Has Oil Bottomed? (Part 1)

It's never easy, folks

Having established a long trade on WTI crude oil just 2 days ago, we now try to answer the panoply of questions that might leave some of us a little more then dumbfounded. Almost at everybody, at some point in their lives, would have begged for answers to questions such as "is this the high?", "is this the low?", "has the bubble popped?". No surprise because these are the simplest, most straightforward questions any punter would ask; questions that if answered correctly could potentially reap windfalls.

The irony in life personifies itself very aptly in cases such as these. Simple questions almost never garner simple answers; they get the incredibly studious responses that are harder to fathom than the square-root of Pi. Those that aren't exposed to the tsunami of infinitesimally articulate details wouldn't be able to understand the trains of thoughts that run in parallel to garner a proper response. The sad truth is that in many cases, flipping coins would have generated better results than deliberation. It is not easy to call anything in the markets; skill, experience, practice, knowledge, and luck all play a role. This is especially so when we try to catch a falling knife, as the age old adage goes.

But we must act. Bulls make money, bears make money, but the pigs get slaughtered. Unless you're selling premium of course, but don't forget to hedge your hedges. We guess traders will toast in unison to this one. Our stance is clear; we are more convicted to higher crude oil prices than lower prices, and this opinion has been reflected in our long position in WTI. We take no offense to the mocking birds that will chirp endlessly at our seemingly amateurish  incontinence, nor will we take the credit of staunch aficionados heralding the bravado of a dying breed of bold contrarians.

Rather, we allow the indiscriminately ruthless markets to judge us. Vindication or violation - that's the rule of the game, folks. It is of course never easy, to be consistently on the right side.


A word about the game

Before we start with business, we want to express what we think about this game of calling markets. People often remember you for your miscalls and never for your calls at are actually right, especially when you manage boatloads of money. Prepare to have your windscreen smashed if you don't deliver as promised. The proverbial shoe in the sand always catches money managers off guard, and those without a strong chin instantly kiss the canvas. It's a very tough trade, calling the markets. Even if you get it right, that doesn't bring money to your table. You've got to be in the markets, exposed and geared. You've also got to manage your exposures to reflect ever changing market dynamics and sentiment; let alone explaining to clients why you did this and not that. 

Acidity gets high sometimes and the smell of mustard in the room warrants excessive physical stimuli.

Sometimes you can be right for an instant and the markets totally go against you. If your conviction is flaccid, you'll probably liquidate; we've seen professionals do this all the time - the senseless and sporadic ebbs and flows of prices reflect just this. Sometimes, you've got to bear with huge drawdowns because hedging is just not economical and emotionally viable, and every professional knows that's acutely painful. Sitting through losses and being a hair's width away from taking the red pill is a serious game. We have seen others others blow up like this - the market stops them out on a trade for a huge loss, then almost instantly rebounds, all for naught. 

We believe consistency and skin in the game are the twin cams that keep this game running. Inconsistent calls just speak one word: Luck. An absence of skin in the game just begs the question "so did you make money?". We're not in the markets to look and feel good. We're here to make money, just like all other businesses. In our eyes, the guys that set themselves apart from the carousel of wannabe traders are those who consistently prove their ability to profit from market calls. We don't look for the marksmen, those don't interest us.

Boxing legend Mike Tyson didn't rise to the figure he was because of sheer brute strength and power, but the finesse of his foot work, his quippy evasion techniques, accurate jabs and devastating uppercuts, but most importantly an iron chin. The same applies to traders and investors. No one can be right all the time. Even if you're right in the direction, you can be wrong on the timing. After you've been right on both price and timing, the rubber only meets the road when you profit directly from the market. Once you can achieve all three points with consistency, access to the upper echelons has been granted to you.

