With thanks to TheSlowLane from SI's "The Woodshed" board for the transcript. (Link below)
(Link to audio version of CC [incl. Q&A] located below text)
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Nesbitt Burns Institutional Client Conference Call for June 17, 2005
Don Coxe Chicago, IL
Chart: Crude Oil – December ‘09
Comment: “The Agony and the Ecstasy of the Oil Futures Contracts”
Thank you for all tuning in to the call, which comes to you from Chicago. The chart we faxed out was the December ’09 contract for crude oil and the tag line was “The Agony and the Ecstasy of the Oil Futures Contracts”.
So what I want to talk to you about today is the unfolding of the story of the change in the oil futures market from backwardation to contango. What this should mean in the valuation of the energy stocks and also what it tells us about the way the way the world is changing in its perception of the opportunities and the risks in oil and gas.
Year to date, crude oil, the spot crude is up 34.6%. The December ’09 contract is up 48.4%. That is the part of this move that we’ve had in the futures market as we’ve gone from deep backwardation, which was the situation where the oil industry seemed to go along with the views of Wall Street, Wall Street’s oil analysts, that oil prices were about to collapse. They went through fourteen straight quarters where they predicted that.
And so the oil companies sold forward heavily and last year so did the commodity hedge funds as a group. We’ve commented on this in Basic Points but for those of you who don’t recall this, the first nine months of last year the commodity hedge funds as a group lost money. That really took some kind of genius to do it.
One of the greatest years for commodities in history. This was a group of funds that in the ‘90s would have had trouble getting anyone to invest in them because commodities were such dreary items. And so here they had a chance to really coin it, but they fell for the reasoning of Wall Street and of so much of the oil industry itself, which is, prosperity can’t last when the price goes up, OPEC will open up the spigots and there’s lots of oil out there and the price will go down again.
And they were backed up in this by no less than Lord Brown of BP, who a year ago in February referred to oil at twenty dollars as an expectation, this year he raised it to twenty-five but then in the House of Lords two weeks ago he raised the price to forty bucks a barrel. So there is a change in thinking within Big Oil itself and that’s part of the much bigger story here which is that the oil industry has finally decided, it looks like, apart from a few conspicuous firms, that remain deeply short on their futures, that prices, even if they should spike in the near term are going to fall in the longer term.
Now I used December of 09 not because it’s the highest price in the futures market, that’s not the case. But I used that because that’s the last contract in this decade and so what it gives you is a sense of how, even a few years out, is trading at a price pretty close to current spot prices. Now today, spot crude is 57.45, up eighty-two cents whereas the December 09 contract is at 55.10, down thirty-five cents on the day. Now that’s a very thinly traded contract compared to the spot. But if we look at the December Crude for this year, it’s 59 and a half, very close to that magic $60 number. And the 06 December contract is 57.80, which is virtually flat with the spot.
So although we have a contango, it’s not the basic contango that they talk about in the grains and in the softs where or for that matter, used to be in the gold market where the price simply rose in response to the Eurodollar rate for holding the basis.
Now, this change from backwardation to contango does mean that whereas in the past I’ve counseled you strongly not to use the futures market for valuing the oil stocks and not to use Wall Street’s oil price forecast, but to look at the supply and demand situation for oil and in particular, the fact that we were passed Hubbard’s Peak for such a huge proportion of the existing oil fields of the world, that the challenge going forward was not just to maintain current production rates but to make up for the declines by bringing on major new fields.
In particular, I’ve been talking for the last nine months about the Ghawar field in Saudi Arabia, the world’s biggest oil field and the fact that it has entered decline. And you recall that when I wrote that up in Basic Points, Al Jazeera picked up the story and took it to the head of Saudi Aramco and although he sputtered a bit, he didn’t deny anything I said in it.
So, we have Ghawar in Saudi Arabia and Chanterelles in Mexico, the two biggest fields in the world that are in decline. And although there’s lots of other oil fields in the world, what this does is confirms the fact that we’ve got to bring on a lot of new production just to stay where we are let alone to deal with increased demand. And increased demand, although China is the biggest factor in this, it’s a world-wide phenomenon.
