Jack Walker

Oil Price Economics the 60 Minutes Way

Eddy,

While you are certainly right to support the concept that speculation plays an important role in the market process perhaps it would be good to back up and look at the bigger picture.

There are important differences between the Commodity Futures markets and the equity markets. The Commodity Futures market is a price discovery market where buyers and seller of commodities exchange their views on market conditions by executing financial commitments in an effort to determine the supply and demand clearing price. The equity markets are for raising long-term investment capital and serve a completely different function than the futures markets.

The argument is being make that institutions who manage long-term investment capital such a pension funds and endowments have lost the distinction between the function of these markets in their effort to generate short-term gains. In the process, due to their financial size, they have distorted the normal price discovery that takes place in the Commodity Futures market to the detriment of both producers and users of many commodities. In their effort to secure above normal returns for institutions of their size they found ways around the normal and established practices of position size limits and then moved their trading off of the exchange in order to avoid reporting and to obscure their activities.

At this point, no one is saying speculation does not play a role in the markets. The legitimate question revolves around the issue of institutions responsible for long-term investments directing their capital to short-term price discover markets thereby distorting the price discovery process. The argument is they should limit their long-term investments to the equity markets that are more suitable for their large investment capital. It is a basic and fundamental suitability argument.

Jack

10 Stupid Moves That Created This Mess

There were many financial engineering participants working together in an effort to perpetuate the basic and flawed assumption that gains in asset prices can be substituted for real income indefinitely. The financial planning strategy of borrowing the gains of house appreciation to bridge the income and expense gap seemed to be the ideal solution. Home equity loans provided tax fee income to continue living above the standard justified by earned income alone. The fatal flaw was the assumption that this could continue. We now see the results created by the financial engineers as house prices will be forced back to levels justified by median family incomes alone. Everyone was involved , Congress, the regulators, the Federal Reserve, the banks and especially the financial organizations involved in the mortgage and lending process that were relying upon commissions and fee income to maintain and increase quarterly results and bonuses.

The driving force was the desire to live beyond ones means. Therefore, the only long run solution is a combination of adjusting life style expectations and increasing real sustainable earned income levels.

What Will Happen If America Returns to an Historical Savings Rate?

Thanks for this very interesting article.

While there are many factors that have contributed to the current state of affairs one of the most significant as you have appropriately identified is the inability of median family income to keep up with rising costs. Many people used the “House ATM” financial planning strategy since it was the only available means to bridge the gap. Those claiming that stability in housing market is the answer to the nation’s economic problem are missing the basic fundamental cause.

We should all be dismayed by the lack of attention being given to the real problem.

Is it inevitable for rising median family income in the developing world to be accompanied by stagnant or declining median family income in the US? Is it a zero sum game and is International Economic Trade Theory all wrong? If so, will the US be forced into trade protectionism?

Interestingly, while Germany and France have single payer health care systems they seemed to have maintained higher savings rates however, Japan, Canada and the UK with similar health care systems followed the US with declining savings rates. What are the determining variables accounting for this disparity? Are they political, social, economic or some combination all them all?

Cross Timbers, Mesa Royalty Trusts Look as Compelling as Encore Energy

Kurt,

How do you rank the Hugoton Royalty Trust (HGT) with an estimated yield in the mid teens?

Thanks,

Jack

James Grant Wants to Know: Who Will Buy Our Greenbacks?

Tom,

Thanks for bringing James Grant's artilce to our attention.

Here are two questions I would ask.

How would you compare the current situation with the 1930s when the US embarked upon a policy of massive fiscal stimulus and public works projects? If I recall correctly inflation was contained until the mid 60’s when the Vietnam war expenditures eventually forced the US to renounce the gold standard in the early 1970s. Was the difference due to the gold standard?

Secondly, as an investment class how did gold perform during the deflationary 1930s?

Jack

Will COMEX Default on Gold and Silver?

Avery,

This is an excellent and informative article.

Is it correct to conclude in the event of a real short squeeze the bullion banks will ultimately be bailed out by the US taxpayers?

As you say,

“The vast majority of short positions in gold and silver appear to be held by only 2 – 3 American banks…,”

Do you know if the SPDR Gold Shares ETF (GLD) is permitted to lease gold holdings to the bullion banks who then us it as margin for shorting or is it all being held long and unencumbered in a depository?

Jack

Oil ETN Liquidity - Long and Short

Brad,

Thanks of this informative and well-prepared article. The addition of OIL and DUG along with perhaps USO would be welcome additions.

Jack

SPDR Gold Trust Inventory Remains in a Very Narrow Range

Tim,

Do you know if the SPDR Gold Shares ETF (NYSEArca:GLD) is permitted to lease gold holdings to the bullion banks who then us it as margin for shorting or is it all being held long and unencumbered in a depository?


Jack

Fiat Money and a Profligate Congress: A Bad Combination

Thomas,

Thanks for bringing Lehrman & Muller's writings to our attention once again.

Even if a new gold standard was the right solution how could it be implemented short of a worldwide economic breakdown and chaos? It seems democracies are incapable of important structural changes without a crisis.

