8/20/08 (Disagree? Oil Direction? Nationalization!)

Traders,

Yesterday we slipped a little further and volatility continues to be the driver in the market. We saw oil see some strength and the dollar start to pull back as continuing uncertainty in the financials are now followed by the retail sector difficulties.
I had an interesting conversation with a colleague yesterday, while we disagree about commodities and the currency – he is bullish the dollar, I am bearish. He is bearish oil, silver, and commodities, and I am bullish – it’s fair to say while we disagree, he also has justified his reasoning. It’s nice to hear opposing views and if it’s those opposing views that create supply and demand. But what more interesting was our conversation on the topic of futures – he made me think about if we didn’t have futures and relied on the spot market what would happen to prices? He seemed to think that without futures oil prices would plummet to $30 a barrel, I of course totally disagree. I think with a monopoly supplier and world demand we not only would see possibly higher prices than what we have seen traditionally in the futures market. I believe that when you choke down the supply lines to one source, in this case the spot market with one controller of price (taking the multitude of futures participants) – one supplier would obviously raise prices as demand rises.

However, one interesting point that he made is that oil prices WILL come down as we move to alternative energies, this I agree with – but there is a BIG BUT! (Isn’t there always!). The big “BUT” is that assumes that those countries like China, Brazil, India and other emerging countries also start switching to alternative energies. That is something I am skeptical of. I think as long as the emerging markets can purchase oil and to meet their demand they will. China doesn’t seem to care about the environment (look at the air condition in their major cities - same is true for many emerging markets) – so they are not going to see pressure from environmentalist. And true, while our demand (consumption) may slow, China’s and other emerging markets will pick up the slack. Looking far into the future is difficult and I agree with my colleague that eventually the reliance on oil will slow and probably quicker in this country than others as we move to alternative fuels. The question is will the world also move quickly to alternatives or not.

As per oil, commodities, and the dollar. I think we may see oil consolidate at these prices and begin to rally again in the next 6 months and also think the dollar will weaken more unless we the economic landscape changes in this country. My colleague, to be fair, has rational and justified reasons for his theories – it’s fine that we disagree and it’s also good that we do. I rather talk with someone that challenges my thoughts and theories (trying to poke holes in it) that have people blanket agree with me. Being able to define ones ideas helps solidifies them. For fun we have a Prop Bet on the dollar in the next 3-6 months, I think weaker he thinks stronger. I guess there is a icy cold beer on the line as to the health of the US economy.

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Oil Inventories

Goldman has raised their target for oil to $149 as expectations for stockpiles may show supplies shrank for a 4th straight week. US gas supplies dropped by 3 million barrels last week and while consumption may have slowed we are still in the peak driving season. Oil has come off about 20% from the highs, but gasoline has only come down half that much (if that – depending on location).
On top of shrinking gasoline supplies, some OPEC members have called for cuts. Seems crazy, but some knowledgeable oil people (Pickens being one of them) has already indicated, while we may not be OUT of oil most OPEC nations are already pushing maximum extraction and are having difficulties running close to 100% extraction rates as it is. When you are pumping more seawater into the reserves than you are getting out, well that should tell you something.

As my colleague correctly pointed out that the US consumption rate has seen a decline, my bigger concern is world consumption is not seeing a declines. The question that I don’t have an answer to, while we (the US) are the largest consumer of oil and our consumption is slowing, how much does that off-set global increase in consumption? More importantly, when does the emerging markets surpass the US in consumption? I think that question is “WHEN” and not “IF”. I think we need to continue to look beyond our shores and remember that while we are the biggest consumers we are not the ONLY consumers.

My thought is that it will be hard pressed to see oil break down through $100 in the near-term, in drops below that would be “fat-tails” and short lived spikes before a rush in to buy it up would happen. If Goldman is right and US supplies continue to drop we could see oil rally from these levels.

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Fannie and Freddie – soon to be Nationalized?

