Safehaven | Capitulation Among the Oil Shorts?

June 13, 2008

Capitulation Among the Oil Shorts?
by Henry To

June 8, 2008

Dear Subscribers,

Let us begin our commentary with a review of our 8 most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

4th signal entered: 50% short position on October 4, 2007 at 13,956;

5th signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

6th signal entered: 50% long position on January 9, 2008 at 12,630;

7th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

8th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively.

While I believed the US stock market would struggle over the summer when we decided to sell our 100% long position in our DJIA Timing System on May 22nd, I had not expected the weakness to come so soon. With a NYSE ARMS reading of 2.61 and a NASDAQ ARMS reading of 2.07 last Friday, the stock market is now oversold in the short-run. Should the stock market experience more weakness come Monday morning (i.e. another sell-off of over 100 Dow points), we would most likely initiate a 50% long position in our DJIA Timing System for trading purposes. However, chances are that the Dow (which has been one of the weaker major market indices over the last few months) and most other major indices will bounce on Monday. On a longer multi-week timeframe, the Dow Industrials and the S&P 500 are still in somewhat neutral territory. Since the global financial markets are still not close to being fully functional (more on that in our following discussion on crude oil) - and given rising inflationary and slowdown fears in many parts of Asia - the "tail risk" embedded in both the US and global stock market still remain relatively high. As a result, we will continue to remain neutral in our DJIA Timing System, and will wait for the financial markets to "show us the money" before we will get back on the long side again (aside from a potential short-term trading setup tomorrow morning).

Let us now discuss our short to intermediate term views on crude oil prices. With the latest two-day US$16 spike in crude oil prices over the last two trading days, there is no denying that crude oil is now very overbought. In fact - as can be seen in the following chart showing the daily spot price of crude oil vs. its percentage deviation from its 200-day moving average over the last 25 years, the price of crude oil is now overbought both in the short-term and in the intermediate term (3 to 9 months):

As mentioned in the above chart, the spot price of crude oil is now about 42% above its 200-day moving average. Based on this measure, crude oil is now at its most overbought level since early March 2000 - when it was just coming off its all-time, inflation-adjusted lows made in December 1998! Prior to this "recovery period" of oil prices during late 1999 to early 2000, one would have to go back to late 1990 to witness a more overbought level, right after the Iraqi invasion of Kuwait and prior to the beginning of the first Gulf War.

The overbought situation in crude oil prices is also evident in the bottom panel in the following chart (courtesy of Decisionpoint.com). The bottom panel shows the ratio of the WTI crude oil prices versus the Goldman Sachs Industrials Metals Index:

Light Sweet Crude Oil (Continuous Contract) - Ratio now at a record high - suggesting that oil prices should at least correct over the short-run!

Over the past decade, it has generally been a good time to short oil and buy industrials metals once the ratio between WTI crude oil prices and the Goldman Sachs Industrials Metals Index reach a level near 0.30 or above. The ratio of the WTI price and the Goldman Sachs Industrials Metals Index is now at an all-time high. Moreover, previous spikes to similar levels (such as March 2003 and August 2005) have always led to at least a short-term (but significant) correction in oil prices. If one believes that oil and industrial metals prices are both good leading indicators of global economic growth, then there is no reason why the rate of change in these two "indicators" should diverge for any sustained period of time. While there are definitely supply issues within the crude oil market, one can also argue the same case for various industrial metals. Furthermore, we know that a significant demand destruction has not only taken place within the OECD countries, but also within emerging markets that have slashed their energy subsidies, including India (which raised gasoline prices by 11%), Malaysia (63% hike in Diesel prices), Indonesia, Bangladesh, and Sri Lanka. China, on the other hand, is the big player in the energy subsidy arena - but even if China fails to curtail its energy subsidies going forward (it doesn't have to, as its energy subsidies are not putting a dent in its budget), there is no doubt that Chinese economic growth has been slowing down as its export markets slowed and as the Chinese central bank continues to hike reserve requirements (rising from 16.5% to 17.0% on June 15th and 17.5% on June 25th). Over the short-run, demand destruction will continue to play a significant role (in the US, this is exemplified by the latest cut in domestic airline capacity by all across the board, which would in turn raise prices and cramp airline travel and jet fuel consumption).

