OIL: weekend thoughts from KM and DJ

Below are our collective thoughts, in response to some thoughtful client questions:
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The immediate term “Trade” in Oil is up from where we bought it ($69). The intermediate “Trend” is as nasty as anything I see in macro right now. The challenge is to maintain those 2 opposing thoughts in your melon, and remain sober enough to make money.

There are two major “Trend” lines in Oil to keep on your screen, $93, then $114.

My summary point of DJ’s fundamental outlook on the “Trend” is simply that scarcities become surpluses during global recessions.
KM

  • Here’s my simplistic take on oil, the demand side will continue to be weak in the U.S. and weaker than expected globally probably into the back half of 2009 (potentially much longer). This is obviously not unprecedented. From 1978 to 1983, Oil demand in the U.S. was down for 5 years in a row for an aggregate peak to trough decline of 19.1%. I’m not saying that will happen again, but there is a reasonable scenario where U.S. demand is weak for awhile and if you see U.S. demand drop by 19% over the next five years, China better be growing more than expected to sustain the price of oil.

  • On the production side, while I totally buy the long term supply constraint argument, in the short term and this is very simplistic, if OPEC has to cut production to maintain price than scarcity value should not be priced into Oil anymore (I think that was part of the argument that people were making when Oil was on its way to $140 i.e. there is a premium above marginal cost for scarcity), thus Oil should trend towards its marginal cost . . .$60/$65?
  • From a trading perspective, we have been watching Oil futures fairly closely and, as I’m sure you know, they are solidly in contango. Which means in the short term, it pays to store oil and we will likely see inventories building, which is a negative fundamental data point. In support of this, while the weekly IEA data doesn’t show inventories that are well above their historical average, days of supply is now close to 24 days versus 21 days a year ago (inventory is normal but supply is down 5%+ y-o-y), which suggests inventory will continue to build in the U.S. in the short term, which will lead to incrementally negative data points.
  • In terms of interest rates, our macro view is that the “Trend” will become higher, and perhaps dramatically, into 2009, which should strengthen the U.S. dollar and, obviously, act as a cap on the price of Oil into 2009 as well.

    From quant perspective, and I’ll let Keith weigh in, Oil is oversold, no doubt there, and there is a potential short term catalyst in the Fed cutting rates again, but even the Fed Rate must be at least partially priced in since the fed futures, last I looked, are close to fully discounting a 50 bps cut.
  • So, in summary, I have a hard time getting excited about Oil in the next 6 – 12+ months. KM likes it, but I can see him unloading it on price in 6-12 days! If that’s what it takes for us to keep outperforming in this market, so be it. Obviously the bearish “Trend” side of oil is no longer a contrarian view at this point, but facts are facts.
  • Daryl Jones
    Managing Director

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