Are we seeing a rerun of early 2008 in diminished form, as least as far as oil prices are concerned? Reader Michael sent along an article by Dan Dicker that contends that oil prices are well ahead of their fundamentals, and that, as before, the oil bulls are taking considerable cheer from Goldman’s boosterism. A key element that Dicker highlights that too often goes comparatively unnoticed is the small size of the oil market, Hence sudden influxes of funds can have a price impact.
Now some readers will pooh-pooh that notion, saying that prices that are “too high” should lead to hoarding. Well, unlike last time around, there are abundant signs of that, with oil in storage at virtually unprecedented levels, Moreover, regulators are increasingly accepting the view that prices in futures markets can and do drive the physical market. From Dow Jones Newswires:
Until recently, the U.S. Commodity Futures Trading Commission had more limited oversight authority over contracts traded electronically on exempt commercial markets such as IntercontinentalExchange Inc. (ICE). But when energy prices rose to record highs last year, lawmakers expressed fears that traders were affecting prices by using exempt commercial markets to bypass speculative position limits imposed on similar types of energy futures contracts traded on exchanges…’We were told to look at significant price discovery contracts and we have been doing that,’ acting CFTC Chairman Michael Dunn said Wednesday, noting that preliminary reports suggest ‘it was much larger than we originally thought’ and that staff was ‘surprised’ by the preliminary findings.
Notice the key expression, “significant price discovery.” Most economists believe that price discovery takes place in physical markets only. Yet as credit default swaps have shown, supposed derivative markets can not only be the preferred vehicle for price discovery, but actually drive prices of the supposed “underlying.”
Now to Dicker via The Street:
Oil has been rallying because of the weakness of the dollar and because of the specter of impending inflation…
Yet in the last several sessions, the dollar has found some amazing strength, and gold, the best proxy for inflation, has come down quite a bit. So what is going on with oil?…
It’s the endless bid.
Goldman Sachs recently revised its oil targets for 2009 and 2010, raising its $52 target price for the near three months to $75. It gets worse, according to Goldman. Year-end targets for the crude barrel in 2009 were revised up to $85 and a $95 target was set for 2010. How do they come up with these figures?
Goldman analysts cite increased demand. Yet there is absolutely no sign that demand is increasing, quite the contrary. Goldman argues that oil is rallying on expectations of increased demand along with similar expectations of recovering economies in the second half of ’09 and into 2010. Even if this gargantuan leap of faith were true, why isn’t natural gas, a perfectly wonderful and plentiful energy source, rallying as well? Why is it languishing at a mere $4s/mmBTU, while crude streaks ever higher?
And how do those Goldman oil analysts even create these mythical target prices?…
The endless bid is what I’ve begun to call the incessant, unrelenting and often unreasonable desire of investors to have exposure to oil…..there is a renewed interest in having oil as a part of every investor’s portfolio.
The oil market is a delicate market. Even more importantly, it is a relatively puny market….the entire notional value of crude oil traded on the Nymex is a little under $100 billion.
That sounds like a lot. But not if you consider that the notional value (market capitalization) of even one oil company like Chevron(CVX Quote) is 40% more. The market cap for Exxon Mobil(XOM Quote) is 3.5 times more. Intuitively, we can expect that even a relatively little amount of new investment interest in oil futures is going to have a huge impact on the price.
That’s the endless bid.
We saw the endless bid fuel the run-up in oil to $147 in July 2008.
We saw the endless bid withdraw just as quickly in late 2008 and through February of 2009 with a resultant low of $32 a barrel.
And now, it’s baaack .. and makes any estimate of a target price for oil a total shot in the dark, a complete guess, practically unrelated to any economic forecasts or supply/demand estimates.
Before you decide to run out and go short, bear in mind that some technicians think that black gold could run further. While I must note that technical analysis has about as good a reputation as astrology in respectable circles, I have also observed that a lot of investors use it as an input in decisions, and it allegedly works better for commodities than for stocks. That is a long-winded way of saying that if enough people utilize it, it can become a self-fulfilling prophecy.
The current rally in oil is nearly twice the average bull market gain in nearly half of the average duration.