Oil is fighting between two opposite forces, leading to almost unfathomable volatility and also, sorry to say, tough trading. But understanding the two competing forces in the oil market is the only way to start to figure out how to play it going forward.
We know that oil has shed more than $8 dollars in less than a week after dropping more than $3 in less than four minutes on Monday afternoon. A lot of theories were advanced for the drop on Monday: a fat finger error, hedge fund liquidation, a lack of liquidity on the Jewish holiday. No matter what you believe happened, one thing is sure: such a precipitous drop is algorithmically inspired and can only happen in a financially dominated and electronically overrun and dysfunctional market.
Of course, that is part of my message in my book "Oil's Endless Bid," but today there are two competing forces inside that dynamic that makes the oil market as unpredictable as it's ever been. First is the endless liquidity injected by the Federal Reserve, known in some quarters as QE Infinity. Continuing rate drops are a continuing incentive for investors to seek hard asset exposure and particularly oil. It is why oil prices staged such a substantial rally from the beginning of July, despite collapsing GDP numbers in Europe and China and increasing supply from Saudi Arabia, Iraq and here in the U.S. and Canada. Bernanke's plan to keep rates low at least until 2015 will put a bid under the oil market no matter what the fundamentals say.
The second competing factor is a fundamental one, also caused by decreasing rates and the skewing of the bond curve caused by QE. With short-term rates running negatively in real terms, there is a negative-cost-of-money factor that has been weighing on the physical players in oil (the guys who actually produce and store the stuff). To try and be simple, the costs of pumping and selling in the future are less compelling than producing now, even if you must continually store what you produce in the near term. What is produced is a deep backwardated crude curve, where prices today are higher than they are in the future.
But at some point in this crazy computation the sheer amount of oil being stored comes up against the slackening demand that dropping growth and corporate profits indicate and the market has a break to the downside. The nature of these breaks, like the one we are experiencing now, is so unpredictable because it is really the fundamentals reasserting themselves for very brief moments in oil. Add in the magic of high-frequency algorithmic players to this soup and you've got a wildly volatile move when most least expect it -- including me.
Here's one thing I can reasonably say. I have watched the fundamentals to oil swamped by the financial inputs for years now and no longer ever expect the fundamental picture to take over the pricing of oil for more than a rare and limited period of time. In other words, I'm not sure where it happens, but every big break in the oil market with QE Infinity in place is an opportunity to buy -- somewhere.
I know that doesn't sound like much. But with oil back down to $91, I don't think that much more downside remains. You won't see $75 again this year. I am looking at some oil stocks that have gotten hit by the precipitous drop, beta names like EOG Resources (EOG) and Apache (APA), and small playing the oil market for a revival rally.