Make no mistake, however, we are now also witnessing signs of capitulation among those players who have been on the short side of the crude oil futures market. Subscribers please consider the following:

The balance sheet problems at many commercial and investment banks have made them reluctant to act in their natural roles by taking the other side of crude oil and general commodity speculators, including players such as fully-collateralized commodity funds from PIMCO and the USO ETF. Up until a few years ago, financial players have traditionally been long (i.e. they took the other side of the natural hedgers such as energy producers) - now, they are short. Given the breakdown of the roles among financial players, there is no question that the crude futures market (and the corn futures market) has broken down. Ironically, the general credit crunch - which in turn has led to a slowdown in credit creation and economic growth - has been partially responsible for the latest run-up in crude oil prices.
The balance sheet problems, as well as the relentless rise in oil prices coming into last week and the bean counters' will in forcing "mark to market" accounting on energy producers, mean that many energy producers now have no ability to hedge their production, as many investment banks have become reluctant to extend margin loans to the smaller energy producers. The lack of hedging "pressure" to counteract the buying power from the index funds has no doubt added to the relentless rise in oil prices over the last few months.
As an extension to points 1) and 2), this has also led the prime brokers to either clam down or cut back on margin loans to hedge funds who want to short oil - thus taking out other significant financial players on the short side as well. Note that raising margin requirements would not affect the long-side players, as commodity index funds and ETFs are in general, fully collateralized. If anything, raising margin requirements will put pressure on the short side, thus exacerbating the current rise in oil prices. Furthermore, the two-day spike in oil prices ending last Friday had all the signs of a capitulation and panic by those on the short side. I would not be surprised if some energy producers actually went into the market late last week to cover some of their long-term hedges - as a way to reduce or eliminate mark-to-market losses in upcoming earnings reports.

In other words, the latest spike in oil prices is mostly due to technical rather than fundamental reasons. With the $5 billion common stock offering just announced by Lehman Brothers, and with Barclays PLC now taping US$5 billion from sovereign wealth funds and potentially acquiring some of the weaker financial institutions (Lehman and UBS were mentioned), my sense is that this extraordinary combination of technical factors in the crude oil futures market is now close to an end. While crude oil prices may well be higher a couple of years from now, crude oil is definitely now due for a short-term and significant correction.

For those who believe oil prices may now be in a corrective phase, my main suggestion - aside from shorting oil or buy certain stocks in the consumer discretionary sector - would be to take a hard look at the domestic airline industry. Given the announced capacity cuts over the last few weeks, and given the upcoming merger between Northwest and Delta airlines, pricing power within the airline industry has dramatically increased. Moreover, many of the domestic airlines are now trading new bankruptcy prices, and assuming that Northwest Airlines announces bigger capacity cuts over the next few weeks, many of these airlines could double in a jiffy. Furthermore, the barriers to energy in the airline industry (which has historically been non-existent since the deregulation of the US airline industry in the late 1970s) has now gotten much higher, given:

The lack of financing in this difficult credit environment - especially financing new ventures in the airline industry. Moreover, given the latest experiments with JetBlue (George Soros was an early investor) as well as Virgin America (which is predicted to be profitable within three years), my sense is that the appetite for funding new low-cost airline ventures has sunk to a new low.
Boeing and Airbus cannot produce new planes fast enough for existing airlines, let alone new airlines who want to compete in the US domestic field. Also, the older planes that CAL just retired are too inefficient for competitors or new airlines to fly even if they could get the financing to buy or lease the planes;

Finally, even Southwest Airlines - who are 70% hedged this year and 55% hedged in 2009 at $51 a barrel, and 25% hedged in 2010 at $63 a barrel - has been expanding much more slowly than they have in the past. For those who want to take a closer look at the airline industry, I would suggest looking at liquidity risk first and foremost. This Morningstar article on the airlines may be a good start.

More follows for subscribers...

Henry K. To, CFA
MarketThoughts.com

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.