Those who are saying “Well, the global economy will slow down. In any case, in the past, any time oil prices got to ridiculously high levels, then people cut back on their consumption.” And something of that may occur, but it will be at the margin. There aren’t very many alternatives. And now with natural gas prices as high as they are, we’re looking at 7.61 for the spot, and if we go all the way out to December 09. it’s 6.99. And yet we are told regularly by some Wall Street analysts that prices like 3.50 and $4.00 an MCF are what you should use for valuing reserves in the ground.
Now in the past, they could back up those claims with reference to the futures market. But this was circular reasoning. They were convincing the oil companies and the hedge funds to go short so therefore it was a self-fulfilling prophecy. They drove out the price further out, where you could do it purely with trading pieces of paper. But the spot price was responding to actual supply and demand and it kept stubbornly staying much higher than they had thought.
Now, when we switch from backwardation to contango, then what happens is you immediately have an increase in inventories. And although I’ve said that before, I just want to reiterate it because it’s important to understand that although this week had a decline in crude inventories in the US, I don’t doubt that on a worldwide basis that inventories are still at a very high level compared to where they were, although not high in relation to history.
The process is this, that if you’re a major consumer of oil, you don’t carry any extra oil on hand when you look at the futures market and you see that you’re being paid NOT to hold any oil. If you’re a purchasing manager for a utility or an airline, you get bonused or penalized based on how well you manage the oil inventories. And so as long as the next month was cheaper than the spot and a year out was vastly cheaper, then what you did was you ran lean.
When we switched then to contango, what that did was change the game. And if we take for example, the December contract at 59.50, that is just about at the level where it’s cost-free, in effect, to hold oil inventories, because the back of the envelope calculation is it costs you fifty cents a month to hold oil.
I don’t know where that number comes from in a sense because obviously it varies from different users in different locations and all of those things. But, what is clear, if you’re the purchasing manager, again, and your boss says to you “Look, we’re holding a lot more oil than we used to have, what’s going on here, it costs us money”, you can say “Look at this, on the basis of where oil prices are headed, we’re saving you money. And in addition, we’re getting free insurance against something that we’ve all been scared about which is some kind of real oil shock occurring. Whether it’s in Saudi Arabia or massive hurricanes in the Gulf of Mexico or civil wars breaking out somewhere. That’s the kind of thing we’re protecting you against, whereas in the past we were relying on running lean, that nothing was going to go wrong. Now we’re carrying some extra inventory and if there is an oil shock and oil spikes to 90 or 100 bucks a barrel, well, we’ve saved a lot of money.”
So, what we assume then that the change in the nature of the oil curve, is gradually changing perceptions of producers and consumers but there’s a certain consistency in the way The Street is treating this. The material coming across my desk emphasizes the movement and particularly the participation in the oil futures by non-commercials. Which is to say that once again the argument is, it’s massive speculation that’s driving it.
Now, this at least is a better argument then what we were getting last year at this time, when the Street was telling us that oil prices were high because of massive speculation, which implied somehow that various retail investors were setting up oil tanks in their back yard and filling them up with crude oil, because the spot price was so high, but the futures weren’t. SO there’s no doubt you get to speculate virtually free if you’re in the futures market whereas in the spot market you better be prepared for the costs of holding the stuff.
So at least now what we’ve got is an argument that yeah, when you’ve had such terrific returns on an asset you’re going to attract lots of speculators. So, reiterating what’s happened to these prices this year it’s been pretty dramatic with spot up 34% and the out months up much more than that.
Well, when I called it the Agony and the Ecstasy…the Agony is that for the huge part of the economy that doesn’t benefit or is actually hurt by soaring oil prices, then this change in the futures market says it’s gonna get worse.
The Ecstasy comes from those in the industry and investors who are saying “You know, we were nervous about our prosperity, because we’re faced with the fact that Street analysts have been now for 3 ½ straight years, consistent in predicting a big drop in earnings for the oil companies, because of the futures price for oil and gas.
