WTI/RBOB Slide After Smaller Than Expected Crude Draw, New Record High Production

With WTI at its highest since July 2015, vol at 8mo lows, and the front-end flipped into backwardation for the first time since Nov 2014, it appears a lot of hope is priced into continued equlilibration (and OPEC). Last night"s API (crude draw) provided some more confirmation but this morning"s DOE data disappointed with a smaller than expected crude draw, and production rose once again to a new record high.

“Domestic production is going to be the big nugget that everybody will be racing to see, in terms of whether those levels continue to rise or not,” John Kilduff, a partner at Again Capital, says.

 

“They likely will, so that can be a counter-balance to the drawdown”

API

• Crude -6.356mm (-2.2mm exp) - biggest draw since August


• Cushing -1.8mm


• Gasoline +869k - surprise build


• Distillates-1.67mm

DOE

• Crude -1.86mm (-2.2mm exp)


• Cushing -1.827mm


• Gasoline +44k (+1mm exp)


• Distillates +269k

DOE disappointed expectations with a considerably smaller than expected crude draw (and well below API) and modest product builds...

As a reminder, last week saw the first rise in total inventories in 8 weeks and that held this week.

US crude production rose 13k b/d to a new record high...

 

Price-wise, WTI went into the DoE report at its highest since July 2015 (both WTI/RBOB higher after API) thanks also to the shutdown of the Keystone pipeline which tightened the market, but both WTI and RBOB slipped after the print...

 

The front-end of the WTI curve is in backwardation for the first time since Nov 2014. The move briefly put all of WTI curve through 2021 into backwardation

However, BofAML analysts including Francisco Blanch said in report, that "bloated crude oil inventories in North America likely will remain the Achilles’ heel of the oil market, negatively impacting WTI."

As Oil Heads For Down-Week, Crude Stakes Are Huge

After five straight weeks higher - read by many as confirmation of how awesome the global coordinated recovery must be - WTI and Brent dropped this week as inventories rose, demand outlooks dimmed, and OPEC hope faded.

As Alhambra Investment Partners" Jeffrey Snider notes, there is a titanic struggle going on right now in the oil market.

On the one side of the futures market are the usual pace setters, the money managers. Last week, the latest COT data available, they went the most net long since March. If it continues, it will close in on the most positive futures position since the record long they established back in February.

Normally that would be insanely bullish for oil prices. But just as in February/March another part of the futures market has intervened on the other side. Back then it was the oil producers who rising inventory forced into a larger and larger offsetting net short (hedge).

This time, however, it is the swap dealers who are short for reasons that aren’t really clear. The weekly COT report for the last week in October showed a record net short for dealers, just beating their most extreme position from the middle of 2013 at -424k contracts. In the first week and November, they blew away that record at -470k.

It clearly matters because in 2017 the oil market has changed. It may be the inventory story, or it may be the exit of producers from hedging that inventory and other products. Whatever the case, money managers just aren’t setting the price like they used to. And it could be that managers have changed their market activities, too, where other parts of the futures market are now cueing off (shorting) this possible difference. I honestly don’t know what it is, but I can safely point out where it is.

Now with swap dealers apparently showing very, very strong conviction on the short side, oil prices can’t gain any traction beyond the $57 established by in all likelihood geopolitical risk.

The fundamentals of oil continue to favor the dealers over the managers, with oil inventories remaining at the same crisis “rising dollar” levels. Being slightly better than 2016 is not a real achievement toward clearing the leftover physical imbalance, not when oil inventories are instead still consistent with late 2014. With 2017 nearly over, there should have been much more progress toward 2013 levels of stock long before now if there was ever going to be a realistic chance to balance the oil market next year (at the most optimistic).

Instead, it indicates yet again a demand problem, as in lack of materializing upside demand due to, as always, economic constraints that in the mainstream aren’t ever considered real (like when the oil crash was called repeatedly a “supply glut”). Pushing the expected rebalancing date into 2019 or even (more realistically) 2020 creates greater downside not upside risks.

That may be why dealers have jumped all over the shorts; if it is geopolitical risks driving oil prices higher, and maybe what managers are betting on now, then if or when they fade the negative fundamentals of oil will be re-imposed on the price. That seems to be what the futures curve is saying, too.

Backwardation indicates expected balance, but at a very low price rather than a rebounding one. In the latest oil pullback since last week, the curve has moved lower in unison, with the same almost identical indicated backwardation rather than toward any serious rewind toward contango.

One additional factor to consider is those record and near-record opposite futures positions. What happens if the oil price starts to move in either direction? There may need to be a whole lot of covering by whichever side ends up on the losing end, perhaps turbocharging the price as it begins to move whatever way it decides to go.

There is right now a lot at stake in the crude market, and it’s not just about oil.

The Single Biggest Bullish Catalyst For Oil

Authored by Nick Cunningham via OilPrice.com,

One of the key objectives for OPEC is to bring down inventories, a goal that has been elusive this year. But if the oil futures curve is anything to go by, the oil market is showing signs of tightening.

Brent futures have recently begun to exhibit a state of backwardation, which is when near-term oil futures trade at a premium to contracts dated further off into the future. This is the first time in years that backwardation has occurred, and most analysts are taking it as a sign that the oil market finally could be getting closer to rebalancing. In the past, backwardations have accompanied a rebound in the oil market after a bust, while a contango (the opposite of backwardation) tends to occur when the market crashes because of a supply glut.

There are several reasons why backwardation is bullish, which has been discussed in previous articles. A declining futures curve makes it uneconomical to store oil, so backwardation could accelerate the drawdown in inventories. It also complicates the hedging strategies of shale producers, which could hold back expansion plans. It also is a symptom of tightening near-term supplies, although, to be sure, the flip side of that argument is that it could merely be a reflection of expectations that the supply glut will reemerge at some point in the future.    

