We should briefly review our Oil views, since Crude has been in the news so much lately. My thesis about Oil and the Markets has, for quite some time now, been that the economic reinflation engineered by the Fed stimulated economic growth, and with it, demand for Oil. US Consumer spending is part of the reason China came online so strong, further accelerating Oil demand. All that was good for stocks, but only up until a point:  Beyond a certain price, its a negative for equities.

As we noted in Stop Blaming Oil!, on the one hand:

"Since October 2002, Oil has doubled, and with it the
Nasdaq. The inverse correlation many seem so found of blaming the Market’s woes
upon seems to come and go with such irregularity that we hardly find it
instructive to quote Oil as the basis for the selling."

Sorry to be a two handed economist but, on the other hand:

"It would be silly to suggest that Oil’s price action is
irrelevant to stocks for one simple reason: Most of the major post war
recessions were preceded by a spike in Oil prices. The period leading
up to and through each recession were bad for equities."

Which leads me to the cliché: 

"So to proclaim that Oil has absolutely no impact on stocks is both factually incorrect, and potentially dangerous. There is a tipping point
for Oil and the Economy — we have yet to cross that level — but once
we do, you can be sure that Oil will impact equity prices."

Where is the tipping point? I tihnk markets are "used to" $50 oil, uncomfortable at $60, and unpleasant over $65, and downright ornery over $70. You can see this reflected in last week’s performance data:

>
click for larger graphic
Wsj_sector_perf_20060120_1

 

Courtesy WSJ

>

(Kudos to the Journal for slipping in the subversive reference to the soft core user created content site, HOT or NOT. I love pop culture references that goes over most people’s heads).

Category: Commodities, Markets

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

27 Responses to “Hot or Not? Sector Analysis and the Tipping Point for Oil”

  1. B says:

    Are we in a blow off top now? This recent oil run appears driven on short term emotion alone. The gaps on the oil chart are very disorderly and speak of a fakeout or double top possibility. Although I surely wouldn’t want to be short anything in that sector.

    People are just plowing into any oil related investment. That smells like danger is getting near to me. I would assume oil will top when the market tops if this upward rise continues. Btw, our government appears to be shrewd negotiators when it comes to oil drilling rights and revenue for such. Or maybe it was Abramoff who negotiated those contracts.

    Think Chavez, Putin or the Chinese would negotiate such deals? (I am not a fan of any name I just mentioned) I sometimes wonder what the hell our government is good for other than ringing up debt.

  2. old ari says:

    One the one hand……. perhaps what you have is a bistable situation, until the tipping point is reached everything will be fine. Once past the point then trouble.

  3. PigInZen says:

    B,

    It’s not just the government that’s good at gaining debt…

  4. David Silb says:

    As my British colleagues say when something is exactly perfect “Spot On!”

    I truly agree with this entry and I also agree with the idea of a “tipping point.”

    If we back away from the from the “tipping Point” do you guys think that this malaise of market , with the market searching for direction, will continue for an extended period of time?

    Or

    Do we need an externality, like a pull out of Iraq and easing of the budget spending associated with it to start to generate energy.

    Or any other example you guys can think of. My fear is an extended period of “Bear” market. (sorry but I really like to be in Bull markets, even though right now I’m with on the “Bear” thing right now. And I know you all want a “Bull” market)

  5. Michael says:

    Tipping point?

    At least from me and anecdotally, it would be when local gas prices reach >$2.90.

    Over $3, and I think it will translate to a consumer shock and finally be reflected clearly in consumer spending.

  6. Andy says:

    I’m not sure that is an intentional reference to Hot or Not. People have been calling assets “hot” and “not” for a long time now… I’m sure you could find an equivalent phrase on Nexis from 1995 or earlier. If they actually used the phrase “Hot or not” in the headline, that would be something.

  7. SINGER says:

    Dude,

    there are full class sessions @ law school being spent on hot or not … by unnamed students of course…

    ps that mystery booty post on “essays” was “off the hook”……

    ONE

  8. wcw says:

    Oil prices do something else, too: influence how much of it is consumed. Cf the most recent chart of stocks vs averages the EIA put out at http://tonto.eia.doe.gov/oog/info/twip/crstuss.gif

    High prices encourage people to consume less. While you can argue about how elastic demand may be, but we’re not diabetics who need insulin. Not quite, anyhow.

