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Sizzle and fizzle

Fri, Aug 1 2008, 14:02 GMT
by Phil Flynn

Alaron

Oil Sizzles then fizzles. The month of July, 2008 saw oil hit an all time high but at the same time saw the biggest dollar value pullback in history of the oil market. Fortunes have changed for the oil bulls as oil is now not being viewed as the best hedge against systemic risk in the economy.

As I have said time and time again a lot of the run-up in oil is not about supply and demand but the revaluation of oil as a commodity that has more value as the confidence in the US banking and economic system was waning. People bought oil as a hedge against the dollar yes that is true. But it was even more than that, they bought oil as a currency of last resort.

Earlier this week I spoke at Dow Jones Commodity AIG Index Commodity Outlook event once again as I have just about every year since the event has begun when they had just launched the Index 7 or eight years ago. And all the years I have spoke at this event this was the first time I did not give a bullish outlook. In fact I told the attendees that I remembered at the first event when the Dow Jones AIG commodity indexes were just being launched how many people wondered why there was a need for a new commodity index. What were these guys thinking?

At that time let’s face it; commodities were not really that big of a story. They had just started their historic rise in price. And a lot of people were not prepared for what was soon to come. Commodities were the forgotten asset class. They were old school. Who needed commodities? You can’t even plug them in. They did not have a dot com after their names. What in were these guys thinking!

We all know now that commodities are no longer the forgotten asset class and have come to the front and center of the investment universe. This asset class has been the hottest investment in this new millennium and the timing of the launching of the Dow Jones AIG index really was picture perfect! I remember at the early events when I spoke of the awesome bull commodity market to come I could sense disbelief! I remember members of the audience jaws dropped when I predicted that oil could actually rise to $30 or $40, $50 or $60 a barrel. You might not believe it but there was a time when the thought of $30 barrel oil was just outlandish, outrageous, and crazy. There was this sense that somehow the world as we knew it would cease to exist if somehow oil went above $30 a barrel. I remember economists telling us that $30 a barrel was the tipping point and that if oil went above $30 a barrel the economy would collapse! They said that oil was a tax on the consumer and that we would never survive $30 barrel for oil let alone $2 a gallon for gas. Good heavens no!

As the years rolled on each year at every Dow Jones AIG commodity index event I continued to predict even higher and higher prices. First in $30 and $44, and $55 and $67 a barrel at every Dow Jones AIG event I always gave a bullish outlook and I've been right on the target. Some years I picked the peak almost right on. Some years it took a little longer but eventually I was always right.

Even last year as oil was struggling around the high sixties and the mid seventies when I predicted that oil would rise to $85 a barrel by the end of the year there were some doubters. You know who you are. Remember last year in July even $85 a barrel that looked iffy. Yet that was my target from the beginning of the year. A target of course I got criticized mightily for when oil dropped - as you might remember - to near $50 a barrel and was struggling in the sixty to seventy dollar range but I stayed with my target of $85 a barrel. Who would have thought last July that at $85 a barrel I was low and that oil would actually go closer to $95. I also predicted that oil would not hit $100 a barrel in 2007 and was right just barely. The truth is that I have been wildly bullish oil long before many were even considering the possibility. And I continued to be bullish as I could see what was happening in the overall commodity cycle.

In the 1990’s commodities were in a deflationary a cycle. A cycle that drove commodities under the radar for many investors. I knew that it was only a matter of time that commodities would come back in a serious way. How cheap commodities would inspire demand and it would grow and start a new bull cycle. I spoke of how strong demand from China and India and would someday change the commodity world as we know it and now of course we now all know it did. And that that was not necessarily a bad thing. I tried to explain to people that the rising price of commodities was not always something that should be feared but be embraced. That indeed that the rising price of crude oil for example signaled some good things, some positive things for the economy. Like for example when it signaled a rebound in the economy after the devastating attacks of September 11. When people started using more oil it was a sign that the economy was recovering from those attacks. Yet the rising price of oil reflected an expanding economy and strong US and world-wide economic growth. How the rising prices of oil reflected the improvement of the standards of living in places all over the globe, especially in China and India. It reflected the growth in the housing sector. Did it ever!

Yet people told me I was wrong and that we should fear high oil prices. Yet the rising price of oil was not all bad as long as oil was rising for the right reasons. The right reasons were strong economic growth. Sure there were wars and hurricanes along the way but in the end just good old fashion strong economic demand growth accounted for the move in oil.

Economist tried to pick that magic number that would somehow sink the economy. They used to say that if oil went above $30 a barrel that somehow the economy would cease to exist as we know it. Then the number was $40 a barrel. Now what is the number? Have we finally reached it?

Well that number did not exist. There was no one magic number that would sink the economy. Oil could go to $300 a barrel as long as the rise in price was driven by strong economic growth and not by other external factors. The main factor for the increase in the price of oil was simply and mainly strong worldwide economic growth. And growth is a good thing. Don’t fear high oil prices as long as it is being driven by strong economic growth. And because of that growth and tight worldwide supply I always picked that higher price.

Of course some thought based on my track record that this year I might be predicting let me see, is it $200 a barrel? How about $300 a barrel! Well I think some were disappointed that I did not continue with my bullish outlook. In fact for the first time since the launch of the Dow Jones AIG index I believe that oil is going lower not higher. Not only is it going lower I think that there is a very good chance that the high made in oil this year will not be exceeded this year and probably not next year.

I was bearish earlier this year and I was no doubt early as I thought that slowing demand would have more of an impact. Yet oil got into a bubble like state that expanded more than I thought it would. Well maybe bubble isn’t the right word because bubble somehow suggests that the price of oil was unjustified and that oil went up just because speculators had this magic power to drive up oil for no reason. Some might think that the term "bubble" suggests that the rise in price had nothing to do with the fundamentals. Well, let me state clearly and unequivocally that is not the case. The rise in the price of oil was always about the fundamentals. Of course you have to make sure you are looking at the right fundamentals though!

