Explaining the Irrational Exuberance of Natural Gas: De-constructing a Dead Cat Bounce

Since the last time I wrote an extended piece on this blog site, the market has moved significantly (56% higher than the low placed about 10 days ago). The market didn’t see this rally coming. And, searching for answers, analysts attempt to attribute a particular fundamental to what has transpired over the last 10 days.  I don't think what has gone on is "fundamental" - as in supply and demand -  at all.  In my opinion, it is a dead-cat bounce.

This rally was a one of human emotion. It was caused by a blend of greed (or complacency) and fear. As the market fell, the front month price fell more significantly than the out months. This Rigzone article discusses that the steepness of the term structure contango was a four standard deviation event - meaning that the difference between the front month price and the out-month price is about as significant as it ever gets.  Considering this, many shorts entered the market in the front month, knowing that the roll from month to month would credit their position and the term-structure "contango" would work in their favor.

These speculative positions in the market were short in the face of the lowest gas prices in a decade. But they were making money, so they remained short. And then….the market rallied 15 cents. Some of them – the recent entrants – were then holding losing (unprofitable) positions. Trading with a stop-loss discipline, they said “enough is enough” and blew out – they BOUGHT. This pushed the market higher, and took even more trader's positions into negative equity situations. As nervous or disciplined investors, THEY headed for the exits, too. They BOUGHT. And this forced the market higher still. At this point the market had rallied maybe 50 cents. At this point, the market move started to attract the hot money that looks for trends with velocity. This money wants to jump on the trending market’s bandwagon and ride that bandwagon for a significant and quick profit. So…the move higher created by nervous investors exiting shorts is exacerbated by new “hot money” longs. The market has ingested these new positions by adjusting price, and by now it is more than a dollar higher. And...here we stand. Such is the status of the natural gas market on September 16th.

Old trader types say “if you drop it far enough, even a dead cat will bounce.” It is because the steady move lower allows folks to get out of position – to blend greed and complacency and find them in an unmanageable position should the market stop behaving in such a convenient and predictable trend. I perceive the recent strength as a dead-cat bounce and I look for more downside as the market adjusts from the exuberance of the last 10 days.

Let’s not forget: Natural gas storages are full. Rig counts are down, and gas production numbers still relatively flat to prior years. There are new and significant sources of shale bed supply that are shell-shocking the market to a new reality, and the demand base is slow to evolve to these breakthroughs. These are all short-to-intermediate term bearish considerations.

As I wrote in my last market commentary extended post, the last two times that natural gas prices have been this cheap, things turned around quickly. People that actively manage energy price risk should consider buying a piece of product at historically low prices if it fits their needs.  And while we all get nervous in this situation, after the market rallies 56% off the lows, it seems reasonable to wait for prices to adjust after such a dead-cat bounce.

One Year Post Lehman: "A Drunken Binge of Excess...is Over"

See the CNBC interview here.

“The West, especially the Anglo-Saxon economies, went on a drunken binge of excess consumption, leveraged up the eyeballs with totally inadequate savings,” Roach said. “It was reckless, irresponsible and it’s over,” he added.

The Oracle: Not Up. Now Down, Either.

Do You Worry about how Your Spleen Works?

A spunky rebuke of Peak Oil theory is found in the Canadian National Post: 

Note how the use of the term “skeptics” suggests that Peak Oil is the mainstream view, which it is not. The word also links unbelievers to beyond-the-pale climate change “skeptics.” Finally, the report suggests that these people are suggesting a “golden age of exploration and supply” although in fact the only relevant quote is from Peter Odell, professor emeritus of international energy studies at Erasmus University in Rotterdam, who merely says, “It’s an amazing turnaround from the gloom of the last 10 years. All these finds will take a long time to bring on stream, but it shows the industry is capable of finding more oil than it uses and shows we have not come to any peak.”
Peak Oil theory represents a combination of economic ignorance and moral rejection of markets as greed-driven and shortsighted. These all-too common attitudes usually go with a profound faith in effective government policy, despite the monumental weight of evidence to the contrary.

