This week, the CFTC (Commodities Futures Trading Commission) published their long awaited report, authorized by Congress, on the subject of speculation in energy prices, and specifically the price of oil.
It came as no surprise to any of the denizens of the Street that the CFTC concluded that over 50% of the recent action in oil futures results from "speculators". It has been pointed out in recent posts in this space that the number is probably closer to 70%, and that a number such as that is normally associated with major turning points in markets. The Shady Side also opined that most of the aforementioned "speculators" follow a strategy known as "trend following", and once the trend was perceived by them as having reversed, their selling would accentuate the downside in oil futures.
Earlier this week, West Texas Intermediate crude oil dipped below $118-a-barrel, which amounted to a decline of over 20% from the previous high of over $146/barrel. That is a Nice Round Number, which readers of the Shady Side will recognize as being theoretically meaningless, but psychologically important. It is almost a certainty that any competent managed futures fund has now blown out of his long positions and probably gotten himself short. The selling of long positions and the probable initiation of new short positions have almost certainly accelerated the momentum to the downside.
One of the events that some say contributed to the drop in oil prices was the flawlessly executed flip-flop by front-running presidential candidate Barack Obama. Having had the fear 0f God thrown into him by a Rasmussen poll showing McCain actually ahead, Obama found religion and "clarified" his position by announcing his support for offshore drilling, an issue that McCain had previously owned.
More importantly for the oil markets, though, was Obama's stated support for selling some of the 700 million barrels of crude in the Strategic Petroleum Reserve (SPR). While Obama is far from the first candidate from either party to advocate tapping the SPR, the fact that he is the front-runner (maybe) increased the perception that the US government, the largest single owner of crude oil in the world, might be a seller. It is unclear how much of an effect sales from the SPR would actually have on oil market fundamentals--the SPR probably contains about as much oil as the world currently uses in about eight or nine days-- but the psychological impact could be huge.
"Hello, Jim? This is George Bush. I am giving you an order to sell one hundred million barrels of West Texas Intermediate with a limit of $100. What's that? The bid is suddenly only $80? Ok hit that bid and keep selling until we break $70..."
That might sound like it's overly dramatic, but the last time a president started selling from the SPR, when Bill Clinton held the job, crude eventually bottomed out in 1998 at $10/barrel, which ultimately bankrupted Russia, which had been financing their entire economy with crude oil exports.
So the idea of Barack Obama (or George Bush, or John McCain) hitting bids in the oil market was taken very seriously by the traders in the pits. At the very least, the previous upward momentum now appears to have been broken. The long trade in crude oil is not such a no-brainer any more, especially when the world's biggest long is not only done buying, it might actually become a seller by the first quarter of next year.
And even if sales from the SPR do not slam the price in the pits so severely, they make good economic sense. Most of the oil owned by Uncle Sam was purchased when oil was well below $50/barrel, so the average cost of the oil there is likely well below that number. Assuming an average cost of $40 (which may be way too high), selling 100 million barrels at an average cost of, let's say $100/barrel, would give the Federal Government a profit of $6 billion. These are conservative assumptions... the reality is probably a much bigger profit. It is pretty easy to imagine a scenario in which the the US government raises $20 billion through selling oil, and is still left with several hundred million barrels in case a war breaks out. $20 billion is a comparable figure to the revenues from the so-called "Windfall Profits Tax" on oil companies, which will do nothing to cause the price of oil to drop.
If sales from the SPR can not be so profitable because the market price drops, that will be fine because the benefits to the economy will have a value worth many times that profit. So selling oil from the SPR really seems like a no-lose situation... either you make a bundle of money on the sales or you drive the price down. Win-win.
Either way, it seems that oil has now entered a bear market. In a bull market, the market ignores the bad news, and in a bear market, the market ignores the bullish news. This Friday morning, there is news of geopolitical unrest: the Russians and their Georgian neighbors are rattling sabers, and there is footage on CNBC of tanks rolling. Since Russia happens to be the second biggest producer of oil in the world, one would expect such a scenario to bump the price of crude higher. Nevertheless, oil is trading down about $2/barrel to around $118. That means that if you bought oil at the high just last month, you have already lost 20%. If you leveraged yourself in the futures market, your losses are significantly higher. It is safe to say that some "speculators" have been wiped out completely by this reversal.
And that is pain much worse than Congress could ever inflict through the proposed legislation to limit "speculation" in the oil market.
So what is the average investor to do? Sell, Mortimer, Sell!
Just kidding. But you want to be very careful that you are not overweighted in energy stocks or commodity mutual funds or ETFs. It probably makes sense to continue to have some energy exposure as an insurance policy, but your overall portfolio will benefit if oil contiues its slide. Keep a hedge in case it reverses again, but do not bet too much of your investment dollars on oil heading back up.
And hope that your energy exposure is the worst performing part of your portfolio. If oil breaks $100/barrel in the next few weeks or months, not an unlikely scenario in light of the recent trading action, it will be great news for your stock portfolio and nearly all of your other investments.
If you are convinced, as many are, that oil is almost certainly headed lower, and you want to speculate on that decline, you might look into buying put options on USO, an Exchange Traded Fund (ETF) that represents ownership in crude oil. Put options are risky instruments that increase in value as the underlying stock or ETF falls. This is not a recommendation, just a suggestion to any speculators who may be reading this.
And if you own USO as a hedge to your diversified stock portfolio? Hope like hell that the USO part tanks!