“Oil to Fall to the Teens”/Commodities

Trader Scott’s Market Blog

January 21, 2017

There’s a Marketwatch story interviewing the manager of a $3.6 billion T. Rowe Price mutual fund who believes oil is still in a bear market. As to crude oil specifically, I’ve been concerned for several months and my outlook remains that we will see a secondary test of the $26 secular low, but at a much higher low. Crude oil is in a major accumulation area, but this bottoming process will take quite awhile. Energy prices in general are very bullish long term, it’s just that crude itself has a lot of competition now and a lot of technology – tho increasing high-yield interest rates will be helpful to knock out some of the weaker fracking companies. Oil production is very capital intensive – the fracker’s supply growth needs both high enough prices and low interest rates. It’s not just prices. And this whole green energy hysteria/government edict/carbon taxes (Trump notwithstanding) is a tough barrier for basically the internal combustion engine and the use of crude oil. But this is looking way down the road, and in the meantime there are potentially bullish geopolitical factors. A selloff in oil and a re-test would be very helpful to strengthen the market. There is a very large speculative long position in crude oil futures currently, and a break of support, like $49.50, will start to trigger sell stops.

The mutual fund manager and myself were in total agreement two years ago about oil being in a bear market. In January 2015, my belief remained that oil wouldn’t even begin to set up a major bottom until it got below $35, and this was repeated  throughout 2015. He’s still bearish and thinks oil is going to the teens. Give him credit for being right for a couple of years, and he may be right with his outlook. But he’s basing his argument on faulty reasoning and data. And someone pays him a lot of money to do this. He said this:

“So, we’re facing a structural oversupply combined with greater efficiency that allows marginal producers to keep pumping rather than get shaken out. In other words, a secular bear market, which for commodities typically lasts 10 to 15 years. The last two commodities supercycles, which included oil, ran 13 years each, from 1968-1981 and from 1998-2011. The bear market between them lasted 17 years. Driscoll said the current moves in oil prices are very similar to the 1980s. ‘You had a big rally in oil from July 1986 to the summer of ’87,’ he explained. ‘Oil went from $10 to $21 and backed all the way to $12 in ’88.’ The 1990-1991 recession kept prices ‘kicking around in the teens.’ Ultimately oil prices bottomed in 1998, when the next supercycle began.”

We agree about the marginal producers and the efficiency, but there are three big missing points. One big reason fracking has been so successful is because of grotesquely distorted credit markets and Wall Street’s “creative” financing. This allowed crappy debt to magically be less crappy. And there’s actually a feedback loop between the junk bond market and the less crappier companies, along with the price of crude. The bear market in crude into February 2016 was a big reason for the selloffs in junk credit, feeding into global stock markets. Hence leading to the Fed whimping out on raising rates “four times in 2016” . So what will happen to all kinds of industries with higher rates and a tidal wave of maturing debt over the next several years. Jeff Cox, the only sane person at CNBC, has a good article about the maturing debt situation. The second point to make is, the gentleman from T. Rowe Price hardly even mentioned demand, and mostly it was about supply. Growth in the new sources of supply are being offset by some decrease in old sources of supply. Demand is steadily growing in the East. And global Governments have decided to move away from their complete failure of monetary policy. Now the geniuses want to move on to what will be their next complete failure - fiscal policy. But that won’t stop them from trying. And a trendy one to “try” is infrastructure projects, meaning more demand for raw materials, which is another reason to be bullish on commodities long term. And the third thing to point out is the awareness of geopolitical problems all over the world, especially in major oil producer nations, which are a huge wild card – almost a given actually.

Lastly, how can he possibly have this outlook about commodities based on only two bull markets and one bear market. What about the numerous bull/bear cycles going back in time, and using a much bigger data set than two and one. Looking back since my great country began, we can see the bull and bear markets in commodities (CCI) in this wonderful chart from the folks at Time-Price-Research. I had accumulated some of this data over time, but these folks did a marvelous job of putting it together in a chart, rather than my stupid doodles.We keep hearing about this grand bear supercycle in commodities. This cycle is espoused by stock market permabulls, gold/commodity permabears, and the deflation forever crowd. There are stories about how technology will continue to decrease the need for commodities. It’s amazing the theories which arise after a 35 year bond bull market, along with disinflation/deflation. There were also a lot of stupid theories about inflation proposed into the 40 year bond bear market bottom in October 1981. The great CCI chart shows something very different to me than a grand commodity bear super cycle – it’s just the opposite and much more.

Commodities traded in a huge trading range for the first 200 years of the United States time era. There were 5 bull cycles and 5 bear cycles until the CCI finally broke out for good taking out all of the trading range highs in the early 1970’s. Some of those trading range cycles lasted over 20 years. Trading ranges are usually either accumulation or distribution. The longer and wider these areas are, the more powerful and sustainable the ensuing trend will be. Powerful accumulation zones give me a lot of confidence in the ensuing power and sustainability of the uptrend. Commodities actually bottomed in 1933 (helped by FDR’s gold “scheme”) in the middle of the “deflationary” 1930’s. Then when the CCI topped in 1951, it did not react back down into the range again – it traded above the top of the range throughout its’ relatively flat 17 year bear cycle. With any chart, that tends to be very bullish – the flat reactions above the range.

So basically to me, the grand cycle in commodities is an even grander bull market on a very long term basis. We have a massive 200 year base, so we’re basically going to be in an uptrend for a long time, with huge selloffs, but eventually followed by higher highs (key word is eventually). But the huge selloffs obviously have been brutal to deal with for folks still having a large long position. So the month to month, even year to year, weirdness in markets will as per usual, have to be dealt with using a risk management approach. The resource stocks were some of the best performers from the last bottom (1999-2001) into the highs (2008-2011), and that will be the case in this upcycle also.

The great folks at Time-Price-Research ended their chart in 2013. This chart from MRCI shows the Goldman Sachs “Continuous Contract” Commodity Index over the last 46 years. Look at the huge range commodities traded in for 30 years, before finally breaking out and retesting it in 2005, followed by the rocket ship rally into the 2008 bubbly highs. Since then the index came down and retested the top of the old range for the second and third time, convincing the crowd that commodities were dead money. It will be a long time before the crowd believes in commodities again, and only much higher prices will “convince” them. My approach is to be in early on this, and the selloffs are fantastic buying opportunities.

About