Factors Affecting WTI Spots

The BP Gulf spill, gasoline demand reaching 3.5% yoy, prices at the pump at $3.00, refinery capacity above 89%, Cushing, OK crude storage dwindling to 14 million barrels, tankers holding countless barrels off the coast, OPEC members breaking quota, unrest in Iran, and sovereign default contagion in Europe have been on the radar of “black gold” speculators for the past two months. These realities are the extension of maturing trends over the range bound past two months, but only one has significantly altered WTI Crude prices. A casual deduction might blame oil’s price destruction on a stronger Dollar, due to the recent flight from all things Euro. Contrarily, we see default risks in the EU and retrenching speculation creating the vacuum through which industrial commodity prices, most notably Oil, will fall.

WTI Continuous Crude Oil Spot Chart

In January we correctly called a bearish trend reversal in Crude Oil prices and predicted the fall to $70 / barrel. Our prediction seemed far fetched at the time, while Crude was trading near $80, but we were right then in identifying the speculative forces surrounding crude oil. Now discounting for newly developed sovereign default risks in the EU and the effects of a plummeting Euro on the price of all industrial commodities, we foresee a very similar reversal the second time around.

Technicals

The MACD peaks have continued along the negative sloping trend line, congruent with a bearish wedge reversal, while recent events regarding the Greece bailout have had direct impacts on the price of the WTI continuous Crude Oil spot price. In April, the WTI spot reached the $87 mark in intra-day trading three times, but each time closed lower and weaker than the last. The Relative Strength Index (RSI) now reads below the neutral 50 mark, suggesting that momentum has reversed and bearish sentiment is now leading prices.

Greek Contagion

Wedensday, April 28 through Friday, April 30, Crude Oil climbed near it’s yearly high of $87 on rumors that led to PM Papandreou accepting a 110 billion Euro bailout from the EU on Monday, May 3. On Monday, the price of crude again reached it’s $87 high intra-day, before closing just above $86.

Greek Bond Spreads to German Bunds, 2yr & 10yr Maturities (April 22, 2010)

So why did crude oil sell off in the wake of this “stability” in the EU? We would argue that the situation surrounding the Greek debt crisis is now anything from stable, and has in fact grown to an unstable monster that could drown much more than just Oil and EU stocks. We don’t claim to have any inside edge on the contagion risks of defaults in the EU, but we do trust a certain Mohamad El-Erian, of PIMCO’s total return bond fund, the largest bond fund in the world. El-Erian appropriately warns, “it is far from assured that this program will forcefully counter contagion risk,” as seen in the recent chart (left), compliments of Business Insider. In the time since this chart was built Greek yields have rocketed even higher, where on May 5, 2010, Greek 1o yr spreads over German Bunds rose to above 700 bps, putting the headline yield on Greek 10 yr bonds above 10.5%.

Austerity measures in the form of  pension reductions, bonus cancellations, and job cuts are planned to cut Greece’s budget by 13 billion Euros, in exchange for EU loans at 5%.  Naturally, markets don’t like the deal, since the EU is absolving Greece’s bad debt at a loss, where the interest on the loan to Greece is half that of the market yield for 10 yr debts.

So how are the Greeks taking the medicine? We’ll let you judge for yourself in this week’s DS Video, compliments of CNBC, covering the the budget cut protests.

The Future of Crude

At this point it isn’t crucial that the EU break up for Crude Oil to fall to $70 or below. 2010 gasoline demand is trending towards 3.5% as prices at the pump average above $3/gallon in the U.S., but leading indicators seem to be topping, as the ISM non-manufacturing new orders component trended lower and retail sales are narrowing closer to 2% yoy for April. The past 12 months have been an atmosphere of loose money and speculation, while globally growth has recovered due to stimulus packages and corporate spending supported by higher equity valuations. All in all, we see global energy demand near it’s peak, given (Quantitative Easing) QE cooling in China and European weakness due to Euro-zone cost cutting.

Our analysis supports the position that Crude Oil spot prices still reflect a great deal of recovery linked speculative forces. Further, moderate gains in demand for crude and distillates are countered by the bulging supply of U.S. inventory and OPEC member countries producing above quotas, partially to fund stimuli plans and state bailouts of their own (e.g. Dubai World).

