Forget Fundamentals When It Comes to Oil

This was originally published on RealMoney on Apr. 24, 2008 at 11:00 a.m. EDT. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

I hope that cold-bloodedly parsing the true causes for this rally will give us the insight to predict how high oil might go and even more, how oil will trade going forward. As a floor trader of oil for 25 years, I have, I believe, a unique perspective on this rally -- after all, I was immersed in this market, almost exclusively, every day of my trading life.

I'm going to draw on that experience to "prove" to you how this market has entirely changed from the days when I traded it using fundamental ideas as predictive tools to now when the market moves almost without rhyme or reason merely on the waves of speculative money meeting the market.

Oil's All About Speculation

A lot of the points I'm going to make I've made in previous columns over the past year, but as oil nears $120 a barrel and validates my predictions about speculative action in the crude market, now would be a good time to put together all of the ideas in one column. By combining them all, perhaps, we can cobble together a thesis for the next several months. So here, in no particular order, are the arguments and proofs of "speculative oil."

The Growth Factor

First, the growth of commodities as an asset class is unprecedented. We need no litany of numbers to prove this point. We can merely look at the volume numbers being posted by all the major commodity exchanges over the last few years.

In oil, I will draw upon numbers from my previous trading home, the New York Mercantile Exchange. At the end of 2007, Nymex reported average daily volumes of 1.485 contracts per day, an increase of 25% over 2006. So far in 2008, growth has continued at an astronomical pace: January volumes increased 6% over the same period in 2007, February was up 28% and March increased an astounding 62%.

We don't need to be geniuses to recognize where most of this growth is coming from. It's not new commercial interests looking to hedge exposure to the ramping oil markets. Whether from managed futures, algorithmic programs, hedge funds or individual traders who are widening their repertoire from just stocks, it all represents an enormous increase in flow of speculative trade.

Second, the energy complex can give us a clue as to how deeply speculative action has skewed the markets. Along with the crude barrel, other oil products are traded alongside, most notably heating oil (HO) and reformulated gasoline (RB). I have written often about these in regard to the refiners -- the price of finished products, particularly gasoline, have been outstripped by the quick rise of the crude barrel.

In essence, speculative action in crude is swamping out other fundamental factors, while gasoline prices are being arrived at still using fundamental measurements. We can see this represented in my favorite "crack" chart, which graphically represents the ratio of the price of crude to the finished product of reformulated gasoline.

Monthly Cracks

Click here for larger image.

Source: CQG

In previous years, refiners would depend upon the summer driving season to return margins to profitable levels. This year, however, it hasn't happened yet, and it's unsure if it will. This is in spite of shutdowns, lower utilization and bullish weekly EIA reports for gasoline in the last several months -- no matter what fundamentals are applied, it can't seem to catch up. Gasoline is trading fundamentally, while crude is trading speculatively.

As an aside, this is why the domestic refining stocks are trading so miserably in the first quarter of 2008 - see Tesoro (TSO) or Valero (VLO).

Finally, the curve of forward pricing for the crude barrel gives us an insight as to how deep this speculative drive has become. Many of the arguments against speculation as the driving force behind rising prices have focused on global growth, and it's difficult to argue against that. In spite of some recent recessionary action, global emerging-market growth is a clear trend that cannot be overlooked.

But the speed of global growth, as compelling as it is, is just not sufficient to explain the 60% rise in price last year and the more than 20% rise we've seen so far this year. As my old trading mentor used to tell me, "In an up market, all news is bullish." He's right -- analysts are forced to find reasons to fill time on CNBC every day for the inexorable rise of the crude barrel and reach for fundamental reasons that are simply insufficient. Just take a look at the crude curve -- the representation of how the market feels crude will be trading one, two and three years from now:

CLZ8	CLZ9	CLZ0	CLZ1
11452	10973	10770	10730
11452	10974	10799	10730
11332	10898	10730	10730
11348	10910	10741	10730
-76	-45	-38	0

We're taking numbers for December crude oil contracts (CLZ) for this year and the next three -- the number following on the top line indicates the year. The key number in each box is the second from the bottom, which represents a last trade and a good "snapshot" approximation of the relative values of crude -- or at least how people trading it are viewing their relative value.

And what do we see? In the midst of global recession, when oil consumption and demand should be decreasing (this year), crude is at its highest price, while further back in the curve, when demand should ramp significantly and inexorably, you can purchase the crude barrel today for future delivery for far less. In fact, the crude barrel gets cheaper the further out on the curve you go.

How is this possible? This condition, called "contango," where prices run in reverse further out in the curve, as opposed to run in premium, has always been an indicator of speculative action. Indeed, if the demand thesis were true, there is no question that $107 oil would represent a tremendous long-term value to present day prices -- but it doesn't seem to be that way.

Of course, the conclusion we need to ultimately draw from this discussion is how far and how completely this speculative action will affect oil and other commodities -- is this a bubble? What can stop the climb? In my next column, I'll try to tackle these questions.

But for now, let me be clear -- fundamental arguments cannot account for this tremendous up move in oil and other commodities -- and don't be fooled by those who would try to convince you otherwise.

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