Peak Oil With a Dash of Politics

We were not planning on doing this post today but after a few conversation that I have had with people that consider themselves informed I thought that it would not hurt.

Oil is in the headlines again as both West Texas and Brent crude have been consistently over $100 for a while now. Of course this isn’t the whole story as we are also in an election year. The price at the pump matters more than normal around elections as voters like to blame or praise whoever is in power for any and everything that is going on.

This is a good time for a disclaimer-Some people might call me right of the right wing when it comes to personal views and voting. When it comes to trading politics absolutely need to be put aside. I take a pragmatic view of things and never confuse politics with policy.

Getting back to oil we keep hearing that when Obama came into office prices at the pump were so low. Well that is a half truth. As you can see in the chart below the price of Crude is in fact higher than when Obama took office.(Click on chart to enlarge)

What we never see however is what oil was doing before Obama took office. If we pull up a 10-Year of crude we can see that not only was oil at its cycle lows when Obama came in but it had just dropped from its all time high of $150 a barrel. Oh and do you remember why oil dropped like a rock? There is a thing called demand destruction. It tends to happen when the globe loses about a third of its wealth inside of a year. Since then we have had a recovery, even if it has not been as robust as we would like, the central banks of the world have pumped in trillions of dollars into the global economy, the Middle East has been in its “Arab Spring” for over a year, and we still have no long term energy policy.(Click on chart to enlarge)

No energy policy? Hah Obama must be doing this to us. If he had that much power then unemployment would be at zero. Fortunately the President while the most powerful man in the world is not that powerful. Until the office of the Presidency includes some grand wizard of alchemy he, no matter which party he is in, will have that power. Obama is responsible for higher prices only to the extent that he like his predecessors have failed to formulate any type of long term energy policy. Just like the developed worlds central banks and their debt can, we keep kicking the energy can down the road as well. T Boone Pickens is not lying when he says that every President since Nixon has declared that we will be energy independent and then has proceeded to do nothing.

So while there are definitely several shorter term issues driving oil such as the problems in Iran and current supply issues to both coasts, the biggest issue is that long term supply is not as strong as we once thought it to be. Most of the world has always thought that Saudi Arabia would always be able to boost production in times of crisis. Well as we saw when Libya had their revolution Saudi Arabia either does not have, or just doesn’t want to use, any spare supply. That fear coupled with more immediate issues is what is keeping oil above $100 and what will likely keep it above $80 for a long time if not forever. What’s that you say? Saudi Arabia can never run out of oil you say? In the chart below we present Middle East oil as a percentage of total global production. As you can see their share of production has not moved since the late-eighties.(Click on chart to enlarge)

What about the rest of the world? Brazil and Russia have a lot of oil don’t they? Well to certain extent they do but that does not mean they have enough to supply the world or to make up for missing supply in times of war or crisis. Here is a chart of global oil production along with the average annual price of crude oil. As you can see during the entire rise in price, production levels were not able to rise to keep prices in line, or to further enrich whatever country has this huge hidden supply of oil the world seems to be banking on.(Click on chart to enlarge)

Getting back to the United States can’t we just drill our way out of this mess? If we got rid of Obama we could drill everywhere and then we would have all the oil we would ever need. As much as some pundits would want you to believe that the truth is that our oil production peaked back in 1970. If in 40 years we have not been able to find enough oil to keep up with our demand then good luck finding all of this supposed oil today. Yes, there is untapped oil but do you really think that it will be enough? Peak oil people could be wrong and we could find Ghawar 2.0 in your backyard?(Click on chart to enlarge)

Oh but what about offshore production? Can’t we just go drill of the coast of California? They have already tried that and while they definitely did
find some oil and some is not currently being pumped there was nothing to lead oil experts to think that there were any mega-wells out there. While on the subject what was happening to offshore oil drilling before the BP spill? Yes, as you can see in the chart below even before the spill oil production was dropping like its hot for almost five years. Not only that but that is coming off levels not surpasses since 1995, an entire 15 years earlier.(Click on chart to enlarge)

So while Solyndra is obviously not the solution to anything, except how to lose taxpayer money, the President can not just wave a wand and have oil start seeping from the ground. Global peak oil is as real as United States peak oil. We are not working towards a long term solution which means that every time anything happens in the Middle East, Russia,
or even Brazil the price of oil will rise. Because of global energy uncertainty oil probably has a long term floor in the $80 area.