The seminal image for depletionists -as for apocalyptic climate change theorists — is that of the photo of the Earth taken from Apollo 17; seemingly dramatic confirmation of finite resources on a “small planet.” In fact, the interpretation of the Apollo picture is symptomatic of how far technology has outstripped our primitive assumptions about the way the world works. But then people don’t have to think about the vast, natural “extended order” of the economy any more than they have to worry about how their spleens work. (italics are mine)

Debate between economists and Peak Oilsters tends to be a dialogue of the deaf. Economists often seem to imagine that they are explaining a technical issue. They note that the alleged failure to “replace” production is in fact due to the way reserves are reported. They stress that startling new technologies –such as the ability to drill in thousands of metres of water to depths of more than 10,000 metres (as at Tiber), or 3-D computer seismic imaging, or horizontal drilling –are constantly finding new oil and gas, and producing more from old reservoirs.

Again, citing how often alarms over “the end of oil” have been sounded since 1880 holds no sway with Peaksters. Since they see oil supply as essentially “fixed” and economists as deluded and morally deficient, delays in the projected “crunch” will only make it all the more painful when it –inevitably –comes."

Let's Be Practical

Barry Eichengreen, a professor at Cal-Berkeley, writes an essay in The National Interest about the future of economics after the fallout from the last year's crisis:

"...Work in economics, including the abstract model building in which theorists engage, will be guided more powerfully by this real-world observation. It is about time.

Should this reassure us that we can avoid another crisis? Alas, there is no such certainty. The only way of being certain that one will not fall down the stairs is to not get out of bed. But at least economists, having observed the history of accidents, will no longer recommend removing the handrail."

Robert Schiller on Human Nature Driving the Economy

from Charlie Rose

Cap and Trade

Meet Cap 'n Trade from Marketplace on Vimeo.

Khurais Oilfield Opens - And Helps Us Comprehend Energy Instability

Khurais Oil Field - Ghawar's little brother - began production recently. Here is an article from the NY Times from a year ago that details the field and the development of the facility. It has been a remarkable undertaking, the scale of which should not be underestimated.

Khurais will produce 1.2 million barrels a day, which is about 1.5% of world demand (per the IEA). The IEA also conservatively estimates in the most recent World Energy Outlook that demand will grow at 1.2% per year worldwide.

Basically, we need the equivalent of 1+ Khurais each year, just to keep up with world oil demand growth. Sound like a challenge?

Alternatively, see what Forbes wrote about the Haynesville Shale...enough natural gas to last a decade...

Oil Market Update

Peak Oil Update

Here are three presentations by Matthew Simmons, the Twilight in the Desert guy.

Mr. Simmons is a big energy bull. The jury is still out as to whether he is full of bull. But his presentations are quite compelling.

LTCM Guest Lecture at MIT

One of the Long Term Capital Management folks, talking about the implosion of this fund from back in the 90's.

* The first 1:05 of the talk is "facts and fictions about the LTCM meltdown"
* Lessons learned begins at 1 hour and 6 minutes.
* Q and A at about 1:10

The Curve of Forward Prices

An article containing some good explanation about what the forward price curve represents can be found at DownstreamToday.com. Here is an excerpt:

Looking at the prices of long-dated oil futures can be useful as they provide the best tradable indication of the future expected price of the commodity. While long-dated futures contracts are traded less frequently than their near-month counterparts, the December contract is an exception as speculators and producers attempt to lock in or hedge oil exposure for year-end.

Oil producers use the futures prices as a key benchmark for domestic production, using the contracts to hedge current inventory or using the price to evaluate potential exploration projects.

"The forward price of crude oil is a combination of the need to fund existing stock levels and trading flows, which in turn embody price expectations," said Lawrence Eagles, global head of commodities research at JPMorgan.

While long-dated futures contracts are still much higher than the near month, a situation described as contango, the forward curve has been flattening out recently as traders have adjusted expectations after weeks worth of data from the Energy Information Administration, an Organization of Petroleum Exporting Countries meeting and bulk shipping statistics. As the curve flattens, the long-dated contracts fall at a faster rate than the near-month contract, or the near-month contract rises faster than those further out. A year-end rally could be thwarted by continued weak demand and burgeoning supplies. Oil demand is forecast to fall to the lowest level in five years, according to the Energy Information Administration. U.S. crude oil inventories are at 18-year highs.

Oil Futures Market Primer

Here is a lecture by Robert Shiller of Yale on the uses of stock and commodities futures. It spends a great amount of time focusing on oil market fundamentals. It takes an hour to get through - but if you are a propane of heating oil marketer this is a solid and easy to understand primer on a key market and how it works.

Southwest Reports that Fuel Hedging Program Creates More Losses

From Southwest's 10Q, released today.

