Toro's Running of the Bulls Market Blog

Oil to Natural Gas Strip Ratio

I am hearing a lot of chatter about the price of natural gas, particularly the ratio of the price of oil to the price of natural gas.  Historically, the ratio of oil to gas has been 6:1 to 10:1.  This week, that ratio soared as high as 26:1.

People are using this ratio as a reason to jump into natural gas, seeing it as extraordinarily cheap relative to oil.  But is it?  If you look out onto the strip, you will see that the ratio collapses out a few months.

"M" stands for month out, so "M4" is four months out.  The ratio is 14:1 at the end of the year, still high but not as high as it first seems.

If you try to play the convergence of this ratio through the futures market or by owning the UNG, you are betting that the prices of near-term contracts will soar as this ratio should fall just by allowing the futures to roll over. 

Now, I do not know if the near-term price of gas will jump.  (I placed a bet several days ago that it would bounce as it was very oversold but liquidated the position when it became apparent I was wrong.)  However, inventory is swamping the gas markets, and storage is tight, so the price could still go substantially lower.  Not saying that it will, rather that sometimes markets can go further for longer than one could imagine.

This is the natural gas strip. 

The horizontal axis is the natural gas futures price for outer month contracts.  For example, "ng3" is the natural gas price for three months out, or the November futures contract. 

Prices in the outer months have fallen over the past few weeks but less so than the near-term contracts.  This is one reason why the stock prices of natural gas companies have held in fairly well even though the spot price of nat gas has collapsed as natural gas producers sell their product across the strip.

Peak Oil, Shmeak Oil?

I have no horse in this race.  However, the debate about Peak Oil goes on, though you hear less about it now that oil is no longer at $147 barrel (for now).

[P]erhaps the most misleading claim of the peak-oil advocates is that the earth was endowed with only 2 trillion barrels of “recoverable” oil. Actually, the consensus among geologists is that there are some 10 trillion barrels out there. A century ago, only 10 percent of it was considered recoverable, but improvements in technology should allow us to recover some 35 percent — another 2.5 trillion barrels — in an economically viable way. And this doesn’t even include such potential sources as tar sands, which in time we may be able to efficiently tap.

Oil remains abundant, and the price will likely come down closer to the historical level of $30 a barrel as new supplies come forward in the deep waters off West Africa and Latin America, in East Africa, and perhaps in the Bakken oil shale fields of Montana and North Dakota.

CFTC May Limit Energy Speculation

I believe that investment funds have had a disproportionate effect on commodities markets over the past five years.  Restrictions on the holdings of commodity futures and swaps by investment funds could have an enormous effect on commodity prices and the stocks of commodity companies as well as resource-based economies if the US government restricts trading in commodity futures.

From Bloomberg

U.S. regulators say they may clamp down on oil and gas price speculators by limiting the holdings of energy futures traders, including index and exchange-traded funds.

The Commodity Futures Trading Commission will hold hearings to explore the need for government-imposed restrictions on speculative trading in oil, gas and other energy markets, Chairman Gary Gensler said today in a statement. The agency didn’t say when the hearings would start or who would be asked to testify. ...

“Our first hearing will focus on whether federal speculative limits should be set by the CFTC to all commodities of finite supply, in particular energy commodities, such as crude oil, heating oil, natural gas, gasoline and other energy products,” Gensler said in the statement. “This will include a careful review of the appropriateness of exemptions from these limits for various types of market participants.” ...

Gensler said in a letter to lawmakers earlier this year that speculators contributed to an asset bubble in commodities in 2008. His statement broke from former CFTC Acting Chairman Walter Lukken, who testified to Congress on Sept. 11 that there wasn’t “strong evidence” index traders were driving up prices. ...

“The CFTC currently sets and ensures adherence to position limits with respect to certain agriculture products,” Gensler said in the statement. “For energy commodities, futures exchanges set position limits and accountability levels to protect against manipulation and congestion. The exchanges are not required to set and enforce position limits to prevent the burdens of excessive speculation.”

The chairman said the CFTC is reviewing exemptions from position limits for “bona fide hedging,” after seeking public comment on whether the exemption should continue to apply to traders who are in the market for financial reasons, rather than those that actually use the commodity.