    FD — I have both some energy longs and some puts, after having been overweight until late last calendar year (yes, I missed being overweight the blowoff top; them’s the breaks).

  9. me2 says:

    You are overlooking some stuff, Barry. The world crude market is at a tipping point, all right. DOWN.

    Last summer/fall when crude was up at $68, wholesale gasoline was at $2.50, heating oil was at $3, inventory was shrinking and we had the potential for a problem.

    Now, inventories are building like crazy, gasoline closed at $1.67 (?) today and heating oil is under $1.80. Refineries are operating with negative margins because crude is high, yet there is a glut of product and prices are falling. The oil reports this week spoke of refineries down for maintenance, but it is WAY early for that to be happening. That is usually an April activity.

    So… I think some speculators are about to learn the hard way that oil is a commodity like everything else and really, we have enough of it. Why do you think OPEC spoke of cutting back supply a few weeks back. They can see it is only speculation that is causing the price to be where it is. But that game is coming to an end too, just like $10+ natural gas.

    As far as there not being enough crude, your chart shows it nicely that every country except the USA is still pumping more of it and there are lots of new developments just coming on line.

    As far as Iran goes, they are never going to shut off production. That is all they have. They have 14% unemployment and their people need to buy things from foreign countries. What do you think would happen to their currency if they stopped exporting ?

    Another thing. We have this resource called the strategic reserve. I saw a calc the other day that if Iran stopped pumping we could live for about 10 years replacing their production with the strategic reserver supplies. What good is that if we never use it ?

    This whole oil thing has been greatly exaggerated. I am pretty sure we saw the biggest shocks we will see in a long time last summer. Yes, we got lucky with a warm winter, but we also got very unlucky with the hurricanes in the first place. So that basically balanced out.

    I say oil will be at $40 or less before the end of the year. Even worse if the housing market crashes or we are forced to get serious about our deficits.

    The $70 oil we saw was great because I believe it prompted people to stop and think about how they use it as well as it spurred tremendous development. All in time for it to go back down to $30 for another 15 years.

    Everyone keeps harping about the Saudis not wanting to prove their reserves. Guess why ? If they had miniscule reserves they would surely show us as the price of crude would go to $150/bbl. The problem is their reserves are huge. If the world knew that there would be no oil fear and the price would be $20.

  10. me2 says:

    Everyone keeps harping about the Saudis not wanting to prove their reserves. Guess why ? If they had miniscule reserves they would surely show us as the price of crude would go to $150/bbl. The problem is their reserves are huge. If the world knew that there would be no oil fear and the price would be $20.

    One more thing. Just because we have lots of it doesn’t mean we should be wasting it.

    If the governments really want to get a handle on the price of crude, all they need to do is limit its trading to companies that either physically produce it or use it. Crude is a currency right now, and like gold, when there is lots of liquidity around it goes up in price. For no good physical reason.

  11. Abobtrader says:

    I’ve always thought about asset markets as policy variables, and while I see scope for oil to “take off” I agree that we are somewhere near that tipping point region, and am betting on the self-corrective mechanism dominating. If the mechanism fails and we get much above 70 then I will jump ship immediately, as the amount of money chasing commodities could see irrationality carry the black stuff a hell of a lot higher.

    I mainly trade fx but have now dipped my toes in to a short oil trade.

    (Just as with equity indices and fx, when these prices get to extremes they can be stimulative or restrictive on the economy and become a more determinate feature in policy making. As the outlook for economic growth is also a factor in determining their prices, this suggests there should be a self-limiting component at work.) This is not true for smaller markets, such as with many individual stocks or with some other commodities, and so they may be less susceptible to this kind of mean reversion.

  12. me2 says:

    And one more thing… this concept of Peak Oil. Just because oil production may have peaked lately, relative to our recent history, doesn’t mean it has peaked forever.

    One has to remember that for many years oil traded in the 20s and oil companies had P/Es of 7-10x. Who wanted to invest in mega oil projects then ? Conversely, who was interested in conserving ?

    This recent spike up has changed all that. Now everyone and their dog is talking about oil and investment and activity is going like crazy. Oil is like anything else. Throw money at it and you will get more.

