Global Margin Call

Global Margin Call Pushing Oil Prices Lower ... by Sean Brodrick

The commodity correction continues. And it's getting more painful by the minute as big trading houses like Lehman and Merrill Lynch go belly up or are forced into mergers. I think we're seeing a margin call on a global scale.
The good news is it should bring incredible opportunities for long-term investors. The bad news is we could see a lot more pain before this is over.
A "margin call" is when an investment, bought with borrowed money, decreases in value past a certain point, and an investor either has to put up more money or sell the investment. And we're seeing margin calls as Lehman and others liquidate their trading books.
What's more, we're seeing margin calls in oil.
Speculators pushing prices down
Now, here's where I eat some crow. Back when speculators were first accused of running up oil prices, I didn't believe it was possible. And the U.S. Commodity Futures Trading Commission concluded that the speculators weren't at fault.
I could find many fundamental reasons for oil to run up over $120 per barrel. And while oil looked bubblicious in the short-term at $150, I thought that any short-term sell-off would collide with the inexorable supply/demand squeeze in global oil supplies.
But oil has pulled back so quickly and so far from its peak, we can't ignore the reality that speculators are a big part of the market. And just as they pushed oil higher on the run up, they're helping push oil lower on the way down.
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Lehman traded the commodity markets — for example, you may have heard of the Lehman Brothers Commodity Index. The London Metal Exchange, the Liffe commodities exchange, and Intercontinental Exchange Inc.'s ICE Futures suspended Lehman on Monday. Funds and traders that knew Lehman was going to implode probably used what they knew would be a big dump of Lehman's crude oil futures.
There are other factors driving oil down, too, and I'll get to those. But there could be many more shoes to drop. After all, Lehman dealt in derivatives of many types, and the global derivatives market is worth about $455 TRILLION.
So around the world, funds and traders suddenly have to lower their exposure to these trades — taking a pre-emptive margin call before they receive a real one. And that unwinding of trades hammered many commodities, including oil, lower.
But a continued global margin call isn't the only thing that could drive oil down. There are four other forces as well ...
Downward Force #1: Impact from Hurricane Ike wasn't as bad as feared
There are a couple of rigs floating adrift in the Gulf of Mexico and oil slicks off the Texas coast. But it seems most of the rigs and refineries were spared. While 13 refineries in Texas shutdown 3.64 million barrels a day of refining capacity, there didn't seem to be much physical damage. And that capacity will come back online as power is restored.
However, it may be a week or more before all the refineries are running again. Those refinery outages could mean that gasoline prices could go higher even as oil prices go lower, because refineries offline mean less demand for oil and less production of gasoline.
Remember that many rigs had stopped working and refineries were already shut for Hurricane Gustav. And according to the Energy Information Administration (EIA), gasoline inventories the week that Hurricane Gustav hit were the lowest they had been in eight years — 187.9 million barrels, or about a 21-day supply.
Hurricane Ike destroyed 10 production platforms.
As for the rigs, the Associated Press quotes Lars Herbst, regional director for the U.S. Minerals Management Service (MMS), as saying that at least 10 production platforms were destroyed by the storm. That's not too bad, though, when compared to the 44 platforms destroyed by Katrina three years ago or the 64 wrecked by Hurricane Rita. And if refineries are offline, we won't notice the drop in supply ... for awhile, anyway.
Downward Force #2: Saudi Arabia is keeping the pumps wide open The Organization of the Petroleum Exporting Countries (OPEC) just trimmed its forecast for global oil consumption. And at its recent meeting, the cartel voted to cut production by 520,000 barrels a day. But shortly after the meeting, Saudi Arabia told its customers that it will supply all the oil they need.
0il Minister Ali al-Naimi announced that Saudi Arabia will supply all the oil that customers need.
Why are the Saudis doing this? After all, it wasn't too long ago that the Saudi oil minister said oil prices should range between $100 and $150. Perhaps the Saudis want to head off increased development of alternative energy. Another theory, put forward by Middle East Strategy at Harvard, is that the Saudis want to have a calming effect on the U.S. economy in the run-up to the Presidential election, because they fear what would happen if the U.S. withdraws from Iraq.
Whatever their reasons, higher Saudi production will weigh on the market going forward ... probably at least into November.
Downward Force #3: The Strategic Petroleum Reserve is being tapped
On Monday, the U.S. Department of Energy said that it had released 939,000 barrels of oil from its Strategic Petroleum Reserve (SPR) after shortages caused by Hurricanes Gustav and Ike. And on Tuesday, it approved another request for 1 million barrels. This seems like a small amount — and it is — but the psychological effect can be enormous.
After all, the SPR holds 707 million barrels of oil, and it can release 4.4 million barrels of oil per day. This reassures traders that the market will be well supplied ... and is another force driving prices lower.
Downward Force #4: U.S. demand is down
In the first half of 2008, U.S. petroleum demand dropped by 930,000 barrels per day, according to the EIA. Higher prices at the pump forced consumers to change their driving habits ... though big draws in gasoline in recent weeks indicate that people were driving more again as prices went lower.
