As Deflation Concerns Abound, Where Will Oil Go?

Includes: DIG, DUG, USO
by: Gregory Levine

How to play Oil?

Oil has been stuck in a $69 to $85 trading range for over a year. Currently, it sits just below middle, at about $75. Yet the economic weather patterns are certainly pregnant with the chill of a deflationary freeze. On Thursday, the Philly Fed Manufacturing Index dropped again - to -7.7, the lowest since July '09, when the "green shoots" were still in infancy. And here's the Biggie: unemployment claims jumped again, to 500,000. This puts us back in recession territory - if you believe it ever ended. The frosting (pun intended) on the cake is Dave Rosenberg's (the best U.S. economist, in my opinion) data from Macroeconomic Advisors that shows GDP growth turning negative in both May and June. So 3rd quarter GDP has a strong chance of coming in negative. Is oil or any other major commodity priced for this?

There are also geopolitical concerns: many worry about Iran's nuclear ambitions and Israel's possible response. In my mind, this is too full of unknowns to make a judgement. I'll leave that analysis for Middle East experts. However, because it is a possible cause of a price spike, the best way to play oil would be with a put option. The option provides leverage, with a maximum loss of the option.

The future of Iraq is a longer-term, but perhaps an even more important geo-political factor. Oil field development contracts that the Iraqi government has signed with the world's major oil companies add up to a shocking total: over 10 million bpd of production by 2012. If Iraq remains a stable country, this level of oil production could make it the world's largest producer. According to the IEA, 2009 production was about 2.4 million bpd. A jump to 10 million bpd would add an enormous margin of production over current and projected demand. The IEA projects world oil demand of 88 million bpd in 2011. Seven million bpd represents an 8% margin of supply over demand. This may not sound like much, but the 1998 low of $12/barrel came at a time of 7% marginal excess supply. So, I think oil could easily fall 20-30%.

The next thing that concerns me before making an investment is how to play the idea. What security or securies should I use? Unfortunately, I'm not a big enough fish to play in the futures pool. Otherwise, futures or options on futures would probably be the way to go. So that leaves ETFs. These are kind of messy and complicated. USO is also in natural gas. Then there are the Ultra's: DIG (oil bullish) and DUG, (oil bearish). Does the leverage in DIG make it a good candidate for puts if I want to take a bearish position on oil? I dug up the following chart:

Interestingly, although DIG is supposed to have two times leverage on the Dow Jones Oil and Gas Index, the chart shows they track very closely over the past two years. However, the implied volatility of DIG puts is in the 50's, while USO puts are in the 30's. So why pay for the higher IV (implied volatility can be thought of as the cost of time decay inherent in the option price) on DIG? USO put options should be much cheaper and just as effective. I will keep these on my watch list and wait for an opportunity to pick them up.

Update on Europe

The German newspaper Spiegel reports that Greek austerity measures are working. So far, the budget deficit has been reduced by a spectacular 9.7%, and total spending has been reduced by 10%, almost twice the 5.5% required to receive burther bailout funds to refinance debt. This should be incredibly good news. So why are Greek 4-year bonds still yielding 11.9%?

Unfortunately, there are a couple side effects to austerity. First, 17% of Athenian stores have filed for bankruptcy. 25% of storefronts are for rent. The shipbuilding city of Perama suffers from unemployment of 70%. Government worker salaries have been cut 20%.

Greek GDP dropped by 1.5% in the last quarter. This explains how a total spending reduction of 10% resulted in a deficit reduction of only 9.7%. The hidden link in this equation is a drop in tax revenues. (If tax revenues had stayed the same, the spending and deficit reductions would necessarily equal each other.) But there's more. The austerity measures were supposed to raise numerous taxes. And revenue still fell. That's a bad omen.

Unfortunately, global liquidity is freezing up after 6 months of worldwide central bank tightening. My opinion is that the austerity measures are doomed to fail soon. The final confirmation of failure will come when tax receipts begin to fall faster than government spending cuts. With GDP forecast to fall by 4% this year, even the eternally overoptimistic species of professional economist agrees that things are going to get a lot worse.

Greece has no source of economic growth, save cutting bureaucracy. In times of economic hardship, however, reforms are much harder to push through. Unfortunately, I believe that we will soon see riots as people get desperate.

The structure of the currency and banking system is also problematic for Greece. Everyone's earnings and savings are in euros. Greek banks are easily linked to other European banks. So it's very easy for anyone with money or savings to quietly move most of it to safe places like Germany. I have a strong suspicion that Greek banks are under very tight capital constraints and very unlikely to lend to small businesses or anyone else.

Author's Disclosure: no positions in any securities mentioned at time of publication