The market doesn’t like the Obama stimulus plan, it doesn’t like the Geithner non-plan, and it just generally doesn’t like anything. I think the problem with all these plans is they are too complicated (even the Obama housing plan, which is relatively simple) and every Tom, Dick, and Harry (or is it Dennis, Steve, and Rick?) has an opinion as to why they won’t work.

What we need is a simple plan that people can understand (bad bank) and to remove any problems (what to pay for the assets).

First of all, I want to say that way to pay for the assets is a relatively simple thing to figure out (there is no second of all, this is so painfully simple it’s annoying that it’s even discussed as an issue). Assume that on any foreclosures you get $0, go buy a Bic lighter ($0.99, and it can be used on multiple homes) and light any delinquent homes on fire. So there are now just 3 variables: income stream, default rates, and cost of capital. Cost of capital should include whatever rate of return you want, in the case of the banks something around 6% would probably provide them with a 3% net interest margin (which means their cost of borrowing is 3% and their return on the borrowed money is 6%). If it was the government you could use a lower cost of capital, since they are hypothetically not in the money making business, but 6% (they are getting 5% on TARP) is not an unreasonable assumption. For income stream, I just assumed mortgage payments based on 7% interest and a $250,000 mortgage ($1,767/mo, or if there were 1,000 similar mortgages that would be $1.8mm/mo). Default rates is where it gets tricky, but in JP Morgan’s (we can still trust their data right?) latest quarterly filing they had subprime default rates at 28% and prime default rates at 7%.

Plug those numbers into a simple Excel spreadsheet (literally 3 formulas) and you can come up with the fair value for a basket of these mortgages today. Assuming 28% default rates (and that all 28% default right away) that basket of mortgages is worth 79 cents on the dollar. If we assume things get a lot worse, and we jack the default rate up to 50% then the pool is worth 55 cents on the dollar. Keep in mind this is assuming zero recoveries from foreclosure (which may or may not be reasonable, but it is as conservative as possible) and that all defaulters default right away (again may or may not be reasonable, but it is the most conservative way to run the numbers). What about prime mortgages? At 7% default rates those mortgages actually have a value of $1.02 per dollar of principal (this is because the interest rate is 7% but the cost of capital is only 6%). At a more aggressive 10% default rate, the mortgages are worth $0.99 on the dollar.

What this means for any individual bank, I don’t know. What I do know is it took me less than 15 minutes to figure out (obviously this is very general) how to calculate a ‘fair’ price to pay for these assets. I’m sick to death of hearing how these things are impossible to price and how we are staring into a black hole of losses for the banks. If held to maturity (which incidentally is what the guarantees for Citigroup and Bank of America are designed to let them do) these assets could reasonably be worth $0.55 on the dollar (for subprime) and $0.99 (for prime). Timothy Geithner should put out an all or none order (meaning all banks participate, which will reduce the risk that individual baskets may have) for all subprime mortgage backed securities at $0.55 on the dollar (or whatever figure he deems appropriate). Problem solved.

Incidentally, the above math is exactly why the banks do not want to sell their exposures. They don’t mind writing them down to zero (or near zero, at least on subprime) but selling them would actually crystallize a loss that they probably don’t expect to have happen. As the loans run off (especially now that refinancing will be less of an issue with the housing stimulus plan) the bank may actually book gains relative to marks (depending on how aggressive those marks were). So we end up stuck in no man’s land… no one is willing to buy them (the cost of capital, including return, for people buying this would be closer to 15-20%) at the price the banks know they are worth.

If the private/public partnership were to take place it’s likely that cost of capital for buyers could be dramatically reduced (the government provides financing at say 3% for 90% of the value, then the blended cost of capital would be closer to 5-7%), but I’m not sure why that’s better for taxpayers. There is a nice 10% cushion on downside, but the taxpayer would be giving up the vast majority of any upside (unless you count the low interest rate).

One of the questions that I have been asked a lot lately is; why is oil so cheap today, when only a few months ago it was ridiculously expensive?  Part of the answer has been provided in the question, it was ridiculously expensive, and despite what every ‘analyst’ on CNBC said; there was no fundamental reason for oil to be $147/bbl.  The fundamentals probably stopped making any kind of sense around $75-$85/bbl, so the question is really why is oil 50% off that price?

What really needs to be understood is that the ‘price discovery’ mechanism for WTI (West Texas Intermediate) crude is NYMEX.  One NYMEX WTI Crude contract is 1,000 barrels of oil, delivered in a specific month to Cushing Oklahoma.  I am not a futures trader, so I may have messed this up, but I think the initial margin for one of these contracts is $9,113 (assuming you aren’t a member, if you are a member it is $6,750).  That means with $38,000 of exposure (at today’s prices) the average member can use about 5.6x leverage with futures contracts. 

The reason why WTI keeps dropping in price is because inventories keep increasing.  When inventories increase traders take it as a sign that demand is low and there is plenty of willing supply at these prices, therefore the price of oil should go down until inventories stop building (i.e. demand equals supply).  The truth of the situation is easy to understand (but doesn’t fit in a headline as nicely); contango (when you can sell a commodity at a higher price in the future) forces crude into storage.  Why sell your crude today for $37 (or in February for $38.79) when you could sell it in March for $45?  Obviously you wouldn’t, you would just pay for storage and sell it in March.  So long as there is an extra wide contango in crude, we will see inventories build, which leads traders to sell crude (which leaves us in a never ending downward spiral).

The contracts for February delivery have 151 million barrels of open interest, and 333 million barrels of February oil traded (closing price $38.79) yesterday.  The March contract has 276 million barrels of open interest, and 235 million barrels of March oil traded (closing price $45.01) yesterday.  That’s trading for 1 day, keep in mind that we only use (across the whole planet) 85 million barrels per day.  So the market trades (when you add in the other months) about 8 barrels of WTI for every barrel of oil (not all oil is WTI) that actually gets used.  I’m skeptical that a 6 million barrel inventory build in a week (about 4.2% of US weekly demand, and about 0.1% of WTI trade volume) has any actual bearing on what the true demand/supply fundamentals of the oil market are. 

We’ve already established that contango puts crude in storage, but not why it keeps falling.  There is definitely an excess amount of supply of crude; none of this would be an issue if supplies were as low as the spring (when China was stockpiling for the Olympics).  The real issue is why contango is so wide in the first place.  When you are in the middle of the worst credit crisis in history it may not be a problem to have an open contract (where you only need 1/5th of the notional value of the trade), but it is a serious problem to accept physical delivery (where you need to pay 100% of the notional value of the trade).  So traders are speculating that the price of crude will go up in the future, but every time a contract becomes the front month (February now) the price drops like a stone because the risk of taking physical delivery increases.  The select few that have financing and the ability to store crude, will take delivery (at this new discounted price) and sell a future contract for a guaranteed profit.  It also allows producers who have a higher marginal cost (like $50/bbl) to continue producing, since they can sell their production forward (say to September) at higher prices ($56.05).

What all that means is there are a few things to look for that will set the stage of a crude recovery:

1. Thawing of the credit markets (which is already well under way).  If people could get financing for the carry trade on crude that would drive front month prices up and later month prices down (removing some marginal supply). 
2. Increased demand.  This is obvious, more demand could reduce some of the excess inventory.
3. Decreased supply.  We are already starting to see a decrease in supply from OPEC nations.

Any of those three things could spark a recovery in crude.  It’s worth noting that two of them are already well underway (although we won’t see the results until it’s probably too late).  So why is crude so cheap?

 There has been a lot of talk lately about the velocity of money, and how it has slowed down dramatically leading to most of our current problems (the subprime crisis caused the decrease in velocity, the decrease in velocity caused the economic crisis).  The velocity of information, meanwhile, has been constantly increasing. 

CNBC is only too happy to tell us, between commercials for the Snuggie and sterile catheters, that they are getting a record high number of viewers every month (ditto for sites like finance.yahoo.com and finance.google.com).  The economic collapse is forcing more people to look for answers, which in turn is forcing reporters and analysts to manufacture them. 