Still, backwardation is occurring at a time when there are other bullish indicators starting to crop up. The U.S. has seen a sharp drawdown in inventories in recent months, down more than 60 million barrels since March. The IEA and OPEC both recently upgraded their oil demand estimates. "World economic growth has gained momentum," OPEC said. "With the ongoing growth momentum and an expected continued dynamic in second-half 2017, there is still some room to the upside."

The view of Wall Street is also becoming more bullish. Hedge funds and other money managers have amassed a large number of long positions on recent weeks. For the week ending on August 8, investors stepped up their bullish bets on Brent by the equivalent of 58 million barrels, according to the FT, which was the largest weekly increase towards net length since December.

“It’s hard to be aggressively negative if every week you’re getting stronger numbers,” Paul Horsnell, global head of commodities research at Standard Chartered, told the FT, although he added that “there is still resistance. The market is not willing to push prices too far up.”

Indeed, there is little prospect of oil prices moving much beyond $50 per barrel. Not everyone is even sold on the notion that the market is tightening. OPEC production is at its highest point so far in 2017, U.S. shale continues to rise, and some long-planned projects are coming online later this year in Canada and Brazil, for example. “There is no way this oil can be accommodated into the market so prices are going to have to give at some point,” Mr Dei-Michei of JBC Energy told the FT. “This bullish sentiment cannot last.”

In fact, swings in sentiment, like a pendulum, are typical. More than once this year, the bullish positions have built up too far, only to be undone when sentiment shifted, causing a steep selloff in oil prices. Following the price crash in June, the profoundly bearish positioning amongst hedge funds and other money managers also went too far, causing shorts to be liquidated and bullish bets to remerge – which, again, accompanied a rebound in prices.

All of that is to say that the most recent shift towards long bets on oil futures probably can’t carry oil prices all that far. The underlying fundamentals simply don’t justify significant price gains…at least for now. “They’re going to have to dig in for the long haul,” Neil Atkinson, head of the IEA’s oil markets and industry division, said on Bloomberg TV, referring to the OPEC cuts. “Re-balancing is a stubborn process.”

In short, the shift into backwardation in the futures market suggests that the supply balance is heading in the right direction, and it probably puts a floor beneath prices for the time being. But it doesn’t necessarily mean that oil be heading much higher than $50 per barrel anytime soon.

Anticipating "VIX Shock", Interactive Brokers Raises Volatility Margins

Even as the VIX has continued to plumb new all time lows, unable to rebound from the realm of single-digits where it has spent a record amount of time in 2017, warnings about a potential surge in the volatility index have been growing in recent weeks.

Last week, in a note looking at what may happen "if the VIX goes bananas", Morgan Stanley"s Chris Metli cautioned that it’s easy to become numb to the low volatility environment and the risks it presents.  While trying to pick a trough in vol has been a fool’s errand, Metli said that focusing on the risks resulting from vol being so low is not, and warned that low vol has produced a regime where the risks are asymmetric and negatively convex, so being prepared for an unwind is critical.  "This is not a call that vol is about to spike, but you need a plan if it does", he echoed many other similar warning issued in recent months.

Of course, while nobody can know when a VIX explosion could occur, Morgan Stanley explained what could catalyze such a violent rise in volatility, showing that "just" a 3% to 4% one-day S&P 500 selloff could result in a 12 point VIX surge, a relationship MS showed through the gamma in vol related products, where demand for VIX futures from three main sources could result in 100,000 contracts ($100mm vega) to buy in a down 3.5% SPX move.  For context VIX futures ADV over the last year is 230,000 (although has risen to as high as 700,000 in big selloffs).

For those who missed it, below we recap some of the salient points of what would happens if the S&P 500 were to fall 3.5% today, based on Morgan Stanley calculations:

• First, the VIX could rise as much as 12 points.  When volatility is low it tends to move a lot for a given change in the S&P 500.  That effect is likely to be exacerbated now because a) skew is steep (and VIX rolls up the skew in a selloff) and b) many players in the VIX market are short.  Taking these dynamics into account QDS estimates VIX could rise ~12 points for a 3.5% 1-day decline in SPX. Of course, a far smaller move in the VIX would be sufficient to result in massive losses among the vol-selling community according to previous calculations by JPM"s Marko Kolanovic.


• Just as concerning, if VIX futures approach +100% in a single day, there is a risk that the providers of inverse VIX ETPs cover the VIX futures that they sold to hedge the products.  This is because there is a mismatch in the hedge if VIX futures rise more than 100% – the inverse ETPs can’t go below zero (-100%) but the loss on a short VIX futures position can be more than -100%.


• For XIV (holding ~73,000 contracts short) the prospectus indicates that it will unwind if the NAV falls more than 80% intraday, with investors receiving the end of day value.  Given this is a known threshold, anything close to a +80% move in VIX futures would likely trigger buying (by the ETN provider and/or market participants) in anticipation of the unwind.  Note that because XIV is an ETN, investors receive the theoretical value of the index based on its rules, not what the provider actually trades.


• SVXY (holding ~37,000 contracts short) does not have a set threshold to unwind according to its prospectus.  That said VIX futures currently have a margin requirement of ~45% of notional for the average of the front two contracts, and any decline in value of the inverse ETPs to those levels could trigger a rapid forced unwind.   Note that SVXY is an ETF, so the NAV is based on the actual holdings of the fund at the end of the day.

• Adding to the pain – on days after the initial shock – would be the flow from annuity and risk parity deleveraging.  Both of those investors are slow by comparison to the VIX market – annuities will sell over several days, starting the day after a selloff.  Risk parity funds are more discretionary, and the supply could come over a matter of weeks.  But given high leverage resulting from the low vol environment, their potential supply is large and could prolong any downturn. Between all three vol players, a 3% drop in the S&P would result in forced selling of roughly $60 billion in one day, growing to $140 billion should the plunge accelerate to -5% intraday.

