Oil Producers: Lower CDS Spreads, Higher Equity Prices

Since the 1973 oil embargo, if not before, the price of a barrel of crude oil has been a key benchmark for investors of all stripes. It has become an indicator of economic health, both from a physical usage standpoint as well as from a financial perspective as its dollar denomination has made it a proxy for the strength and weakness of the currency in which it is priced.

We are now in a time when many of the factors affecting the price of oil, more typically exhibited one at a time, are all swirling simultaneously. As a sign of global economic activity the move off of prices in the $40s was welcomed as an indication that mankind had not been wiped off the face of the earth. Not welcomed would be another move up to the mid-July highs of 2008 but the combination of factors that pushed prices there are unlikely to be seen again. At least until a bigger, better bubble machine is built.

The former oil minister of Saudi Arabia, Ahmed Zaki Yamani, was referenced by Paul Sankey, Deutsche Bank’s oil analyst when the latter published his views on global energy markets recently for his famous dictum: “Just as the Stone Age didn’t end for lack of stone, the oil age will end long before the world runs out of oil.”

The fear of burgeoning demand for fossil fuel from a rapidly modernizing Middle Kingdom is countered by Sankey with the logic that “the Chinese went from writing each other letters with pens to communicating via 3G mobile phones, and they can go just as directly to fuel efficient cars. U.S. and then global oil demand will fall dramatically once the high-efficiency fleet hits critical mass.” Mark one for the bears.

Current tensions in the Mid-East have also been ignored for the most part as the disclosure of Iran’s secret uranium-enrichment facilities brought the possibility of economic sanctions against Iran and a possible oil embargo by Iran all to the fore once again with no spike in oil prices. Oliver Jakob, MD at Petromatrix, an oil-research firm, actually thinks; “There’s never been a better time to impose sanctions on Iran, and there won’t be in the future either. Today, the world can afford to lose Iranian crude exports for a few months.” If Mr. Jakob is to be believed mark another one for the bears.

The dollar becoming the current favorite place to borrow before lending in a higher yielding currency is not the only “carry trade” going on. For some time now it has been profitable to lease tankers, fill them with oil and park them offshore somewhere while selling the contents via one of the back month futures contracts.

In February of this year you could buy oil in the spot market for about $35/bbl, sell it on the futures market one month hence for $40, incur $0.45/bbl storage costs and pocket the $4.55 difference. The trade became “crowded” as all good trades eventually do and that difference has now shrunk to just about the $0.45 it cost to store the oil. As a result there is a lot of oil that was in parked tankers coming to market. If you’re keeping track, more supply than demand usually means lower prices so that would be 3 in the bear column.

The spread reduction that is causing the unwind of the tanker carry trade is a sign of future demand to some as the fact that November futures are trading at the smallest discount to December in almost year is a sign that “demand will soon pick up and eat into stockpiles”, according to Brian Baskin in the WSJ.

Darin Newsom, an analyst with DTN, concurs saying; “The spreads are acting as support. They’re showing there’s commercial strength out there that isn’t registering in the news or might not be showing upp in some [inventory] reports.” One for the bulls.

Costanza Jacazio, an oil analyst with Barclays thinks: “We’re slowly moving towards a gradual rebalancing of supply and demand. The narrow [spreads]. . are in a way a reflection of the continued erosion of the crude-oil inventory overhang.”

The dollar proxy status of crude could also be seen as a major contributor to higher prices on a per barrel basis as Uncle Sam tries to camouflage a stealth devaluation with talk of strength.

The CEC Portfolio is currently long 12 of the 17 names tracked under the “composite integrated oil” including names such as: SU, OXY, HES, and CVX among others. Long positions are the result of lower CDS spreads and higher equity prices happening in unison.

If Costanza and the collapsing carry trade are right “Big Oil” will continue to find demand for its products and services. Additionally, with the weakness in the dollar being countered by the rise in the price of a barrel of oil, price protection overseas is reasonably assured and higher prices domestically are a given.

That would seem like a late game turn-around for the bulls but it might take a review of the highlights to tell for sure.

Enjoy the week.

Comments

[redbaron:]

A nice review, but I was waiting for a recommendation, or conclusion, which seems to be missing. Does the author have some final thoughts?

Oct 13 08:36 AM

[J. Crighton:]

I agree with red.

Oct 14 10:06 PM