Oil Mania Redux

Authored by EconomicPrism’s MN Gordon, annotated by Acting-Man’s Pater Tenebrarum,

Positive Energy

By now, late September of 2018, it has become increasingly evident that something big is about to happen. What exactly that may be is anyone’s guess.  But, whatever it is, we suggest you prepare for it now… before it is too late.

Art auction energizer: Norman Rockwell’s portrait of John Wayne. You can’t go wrong shelling out top dollar for me, pilgrim, can you? [PT]

Several weeks ago, if you haven’t heard, an undisclosed rich guy enthusiastically bid up and then bought Norman Rockwell’s portrait of John Wayne for a cool $1.49 million at the 12th Annual Jackson Hole Art Auction. According to auction coordinator  Madison Webb, “There was a really positive energy in the room.”

Indeed, it takes a lot of really positive energy – and a healthy bank account – to shell out that sum of money for a painting of “The Duke.”  Still, positive energy, like good weather, can quickly turn negative. Soon enough, we suppose, the purchaser’s excitement will transform into a serious case of buyer’s remorse.

Of course, we could be wrong.  The buyer could have a special liking for old John Wayne movies.  Perhaps he’s a collector of Norman Rockwell paintings.  Or maybe he won the lottery and is compelled to burn through his winnings in odd and outlandish ways.

What this has to do with anything is a bit of a stretch.  But art, if this qualifies as such, offers a rough barometer of social mood (see:  The Bubble in Modern Art). Moreover, when the price for a painting of a 20th century actor pretending to be a 19th century character of American nostalgia sells at nearly a million and a half bucks, we suspect something more is at work.

Sanctions and Bottlenecks

Take oil, for instance.  The price of WTI crude oil is back above $70 a barrel. Brent crude trades at over $80 a barrel.  Aside from a brief price spike at the beginning of summer, oil hasn’t been this high since its price collapsed in late 2014. What gives?

WTIC and Brent, daily (continuous contract charts): note the recent “double divergence” in prices.  This is quite an interesting development, because these are the first price divergences between the two types of crude oil since the rally began in early 2016 from below $30/bbl. Every other interim high was “confirmed”, this is to say a new highs in one oil type always coincided with new highs in the other. Note that there was a non-confirmed new low in the correction that ended in the summer of 2017 – this non-confirmation at a low was immediately followed by the strong rally that is still underway. However: crude oil futures remain in backwardation, a bullish factor that has hitherto kept the uptrend alive, despite speculators holding truly huge net long positions in both WTIC and Brent futures for almost a year (in excess of 600,000 contracts net in WTIC futures). This large one-sided position makes the market vulnerable, but as long as backwardation persists, rolling long positions over remains a profitable proposition. It remains to be seen whether the recent price divergences will actually turn out to be meaningful. [PT]

To begin with, oil markets are notoriously cyclical.  Production and consumption rates often crisscross in short succession.  Oil prices swing wildly to both the upside and the downside as supplies shift from gluts to shortages and back again.  But that’s not all…

In addition to regular supply and demand dynamics, oil markets are also subject to extreme government intervention.  Specifically, the Organization of Petroleum Exporting Countries (OPEC) – a 14 nation cartel, which often works in concert with Russia – colludes to fix the price of oil to its liking.

OPEC press conference. It is hard to say how much influence on prices the cartel actually has. After the 1980 oil price peak, oil production in non-OPEC countries was ramped up enormously, which undermined OPEC’s power to such an extent that it had to watch helplessly as prices collapsed by almost 75% over the next 20 odd years. The fact that Russia is cooperating with OPEC these days has strengthened the cartel’s hand somewhat, but the surge in US shale oil production has offset this effect to some extent. [PT]

As far as we can tell, a combination of factors could push the price of oil up much further from here. These factors include U.S. sanctions on Iran’s oil exports and bottlenecks in delivering U.S. shale oil to market. In addition, and despite President Trump’s cajoling, OPEC has only hesitantly hinted at increasing its oil production.  Bloomberg reports:

“Major oil trading houses are predicting the return of $100 crude for the first time since 2014 as OPEC and its allies struggle to compensate for U.S. sanctions on Iran’s exports.

“With Brent crude already jumping to an almost four-year high on Monday, that’s exactly the kind of price surge President Donald Trump has been seeking to prevent by pressuring OPEC to raise production.  Yet the cartel and its allies gave mixed signals at a meeting in Algiers on Sunday, ultimately showing little sign they would heed U.S. demands to rapidly push down crude prices.”

Oil Mania Redux

Yet for every opinion there is a counter opinion.  An argument that goes counter to another reasoned argument.  Taken by itself, each argument stands on its own rationale.  Taken together, they contradict each other.

For example, petroleum geologist and oil analyst Art Berman believes rising oil prices will be short-lived.  According to Berman, a metric he calls comparative petroleum inventories, which compares inventory data to the five year average for any given week, crude supplies will soon move back into surplus.  After that, oil prices will fall.

Commitments of traders in WTIC futures: hedgers currently hold a net short position of roughly 600,000 contracts, which is mirrors the speculative net long position (including non-reportable/small spec positions). Large speculators have pulled back a bit recently, from around 700,000 contracts net long to the current 560,000 contracts net long position. It is interesting that this has happened during a rally. We have seen similar behavior in the final stages of major rally legs in a number of commodities (including oil) in the past. Note that the final upward spike into the 2008 top in crude oil was mainly driven by a few commercial hedgers becoming unable to post enough margin to maintain their positions. A large Asian bunker oil storage company eventually went bankrupt when it could no longer keep up – and this bankruptcy effectively top-ticked oil prices at the time, with WTIC futures rallying by around $10 in a single trading day when the positions of the company were closed out by margin clerks. [PT]

Who is right?  Who is wrong?  Is oil going to $100 or $50 a barrel?  Surely, time will tell. Here at the Economic Prism we will refrain from making an oil price forecast.  However, we will offer one constructive anecdote.

If you recall, back in June 2008, Brent crude spiked up to nearly $150 a barrel. At the time, many intelligent people claimed we had hit peak production, and that prices would continue to go up forever. Speculators chased prices higher reinforcing the popular peak production theory.  Then, over the next six months or so, oil prices collapsed along with stocks and real estate.

“Peak Oil” – a Club of Rome scarcity meme that is revived every time nominal oil prices rise – which usually happens in concert with periods of excessive money printing. Then it is time to write and sell books about the impending catastrophe, which has the same record of predictive accuracy as the original Malthusian thesis on overpopulation, or the countless predictions made by climate scaremongers since the late 19th century, namely zero. Note: Malthus’ belly-aching about overpopulation may have had some merit in pre-capitalistic times, but with the adoption of capitalist modes of production it has not just become obsolete, it has actually become the opposite of the truth. We like the “Peak Everything” book title best, as a marker of “peak hysteria”. What the scarcity scaremongers never take into account are the economics of resource extraction and human ingenuity – and these are decisive oversights. [PT]   

The point is, sometimes prices move according to the fundamentals of supply and demand. At other times they become disconnected from the fundamentals entirely. During a speculative mania, decisions are guided by emotions rather than logic.

At the moment, the markets seem poised for something big. You can sense it. The Fed continues to tighten the federal funds rate. The yield on the 10-Year Treasury note is holding above 3 percent. Emotions continue to strengthen their grip on the markets.

Certainly, the time seems right.  Markets are ripe.  What better vehicle than oil to provide an epic parabolic price spike and crash?