What is interesting is how few adjustments have been made on this now that the futures market curve has changed. The dispersion of earnings for companies continues to be wide.
So there’s a certain dogmatism out there of those who are saying “It will not last”, but for oil investors there has to be a much higher comfort level in saying reserves in the ground now is dramatically higher than a year ago, whereas the stocks have tracked the spot. So if we take a look at some of the companies – and even the oil sands companies, which are the long duration companies – Suncor is up just two percentage points more than spot oil. The granddaddy of them all, in terms of reserves, Canadian Oil Sands Trust, is up just a little bit less than oil this year.
So what has not happened yet in the valuation of these long duration stocks is a huge swing to valuing reserves in the ground. We’ve had much stronger performance from the diversified companies who do have oil sands exposure but are producing otherwise with Canadian Natural Resources up 78% and if we look at other companies in the oil industry what we see is, taking an integrated company such as Conoco, it’s up just a little bit more than oil.
Notwithstanding that, what some of the leading oil analysts are doing is saying “Well the valuation of oil stocks is predicting $50 oil and therefore these stocks are extremely vulnerable.
That is not so.
The fact that they’ve tracked the price of oil so closely does not mean that they’re factoring in $50 oil. Because by definition, if you take oil from $40 to $55 and the stock of the company producing it goes up exactly the same percentage then it is actually discounting a much lower price. Because that extra fifteen bucks a barrel flows to the bottom line in most cases. So the huge expansion in the profit margin of the producers is not being priced in to these stocks.
So we’ve got room to move still, notwithstanding how well they’ve done, because it does not mean that there is yet a consensus that oil prices are going to stay high. And that’s really the purpose of this call, to address the fact that when you’ve got so many of these stocks trading at all-time record prices and oil back up to its former peak, the temptation is to take money off the table because you say it’s all in the market.
No, I believe there are still divisions of opinion, but…and if we take Lord Brown’s damascene conversion going from 25 to $40…$40 oil is still a long way down from $57 oil.
Now, I can’t tell you where oil prices are going to be six months from now…spot or what’s going to happen in the futures contract because there are so many factors at work. But one of the factors that may be actually at work which is of some significance comes from another market, which is the bond market. Next week you’re going to get a new copy of Basic Points in which we discuss what happened in Europe but we also have a section on what’s happened to the yield curve and we’ve addressed Ben Bernanke’s work, about the global savings glut.
This is a big idea. You don’t get many big ideas in this game, but Mr. Bernanke’s work…the more I look at it, the more helpful it is for understanding that notwithstanding the fact that until very recently all central banks were in tightening mode or in hold the line mode, that the bond market never really responded to that and in fact, since the Fed began tightening the 10-Year note yield in the United States has fallen. That is really unprecedented.
So for those who are saying “It’s never different this time”, maybe when it is different this time what you’ve got to do is say “What has changed” and I think that Mr. Bernanke’s viewpoint helps, along with the analysis that we’ve done about the way the derivatives markets and hedge funds work together to create a situation where the classic waves of defining how a yield curve functions going back to John Maynard Keynes and then the experience that I’ve had over my career in the business, which started in ’72. Which is, that the yield curve is to price forward inflation. We’re getting other factors at work here and in particular, it is this huge change in the global savings rate. And what Mr. Bernanke has identified is that a big part of this change has occurred in the emerging world.
Everybody’s familiar with how China has helped manipulate Treasury bond yields by their acquisition of Treasuries, but the process goes further than that. Now why is this important for oil?
Well, if you look at the copper price, which is a good indicator of what expectations are for economic activity on a global basis, not US basis, we’re trading very near a 17-year high at a buck fifty nine. And so although some other industrial metal prices have been weaker, King Copper is still out there as the benchmark industrial metal and what that’s saying is that notwithstanding all those indicators that the global economy has really been slowing down, that it’s not going to go into recession.