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Longer-Term, Get Bullish
The forces I've talked about so far are driving oil prices lower ... but they're all shorter-term. Let me show you three of the longer-term forces that are bound to drop-kick prices higher.
Upward Force #1: Developing economies are booming
We keep hearing about a global recession. While it's true that developed countries are slowing down, developing countries are being driven more and more by internal growth ... in other words, building out their infrastructure. Plus their consumers want to buy lots of stuff and drive cars.
China is expected to grow 10% this year ... India is still managing 7.5% growth ... Indonesia is growing at 6% year over year, Thailand at 5%, and 4% or more in Taiwan and South Korea.
Closer to home, Latin America is still chugging along. Brazil is growing at 4%. And many analysts are waving the "buy" signal over that country ... Mexico is growing at only 2.8% in 2008 (dragged down by the U.S.) but expects to grow at 3% in 2009 ... Argentina is growing at 6.5% a year and Uruguay's economy is growing at 16.3% — the fastest pace in two decades.
The Chinese don't own a lot of cars ... yet.
Why is growth in these emerging markets important? Because these are the countries where consumers don't own a lot of cars ... yet. China has the same ratio of car ownership that the U.S. had back in 1915. As these emerging markets grow, they're going to use a lot more oil and gasoline.
While the pace of global oil demand has slowed down, it's still going up. Estimates vary depending on the source you use. But the U.S. Energy Information Administration projects that global oil consumption should rise by about 970,000 barrels per day (bpd) in the second half of 2008 and by another 920,000 bpd in 2009.
Developed countries may be using less oil. But the emerging markets are using every drop we don't ... and then some!
Upward Force #2: Oil producers consume more of their own product
It's a good thing that Saudi Arabia is producing more oil, because it keeps using more. Saudi Arabia's oil consumption is expected to rise 37% by 2018. And they're not the only ones. In the Middle East, total oil use went from 8.2 million barrels per day in 2001 to 10.6 million bpd in 2007 and will probably rise to 11.8 million bpd by 2012.
Result: According to the EIA, net exports from the world's top oil producers are declining year over year and that decline is accelerating — from a 1.1% drop in 2006 to a 2.5% drop last year.
And I recently told you about the catastrophic decline at Mexico's supergiant Cantarell oil field. Just wait until other supergiants around the world — which have been pumping for decades — start their own precipitous declines.
Upward Force #3: Lower prices will lead to shuttered production
I saw an estimate from one oil firm that claimed it needed oil at $80 a barrel to support pumping oil from its new offshore wells.
Then, last week, French energy giant Total said its Canadian oil sands project needs $90 a barrel oil just to achieve its goal of a 12.5% internal rate of return, while its wells off the shores of Angola need $70 a barrel. And Suncor Chief Executive Rick George has told the press that he believes the oil sands industry requires oil at $75-$80 a barrel to keep attracting investment and moving projects forward.
In fact, there is a lot of marginal oil production that could be shut off rather quickly if prices go too much lower.
Coming Up — The Market Disconnect
Since the Saudis aren't defending the price of oil, it could go lower in the short term. But it's hard for me to figure out where the "real" price of oil should be. We saw oil overshoot on the way up ... and now I think it's overshooting on the way down. Indeed, on Monday, as prices in the futures market plummeted, customers who were taking physical delivery paid a premium of $1.80 to $2.00 a barrel.
This shows you that the physical market could be getting detached from the futures market. We've seen it in other commodities already.
Silver is dirt-cheap, but try buying silver Eagles (1-ounce coins) without paying a hefty premium. Gold is way off its highs. Yet in many places you simply can't buy U.S. gold eagles without paying outrageous premiums. But we're told that there isn't a "real" shortage of gold ... they're just "rationing" them until supplies improve.
So are you really going to be surprised if the price of oil keeps going lower, and you keep paying more and more at the gas pump?
In the longer term, Peak Oil will come home to roost, and fundamentals that once drove the price of oil from $10 to $100 will drive it to $150 (again), $200 and beyond.
And a severe supply squeeze means that, when the next leg up comes, it could be fast enough to make your head spin.
How You Can Profit
In the short term, oil and oil stocks look to be headed lower. If you want to profit from that move, you can check out the UltraShort Oil & Gas fund (DUG). Just remember to exit when oil turns around.
I don't know when the next rally in oil will come. I do know that many great oil exploration and production stocks are trading at lower prices and earnings multiples now than they were when oil was at $75 a year ago. When oil prices go higher, these super-cheap stocks should be snatched up quickly.
You can find a lot of those stocks in the iShares Dow Jones US Oil & Gas Exploration and Production ETF (IEO) which holds a bunch of companies that should do very well as the price of oil climbs higher — companies like Anadarko Petroleum, Apache, EOG Resources and more.
Yours for trading profits,
Sean
P.S. Want to share your thoughts on the economy — or any other investment topic — with our entire Money and Markets audience? Then check out the Editor-For-A-Day contest that we're running right now!
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Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Tony Sagami, Nilus Mattive, Sean Brodrick, Larry Edelson, Michael Larson and Jack Crooks. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Kristen Adams, Andrea Baumwald, John Burke, Amber Dakar, Dinesh Kalera, Christina Kern, Red Morgan, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau and Leslie Underwood.
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