Why oil looks like the latest bubble
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Associate Editor
David Stevenson Jul 03, 2009
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There's nothing quite like a 'rogue trader' story to enliven a quiet day in the markets.
And yesterday, that's what we got. A derivatives broker has just lost £6m on 'unauthorised' punting that oil prices would rise.
OK, in these days where trillions are being blown away by banks – and billions by other rogue traders - sums like this are small beer. And apparently the trade has now been 'unwound', i.e. it's been reversed.
But crude oil still soared on the day the dodgy deal was done. It certainly makes you wonder what's really going on in oil – and how you can profit from it...
What's really behind the surge in oil prices?
In cash terms, the latest 'rogue trader' incident is hardly on a par with the likes of Nick Lesson, the bloke who busted Barings, Britain's oldest merchant bank. Nor is it anywhere near as costly as Jerome Kerviel's activities at Societe Generale, which hammered the French bank for over $7bn.
What is interesting though, is the impact of the trade on the markets. The broker was based at PVM Oil Associates, so the oil market would have sat up and taken notice of any big trades. And this was a big one - "the wayward trade", says Izabella Kaminski at FT Alphaville, could have been the equivalent of up to 9m barrels of oil. That's more than 80% of the maximum daily amount that Saudi Arabia – the world's top oil exporter – is able to produce.
So perhaps it's no surprise that crude prices flipped up by 8% in 24 hours as the deal was done. In fact, Tuesday's oil spurt took the price to an eight-month high of $73 a barrel – almost double the level of just six months ago.
And it's the PVM trade that could provide the best clue as to what's really behind this year's surge in crude costs.
A month ago in the magazine, my colleague Eoin Gleeson explained that 2009's rebound in oil prices has had very little to do with the quantity actually being consumed, and is mainly about a mix of China's stockpiling and investor over-confidence (Profit as oil spikes, slumps, then takes off again. If you're not already a subscriber, claim your first three issues free here).
Clearly the former can't continue forever. Even though they have the money to pay for as much oil as they want – for example, China's foreign exchange reserves currently stand at more than five times Oman's entire proven oil reserves - the Chinese are running out of room to store the stuff.
Lots of 'hot' money has poured into oil
But investor-wise, it's a different story. Oil looks more and more like a new bubble being blown up by speculators. Even the experts are cottoning on. On Tuesday the International Energy Agency commented rather quaintly that "funds or speculations… are amplifying the [upward] movement" in prices.
And the US Commodity Futures Trading Commission has just woken up to the danger as well. CTFC commissioner Bart Chilton said this week that "something is going on in these markets and it's our job to make sure it's nothing illegal, and that there's not any overt manipulation". He's keen "to ensure that we can protect consumers so that they don't pay high prices at the gas pump".
At least that's a start. But it's a bit late - petrol at 105p a litre is digging a big hole in our pockets. And as we've seen several times before, it's one thing for 'the authorities' to spot a bubble inflating, but quite another matter for them to stop it blowing up a lot bigger.
Commodity investors possess huge financial firepower. In 2009's first half, the 1,500 commodity funds tracked by Jennie Byun at JP Morgan Chase pulled in some $25bn of new net cash. That's already more money than commodities have attracted in any single full year previously – and we're only halfway through 2009. "Everybody wanted to get onto the recovery trade", says Edward Meir at MF Global.
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And those former mega-bulls at Goldman Sachs are jumping onto the bandwagon, too. Remember how last year they upped their oil price forecast to $200? OK, it never got past $150, but it still spooked most people at the time. This time they've just raised their end-2009 oil-price target from $65 to $85, and are saying that there's "unusual behaviour" in the market – in other words, there's a lot of punting going on.
Just think – at the end of last year, the world's proven oil reserves stood at 1.26 trillion barrels. If just a £6m 'bad' trade can ramp up the value of that lot by near enough $5 a barrel, i.e. by more than $6 trillion, what's possible – either up or down - if commodity punters get really serious?
Our recent conclusion was that oil will "spike, slump, then take off again". This week we've seen just how easily spikes can happen.
How to profit from oil
So how can investors cash in?
Piling into oil-geared commodity funds feels too dangerous right now. The oil price could easily tumble if investors take fright again, as we saw yesterday. One much safer way is buying the major oil stocks, which are still cheap. BP (LSE: BP) is on a current year p/e of 11.5x, forecast to drop to 8.6x in 2010, while Royal Dutch Shell (LSE: RDSB) is even better value on a 2009 multiple of below 10x falling to around 7.5x next year. And both are on tasty forward yields of over 7%. What's more, analysts broadly agree that their dividends are sustainable as long as the average oil price stays above $30.
And if you see the oil price getting very over-extended and ripe for a plunge, you could always 'short sell' it by buying a 'put' option. That means you'd be buying the right to sell at current levels even if the price plummets, so making good profits. Clearly there's a lot more risk here, as you're effectively selling something you don't own. For full details, see our above-mentioned oil price cover story.
Our recommended article for today
The Federal Reserve wants us to believe hyper-inflation is looming. And analysts predicting it are doing Bernanke's dirty work for him, argues Adrian Ash.
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