What can we do to change this? Well some items that would fit into an energy policy would be natural gas, rail, solar, etc. But until we admit that oil doesn’t grow on trees we will continue to revisit the spot where we now stand and it will happen more often and probably with more force each time. In our work and model portfolio we have a bias towards being long of energy as the long term risk reward is definitely slanted to the upside.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-In our model portfolio we are long OIL, XOP, and short some refiners.

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Deflation And What We Are Doing About It

We decided that it was worth sharing our views of the inflation/deflation debate with all of our readers. In our weekly newsletter we are already positioned to take advantage of some of the current as well as potential trends that will benefit from our scenario.

The following are our views on different parts of the puzzle that show that we are currently in, and will likely be experiencing deflation for longer then most people seem to think.

Savings

Here are some interesting, and unfortunately not surprising, savings rate numbers. The current savings rate is 5.7%, the all time high in 5/1/75 was 14.6%, the all time low was in 8/1/05 with a savings rate of -2.7%, the historical average is 6.8%, and the 10-Year average is 1.7%. As you can see in the chart the past year has seen a huge uptick in the savings rate as consumers are trying to pay off debt and save some money.

Personal Saving Rate

personal-savings-rate

Of course as savings go up spending goes down. While this is good for the individual household it is a negative for the overall economy as it means less money is being spent on items from housing to cars to clothes. While this could just be an abnormal blip in the scheme of things there are

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several reasons to think that this time the trend will hold for a while.

Baby boomers as a group don’t have anywhere near the funds to retire. After 2008 wiped out 42% of the worlds wealth they should be scared and saving for their rapidly approaching retirements. Once the economy starts to pick up they may very well start spending like it was 1999 again but we don’t think that they will because while most people are ok with the idea of working a bit past the age of 65, they do not plan on working into their 80’s and 90’s.

If the savings rate gets back up to the historical average of 6.8% or higher and then stays there for a while, it will be a huge drag on the economy. As consumers buy less and less, pricing will likely come down. We are already seeing this in the form of huge sales in stores across the nation. Many retailers have already had several markdown sales and it is safe to assume that this trend will continue for at least the next year or so. If our projections are right and the savings rate gets back to “normal” we will likely see a re-pricing as most businesses just accept that fact that their profit margins will be smaller going forward.

Housing

The monthly proclamations of a bottom by the NAR notwithstanding we have yet to see anything resembling a bottom in real estate. The Case Shiller 10-City index is down 33% from its peak and the 20-City index is down 32%. Both charts look the same, which is to say each month is lower then the last month. So far there has been no bottom.

Case Shiller 10-City Index

case-shiller-10-city-index-csxr

Not surprisingly housing sales numbers don’t look much better. In spite of the monthly bottom calling we continue to see more new lows every few months. As you can see in the chart below we are just off of new all time lows since the data series started in 1963.

SA Housing Sales

sa-housing-sales-hit-a-new-historic-low-since-series-began

Zooming in a bit you can see that while we have had several blips over the last few years none of them have lasted for more then a few months and all have led to new lows. Our best guess is that we are headed lower in the next few months.

SA Housing Sales-A Closer Look

sa-housing-sales-each-of-these-were-supposed-to-be-the-new-bottom

As if residential housing was not enough, the commercial real estate market is playing catch up. Residential peaked in June 2006 and commercial held up until October of 2007. Since October of last year however commercial has made a valiant effort to catch up and is now down -29.48% since then. In fact from March to April alone it dropped -8.62%. If real estate has found at bottom it is keeping its location secret because none of the data that we have seen points to it.

Moody’s REAL Commercial Property Price Index Composite(CPPI)

moodys-real-commercial-real-property-price-index-down-29

Of course you may be thinking that there has to be some commercial real estate that has found a bottom. This may be the case on a geographic basis but it is definitely not the case when it comes to segments of the commercial market. As you can see in the chart below industrial is the strongest part of the market and yet it is still down -14.26% from its highs. Apartments are next being down -19.01%, followed by retail which is down -23.11%, and finally office space which is down a whopping -30.22%. Judging by the massive drop this last quarter it is safe to assume that we have a ways to go before we really hit the bottom.