Ever since the advent of the Internet and its supernatural growth, there has been no dearth of timeless examples where pundits who were proven dead wrong by none other than the markets, quietly run to the hills dropping a cone of bewildering silence on their followers. Pundits like these never admit they were wrong, but take all the credit when they're occasionally 'right'. Professionals and seasoned participants are able to quickly spot these sour apples. The same cannot be said for the masses, who coincidentally are the targets of these spineless artists. Prime examples would be the doomsayers, bubble callers, economic collapse "gobbledegookers", gold and silver bugs, the list goes on almost in an infinite loop.

We don't take prejudice against this growing group of people, we absolutely loath them and for perfectly justified reasons. Then again, bad apples are part and parcel of any legitimate industry. So much for our rant, because there is little we can do to retard the growth of this mis-practice. 

Verbiage aside, we wish to present our thoughts so that others might be able to gather how we came to our own conclusion to be bullish on oil prices. We'll try to keep it succinct because there is always a chance for the markets to nullify all we will opine on. Godspeed to all who take similar views


Fundamentals

We use a systematic top-down approach for our analysis on energy. We have to say that we aren't experts in this field, and a lot of work has already been done on energy. When we talk about fundamentals in the energy markets, we usually refer to the supply and demand equilibrium or lack thereof. Price formation boils down to this equilibrium, so it's logical to look at this in grander sense. But first, we highlight the key points that we believe helped formed our bias towards higher prices.

Bottom line:

  • Almost everyone agrees that prices will stay low; with Saudi Prince saying "won't see $100 ever again" - and the majority history on the right side?
     
  • Sentiment has been incredibly one-sided; 9 out of 10 analysts we see are bearish
     
  • There is an absolute dearth of bulls; stories are mere extensions or iterations of what has already happened
     
  • Absolutely no word of oil being a commodity, and that commodity prices are always cyclical
     
  • Calling low prices a new paradigm because of the "shale revolution" is akin to 3D printing crowding out traditional subtractive manufacturing lines. Absurd in every way
     
  • Collapse in prices heavily due to activity in the financial markets (hedging, position unwinds, capitulation). This is also not spoken about at large 
     
  • US crude inventories at highs, came in at much higher than expected levels in past week despite WTI nearing $40 handle - will furtherhurt US producers
     
  • Firings and layoffs on an uptrend in the US oil and gas industry, ripple effect already extended; this isn't an infantile development
     
  • US producers tightening production, shutting down rigs; latest Baker Hughes rig count still slumping (1633 last, from 1900+ at highs in 2014)
     
  • Capex in oil and gas (drilling and exploration) sector waning dramatically in almost all parts of world, sowing the seeds for a true supply shock in the future; we will see trend in lower Capex manifest in the months to come
     
  • The alternative/green/renewable energy industries have been annihilated; record bankruptcies and paper-thin margins. Sub-$60 prices will continue nailing their coffins  
     
  • The weak demand story has an even weaker basis; 7%+ growth in China for 2014 anyone?
     
  • 2008's crash was founded on a global recession and a financial meltdown. Price decline on a similar magnitude occurring in an environment where global growth is set to be above 3% for 2014; did everyone start to photosynthesis?
     
  • Fresh production is already being hoarded in offshore mega-tankers and onshore storage facilities; as long as they don't go to market they form part of inventory, not supply
     
  • OPEC decided on consensus to maintain production; portray price inelasticity although budgets hurting
     
  • OPEC has a strategy which is difficult to accurately analyze, we suspect a more sinister agenda behind their facade
     
  • Iraq's production has never been higher, but because its economy requires the marginal revenue from the cheapness of its production; no sensible middle eastern exporter favors low prices
     
  • Death of Saudi King means nothing for kingdom's policy on energy production and exports
     
  • Violent knee jerk reactions to the slightest of comments from OPEC ministers hints of a market in doubt; if we are correct about OPEC's true hand, this will prove ballistic when the curtain be are drawn

Weak Demand? Really?

