May 16, 2015

"Futurization" and Fracking

The scale of futures trading on the oil market--and commodity markets more generally--is a novel feature of the current financial scene. According to the Financial Times, "Daily average turnover has increased from 350,000 futures contracts in 2005, when electronic trading started to dominate, to 1.5m--or 16 times the world's global daily oil demand."  Currently, funds control around 510 million barrels of oil in the New York and London futures markets--"equal to more than five days of global demand, or the combined monthly output of Saudi Arabia, Iraq and Iran, the biggest producers in OPEC." The impact of the shale revolution and fracking on the oil market is well known; less well appreciated, according to David Hufton, an oil broker, is the impact of "financialization." According to Hufton, "Futurisation of oil has been as dramatic in its impact as the arrival of horizontal drilling and fracking . . .  Fracking transformed oil supply dynamics; futurisation has transformed the factors driving oil prices."

David Sheppard and Neil Hume, "Hedge funds loom large in oil price moves," Financial Times, May 15, 2015

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The FT piece contrasts the big movement of macro funds into oil futures with the abundance of oil in the physical market. The supply overhang is also emphasized in the following chart from Britain's Telegraph newspaper. It cites a recent oil market report from the International Energy Agency warning that over supply has reached 2.1 million barrels a day. "Iraq, Libya and Russia are all cranking up output, and Iran is waiting in the wings with an extra 400,000 b/d of quick supply if there is a nuclear deal."

Ambrose Evans-Pritchard, "Epic global bond rout is a QE success story - but it won't last," The Telegraph, May 13, 2015

May 4, 2015

Damn Lies and Government Statistics

A miracle of modern finance is how the markets respond to government reports that are known to be often inaccurate and heavily revised. The inadequacy of the surveys and methods used to compile these reports (especially the market-moving employment report) is often neglected when the markets respond to the release; the “headline number” is all that matters.

One of the most closely watched figures of late has been the weekly oil output numbers released by the Energy Information Administration. The markets have been desperate to know whether the Saudi price war would succeed in flattening the U.S. industry or at least sharply impairing its growth. And yet according to accomplished oil trader Andrew J. Hall, the published estimates are taken from state agencies and lag by several months. The numbers are “essentially an artifice.”

The chart above shows, in orange, the EIA estimates to which all the attention is usually paid, the weekly output figures. It turns out, however, that the agency itself thinks it may have a better gauge. This is represented by the blue line. (I don’t recall having ever previously seen a graphic presentation of this alternative data.) 

Hall believes the recent fall in output as shown by the blue line is very bullish for the oil price, though it might be noted that the adjustments, though showing a steep fall recently, still show production above the normally consulted weekly output figure.

Bloomberg explains the basis of the different methodology:
A more accurate gauge of U.S. output is an “adjustment” the agency uses, which, in addition to the weekly number, adds up changes to how much oil is in storage, how much was used in refineries and how much was imported and exported, Hall said. 
Paul Sankey, an energy analyst at Wolfe Research, also cited the trend in a report Thursday to investors. The amount of production that isn’t accounted for has fallen “dramatically” in the last two weeks, suggesting U.S. daily output may have fallen by as much as 200,000 to 300,000 barrels in April, he said. “That number seems high to us, but it does support the notion that U.S. production is rolling over at present,” said Sankey, a former analyst at the Paris-based International Energy Agency. 
Imports, refinery demand and storage level data all come from surveys the EIA conducts with oil companies. Export data comes from the U.S. Census Bureau. Production data comes from a variety of sources, including state and federal regulatory agencies. In a perfect world, the supply and disposition would equal each other, said Mike Conner, a petroleum analyst at the EIA. But they often don’t, so the EIA uses the adjustment figure to balance it out. “All we really know for sure is the supply components are not enough to make up for the volume on the disposition side,” Conner said. “We don’t know if the error is in field production, imports, refinery inputs or what have you. Different analysts are going to have different interpretations.”
Bradley Olson and Dan Murtaugh, The Shale Boom Has Already Gone Bust—At Least for Now, May 3, 2015, Bloomberg Business 

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Update, May 12: The question of EIA statistics becomes curioser and curioser. The latest was a blast on Monday against the EIA for gross incompetence in its methods of data collection. The EIA, charged oil analyst Philip Verleger, was overestimating U.S. output by as much as 1.6 million barrels a day. The glut the markets had previously identified was seemingly non-existent, a “phantom.”  Verleger was previously on record as predicting that oil prices would fall back to $50 a barrel by the end of the year, a prediction predicated on the existence of a supply glut. So this was a big reversal for him, and it was for oil markets, if true, a very big deal.  

