I always thought that AT Peak Oil we would see nonlinear price behavior; but now we see that it comes BEFORE Peak Oil. Contango is all about a fear of future shortages, even if we have enough currently. We were in contango during the last fast oil rise, from late 2004 to early 2006; and then we flipped into backwardation and it corrected. As discussed in my last post, Oil Dances the Contango, since it has risen so much more this time, the fall will be stunning. But - how is Peak Greed possible, since the funds playing contango have to take delivery? Where will they find the oil?
Let me try to answer this question, which came up in the comments to my prior post. I do not claim to be an expert on oil trading, so this will be of necessity overly simplified.
The question is: don't the speculators need to hold some oil? So, shouldn't we be seeing oil inventories increase? (Or, maybe wells are being capped; the stuff is left in place.) Paul Krugman is a champion of this view, that we simply cannot have speculators drive up oil prices without some form of hoarding.
The funds simply swap contracts every month, selling their current and buying the next - a roll. They do not need to ever take delivery. No new oil needs to be found. If they play the contango curve, they can skip the spot price and buy the next future, hedging with the one after that. (Or go much farther out in time.) They get a month to roll over and lay the game again. As prices continue to rise, they make a spread on the sale of the old, and hedge any 'loss' (paying more than the swap is worth) on the new by selling a (higher priced) future. They won't take delivery, although they take the risk that when we flip out of contango into backwardation, they will be stuck with oil they have to dump onto a refinery somewhere, but they would do this through a swap.
Contango is not about CURRENT shortages, but about FUTURE shortages. If the fear were with current shortages, the spot price would skyrocket ahead of the future prices, as refineries need it NOW. This is why Peak Greed precedes Peak Oil.
Of course, if we flip out of contango, but the funds think we will flip back, they may sit on the oil and pay for storage. Indeed, if a LOT of them do that, it might create an aura of future shortage, putting us back into contango!
Continuous and steep contango is NOT normal for oil markets. Something seems to have fundamentally changed in 2003. No, not the invasion of Iraq - back in 2005 the contango dance was recognized as being driven by the arrival at scale of long-only commodities index funds. Now it is being exacerbated by the de-leveraging off subprime instruments, bringing more funds to the long side.
One oddity of contango is the number of oil contracts themselves are not going up, at least not matching the price rise; instead the funds are bidding up the existing contracts. One reason for this is that during contango, refineries have an incentive to buy and store, as long as the cost of storage is less than the price rise. They have enough supply to fulfill their needs, but are allowing downstream shortages to emerge, driving gas prices up, even though they have supply in storage. Also as I point out in the post, the suppliers at the margin, like the Saudis, also have an incentive to dribble out supply increases, keeping contango going.
Peak Greed explains the inexorable rise in oil prices better than Peak Oil, especially when the Saudis yelp that they are increasing capacity but not finding buyers!
But once the perception of future shortages shifts, whether through new supply, less demand or just the Oil Fever subsiding, a huge shorting opportunity emerges, to short SPOT and hedge with futures. Thus as we flip over, we should see some dramatic moves.
The rebuttal to Krugman then is, you are right! but your time frame is wrong. In contango, oil can first go to unimaginable highs, but then reality will set in and it will fall. Never underestimate the capacity of people to do irrational things when chasing fear or greed. Peak Greed trumps Peak Oil.
I love the smell of crazy people in the afternoon!
It never fails. The people get crazy and the plunge comes.
Dr. Alan Fu is a breath of fresh air.
Welcome bobby. Be careful of some of the big kids. They swear a lot and act nutty but they are harmless.
Posted by: Voice of Reason | Wednesday, July 09, 2008 at 03:18 PM
Gee thanks, Mister. The people get crazy and the plunge comes sure seems like "scientific, well reasoned advice" to borrow a phrase from Dr. Fu.
I can't wait till the future when my grandkids will study Sociobomonics and really learn how the world works.
Isn't it exciting that these Eliott Wave things are making us all so rich? Can't wait to use some of that Socionomitry I been learnin'.
bobby
Posted by: bobby | Wednesday, July 09, 2008 at 05:32 PM
Guys and gals, how about short-term wave analysis here? I think wave D of a triangle (DOW) ended at today's low. Final decline imminent now. Dr. Fu is soooooo right about the Fibo-numbers. Fibo-magnet for yearly bottom is nearby. But not this week.
