oil has reached a whole new level of "strange" that will either further affect the oil market directly or influence quite a few other markets negatively in its wake.

The Oil Market Becomes Even More Dislocated
 December 9,2008
 

There's a moment at which nothing much makes sense. Of course, you may argue that we have passed that point quite a bit already in the oil market. But I'm here to tell you, oil has reached a whole new level of "strange" that will either further affect the oil market directly or influence quite a few other markets negatively in its wake. Let me tell you what I mean.

 
Recently, the Financial Times quoted Francisco Blanch, head of commodities research at Merrill Lynch. He reported on oil, his base case scenario for $50-a-barrel average price in 2009, with a warning that prices could drop as low as $25 a barrel. (Analysts of all stripes around the world seem to quote a base price very much near the price where the market is currently trading, but that's another story.) The $25 low-end estimate Blanch recites is based upon a furthering destruction of Chinese and other emerging-market growth in 2009, and it is astounding if it turns out to be true.

We have witnessed the perfect storm of declining commodity pricing in the last six months -- a tsunami of credit tightening, capital withdrawal on a massive scale, dollar strength, weakening emerging-market growth and finally a deflationary spiral that seems to never be ending.

The oil markets, if they represent perfect efficiency as the equity markets normally do, would indicate either that Francisco is very, very wrong with his oil predictions or that we are in for far deeper problems with the rest of our economy. Far-forward contracts of oil are trading at a premium to front months rarely seen before in my history of trading the stuff and in a way that looks unbelievable to other longtime participants.

As I write this piece, January crude is trading for delivery later this month at $43.40 a barrel. Amazingly, January crude for delivery in December of 2009 is trading at $57.50 a barrel, a premium of more than 32%. This premium (contango) nature of the markets has rarely been so great and would allow for a riskless trade. One could buy crude oil for delivery this month, store it and sell next January's contract for delivery 12 months later. With margin, storage and financing costs, you'd still clear a healthy 11% profit.

Some firms with the ability to self-finance this trade have begun taking advantage, such as Royal Dutch Shell. It has begun taking supertankers capable of holding 26 million barrels of crude out of delivery service (!) and keeping them available instead for storage duties. Imagine, taking ships and cannibalizing them for use as floating storage tanks. That's how crazy it has become.

I say this has to stop -- and soon.

Temporary dislocations in crude oil have been seen in the past, but there are only two ways for them to work out. Either the dislocation is shown to be an opportunity for capital injection and risk, or the dislocation is predictive of even more dire end results than a simple opportunity at a carry trade. The last time contango in the crude market was this pronounced was in 1998, when a worldwide glut in oil forced prices down to $10 a barrel.

There are good reasons to believe (and ultimately root for!) the more likely probability that the crude curve is displaying another of the many market dislocations we're seeing in all of the capital markets right now.

First, there is always a tendency for an overshoot in markets that have already overdone themselves in one direction. Certainly $147-a-barrel oil seen in July of this year represents such a bubble, in hindsight. Second, credit tightness makes the ability of participants to finance a carry trade difficult, so it might be able to exist, at least on paper, for a longer time than you might think. If you can't get the trade financed, you can't swoop down and lock it up. Third, storage has never been an elastic part of the oil market. There is very little storage to begin with -- it has always been expensive and is mostly utilized and not readily available. Like the refining industry, creating new storage has been a loser's game for so long, there has been little incentive to invest in more. Of course, opportunity is the mother of all resources, so a continued carry of this magnitude might change that calculation quickly, as the current use of Shell's tankers as storage makes clear.

Technically, oil is massively oversold, having lost more than 70% of its price from its highs in a mere six months, and it's hard to imagine how it could lose much more value here. Simply put, a $2 shift of $100-a-barrel oil is a 2% move, while a $2 shift of $40-a-barrel oil is a 5% move - it just gets much more difficult to pile on losses at these lower levels.

And finally, the enormous amount of governmental liquidity being thrown at the markets needs to find its result on the money supply. It seems that somewhere along the line, the huge amount of money being made available in loans and guarantees will have to massively inflate currency, driving the prices of all commodities upward -- and oil generally leads such moves.

The continued disjointed market conditions of inflated yet strong dollars, dysfunctional credit markets and oil trading at 10-year lows in deep contango suggest very, very difficult economic conditions -- certainly a global recession in line with 1932. I am not in the camp of those who are predicting this.

For all these reasons, it seems like a very good time to slowly take some exposure back into the commodity sector, particularly oil, either with straight oil ETFs like the U.S. Oil Fund, or with equity energy sector ETFs like Ultra Oil & Gas ProShares -- in essence, a vote that these dislocations are merely temporary.

Know What You Own: Other ETFs that offer exposure to crude oil include iPath ETN Crude Oil, the MacroShares Oil Down ETF, the MacroShares Oil Up ETF and the PowerShares DB Oil Fund.

oil has reached a whole new level of "strange" that will either further affect the oil market directly or influence quite a few other markets negatively in its wake.