The truth of the matter is there is one very simple reason why the stock market goes up or down on any particular day: supply and demand.  Sometimes buyers are more aggressive, sometimes sellers are more aggressive.  Is knowing that the jobs number is crappy really a reason to buy or sell the market?  We already knew the jobs numbers were going to be bad.  Is a build in oil inventories really so shocking that oil is worth 10% less?  We can already see oil is in huge contango (meaning you are being paid an above average return to store oil), so it’s only natural that inventories are going to keep increasing.  As long as it makes more sense to sell tomorrow than today, people will do that.  If oil inventories decrease while there is a huge contango then that would actually be something newsworthy. 

Six million barrels of oil (when 85 million barrels are used per day, and hundreds of millions trade per day) affected the price of oil by 10%.  Over the longer term those 6 million barrels won’t matter, it will be the true supply/demand fundamentals.  In the short term the “tail can wag the dog”.  The most important thing that you need to do (which I’ve been trying to emphasize in my previous posts about the S&P 500 and earnings yields) is to filter out all the day to day noise and look out toward the future.  The charts that I included a few days ago show that stocks are cheap relative to Treasuries.  The chart below (from ”The Big Picture”, who got it from FusionIQ) shows that investment in equities is at 20 year lows, which could be taken as a sign that most of the people who want out are out. 

I don’t know what headline will come out today or tomorrow or next week that will spark a short term frenzy of buying or selling.  What I do know is that there was no one headline that caused the market to turn over in 2000 or 2007, and no one headline that caused the market recovery in 2003.  There was just a combination of things that made the current prices in the market unsustainable.  We are at that point again in 2009.  The market is unsustainably cheap.  Could it get cheaper? Sure, in the short term, but remember; the tail can’t wag the dog forever.

Yesterday we talked about why I thought the market was cheap, although I’m not sure I did a good enough job explaining the situation.  The price you are (or should be) willing to pay for an asset should be based on two things: risk and cost of capital.  If you could make a risk free investment and have it return greater than your cost of capital, then you should make that trade (and repeat until you are a trillionaire). 

Yesterday we covered risk, which in the case of equities boils down to two things: market risk (i.e. everyone getting fearful and selling, which you have no control over) and earnings risk.  The earnings chart showed that earnings for the S&P 500 actually aren’t all that risky, they have steadily grown at a rate of about 5.85% since 1950 even after you factor in this year’s huge fall in earnings.  The market risk is uncontrollable, it could contribute to above normal returns (when everyone gets happy, see the tech bubble and this last bubble for an example) or below normal returns (see 2008).  So, in the realm of things you can control or understand, you are left with earnings and cost of capital.  The below chart shows the 10 year trailing average earnings yield (earnings divided by price) of the S&P 500 from 1962 to present (the last 2 quarters of earnings I guesstimated to be $45 and $40 on a TTM basis).

The textbooks say that you should adjust Treasury yields downward for inflation, because the principal on the bond doesn’t increase in value with inflation.  I haven’t bothered to do that on the chart above, since it just confuses matters.  What the chart shows is that there is a definite correlation between 10 year Treasury yields and the trailing 10 year earnings yield on the S&P 500, over the long term.  Meaning, when Treasury yields decrease, we also tend to see earnings yields decrease (or P/E multiples increase).  So all else equal  in an environment with 2.5% 10 year yields, we might expect to see 2% earnings yields (that’d be 50x trailing 10 year earnings or $52.15 x 50 = 2,607 on the S&P).  As I’ve said before, this is a unique circumstance, so I wouldn’t expect to see 2,607 on the S&P anytime soon.  What is much more likely to happen is the S&P 500 earnings yield begins to decrease while the 10 year Treasury yield starts to increase.  You will probably get some convergence over the next year or two, probably around 4%, which will leave the S&P 500 around 1,300.

The next chart is more for fun, since it’s hard to know what it means exactly.  The fundamental theory behind investing in stocks is that you have ownership on a stream of future earnings.  The idea behind owning bonds is that you get paid interest.  If we ignore one component of stock returns (capital) and pretend that by owning the S&P 500 you got paid all earnings (i.e. we made it more like a bond) for the next 10 years, and we compared them to the compounded return of 10 year Treasuries… what would it look like?  I thought that stocks would have a much better cumulative “return” than bonds based solely on their earnings “payouts” (which obviously don’t occur, since most companies don’t have 100% dividend payout ratios). 

