Crude Move: Portfolio Reallocations and the USDollar (I)

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Gregory Marks's picture

The recent increase in volatility, particularly in foreign exchange and commodity markets, has prompted speculation and confusion as to the direction of prices. In regards to crude, many see the down move in a traditional supply vs. demand context, making the case that demand has decreased with global growth expectations while production out of the US has increased the market supply. Both of these facts are correct, but this still does not address the driver of the recent (and extreme) move itself. Those fundamentals noted have been in play for some time now. It is not as if market participants woke up in June (energy high) thinking to themselves, "Today, I will trade WTI futures rationally considering supply and demand fundamentals.”

            Divergences can build for tremendous periods of time, stretching price from fundamentals while surviving on momentum, expectations or asset allocation extremes. Nevertheless, prices do not occur in a vacuum. In the case of energy, higher prices fed upon higher prices. Diverging above the historical mean brought in players, spurred production innovation and thereby capacity. Even the economic impact of the production itself helped nations on the trade balance, employment and GDP front thus projecting expectations of higher demand thereby supporting price even further. Additionally, OPEC did not shy away from this new price regime, taking the opportunity to boost domestic spending or makeup for terribly structured budgets eroding under excess spending and inefficiency. (On a side note, capacity driven by the higher prices that OPEC welcomed now likely means a lower average price, straining state budgets of petrodollars when most needed.) 

            In the discussion of crude, it is important to note that such a commodity does not experience a 38% decline in under a year because of those fundamentals that have been around for years. Moves of this nature occur because of (1) a rapid change in expectations and (2) a subsequent, large move to reallocate positions by all players considering those changes. If we want to understand those two factors, we must first start with the building of the commodity super-cycle and and the fundamentals that sustained price.

            Commodity super-cycles have occurred in various times during history, the most recent one in energy having been driven by the rise of China and easy money driven global growth. Leverage, low rates, higher input costs and a weaker Dollar can all be included in the basket of drivers. Additionally, a consistent increase in the price of crude beginning in 1999 and the investment abilities that followed the rise of the internet drew an increase in speculators. It wasn’t long before the commodity turned into an asset, a well known and easily investable product to include in a portfolio, be it a pension fund or the average Joe’s online brokerage account.

            As we know with prices that never seem to go down, they keep going higher! A classic strategy of George Soros, among others, remains that when a bubble is spotted one must pile in. (Macro funds often admit guilt in propagating bubbles by taking part in this strategy.) Charles Prices’s comment about ‘dancing so long that the music is playing’ would be the more the metaphorical and well known illustration. 

            And higher crude went, hitting highs above $140 a barrel until topping with a USDollar low in the summer of 2008. I will spare readers of the events that followed, well known to all, better summarized by others and unnecessary to reiterate in detail. In our discussion of crude, what matters is the 21st century version of ‘the committee to save the world’ backstopped global markets, bringing a return of some normalcy to volatility and confidence in systemically important institutions. That was on the market side. On the economic front (important to distinguish the two) we received a US stimulus package in the hundreds of billions of Dollars, followed by an even larger and more potent package in the trillions out of Beijing. This came later, in 2009, when it became clear what a dire social and economic impact declining growth would mean for the mainland, emerging markets and the world. This defibrillator, combined with quantitative easing measures and a commitment to low rates, brought ‘life’ back to prices. Monetary authorities nervously hoisted the ‘mission accomplished’ banner, but continued unprecedented measures in the fight against deflation. Meanwhile, the market began what would become a five year global hunt for yield, borrowing reliable Greenbacks at low rates.

            Challenges ensued starting with Greece in 2010 followed by the rest of the Eurozone bond market in 2011 and the Chinese property market in 2012. Regardless, volatility suppression out of global fiscal and monetary authorities kept the boat afloat and Dollars cheap. Despite rough waters, a ‘do whatever it takes’ attitude pumped out the water, but without addressing structural cracks in the hull. And so established the dominant logic: if we could only return normally to the uptrend in assets through an expansion of monetary base, we might be able to get out of this economic and fiscal mess alive. Market participants played along, allocating investments in logical areas that would benefit from such a policy with once again, cheap Dollars.

Read part 2 here: