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Friday, 15 August 2008 00:00 Written by James Van de Voorde

Since last month’s in depth report on “The Oil Bubble”, the price of crude oil has tumbled from its high price of $147.27 to just over $119 per barrel at press time.  This sharp drop is welcome news for the economy and diminishes what had become one of the greatest headwinds for the consumer and the stock market.  Should the decline in oil prices prove to be more than temporary and even lead to a prolonged and steeper drop (as we expect), inflation pressures will abate and give the Federal Reserve additional cover to maintain stimulative monetary policy, in turn giving the beleaguered housing sector additional time to heal.

The seeming prick in the oil bubble coincided with President Bush’s July 14th lift of the executive ban on offshore drilling, Ben Bernanke’s July 15th testimony that the U.S. economic downturn would prove more persistent than initially thought and the same-day forecast by OPEC that demand would continue to slow.  This one-two punch of the potential for additional supply through drilling with the growing likelihood of demand destruction due to economic weakness sent traders running for the exit aisles, leading to the biggest one-day drop in crude prices in 17 years. 

With commodity prices in freefall, evidence continues to mount that speculative forces were in play during oil’s dramatic rise.  On July 24th, the private, Oklahoma-based oil-marketing firm SemGroup LP filed for Chapter 11 bankruptcy protection, citing at least $2.4 billion of losses from oil futures hedging strategies gone wrong.  That same day, the Commodity Futures Trading Commission (CFTC) charged Optiver Holding BV, a global proprietary trading fund, with manipulation of NYMEX crude oil, heating oil and gasoline futures.  Optiver and two of its subsidiaries employed a “manipulative scheme” known as “banging” or “marking” the close, whereby a trader acquires a substantial position leading up to the closing period and unloads the position before the close of trading.  The Wall Street Journal recently reported of massive losses and redemptions within the hedge fund community, especially for funds tied to energy and other commodities.  The report points to RAB Capital PLC, a London-based hedge fund, which has seen two of its funds that focus on natural resources and energy suffer year-to-date declines of 32.5% and 27.4% respectively through July 24th.  Even blue-chip driller Anadarko Petroleum has found itself caught in the unwinding of the oil bubble as it reported a $1.3 billion charge on mark-to market losses of energy derivatives contracts.  The bet on the continued rise in oil became a very crowded trade and we remain convinced that additional evidence of speculation and trading losses will unfold as oil continues its descent.               

In fact, at press time, the CFTC revised its classification of certain trading positions that it had been previously reported as “commercial” to “non-commerical”, which essentially increases by 25% the number of oil contracts deemed to be held by speculators to 48% of all open interest in NYMEX crude oil futures and options as of July 15, compared with its estimation of just over 38% under the previous classification.  Interesting to note, this reclassification is said to be attributed to only one unidentified oil trader that had apparently amassed a long position in crude oil amounting to as much as 460 million barrels.  Now that’s speculation! 

With oil prices having peaked and the unwinding of the oil bubble underway, the markets will be focused on signs that the housing and credit crisis is easing before the “all clear” signal can be given.  To that end, Barron’s recently ran a report suggesting that the U.S. housing market is showing early signs of recovery.  The article points to research by Wellesley College economist and co-creator of the now infamous S&P Case-Shiller Home Price Index Karl “Chip” Case.  Case believes that home prices are nearing a bottom and notes that new housing starts fell to 975,000 in April from a peak rate of 2.27 million in January of 2006.  There have been three other such declines from more than 2 million to less than 1 million new housing starts in the last 35 years - the first quarter of 1975, the second quarter of 1982 and the first quarter of 1991.  According to Case, “every time this has happened before, housing market activity has rebounded within a quarter and caught experts by surprise”.

The newly passed housing rescue bill should help stabilize the housing market.  The controversial bill allows the Federal Housing Administration to insure up to $300 billion of new, refinanced mortgages, raises the conforming loan limit in higher cost areas to $625,000, provides a lifeline to Fannie Mae and Freddie Mac through a temporary, undefined credit line and creates a new agency with increased oversight over Fannie and Freddie.  With oil prices coming down and the housing market on the mend, we are hopeful that the Fed’s rate cuts can finally filter their way through the system and have their intended impact of boosting economic growth.

GDP rose in the second quarter by an annualized rate of 1.9%.  While this was slightly below consensus, the shortfall was entirely due to a large inventory valuation adjustment that lopped 1.9% off the GDP calculation.  Excluding the inventory component, real final sales were up at a 3.9% annualized rate and reflect strong underlying demand.  Personal consumption was aided by the tax rebate checks and rose at a 1.5% annual rate, while exports continue to be boosted by the weak dollar and rose at a 9.2% annual rate.  Government spending rose by 3.4% and even nonresidential construction rose by a surprising 14.4% for the quarter.  While residential construction continued to be the biggest drag on GDP with a 15.6% decline for the quarter, the rate of decline has improved markedly from the 25% decline of the previous two quarters.  This trend is expected to improve and will virtually neutralize the impact of residential housing on GDP in the coming quarters.

The unsung hero of the U.S. economy just may be productivity growth.  The Wall Street Journal reports that in the six recessions since 1970, worker productivity grew at a “sluggish” average rate of .8%.  But since the end of last year, during a period marked by extraordinary economic circumstances, productivity has grown by an estimated 2.5% annual rate.  Strong productivity growth helps offset inflation pressures and further allows the Fed to keep interest rates low.  In recent testimony, Ben Bernanke remarked that “even during this uproar, U.S. labor productivity has continued to grow faster than almost any other industrial country and it shows how strong this economy is”.  Indeed.

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