    If oil is such a rare commodity, how come the oil company profits are so high ? Obviously their finding and production costs are no where near what they are getting for it. Economics 101 tells us that won’t last long. (Companies will produce more and more until the marginal cost of production equals the price they get…)

    One more thing. Everyone talks about China and its growth and how it needs more oil, copper, zinc, etc. Well, China is growing, but their population is conservative with their spending. Where do you think all that demand is coming from ? Good ole USA. And why ? H-O-U-S-I-N-G.

    Do you think China would be growing at 9% based on its own internal demand ? What do you think China’s growth is going to be like when US housing stops artificially inflating the US consumers ability to spend and China’s exports drop by about 50% ?

    There is no problem with oil. We don’t have Peak Oil. We have Peak Liquidity !

    And if you use that on a talk show, I want credit for it !

  13. Michael says:

    I think we’ve hit “a” top in oil for several reasons. Despite the Iran situation, it couldn’t get thru the Katrina high at 70 – suspect a lotta speculators played the runup from sub 60. (as I did).

    I see on Bill Cara’s blog, there’s some suggestion that China’s demand for crude is slowing. A little here, a little there adds up to less demand. The unexpected would be a drop in crude. Whether it’d trigger some runup in equities or something else, don’t know.

    I caught 60 Minutes on Sunday. When they talk about something, it’s nearing a top. The lead piece was on the Canadian Oil Sands and the boom in Alberta. What everyone knows isn’t worth knowing so I suspect a big pullback in that energy sector. T Boone was in it as well, talking up his positions.

    Reminds me of Exxon’s Parachute, CO facility. When Carter and the Arabs went at it, Exxon was plowing money into it. Then the bottom dropped out.

    Not saying crude will go to 30 but it’ll be swinging a bunch which is great for a trader.

  14. Michael says:

    I think we’ve hit “a” top in oil for several reasons. Despite the Iran situation, it couldn’t get thru the Katrina high at 70 – suspect a lotta speculators played the runup from sub 60. (as I did).

    I see on Bill Cara’s blog, there’s some suggestion that China’s demand for crude is slowing. A little here, a little there adds up to less demand. The unexpected would be a drop in crude. Whether it’d trigger some runup in equities or something else, don’t know.

    I caught 60 Minutes on Sunday. When they talk about something, it’s nearing a top. The lead piece was on the Canadian Oil Sands and the boom in Alberta. What everyone knows isn’t worth knowing so I suspect a big pullback in that energy sector. T Boone was in it as well, talking up his positions.

    Reminds me of Exxon’s Parachute, CO facility. When Carter and the Arabs went at it, Exxon was plowing money into it. Then the bottom dropped out.

    Not saying crude will go to 30 but it’ll be swinging a bunch which is great for a trader.

  15. David Silb says:

    me2,

    I think you make some good observations but I think your statement that “Refineries are operating with negative margins because crude is high, yet there is a glut of product and prices are falling. The oil reports this week spoke of refineries down for maintenance, but it is WAY early for that to be happening. That is usually an April activity.”

    Is a little off. I’d like to know where you get that refineries are operating in the negative margins.

    My understanding is that they are efficient up to $80+ a barrel.

    If what you say is true then wouldn’t this type of problem be on News haedlines: “Oil prices at record highs while refiners may close”…or some silly nonsense like that?

    I think the refineries are doing just fine. If not that is something I would like to know.

  16. me2 says:

    What I am really talking about with the refiners is called “crack spread”. It has nothing to do with buttocks ! (sorry…) The conversion of a heavy hydrocarbon such as crude to a lighter one such as gasoline is called cracking in the industry.

    http://www.nymex.com/lsco_hocrack_descri.aspx

    So… the crack spread right now, using the 3-2-1 formula is

    $67 x 3 for the crude
    less
    $1.70 x 42 x 2 for the gasoline
    less
    $1.80 x 42 x 1 for the heating oil.
    equals
    -$17.40 per 3 barrels or -$5.8 per barrel.

    The usual crack spread is positive $5 to $10 per barrel processed.

    For $67 oil to be profitable for the refineries, they need gas and heating oil to be more expensive and they aren’t because there is getting to be a glut of finished product. The market is running into the fundamentals.