The arguments are heating up, yesterday a member of the Fed voiced his strong criticism that we should of and should now privatize Freddie and Fannie. Many have said the concepts of the GSEs and their ever extended leverage is creating a bigger hole and thus a bigger bailout. It is clear at this point, without the government intervention and aid at the Discount Window these two companies would be bankrupt.

Now, there is over $250 billion of debt maturing in the next month and rising borrowing costs are putting the serious squeeze on these firms. Sec. Treasury Paulson wants authority to pump unlimited capital into Freddie and Fannie as their capital is depleting fast. As news continues to pour out the shares continue to fall. These companies are like watching a massive train wreck and the government is keeping them afloat by loaning more money – unbelievable amounts.

They are at the tipping point, if their capital runs dry they are done – the most important factor is for them to remain liquid. Paulson wants to pour money into them to remain liquid, Barney Frank and his supporters want to Nationalize them.

Over 40% of all US mortgages sit at these two firms and now these firms are be floated. They have to pay $250 billion at the end of the quarter, they DO NOT have $250 billion – so they are going to have to ROLL that debt. The question is that is really NOT how it works, this is NOT a revolving charge card.

There are 3 outcomes, Paulson gets his way and lends them unlimited amounts to stay afloat, Congress pulls the trigger to nationalize these companies, or we let them fail. The last option will not happen. However remember both the first two is still about lending money – either nationalize them and bail them out or keep them status quo and lend them more money.

It’s a massively ugly situation. Most American’s have no clue as to how bad this is or how much this is really going to cost this country – through more inflation and more taxes. Makes me want to puke. I don’t know the right answer, but you have to hand it to Barney Frank and Congress for allowing Freddie and Fannie to EXPAND their debt and turning a mole hill into Mount Everest!

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Futures Pre-Market

We are seeing mixed action, first up then down then flat then up. I think the ARB traders will be sidelined going into the opening and not willing to risk long or short futures legs to against the cash basket. Expect a mix opening and afterwards who knows – energy inventories could inject more volatility when released later.

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Support / Resistance

Up is down and down is up. Volatility is the only sure thing in this market.

INDU 11,275 / 11,500 (The range is narrow because we broke that 11,500 area which was the base of the stepping trend. We also didn’t break down through the 11,275 area. It’s anyone’s game in here – who knows – but don’t expect us to be range bound between 11,275 to 11,500. If we break up through 11,500 we could get another big rally if we can’t hold 11,275 we could be heading fast to 11,000. Expect volatility.)

NDX 1900 / 1925 (Another narrow range – we stopped just above the 1900 area and it seems that a couple of issues in the index are pushing higher in the pre-market. 1925 is in the cards, but if we don’t close above 1900 then a quicker move towards 1850 is in the cards.)

SPX 1250 – 1265 / 1275 (We are in a tight pull back. We stalled in a shallow support and we are either going to break out of 1275 or break down through 1265 and head to 1250. Expect volatility.)

RUT 720 / 740 (Right in the middle – it’s fair game in either direction.)

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Conclusion

My conversation with my colleague had me thinking about some of my observations, but I continue to fall back to the big picture – has anything really changed in the economic landscape? No, consumers are strapped, the GSEs are facing a bailout of epic proportions, oil consumption on the global scale has NOT slowed, and the massive deleveraging continues. He makes some valid and interesting cases for a strong dollar, but in the short-term – I think with treasury auctions having problems and the lending at the discount window (and now a bailout of the GSEs) means MORE money being poured into the system, not less. The M3 levels are ramping hard – even though the government doesn’t want to look at them anymore. So in the short-term, while the dollar did make a big jolt to the upside – I am chalking that up to the big short covering and a rush to liquidity and deleveraging – I don’t think it’s because things are getting better.

One thing we BOTH agree on is to expect more volatility. I appreciate and respect his beliefs and theories and we should all question everything. Don’t take my opinions as fact, they should be challenged as with all opinions. These are difficult times and no one is going to be right 100% of the time. Therefore as my colleague also agrees with – it’s always best to HEDGE your positions in case you are wrong.

Stay vigilant.