Then today (Tuesday) came a further twist, with Verleger performing a flip-flop and saying it was all a big mistake. According to the FT, Verleger “said economists at the Federal Reserve had examined his calculations and pointed out an error.” “The effect of the error is to change the sign of the Energy Information Administration’s mis-calculation of US crude oil production,” said Verleger. “It turns out that EIA is underestimating US oil output.”

Got that straight?

There follows the Monday story in the FT, followed by excerpts from its Tuesday report. Wednesday may bring further clarification, but it would seem, on the face of it, that the heat of Verleger’s denunciation on Monday seems rather misplaced given his reversal on Tuesday.

A prominent oil analyst has fired a broadside at the body charged with data collection on the US oil industry, saying it has probably overestimated the country's crude output by as much as 1.6m barrels a day.

Philip Verleger, an independent energy economist, claims the US Energy Information Agency (EIA) has "drastically" overestimated US oil production because it uses outdated techniques rather than data from the field,  reports Neil Hume, FT Commodities editor, in London

Mr Verleger said in a report published on Monday:

This is a large variance that could have enormous implications for the global economy. Prices will be higher because the [supply] glut was phantom. Federal Reserve policy could easily have been different had the error been understood.

The EIA, which acts as the statistical arm of the Department of Energy, declined to comment.

Mr Verleger, who runs consulting firm PKVerleger and advised both President Gerald Ford and Jimmy Carter administrations on economic and energy policy, was one of the few analysts bearish on oil before last year's dramatic collapse in prices.

Last week he forecast a further decline in prices, which have rallied sharply since reaching $40 a barrel in January.

On Monday, Brent, the international marker, was trading at $65 and the US equivalent, West Texas Intermediate, was at $59.50.

Mr Verleger said in his report:

The rise in oil prices… has baffled many who believed global stocks were surging. Global stocks would have done so had the numbers been correct.

Analysts say investors should be careful how they interpret US production statistics, in particular the EIA's weekly short-term supply numbers. This is because they are based largely on modelled estimates, not hard supply data from the field.

In a recent analysis of historical estimates against lagged production data, Citi found short-term EIA forecasts underestimated final data by as much as 200,000 b/d over the last year.

Mr Verleger has come to different conclusion but says the EIA's reliance on estimates and "failure" to make contemporaneous accuracy checks of its numbers is a "dereliction" of responsibility on the EIA's part.

He said in the report:  

Rarely if ever had a US agency charged with collecting data made a miscue of this magnitude. The EIA administrator should be dismissed immediately for gross incompetency.

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From the Tuesday report:

The EIA belatedly responded to Mr Verleger's report on Tuesday, saying the claim of a massive understatement of production was extremely unlikely

"Notwithstanding a widely-reported note alleging that EIA's domestic crude production data are probably overstated by 1.6m barrels a day, EIA management and staff are confident in the quality and validity of the agency's production data. Furthermore, EIA's monthly crude oil production statistics, based on official State oil and gas data have been closely aligned with the weekly estimates reported by EIA," it said in emailed comments.

"Turning to the larger items in the balance equation, EIA directly collects data on refinery crude runs, changes in crude oil stocks, and crude oil imports every week. We are confident in the quality of these data. Unless the reported runs data, the stock data, and the imports data are massively wrong, production cannot be overestimated by 1m to 1.6m b/d as alleged," it added.

May 3, 2015

The Oil Recovery in 2009: A Precedent for 2015?