“We benefited from significantly lower year-over-year economic jet fuel costs in first quarter 2009. Even with $65 million in unfavorable cash settlements from derivative contracts, our first quarter 2009 economic jet fuel costs decreased 16.2 percent to $1.76 per gallon. With oil prices rising, we have begun to rebuild our 2009 and 2010 hedge positions, using purchased call options, to provide protection against significant fuel price spikes. These new positions present no additional exposure to cash collateral requirements. Furthermore, we have modified our major fuel hedge counterparty agreements to allow us to use collateral other than cash to limit our cash collateral exposure to comfortable levels. Based on our second quarter derivative position and market energy prices as of April 14, 2009, we currently anticipate our second quarter 2009 economic jet fuel costs, including taxes, to be in line with first quarter 2009 (or the $1.75 per gallon range).”

The Company has derivative contracts in place for approximately 50 percent of its second quarter 2009 estimated fuel consumption, capped at a weighted average crude-equivalent price of approximately $66 per barrel; approximately 40 percent for the remainder of 2009 capped at a weighted average crude-equivalent price of approximately $71 per barrel; and approximately 30 percent in 2010 capped at a weighted average crude-equivalent price of approximately $77 per barrel. The Company has modest fuel hedge positions in 2011 through 2013. The current market value (as of April 14, 2009) of its net fuel derivative contracts for 2009 through 2013 reflects a net liability of approximately $950 million.

I am partial to the SWA business model and corporate culture. It has proven its competitive advantage in the best of times and the worst of times. Its team members are friendly and motivated, and its management is aggressive in attacking opportunity. Plus...they are active fuel price speculators. Their hedging program has earned them kudos from the national media, and has been written about on this site several times. But unless your fuel price speculation program is run by Bernie Madoff (pre-ponzi), even the best traders and economists are going to lose once in a while.

More importantly for propane and heating oil marketers, though, check out that they bought long dated CALLS to protect their position. They weren't afraid to spend the premium for the insurance that the calls provide. Also, they view their fuel risk position as a portfolio - and seem to be willing to enter into a number of strategies to achieve their goal. Finally, they have a model that they use that can help them plan what costs will be due to the hedging tools they hold in their portfolio. These are the things that every propane and heating oil marketer should be doing to manage their risk and fine tune their business.

If SWA management needs a post 10q pick-me-up, I am sure that they could step on board one of their planes with this industrious and talented flight attendant.

Barton Biggs on Charlie Rose

This interview is about a month old - but this morning is the first time I had a chance to watch it. Good stuff.

Natural Gas Basics

This is a 4-page analysis of simple supply and demand in the natural gas sector. It was released by the EIA last week, and is a good basic overview.

Causes of the Oil Shock

This article is from Econbrowser, a blog from Dr. James Hamilton - a professor from the University of San Diego.

It discusses a paper he wrote on the causes of the oil price rally of 2007-2008. It is formal and academic, and there are charts and formulas. But here is the bottom line: Dr. Hamilton agrees with my thesis regarding the rally. Dr Hamilton states:

"Growth in world income was the primary cause behind an increase in world petroleum consumption of 5 million barrels per day between 2003 and 2005, a 6% increase over the two years. The next two years (2006 and 2007) saw even faster economic growth (10.1% cumulative two-year growth), with Chinese oil consumption alone increasing 870,000 barrels per day. Yet between 2005 and 2007, global oil production stagnated.

My article (from early January) is here.

The cool thing is that Dr. Hamilton and I agree on the causes. He builds better looking models, though.

Declarations about Certainty and Questions about Nuance

Over the past couple of weeks I have posted several pieces that are skeptical in tone, including (especially) my post on Experts. This posting must have touched a nerve, as I received more comments about this posting than any other prior post on the site. It seems folks thought that was ironic for someone who claims himself to be a commodity market expert to dis experts on his site.

(By the way, one of the signs that my blog is gaining traction is that readers contact me now to provide their opinions. FANTASTIC! And THANKS!! I am lucky to have readers who care, and all comments are appreciated. If something in particular strikes you, leave some comments at the end of the posting for others to consider. Heck, most of the readers of this blog are smarter than I am - so you will probably teach me (and everyone else) something significant.)

Allow me to move back to the "Experts" subject, though. Indeed, I do encourage everyone to have a robust skepticism of what they think they "know". I side with Nicholas Taleb in this regard - in The Black Swan he says that the market is far more random than folks want to believe. There are analysts, marketers, and consultants throughout the world of stocks and commodities that make recommendations on how you (Mr. Third Party) should allocate your assets or time the market. Do they know with any reliable certainty? Of course not, otherwise they would keep their mouth shut and do what they are recommending with their own money.