The only recent game changer for Crude Oil has been Greece and the ensuing sovereign default contagion risk. We are playing this risk using crude oil, because the volatility allows for large price swings to capture gains with positive correlation to the situation in Europe. Finally, the ceiling for WTI spot prices is a firm resistance level ($87), and therefore much safer than the erratic behavior of direct EU crisis plays (e.g. Greece, Spain, Portugal Bonds, the Euro, Euro Equities, etc.). Specifically we like DTO (Powershares DB Double Short Crude Oil ETN), since it’s generally liquid enough for our taste (500k-1 million volume/day), and tracks -2x the WTI Crude Continuous Spot.

Disclosure: Long DTO Over the Next 2-4 Weeks

Even after the TARP fund liquidity injections in the U.S. financial sector in 2008, the E.U. has decided to bail out one of it’s member states, Greece, from insolvency. How can this even be considered?

Yes, the EU constitution is a whopping 7 years young and therefore demands a minuscule thread of adherence by member states, but it still directly contradicts two clauses of the charter, which stipulate the EU has no role in assuming the debts of any one state or backing the credit of any such state so that it may issue debt.

In making an elementary comparison between the financial meltdown in the U.S. and similar insolvency in weaker E.U. member states, let’s first answer a simple question: “In the case study of financial institutions failing in 2008, who would best represent Greece… Bear Stearns or Lehman Brothers?”

It would seem that the role of the maiden union state to cry “uncle”, akin to Bear Stearns in Spring 2008 at the Hand of then Secretary Paulson, is now cast to Greece. However, looking at the sovereign debt situation as a whole, one could make the argument that it was first the UAE who bailed out the Dubai World Sovereign Fund on Thanksgiving night 2009. For humor’s sake, lets assume that Greece is the Bear Stearns of 2010 and limit our scope to the EU. It is after all a united body making decisions sure to cause repercussions, which will be at least initially contained within its members’ fiscal borders.

So then of course the second major nation to go effectively bankrupt, will be one of the remaining three PIGS (Portugal, Italy, Greece & Spain). Considering the leadership in all remaining states and the tie amongst them for impotence, incompetence and corruption; it could be any of the three. However the next to go will spur a decision a lot like the U.S. Lehman deliberation in 2009.

Whether anyone wants to admit it or not, it’s a good thing that Lehman was allowed to fail in 2009. Yes, I said it… growl and moan all you want, but we needed a shred of moral hazard to keep our capitalist hearts beating and Lehman was the sacrificial pig. Little Timmy Geitner would have danced the populist Obama jig right down the line bailing them out one by one, but luckily Bazooka Paulson was in the midst of a grudge match with on of the largest rivals of his alma mater, Goldman Sachs (GS). The only mistake was to then concede defeat to the frozen credit markets by shuffling around a smoke and mirrors bailout plan which ended up profiting the biggest U.S. banks at the expense of tax payer funded backstops. But we digress…

Unfortunately for the world, France is charging ahead and towing the rightfully reluctant Germans towards TARP 2.0. Germany is by far the most solvent of the EU states and the most crucial to a working bailout of Greece, yet France’s Sarkozy is pulling the reigns. The interesting sub plot here stars the leader of the IMF, the institution that would normally intercede as lender of last resort, no other than a Mr. Dominique-Strauss Kahn, the French contender for Sarkozy’s office in the next election. Alas, its no surprise that Sarkozy wants to go to bat with the tax payer’s dollars rather than admit a fellow EU member is among the ranks of Mongolia, Togo, Haiti, and the long list of states faced with the decision to admit IMF intervention or crumble bankrupt.

So will there be a Lehman equivalent EU state nearing a bond payment one dollar too high and an EU governance that tells them tough luck? Absolutely not. There won’t be a Lehman equivalent in the EU because, (a) countries are more difficult to break up and sell off than firms; (b) the expansive and centrally funded social welfare systems of European states must continue to distribute capital to citizens, lest the union be disgraced by the impoverishment of its constituents; and most importantly, (c) a currency crises due to real or assumed default by any state will have systemically negative effects on the value of the Euro itself, forcing the cost of the central welfare programs to rise across the Union. In turn there will form a negative feedback loop, where the next weakest countries to fail will default and the Euro will become even weaker.