The past few days have been rather uneventful, at least as far as the market is concerned.  In fact the only thing that I have taken issue with over the past few days is the constant talk about 2009 earnings and what that means for the S&P 500.  The theory goes something like 2009 earnings (and maybe 2010) earnings will be weak and therefore the S&P 500 won’t recover. 

It seems pretty straightforward, if the S&P 500 has earnings of $40 and you use a 15x P/E multiple then the S&P 500 will end up around 600.  The question is does it really make sense to invest on next year’s earnings?

The market isn’t always rational, so it may make sense to invest with only a view toward next year’s earnings.  If you have a longer term view, however, then now is probably the best risk/reward you’ve gotten from the market in about 20 years.  The below charts show the S&P 500 earnings since 1950, their 10 year moving average, and the S&P 500′s Price to 10 year average earnings. 

As you can see the S&P 500 has grown earnings by about 5.85% per year over the past 40 or so years, even when you consider the huge decline seen this year.  You can also see that the price to 10 year earnings is back to levels not seen since the end of the 80s.  This is during a time when interest rates are zero.  So effectively, by buying the S&P 500 today you are getting it while earnings and multiples are, historically speaking, low.  Of course that doesn’t mean that the market won’t be even cheaper tomorrow, it’s just pretty cheap now.

Yesterday we talked about why it’s important to own “things” (i.e. commodities, stocks, homes) for the long run, especially since the government is willing to dramatically increase the supply of money (making existing money worth less, and assets worth more).  Basically the government is potentially going to create a lot of inflation at some point down the line.  So the question that is always asked is, if we are heading into an inflationary environment shouldn’t we buy gold? 

There are two reasons people buy gold, as an investment or for jewellery (there is a small percentage used for industrial applications as well, but for our purposes let’s ignore that).  I have to imagine that jewellery sales are declining, or at least gold jewellery sales, as silver is currently a more attractive (it’s in style and 1/80th the price) option.  So anyone investing in gold today is making a bet that either a) the economies of the world get materially better (and jewellery demand picks up as people start spending more on luxuries) or b) because there are inflation concerns (money will be worth less, therefore gold is worth more).  If you’re investing in gold because you think the economy will get better and jewellery demand will increase (even at gold’s current high price, relative to everything else) then, simply put, you’re crazy.  If the economy recovers (and with it jewellery demand), and that is the bet you are willing to take, then there are thousands of better investments than gold.

Since I don’t really think anyone is that crazy, then the only rational reason people are investing in gold today is the safe haven trade.  That is, gold is viewed as a safe haven against inflation.  I’m going to lump the collapse of capitalism into “inflation”, meaning the extreme gold bugs who see the US dollar becoming effectively worthless (not worth less) and the world ending, are effectively making an inflation trade.  An extreme one, but an inflation trade none the less.  As an aside, why do gold bugs put US dollar price targets on gold?  The ones that think the US dollar is going to collapse and gold will go to $5,000/oz are effectively saying that they would trade their gold for US dollars at some price.  If the US dollar is worthless, its worthless, why trade your gold for something that is worthless?

Ignoring the extreme case, the argument, going forward, is effectively that the Fed has created such an enormous supply of US dollars that when people get around to spending them the inflation will be massive.  So if you want to protect against inflation you buy gold, since it is perceived to have significant value and that value relative to dollars will be more significant in the future.  Of course that logic is somewhat circular.  Imagine we lived in Perfect and there were 1,000 citizens each with $1,000 dollars.  The price of gold is $850/oz in Perfect and the price of a basket of other goods is $850 and their main index trades at 850.  The government of Perfect decides that the citizens need more cash so they give everyone $1,000 more.  In Perfect the price of gold would go up to $1,700/oz, the basket to $1,700, and the index to 1,700.  You can still only change 1 ounce of gold for 1 basket of goods or 1 unit of the index.  You are only better off having purchased gold as an investment if your alternative was only to leave it in cash.  That is, if you are faced with the choice of money in the bank or investing in gold, then the choice is clear in an inflationary environment… invest in gold.  In Perfect the price of gold would increase at the rate of inflation.

