I also wanted to point out a blurb I found in the Wall Street Journal late last week on what traders are doing with oil - due to the low leverage requirements there is a very popular trade going on, and Dennis references it in the video above. The body of the story has to do with just how much impact does China really have on the oil market but the interesting takeaway was this very popular trade.
- "We create our own reality." With oil inventories high and demand down year on year, yet prices surging, "fundamentalists" are puzzled. Market participants, however, always have an eye on the future and locking in a profit.
- Recently, commodities bulls have been aided by the Federal Reserve keeping rates low and banks' short-term funding flowing. This facilitates commodities trading and stokes fears of inflation. As cash flows into oil futures, their prices rise relative to spot prices. That makes it profitable to buy physical oil, store it and sell it forward.
Energy economist Phil Verleger demonstrates how lucrative this can be. On March 1, the cash price of light, sweet crude was $40.15 a barrel, while the 12-month forward contract sold for $50.26. Assume an investor bought the physical barrel borrowing 80% of the money at a rate of 3%, sold it forward, and paid 50 cents a month for storage. The resulting profit of $3.15 a barrel equates to a 39% return on investment.
Ah leverage - the mother's milk of profits. Financial Engineering the world over - it impacts all our lives.
Keep in mind we mentioned in this weekend's reading [Jun 6: Weekend Reading] we noted a Bloomberg piece that said JPMorgan was buying physical heating oil and storing it for the first time in its history.
And how much of oil demand is China? While they are a huge marginal buyer - increasing imports by one third between Jan and Mar, they still account for less than 10% of the world's purchases.
- China's appetite for commodities is well-established, but the card looks overplayed this time. First, China is big, but not that big. In the first quarter, it accounted for 9% of global oil demand, compared with 55% for the largely recessionary industrialized world.