Moody’s REAL Commercial Property Price Indices
moodys-real-commercial-property-indexes-apartments-industrial-office-retail

Employment-

In case you haven’t noticed employment has been horrible and getting worse. One of the newest “in indicators” is the exhaustion rate. While this indicator is not new it has luckily not garnered much attention over the years because it only gives a real signal once or twice a decade. The exhaustion rate is the rate at which people come off, or exhaust, their unemployment benefits without having securing a job. Why is this the “it indicator” right now? Well if you look at the chart below you can see that we are not only at all time highs but are actually at 49.23%. Yes, that means that almost half of the unemployed are done receiving unemployment money. That of course leads to even less money to spend on anything.

Exhaustion Rate

unemployment-claims-exhaustion-rate

After looking at the exhaustion rate chart it should come as now surprise that unemployment is high. In fact it is at its second highest level ever at 9.4%. As bad as unemployment is right now, it is going to get worse before it gets better. We will likely hit at least 11% ,and we would not be surprised to see 12-14% unemployment before jobs data bottoms out.

Unemployment Rate

historical-unemployment-rate

At this point it should not be much of a surprise but as you can see in the chart below, average weekly hours and non farm payrolls data are also both declining on a year over year basis.

Average Weekly Hours and Non Farm Payrolls

weekly-hours-and-non-farm-payrolls

So how does all of this effect deflation? If people are not working then they are not able to spend as much on consumer goods and services. That includes clothing, food, entertainment, transportation, etc. If they stay unemployed long enough and fall off of their unemployment benefits then they are able to spend even less. Along with the lack of, or at least severely impaired, spending power there is a host of other side effects, which includes everything from defaulting on credit cards to defaulting on their mortgages. As consumers spend less, businesses have to lay off more employees as sales drop off and margins are squeezed with exacerbates the situation. One consistent relationship is that of the unemployment rate and capacity utilization. As unemployment rises, capacity utilization drops as demand falls out.

Unemployment and Capacity Utilization (inverted)

unemployment-and-capacity-utilization1

If there is no demand then there is no spending. If no one is spending then there can be no inflation. If things are contracting then we are in deflation. One more indicator that shows this is that of the output gap. The output gap is the difference between the amount that we can produce and the amount that we are currently producing. In the chart below a positive number indicates under-utilization, and negative numbers reflect over-utilization. If the line is rising things are getting worse and if it is declining things are improving. As you can see the line has risen quite a bit and at least for now is showing no signs of turning around. The output gap is a good indication of available demand. As you can see. the output gap is bad and getting worse as demand continues to decline.

5-Year Output Gap
5-year-output-gap-chart

Banking-

While we could go on and on about banking we will try and keep it short. Most people are pointing to the charts from the Fed on bank reserves and saying that they will cause hyper inflation. Yes, the monetary base is at historic highs but guess what? Until that money is actually in circulation it does not cause inflation. You can print ten quadrillion dollars but if you bury it in a hole then it does not cause inflation.

Look at the chart below of the Adjusted Reserves. As you can see it is at record high levels. While it is extremely high it is not in circulation yet and likely will not make it to consumers for some time.

Adjusted Reserves

adjusted-reserves

This number is extremely high due to all of the money that has been printed over the past year in response to the financial crisis. But the inflationistas are missing one important point, namely that until banks have rebuilt their reserves they will not be lending. As long as residential and commercial mortgage defaults continue banks will continue to rebuild their balance sheets. Once they have a stable asset base they will start lending and we will likely see some really high inflation but until then we will be in a deflationary environment as the money is not being put into circulation.

Commodities-

Commodities are another reason that many use to justify their inflation arguments. After having a good bull market from the end of 2002 until fall of 2007, they took off and got a bit parabolic for the first half of 2008 before crashing and coming back to levels not seen since 2002. Of course as anyone who has filled up their gas tank knows, commodities have started to climb once again moving from 200 up to 250 from the March lows.

Commodity Research Bureau Index

weekly-crb-index

The rise has been widespread with energy, base metals, agriculturals, and even precious metals rising considerably. Aside from precious metals it appears as though the primary reason that we had such a strong rebound was due to buying out of China. In the first two quarters of the year the Chinese government decided to use some of their surplus to buy raw materials. They bought a lot of copper, secured oil contracts, and stocked up on everything else. Now it appears as though their buying is slowing to a trickle of what it was and with the run up in prices they are taking a break as they will likely get to buy more at lower levels.

