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Wednesday, August 13, 2008

 

oil prices and the demise of levered finance


i commented on oil prices yesterday:

while speculative froth seemed to me to clearly have become a major component of oil pricing in june, and the recent battering may not have resolved that problem fully, ritholtz's chart demonstrates why oil prices are not going back to $20/bbl anytime soon. the sharpness and speed of the correction in price has been surprising, but is oil going to head straight down to $75 in a few more weeks? i sincerely doubt it.

this selling stampede in oil has probably about run its course now for the time being -- DJUSEN has been falling from its high on may 20, and has been in earnest decline since july 1. participation in the DJUSEN basket has been improving, and it may be primed for a turn up in the coming month.


enter doug noland's commentary.

I am not one to easily dismiss notions of bursting Bubbles, and perhaps there is something to the energy bust thesis. I’m just skeptical of the idea that a slumping global economy is behind recent stunning price declines. Examining the global market backdrop, I sense different dynamics at play – important dynamics. And I tend to believe rapidly retreating commodities markets should be viewed in the context of a Bursting Leveraged Speculating Community Bubble.

A lot of things had to go right for the vulnerable leveraged speculator community not to be pushed over the edge. Of course, markets tend to not accommodate the impaired – and the current market is particularly ruthless in this regard. The energy trade has unraveled badly. Commodities markets have been in near freefall. The dollar has mustered its most ferocious rally in quite some time. At the same time, agency debt and MBS spreads have widened, while global bond prices have offered little performance help. Corporate debt prices have performed poorly, while “private-label” MBS and various mortgage-related derivatives have traded dismally. Meanwhile, the financial stocks and other heavily shorted equities have rallied significantly. In short, a whole host of popular trades have gone wrong at the same time – a huge problem for the fragile industry.

We’re now in the midst of another one of these precarious periods. I believe global markets – equities, debt, currencies, and commodities – are all in some stage of dislocation (perhaps not emerging debt, at least yet). Trading conditions across the spectrum of markets are as chaotic as I’ve ever witnessed, a dislocation chiefly related to the now forced unwinds of speculative positions. Recent extreme global market volatility is part and parcel to the Heightened Monetary Disorder I have been addressing for months now. The Massive Global Pool of Speculative Finance has Run Amuck. The bulls will celebrate the rally, yet markets this unstable are prone to “melt-ups” that lead to breakdowns. ...

... [I]f the key dynamic is instead a Bursting Leveraged Speculating Community Bubble, entirely different dynamics are now in play. Enormous short positions have built up, the vast majority as part of “market neutral,” “quant” and myriad risk hedging strategies. If today’s dislocation develops into a significant unwind of these positions, the market immediately then becomes vulnerable to a disorderly “melt-up” followed almost inevitably by a sharp reversal and disorderly decline. The unwind of bearish speculations and hedges would be a most problematic market development, unleashing a final bout of speculative excess and disorder that would set the stage for a major market crisis.


oil price declines stalled this morning with an inventory report as the ostensible cue. oil stocks -- having been quietly building for a reversal in my opinion over the last few weeks -- have jumped off the deathbed.

it is, however, EXTREMELY important to keep in mind that the top in commodities is very probably in. the reason why has to do with demand destruction -- not just in the united states (though certainly here and in scary dimension) but overseas as well -- meaning particularly china. this assessment via john mauldin:

Demand for commodities will decline, while more supply from past investments (there is a significant lag) will be coming to the market - they'll come crushing down to earth. Companies that make stuff will suffer, their margins are at multi-multi-multi-year highs, margins pendulum will swing the other way, to the other extreme. Suddenly they won't appear to be as cheap.


vitaliy katsenelson isn't talking about a growth slowdown in china -- he is talking about the "high risk, actually more likely of a certainty" of a "severe recession if growth rates slow down". that slowdown is likely underway today, being telegraphed by the property and stock market crashes, and financial instability will be the result.

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