The curious case of crude oil

Last week’s production cuts and further weakening of the dollar were not able to offset the expectations for slump in demand and crude oil fall to four year lows. OPEC claims that the severe decline is not based on fundamentals and it is pure overreaction. If they truly believe that the current price of crude is unfairly cheap, let step up and start buying oil futures as every self-respected company would buy its shares in a similar situation. Such behavior might seem extreme, but it will have better appreciation impact on oil futures than production cut.

During the last three weeks we experienced a small rally in many commodity related industries. All, except oil. The demand was highest for Gold. If smart money is truly expecting an economic recovery in 2009, it would be buying crude, not gold. Bidding up gold and treasuries is a sign of fear and uncertainty. It reflects a perception of higher risk. It is a desperate move aiming to save some of the purchasing power of the current wealth, which is devastated by FED’s favorite sport – dollars printing.

In the end of last year I wrote a post about crude oil, trying to explain that too high price of the black gold will be devastating for oil producing countries in long-term perspective. First, an extreme price of oil gives people an incentive to invest in alternative, more energy efficient technology. If a human being is motivated to achieve something, sooner or later, it succeeds. Second, high oil price changes people’s habits. They find a way to consume less and tend to stick to this newly found behavior even when the economy starts to recover. At the brink of extremes, people change.

It is fair to point out that OPEC didn’t and doesn’t have a major impact on crude futures. It is well known fact that they were bid up by financial institutions. Disregarding that, oil producers liked the thickness of their wallets and said that they can’t impact the price of oil. Why do they think that they will be able to do it today? They became complacent and didn’t think about the long-term ramifications of high oil price for their economies. Oil was found about 100 years ago and it was adopted as energy source, because it was cheap and efficient. Once those variables change the whole equation changes. People go and find a better alternative.

Earlier this year Bank of Kuwait came up with a report, revealing the break-even price of crude for the different oil producers. It claims it is $17 per barrel for Kuwait, $30 for Saudi Arabia, $33 for Canada and much higher (in the lower 40s) for many others. All small numbers that should suggest that at the current level of crude, many countries should stop producing. I don’t believe these numbers. Oil producing nations have sold profitably its products at even lower prices during the last several decades, even when inflation is taken into account. I would like to see a similar report for break-even prices from an unbiased entity.

What strikes me the most is not the break-even prices, but the claims that many oil producing nations have based their 2009 budgets on $70, $80 and even $95 per barrel. If for a moment we assume that this is true, countries like Venezuela, Iran and Russia are in big trouble. Not only many projects will be postponed (scratched), but their cash reserves will evaporate faster than a glass of water in a dessert. Extreme budget deficits will affect substantially the living standards of their citizens and it won’t be surprising to witness cases of massive civil disobedience. Ironically, political destabilization in any of the major oil producers will lead to far more efficient appreciating shock on oil futures than any coordinated cuts. An extremely low price of oil will lay a solid foundation down for its fast appreciation in a 3-5 years horizon, as an extremely high oil price caused what we are currently witnessing. Remember that for the next 20 years oil will most likely remain the cheapest and most efficient source of energy.

Assuming that the current short-term trend of weakness in crude oil continues, which industries would be the biggest benefactors? The fist groups that come to mind are Airplane carriers and trucking companies, which bottom line should get a boost from cheaper oil. So far there is no sign of that happening. Oil is only one variable in their EPS equation. The current decline in their input cost is more than offset by a decline in their output – people travel less often, companies sell less; less packages need to be transported.

The only industry that currently should thrive in an environment of low oil price is Gold mining. Not only crude accounts for substantial part of its expenses, but gold has been outperforming everything else this year. If this trend continues, and there are no signs that it will end any time soon, gold mining companies’ EPS should get a nice boost. Higher EPS growth often leads to higher stock prices. Certainly EPS is not the only factor that affects price. It is actually of secondary importance when put next to investors’ confidence. A simple way to measure confidence is through P/E ratio. It is self-evident that recession hits investors’ confidence big time. Often a rise in bottom lines of solid companies is offset by general lack of confidence.

The dangers of deflation

In long-term perspective there are two scenarios for the global economy: severe deflation and strong inflation, as they might come one after another in this order.
Severe deflation will mean further shrinking of consumption, unemployment in the double digits. More downside for commodities. Oil might take the elevator to the lower 30s. If this happens, we might see another 30-50% decline in the stock markets, as soon as next year. Earnings expectations are still elevated and negative earnings surprises in the coming quarter might shave the Dow with razor number 6. Many emerging countries will default on their credit following the example of Ecuador last Friday – a dangerous practice that usually leads to tightening of the credit markets, which hurdles economic growth. Severe economic crises around the world might lead to forced change of governments and a revival of nationalistic political systems. No country is insured against the unsatisfaction of the crowds. Countries which have enjoyed higher economic standards during the last decade should be particularly aware of sudden economic slump. People seem to be motivated more by the thought of losing something that by the thought of gaining something of equal value. James Davis states that we are most likely to find revolutions at a time when a period of improving economic and social conditions is followed by a short, sharp reversal in those conditions. Thus, it is not the traditionally most downtrodden people – those who have come to see their deprivation as part of the natural order of things – who are especially likely to revolt. Instead revolutionaries are more likely to be those, who have given at least some taste of a better life. When the economic and social improvements they have experienced and come to expect suddenly become less available, they desire them more than ever and often rise violently to secure them. For instance, it is little recognized that at the time of the American Revolution, the colonists had the highest standard of living and the lowest taxes in the Western World. According to historian Thomas Fleming, it wasn’t until British sought a cut of this widespread prosperity (by levying taxes) that the Americans revolted.
The other, and ironically the preferred path, is inflation. The US government desperately is trying to inflate the economy, trying to prevent Great Depression number two from happening. The financials injections in the economy will lead to severe weakening of the dollar. People, who keep their money under their mattresses or in low interest savings’ account will get poorer. The only way to offset the decline in the purchasing power of your dollars will be to be invested in the stock markets, which are supposed to rise during periods of inflation. Commodities will renew their upward spiral.