While the buying out of China may help commodities put in a bottom, it does not appear as though it will drive them much higher. With the possible exceptions of precious metals and energy we see most commodities turning in flat to slightly negative results for the rest of the year. With the demand destruction that we have seen over the past year commodities have a tough road ahead of them before they will be able to climb higher.

Deflation-

So where does all this leave us? Demand has been absolutely crushed on several fronts: People are finally saving and paying down debt instead of spending. Real estate is still falling, and with inventories as high as they are, will likely not fully recover for years. Employment is as bad as at any time in the Post WW2 era. Banks are still impaired and unable/scared to lend. And with all this demand destruction commodities are unlikely to continue upwards for a while.

Finally there is the matter that while we can speculate on inflation we are currently in deflation as can be seen in the chart below of the CPI. We have officially been in deflation for the last three months and while it might slowdown a bit we will likely stay in a deflationary environment for longer then most people think.

CPI-YoY % Change 1922-Now

cpi

What are we doing?

So if we believe that we are in deflation what do we do about it? The best deflation trade that we have found is to be long bonds. As we stated in our last blog post as well as the last few newsletter we are long TLT-20+ Year Treasury Bond ETF. Not only are we in deflation but the trade was decent on its own merits.

Real yields on Treasury bonds at the end of May were at their highest levels since February 1995 and right now they are at 4.76% for the 10-Year and 5.58% for the 30-Year. In an environment where we expect most assets to fall or go nowhere, we think that Treasury Bonds offer good value.

10-Year Treasury Bond Real Yield

10-year-treasury-real-yield

Treasury bonds got almost as oversold recently as they were overbought back at the end of 2008. By normalizing the trend using a 200-day moving average we build reversion to the mean charts that show how far above or below securities are from their mean. In the case of the long bond our charts showed that it was extremely oversold and that it was a good time to start building a position.

TYX-30-Year Treasury Bond Yield Reversion to the Mean Chart

tyx-reversion-to-the-mean

Looking at the chart of the TLT we could see it running up into the 100-105 range over the next month or two as investors take advantage of deflation, the oversold conditions, and the favorable real yield.

TLT 20+ Year Treasury ETF

tlt-long-term-treasury-etf

While the long bond is definitely our favorite deflation trade, it also makes some sense to go long the US Dollar and/or the Japanese Yen as investors flock towards safety. Other trades would be to short stocks and short commodities in anticipation of them falling as demand continues to decline and margins shrink.

And what about inflation? We actually do believe that eventually all of this printed money will lead to some hefty inflation but right now we are in deflation. Additionally the inflation trade is the most overcrowded and one sided trade in the financial markets right now. If we are right we will do well, and with the aid of risk management if we are wrong we will be stopped out for a small loss.

Happy Trading,

The Macro Trader

Dave@TheMacroTrader.com

Disclaimer-We currently hold positions in TLT

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Where Did All The Contango Go?

For the first few months of the year West Texas Crude Oil was in an extreme contango situation.  In fact it got as high as 20% just four months out.  Looking at the 4-month contango/backwardization  in West Texas Crude Oil we can see that in just the past seven weeks it has dropped from over 15% to just 3.2%.

West Texas Crude 4-Month Contango/Backwardization

oil-contango

Most of the narrowing has happened in the near month futures, since over the past seven weeks the near month has rallied  27% and the 4th month only 14%.

Obviously the big question should be is demand really picking up? If so Oil should rise fairly quickly as we continue to see declining production as well as a decline in the ability to produce via the drop in rig counts over the last eight months.

Or is this a short term rise based on the notion that the economy is improving and this is just an extension of the risk trade?  If so then oil is to be shorted as are many other commodities as the reflation trade is put on hold.

We try not to fight the market and right now it is obviously in bull mode as it has moved up 75% from its lows.  That being said we tend to listen to the signals from economic indicators like capacity utilization, unemployment, and Fed minutes that show anything but an economic recovery.

West Texas Crude Oil

oil-bull

For now the trend is up and we are modestly bullish (that means we are flat) bulls.   However over the next few months we would not be surprised at all to be changing our view to the bear side and going short as the lack of demand likely overtakes these sorry excuses for green shoots and the economy, and therefore demand, roll over.

Happy Trading,

Dave@TheMacroTrader.com

Site Updates- Yesterday we installed Disqus to better  interact with our blog readers.  We welcome your views on energy, the economy, and any other financial topic.