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.