The first chart below shows the perambulations of the oil price from the bottom on December 24, 2008 to June 1, 2009. The second chart shows the oil price movement from late January 2015 to the present (May 1). Note that the first chart shows six months, the second chart four, so they do not exactly align.

In both cases, there was a big rally off the lows (December 24, 2009 and January 29, 2015), with rallies failing over the next month to surmount the level achieved in the first week's big rally, then a retest and brief penetration of the lows about six and a half weeks from the original low (February 12, 2009 and March 17, 2015). At that point a rally begins that over the next six weeks sends the price through resistance and up to a new level. Note that the new level achieved is about five or six dollars above the previous resistance (from c. 49-50 to c. 54-55 in 2009, from about 54 to 60 today).

If the past is prologue, we can expect WTIC to meander in May 2015 in the sort of way it meandered from late March to late April in 2009. That is, it would probe support on the downside, sufficiently so to trigger stops, but without breaking through for more than a few hours, followed by rallies that probe resistance on the upside, but which also fail to break resistance (60) over the next month.

The next chart gives a closer look at the price action from March 20 to May 1 in 2009. From the highs to the lows is around 6 to 7 dollars.

The next chart shows the approximate range (from 60 to around 53.5) of the price action I expect over the next month. Historical precedent suggests that the oil bulls will have to wait till June 2015 for the surge above 60, and that bears will have some opportunity over the next month, but they shouldn't get too greedy. That is my (educated) guess.

One should note that there are many differences between the overall financial and energy context in early 2009 and early 2015. The oil bottom occurred about a week after the stock market low on March 6, 2009, when it was apparent that the world economy was experiencing a deep recession (thus crushing oil demand). There is nothing like that economic backdrop today, and still the oil price has recovered (from $42 to $59). On the other hand, the Saudis were attempting to support the price in early 2009, and now they are attempting to suppress it. Despite these differences in context, it is remarkable that the first three months after the initial lows of late 2008 and early 2015 have followed a similar pattern.

Just for the hell of it, two more charts that show the ratio between the Brent price of oil and Euros in 2008-09 and 2014-15. In neither instance were the initial lows (of late-December 2008 and mid- January 2015) retested.

Finally, for a broader perspective, here's West Texas Intermediate from May 1, 2008 to May 1, 2010.

April 25, 2015

More Drilling, More Earthquakes

From the Associated Press:

. . . A series of government and academic studies over the past few years — including at least two reports released this week alone — has added to the body of evidence implicating the U.S. drilling boom that has created a bounty of jobs and tax revenue over the past decade or so.

On Thursday, the U.S. Geological Survey released the first comprehensive maps pinpointing more than a dozen areas in the central and eastern U.S. that have been jolted by quakes that the researchers said were triggered by drilling. The report said man-made quakes tied to industry operations have been on the rise.

Scientists have mainly attributed the spike to the injection of wastewater deep underground, a practice they say can activate dormant faults. Only a few cases of shaking have been blamed on fracking, in which large volumes of water, sand and chemicals are pumped into rock formations to crack them open and free oil or gas.

"The picture is very clear" that wastewater injection can cause faults to move, said USGS geophysicist William Ellsworth.

Until recently, Oklahoma — one of the biggest energy-producing states — had been cautious about linking the spate of quakes to drilling. But the Oklahoma Geological Survey acknowledged earlier this week that it is "very likely" that recent seismic activity was caused by the injection of wastewater into disposal wells.

Earthquake activity in Oklahoma in 2013 was 70 times greater than it was before 2008, state geologists reported. Oklahoma historically recorded an average of 1.5 quakes of magnitude 3 or greater each year. It is now seeing an average of 2.5 such quakes each day, according to geologists.

Angela Spotts, who lives outside Stillwater, Oklahoma, in an area with a number of wastewater disposal wells, said the shaking has damaged her brick home. She pointed to the cracked interior and exterior walls, and windows and kitchen cabinets that are separating from the structure.

"There's been no doubt in my mind what's causing them," Spotts said. "Sadly, it's really taken a long time for people to come around. Our lives are being placed at risk. Our homes are being broken."