The last year, however, has taught us that we do not live in Perfect.  We live in Far From Perfect, the land where perception is reality.  The perception, as it relates to gold, is that we are entering an inflationary period that is going to send the price of gold skyrocketing.  So the price of gold has held in relatively well (compared to any other ‘asset’ class) and that is the current reality.  The true reality is that inflation CANNOT exist without increased economic activity. That is, you can increase the money supply all you want, but if people don’t spend it then there won’t be inflation.  Inflation occurs when people get into bidding wars for goods and services.  If we have increased economic activity then, as I said before, there are thousands of better investments than gold.

I’m not saying gold won’t increase in price in 2009.  I’m just saying everything else will probably increase more.

From the team at Magna Partners, we wish you a happy, healthy, and prosperous New Year!

It’s December 30th, second last trading day of a pretty bad year.  In all likelihood the next two days will see the stock market go higher as portfolio managers window dress their portfolio ahead of year/month end.  You should take advantage of this phenomenon and take a good long hard look at your portfolio and decide what is worth keeping and what isn’t. 

After year end the market is probably going to continue sideways for a little bit, heading slowly higher as people start getting excited about January 20th and Obama’s big stimulus plan.  That’s the short term picture and that’s just my guess.  I’ll probably be right, but I wouldn’t say my odds are any better than 60/40.

The long term is where I can add some real value, because the long term is so simple.  To understand what is going to happen in the long term you first need to understand money, which thankfully is also very simple (although there are a lot of misconceptions out there).  Money is a medium by which we barter things.  The typical way it works is we exchange our time and knowledge for a salary, then we deposit that salary in the bank, and then we spend it as we see fit through the various methods the banks provide for us (credit cards, debit cards, cash, cheques, etc).  The price of goods (or investments or services) is determined by the demand (and supply) of that particular good, and the demand and supply of money.  For the most part there is a ready supply of any good provided someone can make a profit selling it at that price and there seems to be a never ending demand for dollars (and to a lesser extent goods and services).  Where the situation is somewhat more complicated is the supply of dollars. 

For something so important, the amount of regulation in the supply of dollars is somewhat lacking.  Fractional reserve banking (the system the entire world uses) allows banks to take the money you deposit with them and lend out some of it.  So if you put $100 in the bank, they could lend out $90 to another customer, who would use it to pay another customer, who then deposits the $90.  They could then lend $81 (of the new $90 deposit) to another customer, the end result is your $100 deposit ends up as $1,000 in the economy… provided the bank is keeping 10% in reserves.  The fundamental thesis is that there will never be a situation where all your customers will ask for their deposits at the same time, there probably wouldn’t even be a situation where 20% of your customers asked for their money at the same time.  As an aside, this is why NO BANK, in the entire world, can survive a ‘run on the bank’.  They simply do not have enough cash on hand to pay back all their depositors at the same time.  The problem for the past few years has been an excess supply of dollars as a result of banks lending a lot (perhaps to people they shouldn’t have been lending to).  When the supply of dollars is high, it reduces the value of dollars, pushing prices up.

As a result of some unfortunate events, which I won’t rehash, the banks have tightened their lending standards up again.  This has resulted in a large decrease in the supply of dollars, thereby increasing the value of the dollar, pushing prices down.  In my opinion, if you think about the markets (housing, equities, commodities, and goods – in that order of effect) in those terms (less dollars, therefore lower prices) the magnitude of the decline becomes easier to understand.  Hank Paulson and Ben Bernanke are right, it would have been a heck of a lot worse if they didn’t do the TARP and inject capital into the banks.  Without that capital the supply of dollars would have shrunk even more drastically (a multiple of the $350 billion put in).

