The Rude Awakening
Wall Street, New York
Tuesday, September 12, 2006 ------------------------- - $75...$65...$55...what happens to crude if resource
funds liquidate?
- Learn what this means for your metals and ags,
- The rocking-chair test, the week's data so far and
more...
------------------------- Eric Fry, reporting from the precipice of the commodity
bull market... "Give it the rocking-chair test," a friend of mine used to
say whenever he saw me scowling about some minor (or major)
adversity. "What's that?" I asked after hearing the phrase for the
first time. "This thing that's troubling you today; will you remember
it when you're old and sitting in your rocking chair?" the
friend answered. "If you won't remember it then, you
probably shouldn't let it bother you too much now. That's
the rocking-chair test." Since my friend and I were both actively trading in the
stock market back in those days, the scowls he observed
usually emerged from the angst of lost capital. On a bad
trading day, my habitually cheerful demeanor would
sometimes become slightly less cheerful, which is when my
friend would toss out his annoying "rocking-chair test"
remark. This phrase of his was always annoying...as annoying as any
phrase that seeks to extinguish a fit of anger before it
has burned itself out naturally. But the phrase was also
very true. I still recall it often, amidst minor (and
major) adversities. And not surprisingly, very few
adversities pass the test...even the adversity of lost
capital. Every investor loses money some of the time, even great
investors. Over time, however, capital gains more than
compensate for the losses. (At least that's the theory). In
the stock market, short-term capital losses are an
unavoidable "occupational hazard"...kind of like paper cuts
in the mailroom. As long as the short-term losses resemble
paper cuts, rather than slashed wrists, they will be long
forgotten by the time the first La-Z- Boy arrives in your
living room. Yesterday's market action reminded your editor of the
rocking-chair test. For every investor who owns the shares
of mining or energy companies, yesterday was a very painful
day. Resource stocks of every type dropped sharply. This
one-day drop, as painful as it was, would certainly not
pass the rocking-chair test...except for the fact that this
one-day drop was not exactly a one-day drop. Resource
stocks have been slumping for weeks. All the major
commodity indices and resource-stock indices have dropped
more than 11% since early August. When sitting in their rocking chairs, the owners of energy
stocks might not recall these painful declines (unless, of
course, they are already sitting in a rocker). But these
declines are fast-approaching the threshold that divides a
forgettable loss from a VERY memorable one. The recent "forgettable" losses might well disappear into
the embrace of a new, big rally. But the recent losses
might, instead, expand into something very memorable. The
latter possibility worries us...a lot.
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By Eric J. Fry $75 crude oil seemed relatively cheap...as long as
terrorists were bombing oil pipelines in Nigeria, British
Petroleum was shutting down rusting pipeline in Alaska,
Israel and Hezbollah were lobbing missiles at each other,
Iran was insisting on enriching uranium, oil producers were
struggling to satisfy surging global demand and hurricanes
were threatening to disrupt oil supplies in the Gulf of
Mexico. But now that a geopolitical and meteorological calm seems
to envelope the globe, $75 crude oil feels a bit
pricey...at least for the moment. Indeed, crude's recent steep drop suggests that $65 crude
oil might also feel a bit pricey. Would $55 crude also seem
overpriced? What about the $45 crude price that many Wall
Street analysts are beginning to predict? We would not
argue strenuously against this point of view. The long-term
bull story notwithstanding, several short-term indicators
for crude oil and the rest of the energy complex look
increasingly bearish. The bullish case for crude oil seems to rest upon one
small, but potent phrase: "You never know"...You never know
what geopolitical and/or meteorological threats might
disrupt supplies for a while. The bearish case, however, resides within what we already
know: Supplies are ample, demand is tepid and too many
"paper" investors are long oil. On the supply side, for
starters, domestic crude oil supplies have been building
for more than a year, and now stand at their highest levels
in more than five years. Based on the latest data from the
Department of Energy, U.S. crude oil stockpiles are now 10%
higher than the 5-year average for this time of year. 
To put it another way, the last time stockpiles were this
high, crude oil was $20 a barrel! Obviously, U.S. supplies
are not the only influence over energy prices. A little
country to the East also exerts a palpable influence. Even
so, hefty U.S. supplies are not a comforting sign for the
bull case. Meanwhile, demand for crude has moderated
somewhat. Crude oil's swift 17% drop over the last few weeks amply
reflects the bearish supply/demand data. Unfortunately, a
market in motion tends to stay in motion, especially when
that market is cluttered with sheepish investors. Over the
last two years, tens of billions of dollars have poured
into the formerly hot commodity markets. Which means that
speculative investors wield an outsized influence in many
of the commodity markets, especially within the energy
complex. 
"I have been worried for quite a while that we are going to
see a large liquidation in long-only commodity funds,"
frets Richard Morrow, a friend and seasoned commodity
investor. "Most of these funds are now down on the year.
The most prominent long-only fund is the Goldman Sachs
Commodity Index. The GSCI is down 14% over the month or so.
That's gotta hurt.
"I think there is 25% chance that these long-only commodity
indexes will liquidate at some point in 2006," Morrow
predicts, "and that will lead to a lowering of prices for
all commodities. Long story short, there is a risk that the
long only funds (basically crude longs) could whack this
whole commodity board for no good reason." Morrow, who manages private investment accounts focused on
agricultural commodities, does not buy or sell crude on
behalf of his clients. But he's watching the crude market
very closely, and for good reason... Crude oil, from an investment perspective, is not just the
stuff that powers the global economy; it is also the stuff
that powers the Goldman Sachs Commodity Index. Crude oil,
natural gas and other energy commodities account for about
two thirds of the index. It is not hard to imagine,
therefore, that a panicked seller of crude oil might also
become a panicked seller of natural gas...and wheat...and
soybeans...and sugar, etc. No one can predict when, or if, bloodied crude oil
investors might try to salve their wounds by dumping their
commodity investments. But one can contemplate that
possibility...and respond accordingly. [Joel's Note: And one fellow that will be loving the ride
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