Boba Fett = Somali pirates. The ultimate modern day comparison to the notorious bounty hunter Boba Fett has to be Somali pirates. As discussed previously on the burrito (while referencing another cult movie), the cold-blooded killers on the east coast of Africa have hijacked tankers carrying as much as 2 million barrels of oil, and cost the global shipping industry $9 billion a year. However, in signs that the dark side may be losing its luster, the number of successful attacks by the pirates have fallen substantially in the last year.

Han Solo and Chewbacca = WTI and Brent crude oil.  The theme of pirates continues as we turn to Han and Chewie, who for this purpose represent global crude benchmarks. Despite their very different backgrounds and characteristics, the two have been thrust together as partners. And due to their familiarity, they have become very close.

Although a fatal flaw in one of them (= Han = WTI crude) has led them to become separated (in a frozen-in-carbonite kind-of-way), just as in the Return of the Jedi they will ultimately be reunited (and thus should be the case for Brent and WTI once the conundrum facing the Keystone XL pipeline and Cushing supply glut is resolved).  This also makes the global crude market the Millennium Falcon, the vehicle by which our two scoundrels travel.

The Empire Strikes Back = CFTC. Otherwise known as the Commodities Futures Trading Commission, the regulatory board of futures and options - the CFTC – moved to strike back against speculation late last year, by voting through a proposal to limit the number of contracts a single firm can hold. The problem this poses is that it could lead to higher prices due to its limiting ability on traders to hedge positions. The new caps are set to take effect later this year, or possibly early next. 

The Phantom Menace = geopolitical tension. The invisible 800-pound gorilla in the crude complex is the threat of the phantom menace - that of geopolitical tension. This has been on the rise from various factions of late, from Iran due to their development of nuclear weapons (and subsequent threats to close the Strait of Hormuz), to uprisings in Nigeria in response to the end of fuel subsidies (resulting in the government backpedaling on this decision).

Add this to Syria uprising and sporadic bouts of tension in countries such as Iraq and Kazakhstan, and this leaves the phantom menace to keep crude prices elevated and on tenterhooks.    

Ewoks = Opec. A somewhat wild and unruly rabble, but one that is able to coordinate their efforts when needed, the Ewoks represent Opec. The most dominant character in the Ewoks - Wicket – represents the country in the cartel who wields the most power…Iran (tee hee) ……Saudi Arabia.

There you have it. I think I covered most of the main characters in these past two posts. Thanks for playing…and may the force be with you!

Let’s start with theory, and an old favorite of mine: Bob Farrell’s ten rules of investing. Rule numero uno is: ‘markets tend to return to the mean over time’. Investor judgment is especially clouded at extremes, be it by euphoria at one end of the spectrum, or pessimism at the other. But regardless of these moods and subsequent moves, Bob assures us that markets tend to revert to the mean over time.  

But what does reverting to the mean, err, mean? Mean reversion is a theory which states that even if  prices may throw some crazy moves in the near-term, they will eventually move back to an historical average or a mean. A great example of this in commodityland™ is the price of WTI crude oil. Despite its vacillations, prices tend to gravitate back to the mean reversion of the  200-day moving average (black line):   

Mark Twain summed up this move back to equilibrium when he said ‘history doesn’t repeat itself, but it does rhyme’. Although he was talking in broader terms, this expression is as applicable to financial markets as it is to anything else. History repeating itself – or patterns - represents one of the cornerstones of technical analysis, as patterns can be used to predict future market movements. Ergo, markets get revertigo. That’s why technical analysis is great, and both Summit’s technical guru Brian Swan and Mark Twain are legend…wait for it….dary.  

Despite the naysayers who debunk mean reversion as a thing of the past, there are plenty who are willing to defend the cause. An avid advocate is investment and behavioral finance guru James Montier, who defends his stoic stance on the subject by saying ‘during pretty much every “new era,” someone proclaims that the old rules simply don’t apply anymore’.  But yet we always revert to revertigo.   

Timing is everything.