* * *

In a separate report also discussed here previously, Fasanara Capital"s Francesco Filia revealed what the "wipeout scenario" - one in which the VIX were to double from its current level in the 9/10 range to 18/20 - would look like for vol sellers. In a word, it would be an unmitigated disaster.

Our analysis shows that if VIX goes from 9.60 to 18/20 in absolute values (it was approx. 40 as recently as Aug2015), and stays there for 8 / 10 days in backwardation, VIX-based ETFs may stand to lose up to 55%. Short positions on long-vol ETFs can then lose up to 250% of capital with VIX at 20. Losses are higher in case of wider backwardation of the term structure of the VIX (i.e. front contracts trading higher than back contracts), or the longer VIX stays elevated while in backwardation, or clearly the higher it goes. For example, if VIX quadruples from here to 40, losses on a UVXY position would amount to a staggering 656%!

* * *

We bring up all of the above, because as Morgan Stanley said, "This is not a call that vol is about to spike, but you need a plan if it does" and at least one exchange is doing just that.

In a notice to clients sent out late on Friday, Interactive Brokers admits it is starting to get a worried about the recent VIX record lows and as a result after expiration processing on August 19, "Interactive Brokers will put into place greater margin requirements for Volatility Products."

While the IB notice had it usual dose of fluff and generic admonitions...

VIX has established new all-time lows over the course of the past month. The price dynamics of that product are such that it can have very large relative price increases over a very short period of time base on news and other market factors. In recognition of the special risk of sudden, large increases in market volatility, that is inherent in Volatility Products such as VIX, Interactive Brokers will put into place greater margin requirements for Volatility Products after expiration processing on Saturday, 19 August. 

... It was surprisingly clear in what the specific parameters of the anticipated move are, to wit:

IB"s margin policy will be to consider market outcome scenarios under which VIX might rise to a price of 18 (even when it is currently priced much lower) and under which the other Volatility Products could rise to proportionately similar degrees.

In other words, IB is starting to prepare for the day that the VIX doubles from current levels, which as Fasanara showed above, is sufficient to wipe out most vol sellers, and in the case of those with levered, naked volatility shorts, results in losses greater than 600%.

Who will be impacted:

If you have positions in Volatility Products that have risk in large upward moves of market volatility, then your margin may increase significantly.

Of course, since volatility is the "fulcrum security" of today"s reflexive market nature - does a surge in the VIX send stocks lower, or does a market crash lead to a VIX surge? - the very fact that vol-linked leverage is about to be aggressively cut first by one, then by many more if not all exchanges, as we head into the critical for volatility fall period, these warnings could create a self-fulfilling prophecy whereby the margin increases are the very catalyst that leads to a surge in volatility.

Whether that is what happens over the next two weeks remains to be seen. In the interim, IB said that "it will with immediate effect increase its Initial Margin requirements on Volatility Products to a degree consistent with the upcoming 19 August increases in Maintenance Margin."

What this means is that vol sellers will now have to pay up substantial additional margin (i.e. cash) for new short-vol positions, and that in two weeks, maintenance margins for legacy positions will be likewise affected. It also means that unless the short-vol traders have a generous amount of cash lying around, they will have no choice but to close out of existing positions, in the process sending vol, and VIX, higher if purely mechanistically.

IB also specifically cautions inverse vol sellers:

Some Volatility Products have "ultra" and "inverse" characteristics. Ultra products are expected to have greater daily returns than normal products while inverse products are expected to have returns that are of the opposite sign to normal products. It is therefore expected that an increase in market volatility will result in a decrease in the price of an inverse volatility product. As a consequence, for example, under the new policy the margin on a naked short call will increase for a normal product while the margin for a naked short put will increase for an inverse product.

This unexpected margin hike across the vol universe by Interactive Brokers (to be followed by its competition) is especially notable because one month ago Bank of America warned that the most dangerous moment for markets "will come in 3-4 months", or 2-3 months as of today, when the confluence of the adverse debt-ceiling negotiation, disappointing Q3 earnings, and the Fed"s balance sheet unwind all converge into one broad risk-off shock.

It is precisely this "event" that Interactive Brokers is the first to admit may have drastic consequences on the market.

IB"s full notice is below.

Gold and Silver Price Drop of 3 July, 2017

The price of gold dropped from $1,241 as of Friday’s close to $1,219 on the close Monday, or -1.8%. The price of silver fell from $16.58 to $16.11, or -2.9%. It is being called a gold and silver “smash” (implication being that one party or a conspiracy is doing the smashing).

Our goal is to help you develop a clear understanding. The move today is no mystery. Monetary Metals makes an intensive study of the spread between the spot market—where metal is bought and sold—and the futures market.

Much analysis treats these market moves as mysterious, literally inexplicable except by reference to nefarious actors who are variously trying to make illicit profits or who act not-for-profit to somehow protect the dollar. Which they do by somehow pushing down “paper” gold. Which they do by sheer size, size being the critical characteristic to manipulate markets. However, ask anyone who has ever run a multibillion dollar fund and you will get the opposite picture. Size is a disadvantage, because when you buy, you end up with a higher price and when you sell you get a lower. At least if you are trying to make money.

In this conspiracy view, people who hold gold are long suffering, waiting for the “signal failure” when the banks can no longer hold the price down. And then it will be a moonshot to $13,000 gold (or whatever the magic number is supposed to be).

This same story has been used to explain market moves when the price was $250 and when it was almost $2,000 and today at $1,220. Don’t hold your breath. Instead, use your faculties of critical thinking. Does this make sense? And which is it, anyways? Are these conspirators supposed to be a for-profit racket? Manipulating gold and silver for their gain (in dollars) and your loss?