Yet another study, this one published Tuesday in the journal Nature Communications, connected a swarm of small quakes west of Fort Worth, Texas, to nearby natural gas wells and wastewater disposal.

The American Petroleum Institute said the industry is working with scientists and regulators "to better understand the issue and work toward collaborative solutions."

The Environmental Protection Agency said there no plans for new regulations as a result of the USGS study.

"We knew there would be challenges there, but they can be overcome," EPA Administrator Gina McCarthy said Thursday at an energy conference in Houston.

For decades, earthquakes were an afterthought in the central and eastern U.S., which worried more about tornadoes, floods and hurricanes. Since 2009, quakes have sharply increased, and in some surprising places.

The ground has been trembling in regions that were once seismically stable, including parts of Alabama, Arkansas, Colorado, Kansas, New Mexico, Ohio, Oklahoma and Texas.

The largest jolt linked to wastewater injection — a magnitude-5.6 that hit Prague, Oklahoma, in 2011 — damaged 200 buildings and shook a college football stadium.

The uptick in Oklahoma quakes has prompted state regulators to require a seismic review of all proposed disposal wells. The Oklahoma Corporation Commission, which regulates the oil and gas industry, has ordered dozens of disposal wells to stop operating or change the way they are run because of concerns they might be triggering earthquakes, said spokesman Matt Skinner.

"There are far more steps that will be taken," Skinner said. 

Last year, regulators in Colorado ordered an operator to temporarily stop injecting wastewater after the job was believed to be linked to several small quakes.

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Alicia Chang, Scientists Convinced of Tie Between Earthquakes and Drilling, AP, April 23, 2015. For a scientific study with neat graphics (h/t/Desdemona), see Causal Factors for Seismicity near Azle, Texas, Nature Communications, April 21, 2015:

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Update, May 17, 2015:  It's good to learn that the oil and gas industry takes this problem seriously and wants to find out more. On the industry reaction, see Benjamin Elgin, "Oil CEO Wanted University Quake Scientists Dismissed: Dean's Email," Bloomberg Business, May 15, 2015

April 23, 2015

New Global Temperature Records

The following temperature map from Bloomberg shows the hottest start to a year on record. "Results from the world's top monitoring agencies vary slightly. NOAA and the Japan Meteorological Agency both had March as the hottest month on record. NASA had it as the third-hottest. All three agencies agree that the past three months have been the hottest start to a year."

Tom Randall and Blacki Migliozzi, Global Temperature Records Just Got Crushed Again, BloombergBusiness, April 17, 2015. The piece also includes an illuminating animation recording monthly temperature measures for about 135 years. This is a screenshot of the most recent image from March 2015.

April 22, 2015

The Triumph (Crisis) of American Capitalism

This chart, put together by Andrew Smithers, shows the contrasting rewards to capital and labor over several generations. The blue line (left scale) is profits before depreciation, interest, and tax, as a percentage of output. The red line (right scale) represents employment costs as a percentage of output. After a fairly stable set of relations in the post-World War II period, reflecting the New Deal consensus, a yawning gap emerges in the 21st century. This is not your mother and father's capitalism, it would seem, but a system of political economy very different in salient respects.

The chart helps explain the relative out-performance of US equities as against world stock markets, noted in a previous post. The piece appeared in 2012, so the data is a bit old, but the disparity has probably gotten larger in the last few years. Smithers was bearish on the stock market in 2012 and, assuming mean reversion, believed shares to capital would recede and shares to labor would increase. Since publication on December 26, 2012, the U.S. stock market is up 54%.

The chart appears in an NPR report introduced by Paul Solman, consisting of an interview between Jon Shayne and Smithers, a noted student of financial history.

ANDREW SMITHERS: All output is for somebody’s benefit, either those who work for the firm (the labor share) or those who provide the capital (the profit share). Labor’s share has never been lower or the profit share higher. These shares of course add up to 100 percent, before the government has taxed both labor and capital.

JON SHAYNE: What do you think has caused labor’s share to fall below its average to a new historical low, and capital’s share to rise to the higher highest peak ever?