But herein lies the problem. Despite the knowledge that markets will get revertigo, the hard bit is knowing when. As the lady in the picture to the left will tell you, timing is everything. So I leave you with this final quip. We have previously discussed on the burrito how markets are not always wholly efficient nor rational (through Scooby Doo). Even the best minds in history, such as John Maynard Keynes (great economist, terrible investor) experience this futility. As he most famously quipped, waiting for revertigo can be like waiting for Godot: ‘markets can remain irrational a lot longer than you and I can remain solvent’.

This week is shaping up to be more crucial than most for crude oil, as we see some important developments in key price drivers of Black Gold, Texas Tea. So here are some details which have already been gleaned, and some which are yet to be revealed.

First up, the pressure in general markets is building to a crescendo this Friday, as we await a speech by the Chairman of the Federal Reserve, Ben Bernanke, from the Fed’s annual symposium at Jackson Hole, Wyoming. The reason for such high expectancy is twofold: there is hope of further monetary stimulus from the US central bank to kick-start the US economy (third time’s a charm apparently, after QE1 and QE2 – discussed here on the burrito recently), and secondly, because of its timing.

Last year’s meeting at Jackson Hole produced the announcement for QE2, prompting an almighty run-up in stock prices for the duration of QE2; this rally was mirrored by crude, with Brent prices rallying 47% (and 26% on WTI) over the same time period. With the recent downturn in economic data, there has been a corresponding upswing in anticipation for a repeat scenario this year:

And Brent crude oil:

An announcement of QE3 by the Federal Reserve on Friday seems unlikely, with the more probable weapon wielded by them being that of supportive rhetoric for further intervention should the economic outlook deteriorate. But given the optimism in both equity and crude markets this week for something more substantial, these markets are facing the prospect of being disappointed. 

Next up, I want to highlight something which continues to sit on the back-burner, simmering away: Chinese oil demand. Data from Platts this week shows demand in July averaged 9.05 mb/d, up 7% on the prior year, rebounding from weakness in June caused by seasonal refinery maintenance.

Despite ongoing efforts by the Chinese government to keep inflation in check by raising interest rates, these headwinds to growth are not impacting oil demand…as yet. Further, China’s Ministry of Industry and Information Technology (MIIT) projects crude will maintain the pace seen already in 2011, with consumption to pick up again later in the year. Lest we forget, China is the second largest consumer of oil (behind the US), making up approximately 10% of global demand, and growing.

Third up, homeboys and girls, is the small matter of Libya. As the chart at left illustrates, Libyan production has dropped off a cliff since the beginning of the year with the civil war. 

There are enough wide-ranging estimates about how quickly oil production is going to come back online to prove that no-one really knows at this juncture. All we do know is that its return hinges on two key factors: how much damage has been done to infrastructure, and secondly, how organized the Libyan rebels are in getting the oil industry back up and running again. 

The drop-off in production is set for an imminent turnaround, but as for how much and how quickly, we will just have to wait for further details to emerge.

Finally, this factor is more of a slow-burner than a revelation: stockpiles at Cushing, Oklahoma. The wide spread between Cushing, OK-based WTI crude oil, and UK-based Brent crude oil remains at a near-record, despite a 20% fall in stockpiles at Cushing (which had spurred on the large disparity betwixt the two prices in the first place).

WTI is now somewhat disregarded as a global benchmark as the near-$25 spread between the two prices means WTI is of little relevance to US product prices, as the lion’s share of refining in the US is based off Brent prices (as only the refineries in close proximity to Cushing can access and benefit from its large discount).

Although this disparity is not going to immediately disappear given the triumvirate of an influx of supply from shale plays in North Dakota, from Canadian oil sands, and from the continued delays to the Keystone pipeline, a drop-off in stockpiles at Cushing should have some sort of impact on narrowing the spread and increasing the relevance of WTI. But it hasn’t as yet. 