Or are they not-for-profit, acting without regard to their own balance sheets simply to protect the dollar… protect it from what? What bad, exactly, was supposed to happen when gold reached $1,000? That was the topic of conversation in the late 1990’s, $1,000 was a line in the sand and far away. What happened when gold hit nearly $2,000?

And what is the mechanism of this manipulation? Do they sell metal or futures? If futures, then what happens at contract expiry? If they were truly naked short, they would have to buy back the expiring contract and sell the next one. That would have a distinct signature, with each contract rising sharply into a great contango as it neared expiry (the opposite of what actually happens).

And this brings us back to the market action on Monday July 3, and the spread between spot and futures. Let’s take a look at the price of gold overlaid with the basis.

We see they are remarkably correlated. As the price drops, so does the basis from -0.2% to -0.4%, or -20bps.

This is a picture of selling primarily in futures. Speculators got flushed for whatever reason. The price fell, but our calculated fundamental price barely moved from $1,334 to $1,331.

Incidentally, in the Supply and Demand Report yesterday we noted that the cobasis of the August contract was 0. It is now +0.2%, aka backwardated.

Here is the graph of the silver action.

The silver basis fell from -0.36% to -0.92%. Like gold, the selling in silver was predominantly futures.

A word on this is appropriate. When we say “primarily” or “predominantly” we refer to which market was leading. The absolute change in the spread is very small relative to price. If there had been no selling in spot, and the futures price had dropped by 47 cents, then there would be a 47-cent backwardation. In such case, we would be bellowing from the rooftops about the broken silver market!

Paraphrasing our old buddy Aragorn, the day will come when there is 47 cents of backwardation in silver. But today is not that day!

There was plenty of selling of metal also. It’s simply that the selling of metal was trailing the selling of futures, pulled along by arbitrage and lagging behind.

It makes sense that most big price moves are driven by the futures market. Futures are made for trading: they have low costs, great liquidity—and leverage.

The silver cobasis was also 0 on Friday. It is now +0.6%. Our calculated fundamental price of silver is up 9 cents to $17.94.

Monetary Metals will be exhibiting at FreedomFest in Las Vegas in July. If you are an investor and would like a meeting there, please click here.

© 2017 Monetary Metals

Goldman Warns Of "Sharp Oil Price Drop", Inventory Glut "If Backwardation Is Not Achieved"

Increasingly some of the more prominent sellside analysts appear to be picking and choosing ideas from their competitors. Earlier, it was JPM echoing Goldman"s reco when it cut its 10Y yield forecast. Now, in a note previewing the outcome of this week"s OPEC meeting and proposing a way forward for OPEC, Goldman"s Damien Couravlin adopted the "backwardation" idea presented last week by Morgan Stanley"s Francisco Blanch.

As a reminder, Blanch"s latest thesis on oil market dynamics, is that "OPEC’s goal for the oil market is not a specific price level, but reaching backwardation", (which is also why he does not believe that OPEC will proceed with deeper cuts as this would likely mean ceding more market share to U.S. shale production).

Fast forward to Monday, when Goldman"s energy strategist Damien Couravlin effectively cribbed the whole note by writing that while "oil prices are rebounding with stock draws and greater certainty on an extension of the production cuts" and a "9 month extension would normalize OECD inventories by early 2018" he warns that he sees "risks for a renewed surplus later next year if OPEC and Russia’s production rises to their expanding capacity and shale grows at an unbridled rate."

How can OPEC avoid this boom-bust cycle again and achieve both fiscal stability and rising revenue through oil market share gains? He argument is that "only sustained backwardation can restrain access to the large pools of private equity and HY credit capital."

We believe that low deferred prices can achieve this by (1) increasing the opportunity cost of shale’s capital providers to hedge out their oil price exposure, (2) lowering expected equity valuation and (3) increasing expected leverage levels. Costs will also play a role in setting shale’s growth path but we do not forecast sufficient inflation at this point to achieve the required slowdown next year.

In other words, Goldman observes that curtailing access to capital is required to slow shale grow, and is urging OPEC to eliminate the biggest loophole that has allowed shale to keep producing despite lower prices, namely the contango that has allowed US producers to not only hedge production at affordable prices but to continue expanding production even as OPEC nations have been forced to limit their own output, ceding market share to US producers. 

How can OPEC achieve this? Goldman"s answer is that the bank believes "that OPEC and Russia should (1) extend/increase the cuts until stocks have normalized, (2) express the goal of growing future production, and (3) gradually ramp up production to grow market share but keep stocks stable and backwardation in place."

Goldman concedes that "achieving this will be difficult, but we see templates in both OPEC’s modus operandi of the 1990s of managed but flagged growth and the rationalization of shale growth in US gas, both with backwardation."

The bank also highlights one major risk to its thesis: that cheap, mostly junk-rated credit will remain abundant, allowing shale to continue expanding production regardless of the fundamentals: "while oil hedge ratios are low for 2018, the main risk to this view is that funding markets remain resilient to lower deferred prices, with little HY debt maturing in the coming years."

What does all of the above mean for OPEC"s announcement on Thursday? Under such a proposed framework, "we believe that OPEC should announce a decisive cut on May 25, as normalizing stocks is a required first step (likely a 9 month extension)." Such an announcement would have a two-fold impact on oil prices: first, when it comes to Goldman"s near-term price target, the firm says that its year end Brent spot price forecast remains at $57/bbl. Things change when going beyond the 2017: here Goldman for the first time adds a significant caveat:

"we now forecast that deferred prices will need to decline with 1- to 2-yr WTI forwards of $45/bbl. This leaves us expecting high total returns for being long oil, delivered through backwardation, but recommending that producers increase their hedge coverage. If backwardation is not achieved, however, we see risks that prices fall sharply next year as OPEC reverts to growing market share through volumes."