    Now… refinery X may be making a profit today because of the timing of their sales and purchases. They might be processing $57 crude today and selling it forward for $2.00 a gallon.

    But the immediate spot prices right now have the refineries losing money as far as I can tell.

    I’m surprised this sort of thing isn’t discussed more.

  17. me2 says:

    Oh… the 42 is because a barrel is 42 gallons.

    This page here
    http://quotes.ino.com/exchanges/?c=energy

    has a heating oil crack spread future of $9.31/bbl. I have no idea how they arrive at that number. But I’ve got a feeling that someone somewhere is getting squeezed because of the disparity between the price of crude and the refined products.

  18. me2 says:

    Oops… I got the sign wrong on my crack spread. It should be +$5.80 per barrel, meaning the refiners are at the low end of their profitability, but they are still making money.

    I ran some spreads a while back and they had zero or negative returns.

    I think there is still a squeeze going on with the refiners.

  19. me2 says:

    Here is why oil won’t stay at $68

    http://www.cbc.ca/story/business/national/2006/01/26/oilcos060126.html

    Both of these companies expect oil production to rise. Truthfully, every company in the world is increasing production, except for a few companies with depleted US assets.

    And note the profit margins. Scarce resources are expensive because you can’t get enough of them. The resources at these companies aren’t scarce. They are cheap relative to the price of crude. And it is the same for all the oil companies out there.

    So… every oil company in the world has excess cash and huge profit margins. What will they all do ? INCREASE PRODUCTION. The price of oil will plummet.

    But won’t OPEC cut production ? Sure. Except they have now tasted the huge profits they are presently seeing and nobody will want to see those profits wane. So they will keep production up as the price falls to keep their profits rolling. And, the non OPEC producers are rapidly increasing production as well.

    People, we are sitting on the verge of an oil glut. It might take 6 months to a year to materialize, but the days of expensive oil are almost over. It is time to start shorting oil stocks.

  20. B says:

    This isn’t discussed more on here because people don’t understand it. It is discussed amongst the people who trade the oil markets but they aren’t going to give away their secrets…………….Btw, I haven’t looked at the out months on oil lately but it was trading for less than the current months. That likely meant the producers were locking in prices and delivering product. That is why I expected oil to crater before this Iranian mess. But, this last rally has the feeling and look of a blow off…………..This could be the time oil finally corrects and takes the market with it.

    The majority of new highs are energy stocks. The rest of the market is already bellying up to the terlet for a big ole puke. ie, The market internals aren’t quite so sexy without oil. But, hey, so far it has held up well.

  21. me2 says:

    I expected a sell off before the Iranian thing too. When oil was at $57 before Christmas I thought it was on its way. Then, just in time, the Iran thing springs to the forefront.

    I don’t know if the rest of the market will crater with oil. They might get a rebound from that, rightly or wrongly.

    Hey, if we are going by fundamentals then I think a correction is due any time. The US consumer can’t withdraw from “Bank Home ATM” anymore and will soon be faced with the realization they owe tons on a house that isn’t worth what they “paid” for it.

    Its tough being a bear. I’m sitting on 25% cash with no place to put it.

  22. David Silb says:

    Wow. Ask a question and get some sound answers!!!! Thanks I now have a better understanding of oil and its pricing.

    Better be careful if this gets out you guys might be the first ones up against the wall when the revolution comes. And Me2 don’t say buttocks to me ;^)

  23. me2 says:

    I’d love it if Barry would get some quality one on one time with Kudlo and explain some of this stuff. Maybe it would catch on and people would stop speculating in oil.

    Oil went up today because of the Iran thing. Natural gas, gasoline and heating oil all went down. More squeeze on the refiners.

    We’ve got 22% more natural gas now than the 5 year average and 16% of the Katrina natural gas production is still shut in. If this weather holds the builds in products are going to be HUGE by the time the driving season comes around.

    This cannot continue. Fundamentally supply and demand sets the price and something is going to give. Refiners won’t continue buying high priced crude to put it in storage and sell it for a loss. I think the wholesale price of gasoline and heating oil are going to pull down the price of crude.

    Maybe the sell off in oils will trigger the whole stock market sell off.