Gensler also said the agency was going to improve its weekly commitment of traders’ reports by separating swaps dealers from hedge funds. The agency will continue to collect and report data from swaps dealers and index investors, extending a “special call” from last year, Gensler said.

If this goes into effect, one must consider the secondary and tertiary effects that would certainly come into play.  What would happen to the Canadian dollar? How would that effect the US consumer?  Do you still want to speculate in Calgary real estate?  Would funds pull all their commodity investments out and what would happen to base metals prices?  Such a decision could be wide-ranging.

I am short oil.

Oil Crunch Coming?

From the BBC.

Nobuo Tanaka, the IEA's executive director, warned there could be a "supply crunch"....

"Currently the demand is very low due to the very bad economic situation," Mr Tanaka said.

"But when the economy starts growing, recovery comes again in 2010 and then onward, we may have another serious supply crunch if capital investment is not coming."

He said that he expected world oil demand to rise by about one million barrels per day from next year.

Watching Oil

I am taking a look at oil here.  The front month contract has fallen from $147 in July – remember then? – to $33 Friday.  This is a 77% decline – in six months! 

For what it is worth, the Nasdaq fell top to bottom 77% from 2000 to 2002.

The contango in the futures market is steep.  The December 09 contract was trading at $55 while the December 2010 contract was $62.

I am not an oil trader, so my comments are pretty much based on 99% ignorance (and thus is no different than all your other commentary. – ed.).  However, I think this move has priced in far more than any “deflationary” end-of-the-world trade.

Whatever happened to Hubbard’s Peak?  Whatever happened to the world running out of oil?  Whatever happened to people “rationally” paying $500,000 for bungalows in Calgary?

At least part of this violent sell-off has been driven by the leveraged Mindless Momentum (MiMo) quant hedge funds who buy assets that are going up only because they are going up and who sell assets that are going down only because they are going down. Just like as they helped push oil up to $147 a mere 180 days ago, they are driving it too low.

Yes, I know, the inventory build was greater than expected, Cushing is full, the economy is going into the Great Depression II, deflation of -25% is a certainty, nobody is going to drive a car again, blah, blah, blah.

I am not blithely dismissing the sell-off.  I had been bullish on commodities for much of this decade until markets got really stupid earlier this year.  (I always warn people, "There is a reason why they are called 'commodities!' ") 

Thus, is this 1981 for oil when prices collapsed never to come back, or is this the 1970s, when oil soared at the beginning of the decade, consolidated for a few years, then went to new highs at the end of the decade?

I do not know, and I highly doubt that the denouement now will be similar to 30-40 years ago.  However, unless I have missed something, I have not seen an enormous amount of new supply come on line, nor have I read about 300 million Chinese are moving back to the countryside.  

I do not know how low oil is going to go.  The trend is still decidedly lower, and asset prices always seem to go a lot further for a lot longer than I ever think possible.    

However, the downdraft in WTI over the past few days feels like capitulation selling.  I think oil is cheap and will be looking for an entry point in the not too distant future.

Market Action, September 22 2008 - That Worked Well, Didn't It?

Well, now we know the market's reaction to The Plan to Save the World, aka RTC II. 

Consider

• When I last checked late afternoon, the TED spread - the difference between 3 month LIBOR and the 3 month T-bill - was 2.38%, up from Friday's close of 2.31%.  That is lower than the 3.00% registered on Wednesday and 3.18% on Thursday, but only those two days saw higher rates than today.  The TED spread was a more normal 0.45% three months ago.  One would think that if the inter-bank market was confident that RTC II would solve the enormous problems we face, the TED spread would have plummeted today.  It did not.  Instead, it rose.  Maybe the TED spread will fall tomorrow or next week, but so far, it is demonstrating a discernible lack of confidence in RTC II.

• The Fed funds rate was 0.125% last I checked this afternoon.  Frankly, I do not know why.  However, given the Fed is targeting 2%, I cannot in any way interpret this as a normal market.

• WTI was up an astonishing $25 at one point today to $130 per barrel before settling at $120 last I checked.  Yes, some of that was a technical squeeze given that we were rolling over contracts, but such action is unprecedented and also not evidence of a normal market.