That brings us back to the long term picture.  The supply of dollars shrunk (as banks shrunk their leverage ratios) and deflation became a big concern.  Ben Bernanke, Hank Paulson, and anyone in government (current or future) seems to be dead set on that not happening.  As a result they will be showering the market and the economy in money in 2009 and they have promised to keep doing it until deflation is no longer a concern.  The problem is they have shown that they almost always hit the gas too hard (lowering rates, etc) and hit the brakes too hard (raising rates).  They are pushing the pedal to the metal in 2009, so we may see significant overshoot in dollar supply.  The banks will also lend more once prices start going up (it’s stupid I know) which will also increase the money supply.  So what does that mean? Own things.  The government is going to do whatever it can to increase the supply of dollars (raising prices) in an effort to avoid deflation and to inflate away some debt.  That means that T-Bills (especially with negative yields) are going to be bad investments, while virtually anything else (oil, gold, stock, homes*, etc) should generate positive returns.  So wait until next week (when the window dressing, and subsequent undressing, is over) and look at areas you are most comfortable with in the long term and put that money to work before they devalue it.

*Please do not rush out and buy a house.  While prices are low, houses are not necessarily good investments.  They take a lot of money to maintain and property taxes, etc will probably wipe out any short term gains.  A house should be purchased with an eye to the very long term.

A few days ago we talked about Constellation Energy and the EDF deal.  I made a bunch of points about how I value the company, based mostly on assumptions I had made surrounding the EDF offer.  What I missed was EDF’s analysis of what CEG was worth.  I have included it below in this table:

So that’s why EDF assumes their deal is worth $52/share to common shareholders.  Of course cash is king, so right now CEG is trading for less than half of that.  Importantly the market probably disagrees on a bunch of things like BG&E’s value, Global Commodities, Unistar, and the Non-Nuclear generating assets… or seemingly everything.  Though the main problem is in the valuation of the non-nuclear generating assets.  What I, and seemingly everyone else, has missed is the prescribed value put on CEG’s non-nuclear generating assets in the EDF bid.  That table is below:

I’ve added some of my own information (MW, and the totals).  There seems to be some discrepancy between the CEG website and EDF’s data, which is relatively minor, except in the case of Sunnyside Cogeneration.  That’s not really material though to the overall point, which is that EDF will not be buying ALL of the plants listed for $2 billion, merely some of them.  Importantly they are willing to pay the prices listed above for those particular assets.  So CEG could elect to sell Brandon Shores, for example, and receive $1.658 billion for it.  This puts a definitive market price on all of these assets, lending credence to EDF’s theory that the valuation is materially higher than the market is currently indicating.

The one thing that kind of bothers me about the whole deal is why it is structured this way.  It seems there is significant tax leakage (which the company says they are working to minimize) inside the company, which is effectively lost money to shareholders.  If the deal had instead been structured as a tender offer, where EDF put something out there to buy 50% of CEG (minus the 8.7% they already own) it would seem like both parties would be better off.  EDF would receive half of everything nuclear, BG&E, non-nuclear) and could have paid something like $45/share (about 84 million times, for a total of $3.78 billion).  Any extra funds that they set aside for this transaction (the $2 billion put, the $700 million they would save at $45/share) could have gone towards CEG’s liquidity (in the form of a credit line).  This would have meant no asset sales, and therefore no tax effects inside the company, and all tax effects would then be pushed to the shareholders that sell at $45/share.  That would seemingly have been better for both EDF and CEG shareholders (remember cash is king), the only real concern for EDF would be if no one tendered at $45/share.  This particular deal (where EDF buys half of just the nuclear assets) ensures that EDF gets the assets they want, even if they are paying a higher price for it than they otherwise could have.

I have a long position in CEG, so I may be biased, but I do find it funny the way the market works.  CEG, and their story, is like a microcosm for the whole market.  Credit concerns lead to bankruptcy concerns, someone comes in and sees the value of the company (Mid American), a second bid comes in (EDF), there is some initial euphoria around the second bid ($30ish share price), and finally investors don’t want to risk any money so they sell when a cash offer is off the table.  Sounds a lot like any financial company that was taken out in the past few months (minus the second bidder thing, that was only Wachovia).  Where the market always seems to fall apart is if there is any work to be done to value the company.  It wasn’t a terrible amount of work for me to put this together, in fact almost all of the work was already done for me.  While it doesn’t necessarily lead me to the conclusion that CEG is worth $52/share, it does make me believe that it’s worth at least $30/share with the potential for some upside.  It doesn’t really matter what market we are in, people don’t do much in the way of homework.  But in a bull market the exuberance over having two bidders would have led to a $52+ share price.  In this bear market we end up at half that.