These four factors remain at the helm of the crude complex, driving it  forward. Equities and general risk appetite look set to play a further key role as we try to gauge how well the economic recovery is going. Resolution to the war in Libya and the subsequent return in oil production will be seen as a welcome development, especially for Europe which has seen a tight crude market since production went offline. The timeframe for this, however, remains very much up in the air.

As for Chinese demand, continued strength is encouraging for the global economy, but will also be the canary in the coal mine should it take a turn for the worse. And finally, should we see Cushing stocks considerably drawn down, the more relevant WTI will become as a global benchmark once more. This scenario, much like a return in Libyan production, may be a ways away yet. Many factors to watch, but all fascinating.

In times of market turbulence like this, I find it useful to do two things: make simple observations, and seek solace in the wisdom of others. So this week I have turned to the most voracious voice of reason, Winston Churchill, to help me make some sense of this all. This is what he has told me:

‘I never worry about action, but only inaction’

This simple expression from Churchill underlines the conundrum that the US currently faces. It is loose monetary policy (= low interest rates) which has spurred on the rally in equities and commodities in the past two years. Interest rates reached an historic low of 0.25% in December 2008, as the US central bank (= the Federal Reserve = ‘the Fed’)  took extreme steps to boost an economy in the midst of a severe recession.  

The logic was that low interest rates would encourage both individuals and businesses to borrow and spend, leading the economy back into recovery. This was partly effective, as economic data bottomed out and employment, manufacturing, spending, housing, and sentiment all made a tentative comeback.

However, it was not good enough, as the economy started to stall, and the government had to introduce quantitative easing (to the tune of $1.75 trillion in late 2008) and then the sequel, quantitative easing two (QE2 - a further $600 billion in late 2010) to try and revive the economy by essentially pumping liquidity into the system (by printing money, and buying US debt). 

These two endeavors unfortunately did not achieve their goal of spurring on a sustained economic recovery, leaving the Federal Reserve to announce on Tuesday it will be keeping interest rates at a record low until at least mid-2013:   

So while Winston Churchill warns of the perils of inaction, the Fed is left between a rock and a hard place. The rock is interest rates anchored at near-nil. The hard place is considering QE3.

‘If you have an important point to make, don’t try to be subtle or clever. Use a pile driver. Hit the point once. Then come back and hit it again. Then hit it a third time – a tremendous whack’

So the alternative of inaction by the Fed is further monetary stimulus, which would likely take the form of a third round of quantitative easing. This is considered an increasingly plausible option, especially if  the economy continues on its path to recessionary conditions, and inflationary pressures wane and give way to deflationary fears (while inflation can be fought by raising interest rates, there is nothing to fight deflation – ask Japan).

So while QE3 may seem ludicrous, the Fed may be given no choice if conditions turn armageddonesque. And after the failure of the prior two rounds to spur a lasting and robust recovery the Fed would likely feel pressure to really raise the stakes this time around, and hit the market a third time…with a tremendous whack.   

‘Kites rise highest against the wind – not with it’

Perhaps the most surreal event of the last week – that of the US having its debt downgraded for the first time in history – has prompted a similarly surreal event in…US debt. A combination of this news with a bout of poor economic data have sent equities and (most) commodities spiraling lower. This in turn has sent a flood of money heading into the safe-haven of US government bonds, regardless of the downgrade. Bond yields across the curve have hit fresh lows, as buying appetite has been insatiable:

This move into bonds tells us a number of things; that there is a rapidly rising expectation for a double-dip recession; that deflationary concerns are rising; and that the downgrade of US debt is of little material concern to risk-fleeing Treasury buyers. So as the headwinds for the US economy suddenly hit gale-force gusts, the kite of US debt flies to its highest point.

‘Everyone has his day and some days last longer than others’

Finally, current events are causing heightened volatility across asset classes, which leads us back to commodities. The point of this post was to talk about the bigger picture, as the implications of how current economic events play out will have a profound effect on commodities, and specifically energy. 

