I was in Memphis last week visiting some folks. I found myself in a conference room with some very seasoned commodity traders… veterans of the floor, some going back to the ‘70s. Let me tell you something: if you ever find yourself talking to a 40-year veteran of the commodities markets, you should listen to what he has to say. Anyone who can last that long trading futures is pretty smart.
Funny thing is, I’ve been around long enough that now I am one of the old traders!
But I’m not a commodities guy by training. I’m one of those slicked-back-hair moneychanger guys who is never going to get to heaven. But I always learn a lot when I go to Memphis—which, by the way, is the third-biggest futures trading city after Chicago and New York. There are quite a few large trading firms that specialize in grains, meats, and cotton. Memphis is a big deal, and probably the best-kept secret in the financial world.
So I asked about what it was like to trade live cattle during the BSE (mad cow) outbreak about 10 years ago. “How about limit down for an entire week?” they said. Small traders went under. Cattle ranchers went under, guys who lifted their hedges at exactly the wrong time. It was downright ugly.
That was bad.
But what’s happening to oil is a million times worse.
There are a lot of folks who get pretty angry when you suggest that a near-50% drop in the price of oil might be a negative in the short term. They look at you like you’re dumb. They talk about the massive benefit to consumers, the synthetic “tax cut” that everyone’s getting, what it’s going to do to consumption, etc.
All of this is true. But if you take a major commodity and slice it in half in the span of a month or two, there are going to be major consequences.
When I say that the commodities markets haven’t seen anything like this since 1980 when gold went haywire, I mean it. And you don’t put gold in your gas tank. Sure, there have been some minor calamities, like when cotton went parabolic a few years ago, but crude oil is perhaps the world’s most important commodity when you take into account both its economic and geopolitical significance. People go to war over the stuff. Routinely. And with oil falling from $105 to $57 in just six months, it might happen again.
We’ll get to that in a second. But for perspective, when people look at this move in oil 10 years from now, they’re going to call it the “Crash of ‘14.” That’s my prediction. A move of this magnitude in a short amount of time is a crash. When stocks went down 19% in a week in 2008, that was also a crash.
What’s the definition of a crash? I say any move over six standard deviations. For comparison, the Crash of ‘87 was 25 standard deviations—a move so uncommon, so statistically rare, that it wasn’t supposed to happen in a length of time greater than the age of the universe.
I haven’t done the math on oil yet, but if it’s not six standard deviations, it’s close.
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As you probably know by now, the move in oil has been more of a supply story than a demand story. We were drilling holes all over the planet in search of it. My wife works in the Turkana Basin, on the border of northwest Kenya and Ethiopia, which is one of the most remote spots in the world. They were drilling for it there, too.
That’s what happens when oil gets to $140 a barrel. People are incentivized to look for it. It takes time to explore and produce the stuff. It takes years for wells to finally come online and for supply to hit the market.
There are still projects that may never be completed, like Vaca Muerta in Argentina, that Yacimientos Petrolíferos Fiscales (YPF) is developing in conjunction with Chevron. The poor Argentinians—screwed again.
And like we’ve been seeing in the mining industry, once a company has brought production online, it’s difficult to take it offline. It’s hard to start it back up again, to get all the permits, to hire everyone back. So people will continue to produce at uneconomic levels for a long time, hoping that the price will come back, while simultaneously ensuring that it won’t for a long time.
So back to my earlier point—is it bullish or bearish for the US? It’s not a hard question to answer. People are making it hard. 20 years ago, it would have been unequivocally bullish. Now, maybe not. We produce slightly more oil than we consume. There will be winners and losers, which is being reflected in the stock market.
For some countries, it’s unequivocally bearish, especially for adversaries like Venezuela, Iran, and Russia. But also for allies, like Canada, which is probably in the most precarious economic position of any country in the world.
The takeaway is: an oil crash makes the world less stable.
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I am a decent economic historian, but kind of a crappy political historian. People keep telling me scary stories about Russia—how Russia today closely resembles Germany in the 1930s. How Putin is in the midst of a full-blown currency crisis. How the West is (perhaps foolishly) applying sanctions. How the threat of annexation of Russia’s smaller neighbors could be higher than we think. How the willingness of the West to challenge it would be very low.
All because the price of a commodity crashed.
Russia is very much a petrostate. There are others. Norway has been enjoying a phenomenally high standard of living for years, with some of the highest incomes and the strongest currency in the world on a purchasing-power parity basis. A lot of that had to do with a very successful and well-managed state-owned oil industry, and one of the largest sovereign wealth funds to boot. If you’ve seen a chart of Norwegian krone (NOK) vs. the Swedish krona (SEK) recently, you know that oil’s plummet has been a game-changer.
I fear oil. But I don’t fear oil because oil will make the stock market go down—which it will. I fear oil because there are going to be second- and third-order political effects that we cannot even conceive of right now. Take Venezuela—my prediction is that Venezuela will descend into anarchy and hyperinflation—a failed state. This has consequences for the entire region, but especially Colombia. Take Venezuela and multiply it by 100, and you get a sense of the magnitude of the problem that we’re facing.
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Old traders know: price moves like this do not happen in a vacuum. There’s a chain reaction that extends out for years. So in situations like this, I do what an old trader does: I reduce risk. I cut back my exposure to things that gain from stability, and I increase my exposure to things that gain from volatility.
Nobody has a playbook for this, because nobody saw it coming. But a leveraged long position with no cash is probably a bad idea right now.
Courtesy: Dan Steinhart via Casey Research
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