The only option for EU leaders is to bail out as many as all four of the PIGS and hope that China keeps buying goods. If the Chinese engine starts to sputter, the gig is up and we will see one of the most atrocious currency crises in the history of money, beginning with underlying currencies of the sovereigns which have spent the most and recovered the least since the recession began.

The IMF currently has 163 billion SDRs (Special Drawing Rights) available to loan out in the event that a country needs loan assistance. Equating to almost 250 billion USD, the current lending capacity of the IMF could cover the cumulative deficits of the PIGS in 2009 (totaling $198 billion). Yet referring to the visual below, after accounting for the PIGS’ summed liabilities and net debt interest in 2009, the IMF itself may not have large enough reserves to cover the outlays of these four nations, should vacant labor markets continue to stress the fiscal resolve of European social security.

Greece now has the support of France and Germany, but no one really knows how the drama will unfold when the April Bond payment actually comes due. Will Spain face a similar fate as Prime Minister Zapatero grapples to reign in government spending in the face of striking unions and 19% unemployment? Can the economies in Italy and Spain find a way to continue making bond payments should jobs not return before state coffers are drained?

These questions should make for the most current drama in the seemingly bottomless pit of systemic risk. The nasty twin brother of the benefits of interdependency, from economy of scale and scope of multinational firms and massive trade agreements, systemic risk has matured from private markets to macro trade agreements and this time there may be no lender of last resort.

“That will never happen to this country.”

- Timothy Geitner in response to suggestions that the U.S. Treasury may one day lose its Aaa credit rating.

Perhaps inspired by Niall Ferguson’s dramatic Financial Times piece, “A Greek Crisis Coming To America“, we see today as a prime opportunity to recap our short U.S. Long Term Treasury position and share our argument for why you should buy more TYO (Direxion 3x Bear U.S. 10 Year Treasury ETN).

It’s not every day you hear about nations going belly up, yet this “new normal”, coined early on by PIMCO’s bond master Bill Gross, has even professional analysts spinning deep under water and starving for air. So what is the new normal? Bill Gross claims it’s an investment environment where risk/reward relationships come back towards historical standards and where inflation eventually mucks the lions share of investors’ profits. Now, Niall Ferguson describes it as a world where the U.S. government ranks 6th on the IMF’s list of nations in need of cutting expenditures. According to the report, the United States must cut government outlays by 8.8% over the next 10 years to remain “financially stable”.

Were this the early 1980′s where the 10 year Treasury Note carried a yield near 16%, the talk of insolvency would be merely a footnote to the effective borrowing cost of the U.S. Government. However, contrary to 1981 the current 10 year yield is just shy of 3.7%, which happens to be lower than any point in any year from 1962 to 2003.

So why the low yield, why the high demand for U.S. Treasuries? The argument that treasuries have served as a safe haven from stocks doesn’t hold weight, because global equity markets have surged since March 2009. We all know about the $1.6 trillion U.S. deficit in 2009, the $2 trillion Fed balance sheet, and yesterday’s announcement of tax breaks to hiring businesses; all of which must make it more difficult for the U.S. government to pay it’s bills into the future. According to Ferguson this is just the beginning, since China, the largest holder of U.S. treasury paper, has cut T-bill purchases from 47% of the total issued in 2006 to 5% in 2010.

Who’s buying U.S. debt?

To be blunt, we don’t know. The fact is, it doesn’t really matter. No one SHOULD be buying it, so the fact that they are only increases the potential for us to profit from their ignorance. Take a glance at the TYO chart below.

As noted in the visual, TYO’s handle is sitting right at the 50 day simple moving average resistance line, which bottomed at the beginning of February for the first time. Also, the MACD in the histogram below the chart shows a “bullish” cross potentially occurring in the next couple sessions. We’re putting long term money in this vehicle, since it’s the closest thing to a sure thing.

Either (a) you don’t believe our position that U.S. debt will be devalued and that the recovery will unravel or (b) you believe everything we say. In scenario (a) stocks will do well as bonds suffer and this vehicle will at minimum retain it’s value. In scenario (b) S&P and Moody’s downgrade U.S. sovereign debt in the next two years and the recovery fails to pick up speed, causing for a exodus of money invested in all U.S. Dollar assets, especially U.S. Debt.

The choice is yours…

Happy Trading