Oil Contango Narrows

ASIC has extended the ban on short-selling in Australian stocks until May 31st. Thank goodness. Since the ban was introduced on Sunday, September 21st, the ASX/200 has fallen about 34%. Perhaps that actually constitutes a rally, if you believe the ban on short selling has prevented foreign barbarians from pillaging and destroying Australian shares with vulnerable balance sheets.

ASIC acknowledged that short sellers can help a market find its lows more efficiently by targeting badly managed firms and exposing flawed models. However, it concluded that, “Any possible loss of market efficiency or price discovery as the result of the continuation of the ban is justified given the current market circumstances”. Those current market circumstances, by the way, are that stocks are falling like a stone anyway.

Justification by faith alone.

A revision to our recession reporting from yesterday. We said the ABS reported that the Australian economy contracted by 0.1% in the fourth quarter. It was actually 0.5%.

In any event, the hubbub over whether the economic performance conforms to a textbook definition of a recession is, well, stupid. Imagine you’re in a plane that’s lost power to its engines and is falling from a sky. “Don’t worry,” the passenger next to you says, “it’s not a crash until we’ve become a smoking hole in the ground.”

There is a large amount of denial or obliviousness in the media about just how terrified businesses are. Our prediction: massive waves of layoffs and redundancies this year. Or, if you prefer the politically correct term now in vogue with human resource managers, a lot of employees are about to be ‘dis-established.’

Seriously. We didn’t make that up.

Hey what’s this? Oil prices were up nearly 9% in New York, or about US$3.73 a barrel to $45 a barrel. OPEC production cuts and inventory reductions have brought global supply more into line with global demand (which is dramatically reduced owning to the world financial calamity).

Oil in Contango, Headed Higher

You might not have noticed, but oil has been in “contango” for awhile now. That’s a trader’s term that describes a situation where the futures price of a commodity is higher than the spot price. There are several reasons why this might be the case for oil.

One obvious reason is that traders look at the chart above-and global financial crisis not withstanding-see the oil market moving back into equilibrium (reduced supply, stabilised demand). Lately, there is some hope that China’s stimulus package reignites industrial production or at least commodity demand (although we wouldn’t count on that.)

There’s also a more macroeconomic reason to expect higher oil prices. Global monetary policy is pretty accommodating at the moment. There is a great debate over whether or not this will lead to higher inflation in real tangible goods. If you’re on one particular side of the debate, you’d expect a big increase in the money supply to lead to higher general prices, especially for commodities like oil. Thus the higher futures price.

Of all the explanations for the contango, the one that makes the most sense to us is actually the most indirect. The oil price crash of 2008 has virtually guaranteed future supply constraints. As major integrated oil companies cut back exploration budgets, and as unconventional energy alternatives got put out of business by the crashing price of crude, the foundation was laid for a massive spike in oil prices sometime later this year.

That spike won’t come from some unexpected recovery in demand or global growth. It will come from chronic production declines from the world’s oil industry and national oil companies. More on that next week. In the meantime, the contango is narrowing in the sense that spot prices are catching up with futures prices. There are still some trades to be made, though.

Yes. It’s possible all of this is wrong, including our forecast that gold will rise and U.S. Treasuries are in the formative stages of an uber bubble. It’s possible that the Feds and the pollies have sorted out a precision one-two combination to deal with crisis.

With a left job, the Fed and central banks provide lending and liquidity to the banking sector and the business world. Some of this lending is securitised by real collateral. What it means, practically, is that the central banks backstop the short-term financing needs of the real economy for as long as it’s necessary to organically repair bank balance sheets (or extract nasty tumours from them).

This is what the Term Auction Lending Facility (TALF) is designed to do in the States. If it works, you’ll notice it by declining spreads between government debt and corporate debt (among other things). You wouldn’t expect an explosion of new lending from banks. Prudential standards will have to be reviewed, including capital adequacy. But it would be a long, slow, return to a boring, risk-averse business model.

All the bad loans and bad assets, by the way, would be sent off to the financial equivalent of a FEMA trailer camp/prison where they will either be rehabilitated or never heard from again.

And with the right upper cut? Fiscal policy of course! More stimuli, more mortgage cram downs or first buyer grants (here in Australia). For example, last night the Treasury Department in America announced a vague US$75 billion plan to stem the rising tide of defaults and foreclosures.

We’re not saying it will work. After all, one in five American homeowners is underwater on his mortgage. You cannot legally refinance when you have negative equity (so that law will have to be suspended or re-written). But one way or another, showers of cash will fall on the newly unemployed or the dangerously indebted.

And maybe, given enough time, this one-two combination will paper things over. It will leave a massive legacy of public debt and insure years of much lower economic growth, not to mention government claiming a much larger slice of GDP. But this seems to be the plan. Knock the problem out with a relentless one-two combo until the crisis, the economy, or the people are pummelled into submission.

In this scenario, we think you’ll see one sovereign currency after another go down the global toilet as governments expand their debt-to-GDP ratios and devalue via huge public spending increases. The yen, the pound, the euro, the dollar, and gold. Which will reach the bottom last?

Right now, ye olden greenback looks like it could last the longest of the paper currencies. Global capital is queuing up to get into sovereign U.S. bonds. The global fiat system looks like it has one last big bubble in it. More on that tomorrow.

Reader mail.

Dear DR

Do you think that there is a possibility that the current world economic downturn could lead to something more than a recession/depression i.e. a total breakdown of some of the societies worst affected (e.g. UK and the US), or perhaps a total collapse of world trade resulting in each country having to be essentially self sufficient? There seem to be a lot of writers talking about the US specifically totally falling apart and having martial law imposed.

Clearly the mainstream media massively underplay the scope of the collapse that has and is happening but do you think that such extreme scenarios mentioned above are credible predictions or just overdramatising?

Best wishes

Steve Hall



Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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4 Comments on "Oil Contango Narrows"

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Thanks for the great reports – I do enjoy the humour. Collapse of some variety is guaranteed – all civilisations collapse – have a look at any history book. The question is, will it be in this generation. Going by history there are many signs. Catabolic Collapse is the theory that really incapsulates why it could/will be now or very soon. Or put more simply – when we were kids down at the beach building sand castles we had a lot of fun. But we had the advantage of starting over without pain. When you build a sand castle it… Read more »
knowingisbeing known

Hi Dan,

I love “the reckoning” and have been debating with my wife tonight about the severity of things and your answer to Steve Hall’s question. It is beautifully ambiguous, you could read ‘yes’ as an affirmation for over dramatization or total collapse. Well that is just a bit too neat for the ‘call it as you see it’ approach I’ve come to love, so could I ask you to clarify please?


I think in some respects it’s too early to say how this economic catastrophe will play out, but if you look at the totality of the current global trade system, not just the economics..but the real tangible economy, that of actual “resources” (oil, food, arable land, coal, fresh drinking water) I’d say the calamity is just getting started.

Add the climate change wild card and suddenly the doomers and gloomers don’t seem so “out there”. On the topic of the collapse of civilisations I’d recommend reading “Collapse”, by Jared Diamond, it’s a pretty good history lesson.

Greg Atkinson

I think it is way to early to say predict how this economic mess will play out but I am am not in the camp that believes we are seeing a slide into anarchy. All of the shortage of resource issues mentioned above (oil,drinking water etc) will be solved over time with technology. Oil for example is just a relatively cheap fuel, it is not the only fuel and in every application I can think of it can be replaced. Relax..the world still has engineers even if it does seem economists are everywhere.

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