Monday, August 6, 2007

$60 Oil?

Michael A. Berry had some interesting comments regarding the future fate of oil in his Morning Notes today. I have included the entire commentary below so nothing is taken out of context.

If I were a cynic I would suggest that it would be in everyone’s best interest for oil prices to fall. Fortunately I am not cynical. However the DOW Transports, one of Richard Russell’s favorite indicators, cratered on Friday and broke through support levels. Railroad shares were down by 5% across the board on weak transport prices. One might draw the conclusion that the US economy is cooling, from these data.

This AM my very good friend Dennis Gartman notes that oil players are beginning to “delta hedge” their positions. Thinking back to October 1987 I remember a miracle product called Portfolio Insurance. The idea behind portfolio insurance was that you never had to pay a put option premium because you could easily (too easily it turned out) short the stock index futures to create a delta neutral position. Adjusting the short stock index futures position was of necessity a continuous process to maintain the delta neutrality or the hedge. But the magic was that institutions did not pay an options premium. Dennis points out, correctly, in his Gartman Letter, this AM, that the Saudis have suggested they are “OK” with $60 oil. WTI oil is trading down from its high of $78 to $74 as I write this AM.

A little reprise from the energy squeeze would be welcome to most of the people who have a hand in managing our world. Mom and Pop are scared. There is rampant fear based on the potential for a severe credit contraction. Lower interest rates won’t help that occurrence. Many think this has further to go. My point is this as the price of oil falls – if it falls a lot – the delta neutral hedges will be continuously adjusted to reflect the new spot prices. This can only be accomplished by selling more oil futures contracts. But IF the futures fall to a discount (through selling) with respect to the spot then the spot price is further dragged down and the cycle will repeat. It is a process that can create a meltdown. It is also a process that has the potential to move the spot price. Remember that these futures contracts can be settled in cash (rather that “in kind”) and we all know that there is plenty of cash around.

This sequence is precisely what occurred in October of 1987. There is a sure way to get those oil prices to $60. Let’s see how this plays out. Naturally if such a scenario were to occur you could expect to see many of the oil stocks falling in line with the price of the spot. One significant difference exists today. We are not talking about the S&P500 today. We are talking about a physical commodity, oil, which is in great demand everywhere in the world, even Iran. Perhaps we will find out what oil is really worth."

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