Black Gold

Despite the holiday shortened week in the US, there were plenty of fireworks in the markets.

The party really got started on Friday once the US futures and stock markets re-opened after being closed for Thanksgiving and being unable to respond to the OPEC meeting.

The entire commodity complex sold-off in a big way on Friday, with crude oil losing over 10% for the day and over 13% last week alone.

Last week’s dramatic selloff in crude oil is a good reminder of two things:

Traditional economic theory is wrong.

You can gain an edge over all other market participants by focusing on all the slices in a loaf of bread rather than just the heel.

I'll explain both lessons below.

The Event

Let me set up the Friday selloff with a bit of background.

The crux of last week’s OPEC meeting was that the poorer members of OPEC were calling for a cut in the oil supply in order to stop the hemorrhaging of prices that began this past June.

Not every country that exports oil does so at the same cost. For instance, at one end of the spectrum, Venezuala’s breakeven price on oil is $121 per barrel and on the other end of the spectrum, Qatar’s breakeven price for oil is $65 per barrel.

On Wednesday, there were a number of sound bites coming out from the different countries involved. The United Arab Emirates said that OPEC will do what it takes to balance the market and Angola predicted that an agreement would be reached to cut oil supply at the next day’s meeting.

It should be noted that Angola’s breakeven price for oil is $95 per barrel, so a cut in the oil supply would help stem their losses. Saudi Arabia’s oil minister said on Wednesday simply that crude prices would stabilize.

So, it shouldn’t have surprised anyone when on Thursday, Saudi Arabia, the de facto leader of OPEC, blocked the idea of lowering the supply ceiling. The fact is that the Gulf producers have the foreign currency reserves to weather a low price battle for market share and countries like Iran and Venezuela cannot.

Saudi Arabia is willing to live with lower prices in the short term, in order to shake out the weaker producers in the US and elsewhere, so that they can enjoy more stability at over $80 a barrel in the long term. Now that we’ve covered the event and the rationale behind the decision, let’s dig into the market implications of the decision.

 

Traditional Economic Theory is Wrong

In traditional economic theory, information is treated as a generic item and the investor is treated as generic and rational.

Both of these assumptions are inaccurate.

This generic approach also implies that all types of information impact all investors equally. This, too, is wrong.

The market is made up of all different types of investors with varying time horizons and information has different impact over different time horizons. The market remains stable because different time horizons value the same information differently.

Market stability relies on a diversification of the investment horizons of its participants. Heterogeneity of market participants is, in turn, what allows for markets to be liquid.

Liquidity is not the same thing as volume. Liquidity is the balancing of supply and demand within a given market.

Markets become unstable and illiquid when market participants all have similar time horizons, like when long-term investors become short-term traders. This illiquidity played out on Friday in the crude oil market, as well as many other commodity related markets.

Yes, there may have been plenty of volume but what prices were available? For starters, crude gapped 6% lower from Wednesday’s close to Friday’s open, so there was no opportunity to trade in crude oil between 73.53 and 69.39.

In addition, the high to low range for crude on Friday was 69.59-65.69, but there was certainly not ample liquidity and each $0.01 increment in the entire range. Some investors are forced to become short-term traders because of margin calls that force them to sell into the decline.

Other investors choose to become short-term traders, such as Brevan Howard, one of the largest hedge fund firms in the world, began liquidating a $630MM commodity hedge fund last week, further exacerbating the down moves across the entire commodity complex.

So, while volume may be ample, liquidity, or the ability to trade in size at a given price, decreases dramatically when a majority of market participants are either buying or selling based on the same time frame.

 

Loaf of Bread

In markets, any act, be it an economic data point, company earnings or central planning, gives birth not only to an effect but a series of effects, like a loaf of bread. Only the first of these effects, the heel, is immediate and seen.

The other slices and effects unfold in succession; they aren't seen until they're exposed.

Friday’s market action was based on the immediate effect of market participants reacting to the fact that OPEC was willing to let the market dictate lower prices.

Market participants were focused on the heel and traded accordingly. It's critical to have the ability to keep the whole sequence of slices of time rather than arbitrarily focusing on the very first slice, or effect.

To gain an edge over other market participants, you have to look beyond the obvious of the immediate effect and foresee what is to come in the middle slices.

How do you apply this type of framework to the oil market?

First, the Saudis have made it clear that while they're willing endure lower oil prices over the short term for long-term gain, $60-65 a barrel is their floor.

If prices fall below this floor for a period of time, they would step in and take action.

So, while Friday’s action saw a lot of long positions sold, there was also a fair amount of short exposure added.

Does that make sense?

If you're adding short exposure on Friday, you’re focused on the heel and not the fresh slices in the middle. If we know that $80+ a barrel is preferable for oil exporters and the Saudis have set a floor at $60, then which trade, long or short, at $65 a barrel has the better risk-to-reward?

The long trade has you risking $1 to gain $3, and the short trade is the reverse of that.

Another example of focusing on the middle slices and the series of effects of the OPEC decision is to look at how the oil market impacts other markets. In the US, market participants focused on the heel will say that lower oil equates to lower prices at the pump, which is the equivalent of a tax break and gives US consumers more money to spend which boosts the economy. This may be true for a period of time.

However, the energy sector represents 33% of the S&P 500’s capital expenditures and 35% of the S&P 500’s earnings per share come from this investment and commodity spending.

So if you’re focused on the middle slices then you know that any “boost” to the US economy that comes from consumers spending what they save at the pump will be more than offset by the decline in GDP that comes from energy-related companies that are leveraged to the price of oil when they stop investing in growth or hiring.

Obviously the impact to US GDP is a function of the magnitude and duration of the oil price decline. The point remains the same.

By focusing on the middle slices, you can use today’s price movements based on investors focus on the heel to position yourself for bigger gains.

Finally, how does a continued and prolonged slide in oil prices effect the Eurozone and Japan, who are currently in a battle for their fiscal lives with deflation?  Poorly.

Among other implications, this means a continued slide in their respective currencies and further gains for the US Dollar.

Opportunity comes when the public’s perception of an event diverges from the actual probabilities.

Human-ess gets in the way of being able to consistently implement a framework like the one described above. The more we can understand this quality, the better we can gain insight into other market participants by gauging their perceptions and reactions across time. This allow us to use the present as a means for opportunistic exploits in the middle slices.