Firstly, note that this chart is deceptive because it uses a logarithmic scale ($1-$50 takes up more than 70% of the entire scale). We did not create this chart, and we wouldn't have done it this way either.  This chart does though illustrates how out-of-whack the current phase has been. The magnitude of price decline has only been rivaled by previous episodes where something major occurred; the Great Recession being the most recent. Although one might be able too handily slip in 2014's Ebola outbreak break to fit the curve, the argument is easily refuted because as scary as the outbreak was, the situation was mostly contained in West Africa and did not see widespread migration. Are oil prices then serving as a harbinger for a recession to come, or a popping of a major bubble? All these are just too far fetched, and markets do not simply lead actual events by a year. It will only be in retrospect that we will be able to discern fact from fiction

Firstly, note that this chart is deceptive because it uses a logarithmic scale ($1-$50 takes up more than 70% of the entire scale). We did not create this chart, and we wouldn't have done it this way either. 

This chart does though illustrates how out-of-whack the current phase has been. The magnitude of price decline has only been rivaled by previous episodes where something major occurred; the Great Recession being the most recent. Although one might be able too handily slip in 2014's Ebola outbreak break to fit the curve, the argument is easily refuted because as scary as the outbreak was, the situation was mostly contained in West Africa and did not see widespread migration. Are oil prices then serving as a harbinger for a recession to come, or a popping of a major bubble? All these are just too far fetched, and markets do not simply lead actual events by a year. It will only be in retrospect that we will be able to discern fact from fiction

Let's address the issue foremost in our minds. The issue of weak global demand for oil. The ongoing struggle to define what is driving crude oil prices lower is perhaps another instance of a past cycle being reborn. With oil prices now heading much closer to the $40 handle than $60. The move in prices this past 7 months has been nothing short of astounding. At about $45 current prices the collapse from the recent peak now equals only previously significant global recessions under the oil regime that began in the middle of the 1980s.

This infographic tracking the number of new skyscrapers in existence and completed each year proves our point on how global growth is not stalling, but is in actual fact on route to accelerating even further; fueled by the renaissance in the East and the years of pump priming by major central banks. The smaller pane on the right shows the number of skyscrapers (200m and above) in existence: 615 (2010), 696 (20110, 767 (2012), 838 (2013), 935 (2014), 1,040 (expected 2015). The trend is unequivocally up, and there is little contest to this. The number of of skyscrapers completed each year since the nadir of 2007 has been accelerating; meaning the pace of completions and projects in backlog has also been increasing. Completions are increasing each year and at a faster pace every single time. If sentiment and global growth was indeed in the quagmire talking heads portend them to be, the facts clearly do not support those claims. 2014 saw a massive surge in completions, 97 new skyscrapers vs. 71 in 2013; 11 300m+ buildings vs. 8 in 2013. Nothing but impressive

This infographic tracking the number of new skyscrapers in existence and completed each year proves our point on how global growth is not stalling, but is in actual fact on route to accelerating even further; fueled by the renaissance in the East and the years of pump priming by major central banks. The smaller pane on the right shows the number of skyscrapers (200m and above) in existence: 615 (2010), 696 (20110, 767 (2012), 838 (2013), 935 (2014), 1,040 (expected 2015). The trend is unequivocally up, and there is little contest to this.

The number of of skyscrapers completed each year since the nadir of 2007 has been accelerating; meaning the pace of completions and projects in backlog has also been increasing. Completions are increasing each year and at a faster pace every single time. If sentiment and global growth was indeed in the quagmire talking heads portend them to be, the facts clearly do not support those claims. 2014 saw a massive surge in completions, 97 new skyscrapers vs. 71 in 2013; 11 300m+ buildings vs. 8 in 2013. Nothing but impressive

The present decline has been likened to that of  the 1997-1998 Asian Flu episode where mainstream convention was similarly convinced that it was massive oversupply at defined weak prices. It was then to the extent that the consensus was incorporated into the International Energy Agency’s (IEA) estimates of oil inventories. There is however a great differentiating point between the Asian Flu episode and the current "Ebola" episode: An epoch of 1160 million barrels of oversupply, oil that was already produced but not yet brought to market.  