However, just because the markets are more random than we perceive or want them to be does not mean that they are ALWAYS random. There are times when folks can execute a winning trade through research and discipline (and serendipity).

Unfortunately, the fact that the markets are random does not excuse us from having bottom line accountability to our banker (or our wife or our employees or our manager or our owner or our shareholders). It is the game we play, and those are the cards we have been dealt. The fact that markets is difficult or irrational does not excuse a business owner from making educated decisions.

Working with a market professional whom you trust can help you stay away from the cycle of greed, hope, and fear. Professionals can advise you on on the fundamental, seasonal, and technical factors in play in the market. Most importantly, professionals can help you discern the questions to ask yourself about your business. When you understand the questions, you can define the answers...and when you know the answers with certainty, decisions can be made with confidence. It is lonely (and a little scary) to make those decisions in solitude.

I appreciate the role of experts. But we must ask ourselves if those experts are engaging speakers that make declarative statements about certainties or whether they are humble market professionals that ask questions about nuance.

Any thoughts???

China Owns Too Many Dollars

One of my favorite articles over the last several years was "The $1.4 Trillion Question" from the Atlantic Monthly. It discussed how the Chinese were amassing huge amounts of dollar denominated assets, and asked the question "what will happen next?" or maybe "what might go on to get the Chinese to be sellers of their stash of US dollars?"

Paul Krugman opined on this subject yesterday in the New York Times (15 months after the Atlantic Monthly piece was published). Here is a piece of that article:

Some background: In the early years of this decade, China began running large trade surpluses and also began attracting substantial inflows of foreign capital. If China had had a floating exchange rate — like, say, Canada — this would have led to a rise in the value of its currency, which, in turn, would have slowed the growth of China’s exports.

But China chose instead to keep the value of the yuan in terms of the dollar more or less fixed. To do this, it had to buy up dollars as they came flooding in. As the years went by, those trade surpluses just kept growing — and so did China’s hoard of foreign assets......

Was there a deep strategy behind this vast accumulation of low-yielding assets? Probably not. China acquired its $2 trillion stash — turning the People’s Republic into the T-bills Republic — the same way Britain acquired its empire: in a fit of absence of mind.

And just the other day, it seems, China’s leaders woke up and realized that they had a problem.

And the Chinese DO have a problem. They have amassed a position in US dollars that is so large that it does not have ample liquidity for an orderly exit. That's just crazy...US Dollars are the most liquid asset on Earth! This isn't a tertiary market like pork bellies or frozen concentrated orange juice, Mortimer - it is the sovereign currency of the largest economy in the world.

I figured the Chinese knew what they were doing when they were buying all those dollars. I figured they had the best and brightest of the People's Republic in a quiet and stoic bureau somewhere in the governmental center of Beijing, and that those folks were planning for Chinese economic dominance on the grandest scale (like so many drummers at the Olympics Opening Ceremonies).

Maybe it was all an economic accident. And the global economic quandary for our times....

Kamikaze Spending In Japan

The Wall Street Journal Asia Edition has a short editorial today regarding the stimulus effort undertaken by the Japanese government:

Prime Minister Taro Aso yesterday ordered his government to draw up yet another stimulus package to buoy his sinking economy. In an interview with the Journal's Yuka Hayashi published on Monday, Economy and Finance Minister Kaoru Yosano said the program will "far exceed" the 2% of GDP recommended by the International Monetary Fund and will include measures to boost credit, maintain employment and strengthen the social safety net.

This takes fiscal profligacy to a new level. Mr. Aso's Administration and its immediate predecessor have already rolled out about 1.5% of GDP in new spending since the financial crisis hit last year. As of today, Tokyo estimates government debt-to-GDP is at 157.5%. The OECD puts that figure higher, around 180%. Mr. Aso said yesterday he would "not hesitate" to issue bonds to pay for his plans.

I mentioned in the most recent 4+1 commentary that the US dollar stands to be the "least worst soverign currency." Of course, 2 days later the government announced a plan to buy a trillion dollars of paper and the dollar took its biggest one-day hit in almost 50 years.  I am still bullish the dollar - not necessarily because of the strength of the domestic economy, but rather because of the weakness of other economies worldwide.  The stimulus of a slowing Japanese economy is another example of worldwide weakness.