Another day, and another chance for me to start my post with “the carnage in the oil market continued yesterday.”
The latest bout of selling is courtesy of the Goldman Sachs analyst who changed his forecast from $80 down to $42 for Brent. His analysis is based on the idea that the Gulf oil producers do not show any signs of being willing to cut output. No shit Sherlock. That is some pretty prescient analysis… Almost halving your target overnight sounds more like capitulation than any value added wisdom. Not only that, but it’s not like his call is based on some sort of brilliant insight that the rest of the market is missing.
Yet the market wants to go down, so for me to poke too much fun at the GS analyst just ends up sounding like a sore loser. I have been wrong in my call that Saudis would stabilize the oil market. In fact, it looks like there is actually a concerted effort to achieve just the opposite. The Saudis and other rich Gulf oil producing nations are trying to squeeze as many high cost producers and countries out of the market as possible. Make no mistake – we are in a monster game of chicken.
Again this morning we get the Kuwait oil minister reiterating that there will be no OPEC meeting before June. If he was trying to maximize revenue he would keep the hope of the meeting alive so that they could make sales at elevated levels. At the very least he would just keep his mouth shut. But no, he is actively jawboning the market lower.
This is causing a huge amount of pain for countries like Iran. The Iranian oil minister said yesterday that “those who make oil fall at Iran’s cost will ‘regret’”. The Iranians know that there is a definite attempt to push oil as low as possible over the short to medium run. Who knows if they can do anything to make the other gulf oil producers ‘regret it’, but the Iranian leadership is increasingly looking like a cornered tiger. I wouldn’t put mustering up some sort of geopolitical instability past the Iranians…
Although I believe that the downdraft is being made worse by Gulf oil states that are actively pushing oil as low as it can go, I am also concerned that global demand has fallen off a cliff. I have been aware of the large increase in supply over the past half dozen years, but I mistakenly thought that demand from countries like China would take up any new supply easily.
I am concerned about the fact that this call has been so wrong. The crude oil decline is spiralling out of control and demand is not increasing with the lower prices as one would anticipate.
One factor that I underestimated was the declining energy demand from Europe. Have a look at this great chart from the Resource Crisis Blog:
Italy’s energy use hit a high in 2008 and has been steadily falling since then. It is down almost 25% in the last 5 years! That is a shocking decline. I would not expect robust growth out of Italy, but this was during a period when the global economy was supposedly recovering from the great credit crisis of 2008. You would at least expect energy demand to go sideways during this period, or maybe even rise slightly.
How many other Western nations are also experiencing this sort of falling demand? Combine that with a China that is also disappointing in their GDP growth, it is no wonder that oil is falling so precipitously.
Anytime a commodity gets halved in less than six months, you have to wonder how the market could have gotten it so wrong. It seems like all too often we attribute this to a “perfect storm”, but that seems like a cheap excuse. This is yet another case where the market was too optimistic about future growth and the excesses of easy monetary policy produced too much mal-investment based on that growth.
Yet I believe the day to day trading has reached a bearish crescendo. We now have daily mini-panics from analysts halving their targets overnight. The day before when the Goldman Sachs analyst’s target was $80 it made no sense to listen to him, but now that he has predicted a lower price he is some sort of guru whose advice should be followed? The bearish comments from rich OPEC nations are similarly excuses to get even more short. Heck we know these guys are only making these sorts of comments in their attempt to maintain a fair and orderly market. There is no way that they are self serving manipulators.
I suspected that the decline might get disorderly, and the volatility has exploded even higher over the past week. We are getting regular 4% moves to the downside. I know that everyone is bearish, but I am hanging in there with my call for a face ripping rally. Although the Goldman analyst is busy recommending to clients that they should sell their crude oil, my guess is that the GS traders are busy taking the other side.
But do not make the mistake of buying energy stocks as a way to play a short covering rally. The energy stocks are going to suffer from underperformance for many quarters to come. The stocks have not experienced the same sort of negativity as crude oil. In fact, it seems that many knife catchers have chosen to buy the energy stock ETF XLE instead of buying crude oil futures.
Even though the XLE has declined from $95 to $75 over the past quarter, the amount of shares outstanding has increased from 110 million to 151 million! This is not a market filled with negativity. This is a market stuffed full of knife catchers.
I am sticking to buying actual crude oil instead of energy stocks. I still think we rally back to $55 to $65 in the coming months. But that sort of rise is not going to be enough for the energy stocks, and I expect them to drift lower.
VIX vs 5 Year break even
It is not only crude oil that has experienced a pickup in volatility. Since the new year, the stock market has also been trading with a lot more zing. Although VIX is elevated, it might be headed even higher. Have a look at this chart of the VIX versus the inverted 5 year US break even rate.
The relationship is not perfect, but it is interesting. I continue to be bearish on the US stock market, and even though implied volatility is elevated, it might still have more room to run.