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A Perfect Storm in Crude Oil?

By Akram's RazorCommoditiesMar 19, 2012 12:48AM ET
A Perfect Storm in Crude Oil?
By Akram's Razor   |  Mar 19, 2012 12:48AM ET
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"Because things are the way they are, things will not stay the way they are." Bertolt Brecht

"Words ought to be a little wild, for they are the assaults of thoughts on the unthinking." - Keynes

"Cycles of shortage and surplus characterize the entire history of oil." Daniel Yergen

"Oil Wealth is an Arabian Curse"- Abu Bakir Bashir

"As it turned out, sharing was not broken. Sharing was working fine and dandy, Google just wasn’t part of it. People were sharing all around us and seemed quite happy. A user exodus from Facebook never materialized. I couldn’t even get my own teenage daughter to look at Google+ twice, 'social isn’t a product,' she told me after I gave her a demo, 'social is people and the people are on Facebook'. Google was the rich kid who, after having discovered he wasn’t invited to the party, built his own party in retaliation. The fact that no one came to Google’s party became the elephant in the room."- James Whitaker

Over the past two days no less than ten notable pundits, hedge fund managers, and strategists have declared that the bull market in bonds is over. There have also been countless articles written on the topic with most focusing on the possibility that an inflation scare may be upon us. This is not a very surprising development if you factor in the fact that recent US economic data has been running a little hotter than expectations, but despite this shift in the tides I still do think that positioning for genuine inflation at this point in time is warranted. Meaning, don't go out and buy commodities, and commodity producers because ten year yields have spiked.

Even though retail sales and the PPI both came in a bit stronger than expected and the employment picture in the US is gaining some traction; I think you need to be a little more wary of the global macro forces at work here. The main driver behind elevated prices has been extremely accommodative monetary policy. Investors have for the most part become accustomed to this environment, and as a result have strategically been overweight the assets most sensitive to easy monetary policy. However, with the US economy showing signs of life, the sustainability of such policy is being called into question. So, take the punch bowl away, and commodities should no longer be trading at levels that are way out of sync with economic growth.

Basically, going long commodities here as an inflation hedge because ten year Treasuries and bunds have spiked somewhat is counter intuitive. This is not a true inflation scare because the supply/demand dynamic in basic resources is nowhere near the levels implied by prices. Commodity prices have largely been driven by financial factors, and with those factors starting to shift, prices should respond accordingly. This is why I strongly disagree with anyone that thinks you should be long commodities as well as short 10 yr Treasuries and bunds.

And it's not like this is the first time this scenario has popped up over the past four years. Since the peak of the crisis we have had two major false positives during the recovery in which major western central banks seemingly positioned themselves to exit, and in both instances yield spikes were immediately reversed and followed by sharp sell offs in risk assets.

But something is different this time around. In the previous two scares, the mistake was focusing on the Fed because growth in Emerging Markets (EM), largely driven by very robust credit expansion in China, was driving commodity demand. This time around most EM central banks are easing as they attempt to counter slowing growth which can be mainly attributed to China's screw tightening driven attempt to re balance its own economy.

Add in the fact that there is plenty of slack in Europe right now, and a shale boom in the US boosting energy production and you might start to understand why I'm more inclined to be a commodity bear here despite the fact that I have favored a temporary short position on 10 yr Treasuries.

We are right now in an environment that is extremely bullish for the US dollar, and I don't expect that to change until I see a somewhat significant decline in the prices of crude and copper. The cure for high commodity prices will again be high commodity prices. The trick here will be in assessing how long it takes for these commodities to fall which brings me the next issue I wanted to touch upon today..........

Is there a perfect storm brewing in WTI?

For the most part, the most obvious place to focus one's attention if US monetary policy at the margin is shifting away from ultra dovish is on 10 yr Treasuries and precious metals. Ever since Bernanke's testimony these two assets have tended to move together, and I doubt that will change anytime soon.

Gold and Treasuries should underperform as long as the perception remains that the Fed is now constrained by a slow but somewhat gradually improving growth picture combined with elevated commodity prices. But what about crude? As things stand, the crude oil market looks like it is stuck in neutral.The prospects for less monetary accommodation out of the Fed and slower growth out of China are bearish for the market while Iran-driven supply disruption fears and signs of economic growth picking up are bearish. What forces will prevail?