After much haggling and investigation, the IEA eventually declared that there had been a gargantuan oversupply, 650 million barrels to be precise. On top of that, the IEA also announced that it believed there were a total of around 510 million barrels of oil that were missing, the so called "ghost barrels". Global inventories were constantly revised upwards to reflect the IEA's estimates.

Almost 2 years after the IEA first brought the "ghost barrels" to light, it concluded that some 510 million of those missing barrels resided in unregistered storage facilities in developed nations.

Of course the rhetoric is hard to prove entirely, but taking the IEA's accreditation into account, we assume some truth in its publications. Those 1 billion (that's a "B") barrels of oversupplied oil caused the market to discount prices by nearly 60%. That was on top of an influenza pandemic occurring in Asia which eventually sparked the Asian Financial Crisis of 1999. It was a very heavy fisted double whammy to oil prices. It is safe to assume that if the IEA were to gradually announce an oversupply of commensurable magnitudes we would be looking at $10-$15 oil by now.

Even with 2015 GDP growth forecasts being revised lower, most of the world (ex. Europe, Russia, and Japan) should see growth of above 3%. Actual growth figures have beat 2014 estimates. We believe there is excessive pessimism, especially once sub-$50 oil prices are taken into consideration. India is set to become the world's second fastest economy of the G20, behind China. The US is no slouch either, as we expect cheap energy to translate into higher discretionary spending by consumers and higher profits for corporations This different form of "wealth" effect has never been widely talked about. We feel this will come as a pleasant surprise to the markets once they realize how much the 2 largest economies, US and China, benefit from cheap oil

Even with 2015 GDP growth forecasts being revised lower, most of the world (ex. Europe, Russia, and Japan) should see growth of above 3%. Actual growth figures have beat 2014 estimates. We believe there is excessive pessimism, especially once sub-$50 oil prices are taken into consideration. India is set to become the world's second fastest economy of the G20, behind China. The US is no slouch either, as we expect cheap energy to translate into higher discretionary spending by consumers and higher profits for corporations

This different form of "wealth" effect has never been widely talked about. We feel this will come as a pleasant surprise to the markets once they realize how much the 2 largest economies, US and China, benefit from cheap oil

We also have to consider that financial markets were much less integrated and interconnected back then. The velocity of trading lagged massively, open interest was minuscule compared to today, there was hardly any algorithmic and high-frequency trading, information flow with much more latencies. In short, the market was in much lower gear than it is today. Extrapolating, one cannot help but to gasp in astonishment, if what transpired in 1997-1999 did so in 2014. We know that did not occur, so that's one myth busted and many more to go. We will of course not bother wasting time on that.

The simple conclusion we draw from looking at previous episodes where declines in prices were of similar magnitude to that seen presently is that they all occurred in the midst of some exogenous shock; be it a recession, war, financial crisis, epidemic. Looking back at 2014, besides the Russian-Ukrainian civil war, the Ebola outbreak in West Africa, a resurgence of the terror group ISIS, Japan slipping into technical recession (4th time in 5 years so nothing special), and the end of the Fed's QE program, there was nothing much else notable. Hence, even if we tried to curve fit this "weak global demand" story, there is still hardly any way that the full onus be placed on the "lower demand hence lower physical clearing prices" rhetoric. This is clear a dead end not worth pursuing anymore.

Lastly, recall also that the then Chairman of the Federal Reserve Alan Greenspan lowered rates from 5.5% to 4.75% late 1998 even though America was largely unaffected from Asia's cold. Contrast the events then to what is happening today: The same Fed is contemplating raising rates from the zero-bound, while the US economy looks set to record a better than expected GDP growth figure for 2014. China's economy, the world's second largest, was last reported to have grown by 7.4% for 2014; although the "slowest" in 24 years, it beggars believe that China's "socially financed" economy is heading to the doldrums. Quid pro quo. We certainly see where the "massive slump" in global demand is stemming from, because the talking heads do make it seem as though a quarter of the world just entered into recession. Yes, we meant to be sacarstic. More on this later. 