  24. me2 says:

    Here is another thought. Can you imagine the money being made and lost in natural gas right now ? Back in December the Jan and Feb natural gas futures were selling for $14, $15. Now the spot price is at $8 and falling.

    I watched the inventories since Katrina. At no time were we ever less than about 10% more natural gas in inventory than the 5 year average. Was the run up over done ? Was it even warranted ? Sure we still have 16% of the Katrina production shut in. But that also means we have 84% running and that says nothing about all the other gas production around.

    I think consumers get burnt with hedging because they have real physical needs and pretty much must hedge to ensure supply. Whatever the price. The producers and speculators don’t have physical needs and can just sell at a later time.

    I think that sooner or later governments have to step in and control the speculation in oil and products.

    I wonder if there are any hedge funds losing their shirts right now from being offside in natural gas hedges ?

  25. Eric A. says:

    me2 said: “And one more thing… this concept of Peak Oil. Just because oil production may have peaked lately, relative to our recent history, doesn’t mean it has peaked forever.”

    Peak Oil doesn’t have to be false in order for that to be true. In fact a recession may postpone the peak, or split it into two peaks, etc.

    Peaks charted out over limited locales (say, USA, or Texas) can be sharp because once a decline starts, local deficits can be made up for by importations, so the local economy can continue to deplete the resource. A global peak is more likely to be spread out, or to consist of a period of oscillation before a long decline, because supply deficits are global and cannot be made up, and therefore cause global economic shocks, which in turn affect the demand/supply balance.

    That is how I understand the oscillation during 2004 and 2005 between job creation and “soft patches”–every time the economy started to grow, the oil price shot up and the growth faltered, sending the price back down, stimulating growth, ad nauseum. Seasonal patterns of use obscured this oscillation somewhat, as did “random” events like hurricanes, oil strikes, terrorism, etc.

    me2 said, “Oil is like anything else. Throw money at it and you will get more.”

    This is cliche by now–it’s the economist’s side of the debate versus the geologists about whether oil supply is limited or unlimited. This debate is clearly explained in this meaty data-packed paper, with some beautiful charts:
    http://www.peakoil.net/Publications/International-Summer-School_Salzburg_2002.pdf

    me2 said, “If oil is such a rare commodity, how come the oil company profits are so high ? Obviously their finding and production costs are no where near what they are getting for it. ”

    I don’t understand. Aren’t rare things pricey? Just because they are making a killing, that means supply is plentiful? On the contrary: high prices are evidence for a lack of supply (although they can result from other things as well).

    Perhaps one confusion comes from discussing two different kinds of “supply”. One is stockpiles, which I agree can overly pile up due to limited foresight, especially when there’s unexpected growth (say China) followed by an unexpected slowdown.

    But then there’s the other kind of supply: production capacity. It is a crucial part of the equation for producers who seek to forecast future demand and plan accordingly. If producers predict demand at some time in the future which is larger than predicted production capacity at that time, they would be wise to increase stockpiles while they can. Thus rising stockpiles are evidence for producers predicting such a situation in the future.

    Of course, they can get the predictions wrong. But I do see more than one reason why they would want to increase stockpiles now.
    Don’t you?

    For example, climatologists are expecting more strong hurricanes in the Gulf of Mexico this year.

    On the other hand, I do agree that if there is a recession, overstocks will probably drive down the price of gasoline, etc.

  26. me2 says:

    Strong hurricanes forecasted already ? That is funny. Spoken like an oil speculator. The market is living on hope right now. Fundamentals will take over.

  27. Eric A. says:

    me2, Perhaps I was exaggerating– maybe shorter term concerns are more likely explanations.

    In any case, here are some googled links on the 2006 hurricane season.

    A scientific perspective:
    http://www.msnbc.msn.com/id/10350898/from/RSS/

    And the actual report:
    http://hurricane.atmos.colostate.edu/Forecasts/2005/dec2005/

    A “debate” over the role of global warming in the current hurricane cycle (note the absence of controversy about the hurricanes themselves):
    http://www.cnn.com/2005/TECH/science/09/23/hurricane.cycle/

    An insurance industry perspective:
    http://money.cnn.com/2005/12/14/news/international/update_swissre.dj/?section=money_latest