Just to recap, here is Goldman"s summary of what it dubs "OPEC"s dilemma":

Herein lies the OPEC dilemma - a return to production capacity in 2018 to grow market share would lead to a sharp collapse in prices. This would extend the tug of war between OPEC and shale with the former ramping up production in 2015-2016 and 2018 but shale growing sharply in 2013-14 and 2017.

This dilemma is well illustrated with Saudi Arabia. While the Kingdom reduced its fiscal deficit in 1Q17, its roll back of austerity measures necessitates higher oil revenues in 2018 to prevent renewed large deficits. While further cuts in 2018 to support oil prices near $60/bbl would guarantee such higher fiscal revenues, this strategy would prove self-defeating longer term as high cost producers globally would ramp up activity at such prices, reducing Saudi’s long-term revenues. In turn, we do not believe that Saudi’s spare production capacity is large enough to be able to grow volumes sufficiently in 2018 to offset a sustainable decline in prices to $45/bbl and keep oil revenues at 2017 levels.

How can OPEC therefore achieve both fiscal stability and rising revenues through market share gains? We believe that the answer to this question is backwardation as low deferred prices can restrain access to capital for higher cost producers such as shale. Furthermore, backwardation maximizes low cost producers’ revenues relative to higher cost producers that hedge, as they instead sell all their production at spot prices.

Finally, we will note that the irony embedded of Goldman"s latest analysis is two-fold: on one hand the bank has to come up with a comprehensive strategy to bypass the liquidity gusher unleashed by the Fed and other global central banks. One issue with the Goldman analysis is that while it may be absolutely correct, and that backwardation will likely impair the fundamental profile of US shale producers, all that would result in is higher yields for corporate issuers which in turn would lead to an oversubscribed, bidding frenzy as the buyside rushes to allocate "other people"s money" in distressed names. As such, Goldman"s assumption of an efficient capital allocation process in a time when there is $18 trillion in excess liquidity is almost certainly wrong.

Funding aside, what is also ironic is that a US investment bank, one which effectively controls the White House, is tasked with conceptualizing a scenario which leads to a Saudi "victory" in the war with shale, an outcome which would result in thousands of lost US jobs, even as Saudi state revenues recover, and save the kingdom from its recent near budgetary death experience. It begs the question: if push comes to shove, will the Goldman Trump White House pick the side of the US shale industry, or that of Saudi Arabia, which this weekend announced intentions to purchase $350 billion in US arms over the next decade. Unfortunately, the answer is not self-evident.

A Bumper Under that Silver Elevator, Report 14 May, 2017

If you can believe the screaming headline, one of the gurus behind one of the gold newsletters is going all-in to gold, buying a million dollars of mining shares. If (1) gold is set to explode to the upside, and (2) mining shares are geared to the gold price, then he stands to get seriously rich(er).

We are not mining experts, but we will address (2) by saying that mining shares only go up if the input costs don’t go up as much as the price of gold. And if the company keeps efficiency up, and costs down. And if local tax authorities don’t get greedy. And if mine labor unions don’t get violent, environmental regulators don’t make expensive demands, etc. And if the company finds new ore bodies at the same rate it depletes them.

Here is a graph showing the price of the VanEck Vectors Gold Miners ETF (GDX) against the price of gold. We have plotted both price as a percentage of the start price to put them both on the same scale.

GDX vs Gold

You can see the problem. The price of gold from late May 2006 through present. In five years, the price of gold rose to 288% of its starting level. GDX was more than 100% behind, at only 170%. Note that the GDX is more than 40% down from its level in 2006. For comparison, the price of gold is just under double over the same period.

If this is gearing, then it looks like the gear box was bolted on backwards.

To bet big on gold mining shares now, your bet includes another conditional: (3) if the gearing has since been fixed…

Anyways, this is not really our wheelhouse. We focus our commentary on (1). Did something change in the market, that will drive the price much higher? Before that can happen, we would have to see something happen to put a bumper under that falling silver elevator.

Below is the only true look at the supply and demand fundamental of the metals, but first, the price and ratio charts.

The Prices of Gold and Silver

Next, this is a graph of the gold price measured in silver, otherwise known as the gold to silver ratio. It began the week moving up, but then reversed and ended lower.

Last week, we said:

“If it breaks above 76, then the next resistance looks to be 80.”

It did not break 76. It closed Monday at 75.7, but ended the week below 75.

The Ratio of the Gold Price to the Silver Price

For each metal, we will look at a graph of the basis and cobasis overlaid with the price of the dollar in terms of the respective metal. It will make it easier to provide brief commentary. The dollar will be represented in green, the basis in blue and cobasis in red.

Here is the gold graph.

The Gold Basis and Cobasis and the Dollar Price

Note that the June contract has just a touch of backwardation, with the cobasis now at + 0.01%. Back in early 2013, we dubbed this new normal behavior, when each contract would go into backwardation before it expired, temporary backwardation. That is all this is, and not a very impressive specimen either.

Yes, it is true that the scarcity of gold has been rising for about a month (look at the red line, the cobasis). However, that corresponds to the rise in the price of the dollar (which is the inverse of what most people measure, the price of gold in dollars). On April 12, the dollar was 24.18 milligrams gold, corresponding to a price of gold at $1286. The cobasis—our measure of scarcity—was at -0.81%. Since then, it has been a run up on the price of the dollar (which most people perceive as a run down in the price of gold), to 25.52mg gold (which people generally think of as a price of gold of $1,219).

When we see such a clear correlation between the price of the dollar and the cobasis, we know that the move is just speculators repositioning (in this case, obviously selling). The more the price of gold is down, the more speculators liquidate their futures, the scarcer the metal becomes.

Our calculated fundamental closed the week up $3, to $1,254. While this may be welcome news for gold speculators after a few weeks when it fell, it’s hardly the stuff of making million-dollar bets.