Occam's Razor

Over laying price action from that of the 1985-1988 episode with today's, we start to gain a clearer context of where we stand. the current decline has been less accute than it was previously, but are ore oversold than ever before because of the extended nature of the decline. We should of course never curve fit such interpolations. nevertheless, it serves as a good reference

Over laying price action from that of the 1985-1988 episode with today's, we start to gain a clearer context of where we stand. the current decline has been less accute than it was previously, but are ore oversold than ever before because of the extended nature of the decline. We should of course never curve fit such interpolations. nevertheless, it serves as a good reference

Sticking to the Asian Flu cum Asian Financial Crisis redux, is then turns out to us that it was a question if Occam's Razor was appropriately applied to form an attribution for the 60% discount in oil prices.

Although we would tend to agree that parsimony is the more relevant of approaches in our current age, the conundrum of "supply or demand" still bears its grunt. Even with super computing and cutting age mathematical modeling, it is still infinitely tricky to say if lower prices were a result of crude oversupply or a function to clear prevailing supply of production at a lower level of demand. 

During the aforementioned period, both tectonic plates were mashing into each other, assuming at least a half-truth to the IEA's claims of massive oversupply. The Asian Flu pandemic has obvious negative consequences on demand, much of Asia slipped into recession due to draconian slowdown in economic activity. Global supply needed a long time for clearance even at their already low prices. The idea that it was purely a supply or demand tale is complete hogwash

That was the easy part. The neuron-killing part comes in the tune of which triggered the other, or which came first. Harken back the days of the Subprime mortgage crisis. In the fallout of that saga, commentators found it hard to determine if it was actually easy credit that fueled the unsustainable boom or a raging appetite for cheap loans and financial institution's recognition of that potential, that caused the bubble to inflate beyond reasonable control. Such heuristics may never be answered with absolute precision due to the first actual nature of time. 

But to back to the 1997-1999 cyclical downturn in prices. Fast forward 2 years to the tech bubble and the 9/11 terror attacks which triggered an entire swath of offensive operations against Iraq and terrorist groups in the the Middle East, we also had an apparent impetus for 48% crash in crude oil prices. The bursting of a bubble the size of Silicon Valley and beyond raises no doubts that demand for energy would have been impaired to a significant extent. The dot.com bubble spawned a rather brief interlude in economic prosperity most of the world was enjoying for the former half of the past decade. The previous chart makes obvious the difference in duration of the respective oil price declines. The 1997-1999 episode was more protracted, reflecting more complicated dynamics. The dot.com episode was over in stark time, indicating a direct driver for that negative price shock.

Again, as we juxtapose 2001's episode to today's we reach yet another dead end as the similarities end with much lower oil prices. However much our doom and gloom buddies over at the miserable side of the world wishes that global stock markets stage an orchestrated crash in 2014, they didn't. The wealth effect has in fact never been more prolific; US equity indices performed ebulliently in 2014 despite 2 major hiccups that frayed some nerves. The Ebola outbreak situation in West Africa had already started to stabilize towards Christmas. Yet crude oil prices were still crashing through $60, then $50, and only recently testing the lowest end of $40.

Occam's Razor needs no further elaboration. The talk has been all about a supply shock after OPEC met in late November 2014 and decided to maintain their current level of production. Prices have cascaded in a waterfall ever since, as the markets started discounting OPEC's steady stream instead of the 500-1,000 Mbbl/d anticipated from the meeting in Vienna. We agree that global demand has pulled back slightly in 2014, but no where close to the extent espoused by the masses. We also feel that there lies a more profound agenda behind OPEC's strategy than to crowd our the so called shale-oil producers in the US.

In short, Occam's Razor is telling us the market has overshot its economic equilibrium; we feel the downside that oil prices saw under $55 (thereabouts) was mostly due to selling pressure in the markets rather than fundamental drivers. Unfortunately, we do not have the resources nor the time to validate this stance. The smart minds on Wall Street should concur on this one too.


We will discus more on the supply dynamics and much more in Part 2, so stay tuned...