Silver and Oil Moving in Tandem: Large Hedge Fund Liquidation?

by: Kenneth D. Worth

Over the past week, two markets that are not normally highly correlated in the short term, silver and crude oil, have moved almost in lockstep in moves so large, 5-sigma in the case of oil, they would occur normally about once in every 7,000 years. This would be the proverbial "fat tail" of the distribution curve.

My argument: Somewhere out there a very big hedge fund is blowing up.

Over the very, very long run you would expect crude oil and silver to track one another pretty well. Both are physical commodities with an intrinsic value that will rise over time as inflation erodes the purchasing power of the US dollar.

In 1986, silver was around $5 an ounce, and oil was around $15 a barrel. Today, silver is about 35 an ounce and oil is around $110 a barrel. In other words, both are almost exactly seven times their prices of twenty five years ago, indicating an annual price appreciation of about 8% (slightly in excess of inflation as they were both coming out of severe bear markets.)

On the other hand, in the medium term, strength in crude oil would indicate growth in the economy, while strength in silver would indicate fear that the economy will perform poorly and other investment assets such as stocks and bonds will fall in price. Silver and gold are safe havens in a bad economy. Oil is not. During the Great Depression, the price of oil fell 95% from $1.88 a barrel (in 1925) to ten cents a barrel (in 1932) due to massive oversupply from Texas oilfields and a weak economy.

Yet here in the very short term we have dramatic correlations in not highly correlated assets in the context of a massive correction in the price of silver and a series of 1 in 7,000 year moves in crude oil and gasoline.

Something very strange is happening.

The fundamentals for oil remain very good as the global economy continues to grow. There was a slight inventory build in the US last week, but the US consumes only 22% of the world's petroleum and slightly weaker demand here makes little difference to the global price. Just consider, according to the EIA, US gasoline demand was down 117,000 barrels per day last week, but that is only .13% of global demand. Compared to the loss of Libyan production of 1.2 million barrels per day in February and the additional loss of 800,000 barrels per day of Saudi production in March, the minuscule drop in US gasoline demand is completely irrelevant.

OPEC refuses to increase production (or can't). The global economy continues to grow. So, the long-term picture is unchanged. Increased demand + falling supply = rising prices.

Meanwhile, to make the picture for gasoline prices even more bullish, the greatest flood of the Mississippi River since 1937 with flood waters expected to crest over 60 feet is headed straight for 11 Louisiana oil refineries and may take out 12% of the US refining capacity. So, sell gasoline futures?

What's really going on? My guess would be a very large hedge fund liquidation. Somebody got caught on the wrong side of the silver trade and has to liquidate. Higher margin requirements for silver compounded the problem. Like we saw in 1998 with Long Term Capital Management and in the financial crisis of 2008, to raise capital in a hurry a hedge fund in trouble has to sell everything it can, whether it wants to or not.

Silver may continue to sell off as it corrects down to 30 or so. But use this as a buying point for crude oil (USO, BNO), gasoline (NYSEARCA:UGA) and oil related stocks (OIH, XOP, XLE). Some over-leveraged big hedge fund out there is having a fire sale, and you want to be one of the lucky buyers.

Disclosure: I am long UGA, BNO, XOP, XLE.