Friday we did a morning commentary about the expiring WTI January contract (for oil) and the huge price discrepancy between it and the January Brent contract and the February WTI contract.  The reason for this discrepancy, we assume, is that someone got caught long oil and was unable to take physical delivery of it due to lack of storage. 

So the January contract traded under $33/bbl while the February contract stayed above $42.  Quite an arbitrage spread if you had the storage capacity and it certainly doesn’t speak to the health of the current oil market.  Yet we remain bullish.

There are a couple of facts about oil, in 2008 demand was about 85 million barrels per day and supply was around 85 million barrels per day.  Obviously when oil prices were extremely high, we saw all kinds of new supply coming on.  I read a story about some dentists and doctors in Saskatchewan that set up their own oil rig in the summer. Even still, the supply of oil from 2004 ($37.66/bbl average price) to 2008 ($97.98/bbl average price) only increased from an estimated 83.1 million barrels per day to a peak of 85.69 million barrels per day (those are EIA estimates).  During the same time period demand increased from 82.41 million barrels per day to a peak of 86.94 million barrels per day (currently they estimate we are at 85.27 million barrels per day).  OPEC made up about 30-32 million barrels per day of supply during that time period.  They have some of the cheapest production in the world, but are planning to cut to 25 million barrels per day.  Assuming they can only get to 27.5mm (due to cartel cheating) then world supply goes from 85.69 barrels per day (Q3 estimate) to something in the neighbourhood of 81.19mm bbls/day to 83.19mm bbls/day.  That of course assumes that all the increased supply of the past 4 years does not disappear due to lower prices.

World estimates for 2009 oil demand usage are falling, but most estimates are still in the 85mm bbls/day range.  That means, once OPEC cuts are in place (even though we know they are going to cheat), there will be a daily shortfall of approximately 2 to 3mm bbls/day in supply.  I have seen estimates put the amount of crude at sea (as floating storage) at between 50mm and 100mm barrels.  Meaning, within 50 days of the supply cut (and once again, bear in mind that these numbers completely overlook any shuttered non-OPEC production) all of the floating storage will be used up.  I honestly don’t know how the market will react to that news, since as I’ve said before I don’t have a degree in psychology, but I would have to imagine that what is currently holding the crude market down is the excess inventory.  If that is removed I have to imagine the crude prices goes higher, albeit not back to $100/bbl as there would be plenty of shuttered production to come back online to demand. 

While I cannot be 100% sure that we are at the true bottom of the crude oil market, it is important to note that the January delivery crude contract (the one currently quoted on CNBC and BNN) is expiring today. Do you remember a couple of months ago when oil went from $102 to $130 in one day? That was also expiry day, what happened there was someone was caught short and couldn’t find the physical supply of crude (or didn’t want to) to deliver.

As a result they were forced to pay up substantially to get out of the contracts. The next day, when contracts flipped over to the next month, crude was quoted (by CNBC/BNN/etc) at $108 (importantly they did not say down $22). What is happening with the January contract is the exact opposite. There is someone caught long, and as we all know, there is no storage available for crude. The only option for this investor is to sell down his position until someone will let him out of his position. Here are the facts that support this hypothesis:

·         January WTI is trading at $34.80 per barrel, versus $41.93 for February WTI. This is a ridiculously large contango on an absolute and percentage basis.

·         Brent Crude, which is slightly lower quality than WTI crude, is trading at about a $10 premium to WTI crude.

·         This is one of the widest differentials in history (albeit we are measuring Jan WTI vs Feb Brent). Paying 33% more for inferior crude makes no sense, especially when you consider that a large amount of crude is being stored at sea. Why not just direct those ships to drive over to Europe to sell WTI at Brent prices?

On Monday CNBC and BNN will be quoting $41-$43 crude, and WILL NOT say that it is up $9. There may be no way to trade this (the HOU and other ETFs is likely already exposed only to forward months), but knowing the “true” price of crude may prevent some panic sales.