• The dollar, as represented by the dollar index, fell the most it has fallen since May 1995.

• Gold traded above $900 after trading as low as $825 on Friday.

• Stocks wiped out all Friday's gains and more.  This is similar to the action after the GSEs were nationalized.  About the only positive thing that can be said about stocks today was that volume on the NYSE composite was a "mere" 5.1 billion shares, roughly half the volume on Thursday and Friday.

 

• The bank index, the BKX, fell 10.3%.  Since this plan is supposed to bail out the banks, one might think the response would not have been a violent sell-off.

Perhaps today was a knee-jerk sell-the-news reaction and the market will move higher in the not-to-distant future.  However, for today, the reaction was unreservedly bad.

Oil Speculation Dominated by a Few Firms

From The Washington Post

Regulators had long classified a private Swiss energy conglomerate called Vitol as a trader that primarily helped industrial firms that needed oil to run their businesses.

But when the Commodity Futures Trading Commission examined Vitol's books last month, it found that the firm was in fact more of a speculator, holding oil contracts as a profit-making investment rather than a means of lining up the actual delivery of fuel. Even more surprising to the commodities markets was the massive size of Vitol's portfolio -- at one point in July, the firm held 11 percent of all the oil contracts on the regulated New York Mercantile Exchange.

The discovery revealed how an individual financial player had gained enormous sway over the oil market without the knowledge of regulators. Other CFTC data showed that a significant amount of trading activity was concentrated in the hands of just a few speculators.

The CFTC, which learned about the nature of Vitol's activities only after making an unusual request for data from the firm, now reports that financial firms speculating for their clients or for themselves account for about 81 percent of the oil contracts on NYMEX, a far bigger share than had previously been stated by the agency. That figure may rise in coming weeks as the CFTC checks the status of other big traders. ...

CFTC documents show Vitol was one of the most active traders of oil on NYMEX as prices reached record levels. By June 6, for instance, Vitol had acquired a huge holding in oil contracts, betting prices would rise. The contracts were equal to 57.7 million barrels of oil -- about three times the amount the United States consumes daily. ...

The biggest players on the commodity exchanges often operate as "swap dealers" who primarily invest on behalf of hedge funds, wealthy individuals and pension funds, allowing these investors to enjoy returns without having to buy an actual contract for oil or other goods. Some dealers also manage commodity trading for commercial firms. ...

Using swap dealers as middlemen, investment funds have poured into the commodity markets, raising their holdings to $260 billion this year from $13 billion in 2003. During that same period, the price of crude oil rose unabated every year.

CFTC data show that at the end of July, just four swap dealers held one-third of all NYMEX oil contracts that bet prices would increase. Dealers make trades that forecast prices will either rise or fall. Energy analysts say these data are evidence of the concentration of power in the markets. ...

Exxon Topping

It appears that Exxon has put in a structural top and may have seen the highs it will see for many years.

What does it say about the price of oil when the multi-year bull market in the stock of the world's largest energy company may be over?

We may have seen the highs in the oil price.  Commodity stocks often presage the movements in the underlying commodity.

I think there is a fairly good chance WTI will fall to $100-$110, then bounce to retest the highs.  At that point, I will consider aggressively shorting oil.

Evidence of Speculation and Hoarding in the Oil Markets

At SSRN

In this study, we examine the relationship between the U.S. real price of oil and factors that affect its movement over time: futures prices, the value of the dollar, exploration, demand, and supply. All of these variables are treated as jointly endogenous and a reduced form vector error correction model, testing for cointegration amongst the variables, is estimated. We find that for model specifications with short-term futures contracts, supply does indeed dominate price movements in the crude oil market. However, for specifications including longer-term contracts that are inherently more speculative, the real price of oil appears to be determined predominantly by the futures price. Moreover, there is empirical evidence of hoarding in the crude oil market: both oil stocks/inventories and futures prices are found to be positively cointegrated/correlated with each other. [Emphasis added]  From a policy perspective, the results of this analysis indicate that if regulators really wanted to limit speculation in the oil market, it should keep the shorter-term futures contracts and eliminate the more speculative six months futures contracts.

Gas Consumption Falling

No surprise.

From the WSJ, via The Big Picture