Jack

Hedging Goldman's Earnings Report

Yo Bob,

Thanks for the comment. The good folks at Seeking Alpha have made the correction. Yes, it is tomorrow December 16, 2008.

Jack

Book Review: The Return of Depression Economics and the Crisis of 2008, by Paul Krugman

John,

It is a pity that Milton Friedman is not available to respond to Paul Krugman’s book.

Jack

Paul Volcker: Frugal to a Fault

Tim,

Thanks for bringing Ralph Vartabedian’s excellent and timely Los Angeles Times article to our attention.

We can only hope that Paul Volcker’s influence in the new administration will become the predominant economic force and will not be drowned out by calls for the return to profligate consumerism that have already begun.

Those claiming that public infrastructure projects will take too long to get started should read the economic history of the Hoover Dam. No doubt this project took a great deal of time in planning and construction while employing thousands of engineers and construction workers, but it is still producing power more than fifty years later.

Today many say we need a national electric grid to distribute power. This could be the opportunity to build another important national capital investment that will produce economic results for another fifty years while employing thousands of engineers and construction workers once again.

Hopefully we will follow Volcker’s advice and reduce consumption while increasing investments that enhance our capacity to produce for many years.

Jack

Saut: When Stocks Ignore Bad News, That's Good News

Jeffrey,

We wrote yesterday about the market’s reaction to the bad news. We would like to add it in further support of your article.

Last Friday’s equity market trading reminded us of this old Wall Street saying,

“The market bottom is defined when it stops going down on bad news.”

Recall last October the equity markets were still going down on what should have been considered good news with respect to the actions that were being taken by the Treasury and Federal Reserve to rescue the credit markets and the financial sector.

While there could be many explanations why the equity markets ended the day higher and not lower on the bad news, including short covering on the widely expected bad employment report. We also wonder if there is another possible answer like the one raised by Richard Russell last October when he said:

"Bear declines end in only one way -- in exhaustion."

Has most of the selling been done and could we be near the exhaustion point? Friday’s market action raises this possibility.


Jack

Energy Investing: Scenarios for a Turnaround

Jim,

Perhaps one answer to the oil stock investor’s dilemma is to use a strategy that provides a defined and limited risk while staying in the game. This can be done by starting with a high quality integrated company that is not over leveraged and then buy a long term options bull call spread.

For example: ConocoPhillips (COP) 45.59. Here is an integrated with a debt to equity ratio of .24 that is not likely to run out of cash. Consider:

Buying the Jan 50 call YROAJ at 9.775 and then selling the Jan 55 call YROAK at 8.15.

The difference is the cost of the spread and is indicated above using the mid-prices between the bid and offer of 1.625. In order to get this spread, be prepared to pay a bit more, perhaps 1.75. For a one-lot position of 100 shares the cost is therefore $175.

The upside is limited to the difference between the strike price or 5, less the cost of 1.75 for a maximum gain or 3.25, which is almost twice your investment. In the meanwhile, if the recover is still years away, and oil price do not recover in the next year, the total loss is limited to the original debit cost of $175. In addition, since the position is long one option and short another it is insulated from changes in options implied volatility and time decay.

The large integrated oil companies trade with good options volume so the important options liquidity is available. XOM and CVX are two others to consider.

With this strategy an oil stock investor can stay in the game, limit risk and have a goo potential gain if oil prices recover in the next year.

Jack

Atlas Pipeline: Call Option on Oil

Tim,

APL does indeed seem like an interesting situation with the stock selling at $7.25. With a trailing four quarters distribution rate of $3.82 the ROI, if it can be maintained is 52%. However, the question is how soon and how much will the distribution rate will be cut?

Assuming it is cut 2/3 that would bring it down to .32 quarterly or at an annual rate of $1.28 it would then be running at a 17.7% rate.

We then suggest going one step further and adding an options collar to protect the downside for the long stock position.

For example, if we look at the May options, which would be about right for the seasonal recovery in crude prices, we find the May 5 put is selling at an indicated mid price between the bid and ask of 1.325 and the May 10 call is selling at 1.175.

The collar trade is to buy 100 shares of stock at 7.25
Buy the May 5 put APLQA 1.325
Sell the May 10 call APLEB 1.175

Based upon the mid price the debit cost of the collar is .15. However, the options are thinly traded so it will cost more, as we will have to sell our call for something less and pay something more for the put. As example, if we paid something between .30 and .45 it would be about right.

Now we would be long 100 shares of stock at 7.25. Assuming we paid .45 for the collar and assuming the next distribution was .32 we will have almost covered the cost of the collar on the next distribution expected in early February and will have exceeded its cost on the May distribution before the options expire.

Now that we have protected the downside let’s look at the upside. If you are right and crude oil prices are back toward the $70 level and APL is trading above $10 then our stock will be called away at $10. Using the assumption above our basis in the stock would now be $7.06. That’s $7.25 for the purchase, plus .45 for the collar, less .64 for the two distributions. The ROI on this hedged position with our stock called away would be 41.6%.

If the stock recovers sooner and is called away before we have received our distributions then we will still have a gain, but not quite as much in a shorter period of time.

If by then there was a good defined uptrend we could do another hedged trade at a higher price.

Jack