ANDREW SMITHERS: The change in the way company managements are remunerated has been dramatic in this century. Salaries have ceased to be the main source of income to senior management, with bonuses and options taking over. There has been major change in management incentives and it should not cause surprise, though it evidently has to most economists, that management behavior has changed. The current incentives discourage investment and encourage high profit margins.

This is dangerous for companies’ long-term prospects as it increases their risk of losing market share and reduces their ability to reduce costs. It is very damaging for the economy, but it maximizes the income of managements. Senior management positions change frequently, so if management wish to get rich, they have to get rich quickly. I am not alone in this diagnosis. A recent report from the Federal Reserve Bank of New York comes to the same conclusion from a theoretical analysis as I have come from data analysis.

JON SHAYNE: How do bonuses today encourage profitability above investment? I guess you mean that they are tied to changes in earnings per share, or return on capital, rather than to the growth of companies’ output?

ANDREW SMITHERS: Yes, the current way in which managements are rewarded is perverse from an economic viewpoint. Adam Smith pointed out that some characteristics of human beings such as greed, which are often unpleasant at a personal level, can nonetheless bring social benefits. But this is not necessarily the case under current remuneration systems; greed is increasingly the cause of harm rather than help to the economy.

JON SHAYNE: On the graph, do we know how much of labor’s share represents what managers earn? If their share has gone up over the decades, through stock options and the like, which I believe is the case, then the average worker is getting even a bit less than it looks, correct?  

ANDREW SMITHERS: Yes, there have been two major changes. First, the share of output which goes to all employees has fallen to its lowest recorded level. Second, the proportion of total remuneration that goes to the higher paid has shot up. Both of these changes have been bad from the viewpoint of the average worker. The result is that current management reward systems are producing both economic damage and social disquiet. . . .

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Paul Solman, Capital Wins, Labor Loses, But Andrew Smithers Says It Can't Go On," PBS Newshour, December 26, 2012

April 18, 2015

The Most Important Chart in Finance

The following chart shows a ratio between the SPX (the S&P 500 US stock index) and the MS World Index (an international equity index that excludes the U.S. market). It shows the dramatic disparity between the U.S. and foreign equity markets since the financial crisis and the ensuing Great Recession. As the separate price indices in the two panels below show, the world index is barely above the level it reached in 2000, whereas the S&P 500 long ago surmounted the twin peaks of 2000 and 2008. The chart supports the general conclusion that international stocks are a better bargain than domestic stocks.

The ratio turned on or about January 1, 2015, and has barely looked back since.

Apart from the overall disparity in valuations suggested by the chart, there are additional reasons for thinking the ratio line will continue trending lower. One is the collapse in oil prices, which disproportionately benefits big oil importers (Europe, Japan, China, India). Another is the turn of world central banks to quantitative easing. QE may or may not be healthy for the overall economy, but it has undoubtedly been very, very good for U.S. equity investors. The U.S. Federal Reserve purchased $3.75 trillion of debt in its various QE programs. Observers called it the "Bernanke put," meaning that the Fed had put a floor under the stock market, but it might more justly be thought of as the "Bernanke call." The effect was to send U.S. equities into the stratosphere. The end of the U.S. program and its embrace by others (especially the Bank of Japan and the European Central Bank) is another spur to relative outperformance by the world index as against U.S. equities.

The headwinds facing U.S. equities, after so steep a climb from the pits in March 2009, are also suggested by the following chart, prepared by Absolute Strategy Research, and unveiled in a recent interview conducted by John Authers of the FT with Ian Harnett of ASR. (This is a screen shot from that interview.)

The Activity Surprise Indicator gathers all the economic numbers published daily and measures them against expectations. With the exception of the labor market numbers, says Harnett, disappointments have proliferated at a rate not seen since 2011 (the time of the last big correction in the U.S. stock market). The driving force has been the collapse in the oil price (penalizing the energy sector) and the rise in the dollar (the latter impairing the earnings of U.S. based multinationals.)

Authers, "US earnings season--correction ahead?" Financial Times Video, April 13, 2015


Here's another look at the disparity between U.S. and world equity indexes. EFA is the etf for the EAFE index, which covers developed markets in Europe and Asia. EEM is the etf for the stocks of emerging nations. The first chart shows the SPY:EFA ratio, the second the SPY:EEM ratio.