Posted by: Upstart | Wednesday, July 09, 2008 at 06:34 PM
Skiwaver, you laid out how this is working! Maybe the spread *should* get arbitraged away, but the increase in the long-only funds has inexorably pushed prices up. Also consider in your thinking what happens if the whole oil curve keeps increasing. The basis may be about the same but the price is rising so the roll works (you roll forward into new positions that ever increase). This will continue to work as long as the suspension of disbelief continues; then it drops hard, like every parabolic market.
This whole thread on oil and the contango dance shows how the 'fundamentals' can confuse whereas TA (technical analysis) is clear: the chart is parabolic, hence driven by something beyond supply/demand.
Posted by: yelnick | Wednesday, July 09, 2008 at 09:18 PM
“Dr. Alan Fu”
Looks like you blew your cover and gave yourself away as the biggest ignoramus of all, possibly rivaled only by Prechter himself. Socionomics is tainted and tainted badly by a similar style of thinking, as you possess.
"It is pure and true, like physics, biochemistry, and computer science", you say, but you overlook that these other sciences are provable any day of the week and are consistent every time. Socionomics, although like I said before has some merits, has no such qualities.
"It is not open to human conjecture or bias or misapprehension" you claim, yet I have actually witnessed Prechter's people attempting to predict the next bear market leg down since 2003. Two times EWI did this right on their own message board. Wrong both times. The fact is those guys can’t seem to hit the side of a mountain with a shotgun at 100 feet. If some day a useful subject can be evolved that reliably predicts human behavior, it certainly won’t be Prechter doing it. The very fact that he’s a psychologist already puts him at a grave disadvantage.
“ It is one of the immutable, natural laws of the universe, provable by simple mathematics and moving in precise, mathematically, scientifically elegant fashion.” Nice (but glib) theory that may be true, but that definitely eludes Prechter’s cognitive powers.
“Socionomics is the immutable, natural law of man's behavior as elucidated by the genius of one man who had the bravery and wisdom to give words to it. There was darkness and then Prechter did something strange and wonderful and miraculous: He turned on the light!” You definitely must be Prechter’s mama sticking up for his well meaning, but delusional, ego-centric little boy.
Obviously you can’t reason very well but hopefully it is because you are having a bad trip and do not exhibit this behavior chronically. The name you chose for yourself actually is quite appropriate as you really seem to be F’ed Up in the head.
So Robert, If you are getting desperate and trying to lure people to your website of mis-information you are going to have to learn to reason in such a way that actually makes sense and produces results in the real world. Everyone on this web site has at least 20 I.Q. points on you. You smell bad dude.
Posted by: min | Thursday, July 10, 2008 at 03:02 AM
Yelnick/ RP/SW :
(1) If the funds or speculators avoid near months and keep dealing only in forward months, they can avoid the "delivery" loop altogether. Can this can explain the contango (beyond the carry costs)
(2) The arbitragers would work at reducing the contango over time; but this may be happening through spot price being bid up rather than by futures price coming down?
Y : What is your count on Oil. Earlier you expected topping out at 160+ range. Do you think 145 range is a good enough turning point?
Posted by: KRG | Thursday, July 10, 2008 at 03:34 AM
KRG - good questions, and an answer to john walker's comment.
(1) the funds never take delivery and never suffer the carrying costs. they roll forward before delivery.
(2) yes, usually contango happens when the spot drops, and so the traders prefer backwardation; but in this case the spot is going up, as are the future delivery contracts
I had bought into the original count which put a cap at $131/bbl, but when we blew by that the count morphed to allow an extended 5th wave. It could end anywhere since such blow-off extensions are a bit out of pattern; but based on fib relationships it should go to $160-189/bbl according to Prechter. I have no reason to second guess that.
I don't think we have topped, nor will top until something shakes the psychology such as China clamping down post Olympics or the US getting serious about energy.
Posted by: yelnick | Thursday, July 10, 2008 at 05:07 PM