Personally, I favor the former. You have slower growth out of China, a Fed that has clearly signalled over the past few weeks that the economic surprises of late have been on the upside, declining gasoline demand in the US, increasing crude oil production in the US, extremely cheap natural gas prices leading to more substitution and permanent switching away from liquids, Cushing inventories of 38.7 million barrels which are just shy off all time highs, and OPEC production at three year highs.

Put all these together and you will be hard pressed to convince me that WTI should not be trading closer to $80 a barrel. Add in the fact that I don't believe gangbuster growth in the developed world is around the corner, and that some of the bearish forces are more secular than cyclical, and you might just be more inclined to believe a major decline in oil prices is not such a far fetched idea.

All you need to do is figure out the missing piece of the puzzle, which is whether or not a major conflict is coming to the Persian Gulf, and even that seemingly impossible-to-forecast event doesn't require much thinking if you ask me. If Iran was attacked and the fallout were to spread to the Gulf and significantly impact global crude supplies, the shock that would follow would eventually sow the seeds of its own destruction. Basically, a prolonged spike (I define prolonged spike as a 25% surge for more than 1 month) in crude prices from these levels would be inherently unsustainable as it would likely lead to a fairly rapid crash in a world already plagued by rather lackluster economic activity. And if it is a quick military strike that leads to minimal or no supply disruptions then we will end up with the most anticlimactic event the crude market has ever seen as a temporary spike will be reversed in a matter of days.

But what if nothing happens? I know many investors are probably thinking the rumored Israeli Security Cabinet 8-6 vote in favor of attacking Iran is a sign that an attack is inevitable, but I am not so sure. After this recent Afghanistan fiasco, and all the other issues in the Middle East I seriously doubt Israel can launch a unilateral attack without virtually guaranteeing enraging the Muslim world past a point of no return. It would be a political disaster.

The only way anything is going to happen is if the US and Europe are on board with Russia and China willing to turn a blind eye. I don't see that happening. Despite all the tough talk out of the Obama administration, it is becoming pretty clear that they have no desire to attack Iran. And since this is an election year, I don't see that changing anytime soon. And if that is the case, then you have just removed the one reason out there keeping most traders and investors from positioning for lower WTI prices. See if oil was trading at $80 the risk/reward element of a Iran shock would be enough offset most of these other bearish factors, but at $107 that is just not the case.

Regionally how would one position for a major decline in oil prices?

The obvious answer is to avoid the Petchem space, and the Saudi equity market in general. I would also expect a sharp decline in oil prices to probably weaken broader equities across the region, though I would view that as a buying opportunity in non-oil related sectors. This would be good news for logistics and travel. So, Air Arabia and Aramex would be worth looking at it. I also think such a decline won't hurt a tourism/service driven economy like Dubai, so if you are long Emaar I would buy the dip in any oil macro driven sell-off in the shares if it were to occur. As far as broader markets go, anyone agreeing with this thesis should also favor increasing exposure to Egyptian equities and paper as input price pressure relief is always good news for that economy.

Beyond the region....

I still like E&C and oil services on the back of a secular theme and decent valuations, but would avoid E&P. I would continue to avoid coal if you haven't been already, and I probably would be wary of alternatives like solar though any regular reader of my notes will know that's not saying much at this point based on what has already transpired in that space and the fact that consolidation is a more important factor for investors moving forward. I'd obviously want to own the transports, and anything consumer discretionary that is still not expensive (good luck with that) . Though generally speaking when it comes to equities in developed markets (US more so than Europe on valuation) I wouldn't be putting too much weight on a move down in oil beyond the really obvious sectors. Macro wise I think you are going to run into more issues tied to intermediate rate pressures and stretched valuations. You will want to avoid banking and real estate in Canada and Australia as well as both currencies. And as long as you are short yen you should be content to be long Japanese equities. Outside of the aforementioned countries, financials should continue to be a relative outperformer.
A Perfect Storm in Crude Oil?

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A Perfect Storm in Crude Oil?

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