Far be it from us to get in the way, when there’s serious money to be made. It’s a (more or less) free market. Where there’s an opportunity, people will take it. We refer, of course, to the newsletter hawkers and their explosive upside call. We assume this is a lucrative business.

However, unlike the opportunity to sell newsletters to gold speculators who don’t know what most newsletters have been promising over the last 6 years, the opportunity to bet on a gold price increase looks rather less likely, at the moment.

Now let’s look at silver.

The Silver Basis and Cobasis and the Dollar Price

Silver does not yet show any backwardation, though it’s close at -0.03%.

However, the sharp and sustained rise of the cobasis is notable—along with the sharp and sustained rise in the dollar. Measured in silver, the dollar has risen from 1.68 grams of silver to 1.92 grams earlier this week. That’s a big run up (i.e. run down in the price of silver as popularly perceived).

We have been talking about an ongoing flush in the silver speculators. The price fell through Wednesday, then rallied sharply on Thursday and Friday. Perhaps that elevator has found a rubber bumper?

Significantly, our calculated fundamental price rose a buck this week. From around $15 last week, it’s now $16.

We will end on an amusing note. Last week, we said:

"We saw a technical analysis trader write a note this weekend. He said he plans to short silver on Monday. When the technicals and then fundamentals align, that can make for an interesting week."

Assuming he shorted it early on Monday morning, he might have top-ticked it at $16.40. On Tuesday, he could have closed at $16.05, for a gain of 2.1%. There has to be an easier way to earn a few bucks (and we never recommend naked-shorting gold or silver).

Keith will be speaking at the Metal Writers Conference in Vancouver, at the end of the month. And at the Mining Investment Europe event in Frankfurt in mid-June.

© 2017 Monetary Metals

Why Goldman Thinks You Should Go Long On Oil

Authored by Nick Cunningham via OilPrice.com,

As pessimism sweeps over the oil market, a few prominent voices are unbowed, arguing that the market is well on its way towards balance.

Goldman Sachs’ head of commodities Jeff Currie said at an S&P Global Platts Conference in London this week that investors should probably be going long on crude oil because the market is already in a supply deficit. He pointed to the futures market, where the curve could be headed into backwardation – a situation in which near-term oil futures trade at a premium to contracts further out. That structure points to concerns about a deficit in the short run, which is why front month contracts would trade at a higher price than deliveries six or twelve months away.

But the backwardation is also a symptom of fears over long-term oil prices. Goldman Sachs has consistently argued that crude prices could remain relatively low for years to come as the cost of production has shifted lower. So, lower long-term prices have pushed the back end of the futures curve lower, with near-term prices trading higher.

There is a feedback effect from the market shifting into backwardation. If spot prices are above long-term prices, then fewer companies will be willing to lock in next year’s production at those lower prices. Without industry-wide hedging, the ability to grow production is diminished. Or, as Goldman Sachs put it in its latest research note, “fear of long-term surpluses reinforces near-term shortages.”

Putting some of the jargon aside, Goldman is simply arguing that the oil market will be much tighter this year than most people seem to think. The investment bank forecasts returns on commodity prices on the order of 13.3 percent over the next three months and 12.2 percent over the next 12 months.

That prediction is based not just on the idiosyncrasies of paper trading, but ongoing improvements in the physical market. For example, Goldman predicts a rather modest inventory build of just 6 million barrels (crude oil and refined products) across the U.S., Europe, Japan and Singapore between March and April, which is much lower than the typical 16-million-barrel increase for this time of year.

Goldman also cautions everyone not to read too much into the exceptionally high inventory level in the U.S. because the U.S. has the lowest cost storage capacity, and as such, it will be “the last to draw.” Also, the U.S. has the most “visible” data, so there are a lot of drawdowns happening elsewhere in the world out of full view of market analysts. In short, U.S. inventories are a “lagging indicator of the rebalancing.”

And even that lagging indicator is starting to improve. The EIA reported on Wednesday a surprise drawdown in oil inventories, with stocks dropping by 5.2 million barrels, much more than the markets had anticipated. That led to strong gains for WTI and Brent, both of which were up nearly 4 percent during midday trading on Wednesday. Even better, gasoline stocks did not rise, bolstering the view that the drawdown was for real and not just a shifting of product from crude storage to gasoline storage.

If U.S. inventories are the last to draw down, as Goldman Sachs says, then the fact that they are indeed drawing down lends some credence to the investment bank’s assessment.

The IEA agrees with Goldman’s view, arguing that supply is already exceeding demand in the second quarter, and the deficit will grow in the second half of the year as long as OPEC extends its production cuts. “It is starting to become clear that if the objective of the OPEC cuts was to flip the market from surplus into deficit that is now slowly beginning to happen,” the IEA’s head of oil analysis, Neil Atkinson, said at the Platts London Conference.

So why did prices sell off so sharply last week? As they have mentioned before, Goldman chalks it up to technical trading and sentiment, not because of poor fundamentals. They admit that the market is balancing slower than everyone expected, but the investment bank stood by its prediction that the oil market is tightening.

Technical vs. Fundamental, Report 19 Mar, 2017

Every week we talk about the supply and demand fundamentals. We were surprised to see an article about us this week. The writer thought that our technical analysis cannot see what’s going on in the market. We don’t want to fight with people, we prefer to focus on ideas. So let’s compare and contrast ordinary technical analysis with what Monetary Metals does.

Technical analysis, in all of its forms, uses the past price movements to predict the future price movements. In some cases (e.g. momentum analysis) it calculates an intermediate signal from the price signal (momentum is the first derivative of price). But no matter the style, one analyzes price history to guess the next price move.

This is necessarily probabilistic. There is no way to know that a particular price move will follow the chart pattern you see on the screen. There is no certainty. And when it does work, it is often because of self-fulfilling expectations. Since all traders have access to the same charts, and the same chart-reading theories, they can buy or sell en masse when the chart signals them to do so.