Analysing yourself

“At the end of each trading day (week) you shouldn’t focus solely on your P/L. Instead, focus on your thought process during the day and how well you executed your plan. If you consistently execute your trades according to plan and still lose money, then you need to reevaluate your approach. While there is definitely a cyclical rhythm to the market, no strategy will always work. You need to constantly  and objectively  review what is working and what is not so you can make necessary adjustments to you plan.”

Brian Shannon

Having a plan

Having a plan of action allows you to be objective when others are often reacting emotionaly. Every weekend I sit and create a list with potential trading candidates for next week. I choose 5 longs and 5 shorts, representing different industry groups, which my analysis reveals that might have a significant move during the week. Watching such a small number of stocks helps me to be more focused and objective. Usually only 2 or 3 out of the chosen 10 stocks will behave the way I expected, but in my scheme of things this is more than enough.

Thinking out of the box

The current market is unique. It has never been so volatile; therefore the danger and the opportunities have never been so plentiful. No one has ever traded in such market, so past knowledge and experience may only be a hinder to adopt faster in the new environment. No system is profitable all the time and traders with 20+ years of profitable track record are in the process of realizing that. In time of extreme changes survives the one, who is more flexible, not the stronger one.

Conventional wisdom will bring you only losses. You have to learn to think out of the box. Conventional wisdom says that in bear markets you should be only short or neutral. In case you absolutely have to have long positions in your portfolio, you should choose among the stocks with highest relative strength – the ones that somehow managed to weather the storm.  Wrong. Buying high RS in this market doesn’t work. Current price leaders are not only underperformers during sharp bear market bounces, but one by one, industry group by industry group, they are all taken down. In bear market they are all taken down, sooner or later.

Conventional wisdom says that we should short low relative strength (52 week lows for example) in this market environment. This is a strategy that makes sense, but a very, very dangerous one. Remember, market can remain irrational longer than you can remain solvent. Some of the most powerful daily and weekly upside moves have happened during severe bear markets. Last week there were 148 stocks that went up 20%+. (Priced above $2 per share and average daily volume above 50k). The majority of them did that from their 52 week lows – the most beaten down stocks. Every week there is an industry or two that revive from the dust. Past week that was Medical instruments and Insurance companies. The week before was good for solar companies. The week before that was good for gold miners. The one before that was good for airline companies.  Stocks tend to move in groups. When you are looking for short-term trading opportunities, you should look at industry groups’ moves first.

Certainly trying to pick a bottom is a very dangerous game. Last week 189 companies went down 20%+. Most of them were close to their 52 week lows and had their leg down after a short-term bounce. More than half of the worst performing stocks last week belong to Oil related industries.

Market is so volatile that it takes stops out on a regular basis, shaking out both long and short swing traders. Percentage stop losses don’t work in this environment.  If you are going to survive and thrive, you need to decrease your trading horizon and the size of your trading. I remember that about a year ago, I found out that many, who were swing traders at the beginning of their careers at some point switched to day trading. I wondered why and started asking questions. My initial guess was that the tremendous volatility in 2000-2001 has made those traders change their strategy. The answers received were a little bit different. Most traders told me that it is a more psychological thing. They have found what suits their personality and goals best.

Markets are made from people. In theory everyone could be profitable if there is a continuous flow of fresh money into the market. Recently this has not been the case. Someone has to lose. In order to be profitable you need to follow a very simple rule – to buy only what you could sell later at higher price and to sell short only what you could buy later at lower price. Like the owner of a small shop, you should not buy inventory that you personally like, but stuff that could easily be sold this season. Yes, stock traders are in the retail business and their products are called stocks. I realize that such how scrupulous such way of thinking sounds and that it contradicts the initial purpose the market were created, but this is the reality.

Initially markets were created :

          To offer an alternative exit strategy (therefore motivation) for entrepreneurs;

          To provide new means of cheaper financing for business’ expansion;

          To allow ordinary citizens, who don’t have the idea, the will or the necessary capital to start their own business, with the opportunity to participate effectively in the economic growth of the country/the world.

All those things don’t matter anymore. Markets have long turned into a speculation arena, where everyone tries to outsmart the other.