Remember that speculators do not drive markets but they are driven to the market by strong fundamentals. And the fundamentals more than explain why oil prices surged to a record high and why they more than likely will fall in the future. That is why I don’t like the term bubble when describing the run up in oil this year. Bubble is a hard word to define because I believe that whatever the price that trades for oil is a fair price. In commodities for every buyer there is a seller and for every seller a buyer. If speculators drive the price too high then no one should buy it.

In the last few years those fundamentals, to me anyway, were pretty clear as demand was growing year in and year out gaining on supply. Oh sure they were some geo-political tensions and some weather related issues but at the end of the day the run up in prices was mainly about strong economic growth and a race to keep up with supply.

This year things were different. Oil ran up not so much because of strong economic growth but because people were buying oil as a hedge against risk in the economy not strong demand vs. supply fundamentals. Instead of a bubble the better way to distinguish this run up in price from previous years is we should perhaps categorize a sharp rise in the price of oil not backed by normal supply versus demand fundamentals as an “Oil Crisis” and a rise in the price of oil backed by strong fundamentals and strong economic growth as an “Oil Boom”.

How to you differentiate from a rise in oil from an oil crisis rise or an oil boom rise? It is not easy. But what you have to do is determine what is driving up the price of oil. In the past years as I have stated, the predominate cause in the price of oil rising was strong growth. This year though strong growth globally was supportive but it did not explain the meteoric rise that we have seen over the majority of this year.

This year oil soared mainly as investors went to seek safe haven away from the credit crisis that gripped the US economy. Oil soared as demand fell. I don’t know if you caught it but demand for gasoline fell by a record 3.7% from a year ago in the month of May. That is the equivalent of 40.5 billion miles of the road less traveled. So because of this, we have a year of an oil crisis not an oil boom. Oil is rising for the wrong reasons. Oil has not risen because of strong growth but it has risen as it tried to adjust to the US subprime crisis. Investors around the world and oil traders used oil as a hedge against uncertainty. They used oil as a hedge against risk. Like I have said oil was used as the perfect hedge against any occasion.

In fact look when oil really started its meteoric rise. It was when Ben Bernanke surprised the market with a 50 basis point interest rate cut. That is when we knew we had a problem. Oil has risen as demand had fallen. Oil was being bought because many lost faith in the dollar. Around the globe people were buying oil because they lost confidence in the US banking system. They bought oil as a currency of last resort as our US dollar sank in value.

Now don’t call this speculation. This is a real fundamental. If the dollar gets weak and an oil producer wants more oil that is a fundamental. If traders think that the banks are going to fail then oil has more value. Not the normal supply and demand fundamentals we normally watch but a real fundamental that fundamentally changes the value of a commodity.

In the past years when oil rose oil added roughly about $10 a barrel to the high year after year. This year oil had almost doubled in a few months. Yet it appears now that we have priced in a lot of the bad news. Can we say that in oil we have bought the rumor and sold the fact? It is possible that the oil hedge against systemic risk (Or Fannie and Freddie failing and bank failure) play is coming off the table? As traders ran to oil in a flight to quality mode as a hedge against, well just about everything, is that play finally coming off?

We had problems with Nigeria and Iran but we have had problems with Nigeria and Iran before. The bottom line this rally in oil has been mainly a financial play.

Early on I could see the demand trends changing and we were ahead of most predicting the type of demand destruction that was to come. Of course we underestimated how strong the financial hedge trade would be and it exceeded our expectations. The market failed to care about evidence of faltering demand and focused more on running for cover. We thought that traders would at one point embrace more traditional risk hedges as bonds and precious metals and realize that slowing growth would hurt oil prices. That may be happening now as precious metals soared yesterday and oil is falling.

With the Fannie and Freddie stuff out in the open and the failure of Indy Mac known to everyone, let’s face it all the cards are on the table. Traders and funds that have been buying oil and buying gold and commodities on the rumors of major problems in the US mortgage and banking industry are now selling the fact. The oil as a hedge play has been about the dollar but it has been more than just that. It’s been bought as trader’s feared financial meltdown. Now that the dirty laundry is out in the public and the demand numbers are falling, oil can now sell off.

There is bearish news on Iran as their production is running consistently at the highest level since the US invasion. There is also more production coming out of Saudi Arabia as well and we are seeing signs that demand in China is slowing as well.

Of Course there are other Issues other than Nigeria and Iran to worry about. I mean you always have Russia. First they used natural gas as a political weapon, could food be next? Today’s Financial Times says that Russia is going to seize grain Export controls raising fears that Food may be used as a diplomatic weapon. I wonder if they learned to do this from President Jimmy Carter. It worked real well for him. Did it not? The FT says that Russia plans to form a state grain trading company to control half of the country’s cereal exports, intensifying fears that Moscow wants to use food exports as a diplomatic weapon the same way Gazprom has manipulated natural gas sales. The FT quotes a US agriculture diplomat as being less than diplomatic by saying that this is a big step backward to the Soviet era. SP

See me today on the Fox Business Network!! Also sign up four your free trial of www.alaron.energies.com Call me to open your account and call for intraday profit targets and day trades at 800-935-6487 or email me at pflynn@alaron.com.

Short September Crude from apprx 12570 - stop 12870.

Sell September heating oil at 36000 -stop 36300.

Sell September RBOB at 32520 - stop 33000.

Sell August natural gas at 1050 - stop 1070.

Have a GREAT day!

Published on  Fri, Aug 1 2008, 14:09 GMT