We are not here to argue for or against technical analysis. We simply want to say that it’s not what we are doing. Not at all.

Our analysis is based on different ideas. The key idea is that there is a connection between the spot and futures market. That connection is arbitrage. Think of each market as a platform that moves up and down on its own vertical track. The two tracks are close together. And the platforms are connected to each other by a spring. Suppose platform A is a bit above platform B. If you push up on A, then the spring stretches a bit more and will pull B up, though perhaps not as much. The same happens if you push down on B.

Conversely, if you push down on A, then it will compress the spring and platform B will tend to go down, though not as much.

A and B are the futures and spot markets for gold (the same analogy applies to silver). Arbitrage works just like a spring. If the price in the futures market is greater than the price in the spot market, then there is a profit to carry gold—to buy metal in the spot market and sell a futures contract. If the price of spot is higher, then the profit is to be made by decarrying—to sell metal and buy a future.

There are two keys to understanding this. One, when leveraged speculators push up the price of gold futures contracts, then that increases the basis spread. A greater basis is a greater incentive to the arbitrageur to take the trade. Two, when the arbitrageur buys spot and sells a future, the very act of putting on this trade compresses the spread.

If someone were to come along and sell enough futures contracts to push down the price of gold by $50 or $150 or whatever amount is alleged, then this selling would be on futures only. It would push the price of futures below the price of spot, a condition called backwardation.

Backwardation just has not happened at the times when the stories of the big “smash downs” have claimed. Monetary Metals has published intraday basis charts during these events many times.

The above does not describe technical analysis. It describes physics—how the market functions at a mechanical level.

There are other ways to check this. If there was a large naked short position in a contract that was headed into expiry, how would the basis behave? The arbitrage theory predicts the opposite basis move. We will leave the answer out as an exercise for the interested reader, as thinking this through is really good work to understand the dynamics of the gold and silver markets (and you can Google our past articles, where we discuss it).

This check can be observed every month, as either gold or silver has a contract expiring (right now it’s gold, as the April contract is close to First Notice Day).

This week, the prices of the metals both rose. The price of gold is almost back to where it was the prior week, but that of silver is not.

Below, we will show the only true picture of the gold and silver supply and demand. But first, the price and ratio charts.

The Prices of Gold and Silver

Next, this is a graph of the gold price measured in silver, otherwise known as the gold to silver ratio. It moved sideways this week.

The Ratio of the Gold Price to the Silver Price

For each metal, we will look at a graph of the basis and cobasis overlaid with the price of the dollar in terms of the respective metal. It will make it easier to provide brief commentary. The dollar will be represented in green, the basis in blue and cobasis in red.

Here is the gold graph.

The Gold Basis and Cobasis and the Dollar Price

NB: we switched from the April to the June gold contract.

As the price of the dollar fell (inverse of the rising price of gold, measured in dollars) we see the cobasis (our measure of scarcity) increased a bit. This means the buying in gold, which pushed up the price, was buying more of physical than of futures. This seems to be the new pattern of late, though it is sputtering a bit like an engine trying to start up and run at a steady RPM.

Our calculated fundamental price of gold is up nearly $50. It is now over $1,400.

Now let’s look at silver.

The Silver Basis and Cobasis and the Dollar Price

The story is the same in silver. Rising price accompanied by rising scarcity.

The silver fundamental price rose 50 cents. It is now aboit $1.30 over market.

© 2017 Monetary Metals

Why Did Silver Fall, Report 12 Mar, 2017

The question on the lips of everyone who plans to exchange his metal for dollars—widely thought to be money—is why did silver go down? The price of silver in dollar terms dropped from about 18 bucks to about 17, or about 5 percent.

The facile answer is manipulation. With no need of evidence—indeed with no evidence—one can assert this and not be questioned in the gold and silver communities. We have recently come across a term normally used to describe Leftists and Social Justice Warriors, virtue signaling. One piously declares that one supports the cause, one speaks truth to power, one sticks it to The Man, well you get the idea. The concept of virtue signaling seems equally appropriate to those who sing the chorus on every price drop, “manipulation.”

Besides, we have peeps in high places in London and New York and Beijing, and they tell us silver is manipulated…

Actually, we rather prefer to look at data than listen to whispers. What would the data show if demand for physical silver metal was robust and rising while someone sold so many futures contracts that the price of the metal was forced down just about a dollar?

The basis and cobasis are spreads between physical silver metal and futures. The scenario we just described would collapse the basis and skyrocket the cobasis.

Is that what happened this week?

Before we get that, we want to note that crude oil fell from $53.33 last week to $48.49, or -9%. Copper fell from $2.70 to $2.60, or -3.7%. Wheat fell from $4.53 to $4.40, or -2.9%. People miscall this deflation.

We don’t know whether this will affect the Fed’s seeming commitment to damn the economy, full rate hikes ahead. However, we do know that sentiment bleeds from one speculative asset to another (and in a near-zero interest rate environment, all assets are used by speculators). “If energy, industrial metal, and food are going down, then surely silver should go down too,” seems to be the logic.

At least this week.

We are much more interested in the supply and demand fundamentals. We acknowledge that speculators can temporarily move prices—sometimes a lot—but we firmly insist that eventually the market price reverts to the level called for by supply and demand.

So what happened to those fundamentals? Below, we will show the only true picture of the gold and silver supply and demand. But first, the price and ratio charts.

The Prices of Gold and Silver

Next, this is a graph of the gold price measured in silver, otherwise known as the gold to silver ratio. It moved up sharply this week.  If we were chartists, we might note that the ratio seems to be making a series of higher lows since mid-July.