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Update, 4/26/15: Underlining the disparity in valuations as between U.S. and international markets is the following statistic from Barron's: "Even when smoothing out the most recent bull market—which the Shiller CAPE (cyclically adjusted price/earnings) ratio does by averaging 10 years’ worth of earnings and adjusting for inflation—U.S. stocks seem pricey. The S&P 500’s CAPE ratio is 27, well above its median of 16. The rest of the developed world, meanwhile, averages a CAPE ratio of 17, below its median of 22.5, according to Research Affiliates." Chris Dieterich, International-Focus ETFs Beat U.S. Counterparts, Barron's, April 24, 2015. 

For a thorough examination of issues associated with global stock market valuations, see numerous entries in the excellent blog Philosophical Economics, especially this one from August 2014.

Here's another look at an index of economic surprises, this one compiled by Bloomberg (Matthew Boesler, "The U.S. Economy Hasn't Disappointed Analysts This Much Since the Great Recession," April 23, 2015, Bloomberg Business)

April 16, 2015

OPEC Revenues on Roller-Coaster

A new report from the Energy Information Administration shows net oil export revenues for OPEC over the last 45 years. The graph excludes Iran, noting difficulties in estimating Iran's earnings. Oddly, the EIA seems not to include Iranian data for the entire 45-year period; they would have done better to make an estimate for the last few years than to eliminate Iran from the whole series.

Despite this omission, the graph speaks volumes. It shows the return of the energy crisis in the last decade, outdoing even the first great go round in the 1970s. It gives a vivid picture of the explosion in energy prices from $10 a barrel in 1998 to $145 a barrel in the summer of 2008--inducing shocks that played a significant role in precipitating the Great Recession. The figure also shows how volatile the energy sector has been over the last ten years. Two spectacular rises, two spectacular falls, all in less than a decade.

OPEC oil revenues also have played a key role in shaping the US current account balance, especially in the last decade. The following graph from the Council of Economic Advisors (November 2014) shows that the current account balance had two great lurches downward in the 1980s and 1990s. Then it fell yet further the following decade, driven especially by the increasing price of oil.

After 2010, the current account balance would have headed back down were it not for the shale revolution in America, which added 4.5 million barrels per day of new production in four short years. Now, with the price of oil falling by fifty percent over the last six months, there have been corresponding improvements to the US current account. But though the effect of the price collapse on the US balance of payments has been dramatic, its effect on US oil production remains very uncertain. Most forecasts foretell a stoppage of growth, not a decline of production. We shall see.

April 14, 2015

Cities by the Sea

From the February 2015 National Geographic, a graphic showing potential costs to coastal cities from rising sea levels.

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Gideon Mendel, "Drowning World," National Geographic, February 2015, 126-27.

California in Your Future

So it used to be said. Whatever happened in California would later happen in the United States. What happened in the United States would then happen in the world. As a Coloradan, I should like to say: Say it ain't so. 

These graphics from Bloomberg gave the incredible scale of California's epic drought and heat wave. The first shows temperatures well outside the range of recent experience: 

The next chart shows a drought measure called the SPEI, which takes account of both rainfall and heat. In weather charts, as in stock charts, it's generally not good to be on the bottom right of the panel. That means you're toast. 

The drought is also conveyed in a series of moving figures from 2011 to 2015: here is a snapshot of the last in the sequence:

Explains Bloomberg:
More than 44 percent of the state is now in “exceptional drought” (crimson). It’s a distinction marked by crop and pasture losses and water shortages that fall within the top two percentiles. California has seen droughts before with less rainfall, but it's the heat that sets this one apart. Higher temperatures increase evaporation from the soil and help deplete reservoirs and groundwater. The reservoirs are already almost half empty this year, and gone is the snowpack that would normally replenish lakes and farmlands well into June.  
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Tom Randall, California's New Era of Heat Destroys All Previous Records, Bloomberg Business, April 10, 2015