollahs a barrel. Agreed, that was an overshoot to the downside. But irrational markets are constantly overshooting on the upside and downside.

    Sure, there’s been some inflation since 2001. But a downside overshoot which is three times higher than the previous one ($60 versus $20) is hardly incredible.

    In the late-1990 runup to Iraq War I, Claudia Rosett huffed in the Wall Street Journal that forty-dollah oil would be with us for years. Crude promptly got chopped in half; and as noted above, was still half that price eleven years later. With the rubber measuring stick of fiat currency, any price is possible, my brothers.

  19. Doc Holiday

    Hey,

    I posted this yesterday and sorry for the re-post, but this fits in with a Hussman Perfect Storm, or is it mine, i.e, oil down, dollar up, and then guess what, whoever is holding cheap dollahs wins the casino:

    Hot Money Headache
    http://online.wsj.com/article/ SB…=googlenews_wsj

    The starting point is the fact that since last October interest rate differentials between dollars and yuan have reversed. The U.S. Federal Reserve aggressively lowered rates just as the Chinese central bank, the People’s Bank of China, was pushing up domestic rates to fight inflation. Currently, rates on the Chinese central bank’s one-year bills are about 170 basis points higher than comparable U.S. Treasuries.

    This has created an arbitrage opportunity that local firms are exploiting on a massive scale, borrowing cheap dollars to substitute for more expensive borrowings in yuan and for local investments. A second factor driving this arbitrage is the wide-spread expectation that the government will either speed up the rise in the yuan’s crawling peg or implement a one-off revaluation.

  20. Mr. Sparkle

    I’ve been watching NYMEX futures open interest since last September when I began to get interested in what I then thought was bizarre behavior in the open interest. Anyhow, here’s a chart showing open interest by day for 6 months out so you can see how contracts tend to be rolled month-to-month. However, this past month I noticed that the peak OI was about 325K contracts as opposed to the 380K it has been for the last few months. When it happened I started to wonder why, and then Yves posted the old story about the silver market and the rules change and it started to make sense. Now this piece from Hussman…

    Here’s the link to the chart:
    http://img157.imageshack.us/img157/2553/crudeoichart070808bs0.png

  21. Mr.Sparkle

    George – I’ve actually posted/sent that chart a few places as the “blame the speculators” chorus got louder. (TBP,CR,Mish’s)

    Nobody seemed to know what was going on though. Open interest data isn’t something that’s easily accessed for most of us. I’ve always thought that was odd since it informs so much about the approximate cost average of contracts in the OI.

  22. STS

    What George said, Mr. Sparkle. Thanks for sharing the chart. It would be fun to see the front month price super-imposed on each of those OI peaks.

  23. Anonymous

    I have often wondered if a contrived oil shortage is a mechanism to monetize a play on the dollar in some way, which would help bail out and socialize the mistakes made in the wall street subprime era. Collusion, corruption, conspiracy, anti-trust — who cares if the debts can be spun into profits as fast as possible!

    Doc

  24. mxq

    RE: Mr. Sparkle

    Thanks for posting that chart. However, that is not the full picture. There is a ton of trading for which we have no data.

    According to the CFTC, 85% of index investing is done outside of regulated (i.e. reported) futures exchanges.

    In addition, the BIS puts the notional value of all otc commodity instruments at $9 trillion (oil is probably the majority of that amount) while total futures (regulated and unregulated) amount to about half that.

    As far as I know, nobody has any data on otc contracts, as they are completely unregulated. (all of these stats were cited in this wsj piece)

  25. burnside

    Doc, regarding your ‘one last thought’ infra,

    I think if you’ll interleave personal, corporate and governmental insolvencies into that scenario, you’re pretty close to describing the domestic reality.

  26. STS

    Mr. Sparkle,

    Thanks for the new chart. I didn’t expect any particular correlation — sort of like trading volume vs. price, which don’t correlate much — just thought it would be entertaining.

    I agree with mxq that there is a deeper question about how much of a “shadow futures market” may exist — essentially speculative swaps that pay out based on performance of commodities futures.

    One important re-regulation initiative we need is to put a LOT of this activity onto exchanges with transparency about price auctions, contract terms, etc.

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