The Ratio of the Gold Price to the Silver Price

For each metal, we will look at a graph of the basis and cobasis overlaid with the price of the dollar in terms of the respective metal. It will make it easier to provide brief commentary. The dollar will be represented in green, the basis in blue and cobasis in red.

Here is the gold graph.

The Gold Basis and Cobasis and the Dollar Price

As the price of the dollar rose through the week, so did the cobasis. The price of the dollar is the inverse of the price of gold in dollar terms, and allows us to see a clearer picture. It is not gold going anywhere, but the dollar going up and down. The cobasis is our indicator of scarcity.

While the dollar went up 0.5mg gold, the cobasis went up 24bps. This is the old pattern, rising gold scarcity as the dollar rises. The same happened in farther contracts, to a smaller degree.

While the market price of gold fell $24, our calculated fundamental price went down only $15. It’s more than $150 over the market price.

Now let’s look at silver.

The Silver Basis and Cobasis and the Dollar Price

The cobasis in silver actually fell. It didn’t fall a lot, but this drop came in a week when the price fell substantially. This puts the lie to the allegation of manipulation. Selling of futures would push the cobasis up.

Silver fell because owners of metal decided to sell and/or buyers of physical metal slowed their purchases. We can debate why they did that, but not the meaning of the data.

Note also the much lower absolute level of the silver cobasis. Silver is -86bps compared to gold at +8bps (a slight temporary backwardation).

The silver fundamental price also fell, about half as much as the market price. It is now $1.03 over market.

This means that, while those who need to unload their silver are unhappy, those planning to load up can now exchange the same quantity of Federal Reserve Notes for more silver than last week. With (slightly) better fundamentals too, as last week the fundamental was only $0.87 over market.

The only question on that front is the trend. For two weeks, the fundamental has become weaker.

© 2017 Monetary Metals

A Hint of Gold Backwardation - Rising Gold Scarcity

Last month, we noted that there could be a trend change in progress. Not only are the prices of the metals rising (which is just a mirror-image of the dollar falling, from 27.6 milligrams of gold just before Christmas to currently under 26mg). But the scarcity of gold as we measure it, using the spread between the price of gold in the spot and futures markets, has been rising.

What could cause this? One thing is for sure. It is not about the quantity of dollars. This theory is as popular as ever, despite the absolute lack of a rising gold price from September 2011-2016. The quantity of dollars has risen steadily since then.

We write much about the frequent cases when traders place big bets on something which is wrong. But the fact of their big bets drives up the price. Suppose speculators were betting on a big increase in the quantity of dollars under Trump. Then we would see a rising price alright, but we would see a rising basis—our measure of abundance of gold to the market. This cannot explain the current market either.

So what can? Recall Keith Weiner’s gold backwardation thesis. In times of stress or crisis, it is always the bid, and never the offer, which is withdrawn. Suppose the US Geological Survey were to make a dire announcement—THEY ARE NOT SAYING THIS, SO DO NOT MISCONSTRUE!! Suppose they said that there will be an earthquake in LA, an 11 on the Richter Scale. Nothing taller than a dollhouse will be left standing.

There would be no lack of offers to sell real estate. Some would hold out hope of getting “their price”. Others would generously offer to discount it 10% or 25% from the previous level.

However, what would be conspicuously absent would be a bid. Most likely from Santiago Chile to Vancouver, British Columbia and as far east as the Mississippi River. At least until the quake hit and the danger was passed.

It is gold that will withdraw its bid on the dollar. The bid sputtered 8 years ago, and intermittently since then. Then it has mostly been steady in the past few years. And now there is a hint of it, in the February gold contract. It’s just what we call temporary backwardation—a short term blip confined to the near contract that is heading into expiry.

However, we think it is notable. It means someone or many someones are switching their preference to gold, in spite of the higher yields available in the market now. Or maybe because of it. This preference, unlike speculators buying futures with leverage, is not about betting on price. It is about safety. Gold, unlike a bond, does not default.

Is this the explanation, and the whole explanation? We don’t know. We can only report that there is a change in behavior in the market. Whereas previously—this was the pattern for years—a rising price was accompanied by rising basis. And now we have rising price and the cobasis is rising instead. Rising scarcity rather than rising abundance.

To be sure, it is still a nascent trend. There is no guarantee that this won’t go poof like it has in the past. We will keep showing the data, and calling it like we see it.

Indeed, look for a new website soon. We plan to have more charts, many more, and updated daily. Including one data series that all the experts said could not be calculated.

Below, we will look at the supply and demand fundamentals for gold and silver. But first, the price action.

The Prices of Gold and Silver

Next, this is a graph of the gold price measured in silver, otherwise known as the gold to silver ratio. It fell a bit this week.

The Ratio of the Gold Price to the Silver Price

For each metal, we will look at a graph of the basis and cobasis overlaid with the price of the dollar in terms of the respective metal. It will make it easier to provide brief commentary. The dollar will be represented in green, the basis in blue and cobasis in red.

Here is the gold graph.

The Gold Basis and Cobasis and the Dollar Price

Look at that rising red line, the cobasis (our measure of scarcity). Since mid-December, it has moved opposite to the green line, which is the price of the dollar. Previously, they had moved together. That is, a rising dollar (i.e. falling price of gold, as measured in dollars) went with rising scarcity of gold, and a falling dollar had falling scarcity.

And now they are opposite. The more the price of gold is bid up (i.e. the more the dollar is sold), the scarcer gold becomes.

On Friday, our calculated fundamental price was just about $100 over the market price.

The February cobasis is +0.12%. That is, the Feb contract is backwardated.

Now let’s look at silver.

The Silver Basis and Cobasis and the Dollar Price

In silver the cobasis is rising a bit, though it is at a much lower level. Far from backwardation, it is -.90%.

Our calculated fundamental price moved up 3 cents from last week. It is no longer above the market price, as that moved up a lot more.

© 2016 Monetary Metals