With crude oil taking direction from the equity markets (the litmus test for risk appetite and market sentiment), it is only natural to see prices reacting accordingly with such volatility, and with such a sharp correction. And the volatility at least will likely continue over the coming weeks as uncertainty continues to unfurl.

Meanwhile, other commodities such as US natural gas and coal are showing a muted reaction, somewhat insulated by their own market-specific fundamentals. And then there is Dr. Copper (the metal so good at gauging the economy it is considered to have a Ph.D in economics) and gold (the ultimate safe-haven). Copper is crestfallen, while gold is having its day and hitting all new nominal heights. And just as volatility is set to persist in general markets, gold is likely to see its day is lasting longer than others:  

This latest rumination about the future of natural gas was kick-started by a colleague mentioning ‘The Pickens Plan’ earlier this week. While being up to speed with the potential longer-term impacts on natural gas by LNG exports and shale plays, I wanted to know more about Mr T-Boone Pickens’ plan for a future fueled by the stuff. So some digging inadvertently sent me off on a wild goose chase through all things natural gas-like; here are some bits and bobs I discovered along the way: 

This first tidbit relates to natural gas transportation (also one of the pillars of The Pickens Plan). But this is not just the transportation fuel of the future, it is of the now. Amazingly, 61% of vehicles in Pakistan are currently powered by natural gas, while the number in the US is…0.04%:

This is because compressed natural gas (CNG) vehicles are more prevalent in the Asia-Pacific region and in Latin America as these regions look to combat rising fuel costs. For the US to increase the number of natural gas-powered vehicles on the road, it would likely take government subsidies; higher costs are involved to configure vehicles to run on natural gas than diesel while the economies of scale are not in place to mass-produce CNG vehicles.

 The idea of natural gas for vehicles dovetails nicely into ‘The Pickens Plan‘, which is based on four pillars:

–Create 22% of electricity in the US from wind 
–Build a 21st century backbone electrical transmission grid
–Use natural gas to replace imported oil as a transportation fuel
–Incentivize homeowners and owners of commercial buildings to upgrade their insulation and other energy savings options

According to the plan, nearly 33% of every barrel of oil imported by the US is used by 18-wheelers to move goods across the country. The Pickens Plan targets fleet vehicles such as buses, taxis, delivery trucks, and municipal and utility vehicles to be replaced by natural gas-powered vehicles. This is a sentiment echoed by the government in their energy policy document, ’A Blueprint For a Secure Energy Future‘, released in late March of this year.     

To target such demand growth in natural gas means an incredible reliance placed on the shale revolution coming to fruition. Yet these fears can be assuaged by taking a look at a simple snapshot of the EIA’s projection for shale growth in the latest Annual Energy Outlook:

Despite the current backlash experienced by shale and hydraulic fracturing (‘fracking‘), the dependency placed on it in the recent energy policy release by the government only goes to highlight that environmental issues will be resolved, most likely through increased regulation.

Another large piece of the long-term natural gas puzzle is LNG exports. As the above chart illustrates, the domestic supply of natural gas is to ramp up in coming years. One way for domestic producers to take advantage of higher global prices is to export natural gas in its liquid form (LNG). The problem is, to build an LNG export terminal takes up to six years; up to half of this time for the engineering and permit approval, and the other half for construction.

There are currently two terminals proposed in the US; one at Sabine Pass, LA, and another at Freeport, TX, which would create up to 4 Bcfd of export capacity. The terminal at Sabine Pass received approval to export from the Department of Energy (DOE) in May, and now awaits approval from the Federal Energy Regulatory Commission (FERC). The Freeport site submitted its application to the DOE in December 2010. Based on current timelines, LNG exports should be underway from 2015 onward.

So where does this leave us? After the announcements so far this year, from energy policy to LNG export approvals, the forward curve is weighing up the potential impact from these changing dynamics. While immediate near-record supply continues to weigh on the front end of the curve, the expectation for higher demand as we reach the middle of this decade is driving up prices at the longer end. Given the timeframe for these impacts to take hold, there is likely to be a whole lot more talkin bout this revolution before it actually takes place.