Now why is this important for oil?
Well, because of course oil is a cyclical commodity. Yes, most of oil usage goes on whether there’s a recession or not. But at the margin – and we’re now working at the margin all the time with oil because supply and demand are in such tenuous and dynamic balance- then if the global economy is not next year going to be anywhere near a recession, then what that means is that oil demand is going to be higher next year than this year and it’s not clear yet where the new production will come on stream. Depending on how fast the rate of decline on the Hubbard’s Peak basis is from existing fields.
So I think that when you have long-term interest rates so low – the German Bund’s around 3.20, for example – on a global basis it means that those who want to borrow money can borrow it so cheaply that it’s as if central banks didn’t exist.
The Euro currency market is awash in liquidity. You can get all the Eurodollars and Euros that you want, let alone the Euro Yen, for financing. So you can make the case that in a funny kind of way the central banks are like OPEC. Which is, that the market is stronger than they are. Now there’s no question that if the Fed chose to raise rates seventy-five basis points at the next meeting, that would produce massive shocks all over the place. But if they’re just continuing with their twenty-five basis point tightening the market seems to have priced this in and liquidity remains. Liquidity is somewhat independent of price. As long as the price of money isn’t high and it’s freely available and flowing then you’ve got the stuff of economic activity.
What position we were in in March was we had soaring oil prices and soaring short rates and so we had a shortage of oil and a shortage of money. What is clear now is that the shortage of oil is likely to stay with us for a time but money is available at a price, the liquidity is continuing there, and we’re not likely to run into the inverted yield curve which has always and always meant a recession.
None of this is good news for the bank stocks. So, a cautionary note here, we have been bullish on these stocks. I think that when you look at the valuation of the stocks you should really move up your weighting of what factors you use, you should go to the dividend outlook for them. You should value the bank stocks on the basis of whether they qualify as the great dividend stocks.
Because it’s quite apparent that although hedge funds and other users of capital have found ways around the flattened yield curve. It’s very difficult for the bankers because when they get to the stage that what the can lend money out at is barely above the cost of funding, their profits are really squeezed and in addition, if we should get to the stage, you know, we’ve got all sorts of predictions out there that the Fed funds rate could be 4% by year end.
Well, if the Fed funds rate is at 4% by year end, then we’re looking at a situation where there’s virtually no spread out there. Now admittedly bankers aren’t lending out at the 10-Year note rate, but what’s left in there for them is pretty thin gruel.
So I put all this together and say that it’s more than ordinarily difficult to come up with a view as to what the global economy is going to do under these circumstances. But there is a risk in using the obvious and the recent history excessively, which is, soaring oil prices and a tight Fed, producing a massive slowdown.
Further evidence of the Bernanke viewpoint is we had a gigantic jump in the mortgage refi in the United States again, which means that notwithstanding all those moves of the Fed, that what matters most to the 69% of Americans who own their own homes is that they got cheap money. And therefore the housing bubble, which is a worldwide phenomenon, is going to continue.
Amazing that we should have what could be the biggest worldwide housing bubble in history occurring at a time when as the European votes has shown, deteriorating demography has finally become a part of the political economic process. SO the old argument that you certainly should buy real estate because there’s always going to be more people to bid up the price, at a time when demography is turning negative around the world is an odd time to have the biggest housing boom in history.
SO wrapping all this up then…the forward oil curve undoubtedly now has a huge component in it of retail speculation, but this is small in relation to the heft of the oil companies and the oil companies have as a result of Rule 133, the oil companies in the US have pulled back on their forward selling which means there are premia in there and most importantly what it means is that looking way out to the end of the decade, oil is trading at $55 or higher.
And all of that supports a higher valuation for the oil stocks and yet this does not in itself mean that the world has to fall into recession despite the tightness of the Fed because there’s enough liquidity out there and rates are not high enough because there still is fundamental dynamism. And the main source of that dynamism for the world, China, although it may be slowing a bit, going from 10% down to 8% isn’t enough to derail this train.
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