Wednesday, January 14, 2009

Crude Contango versus Expected Fed Funds

The above sketches the market expectations for Fed Funds out to March 11 compared to the contango for oil.

Not to dive in about my usual spiel on how crude oil is a bubble that is in end game post crash, but even if I accept the "peak oil" fellows, it makes sense that before "peak oil" can kick in we have to return to a "normal" growth or eliminate the output gap in GDP.

Logic then is clear - Fed Funds reflect over time nominal GDP. Even 2 years forward Fed Funds show a nominal GDP expectations of about 2%, about 1 1/2% below GDP potential assuming a 1% to 2% inflation.

If the "peak oil" requires a return to trend growth, it is interesting to compare the contango so as to "calibrate" to the expected Fed Funds. This doesn't seem to work out. Though both schedules are sloped in the right manner, if the steepness of the oil contango is justified it has to match reasonable nominal GDP expectations repair, with a large part of the output gap eliminated and a return to "potential" trend nominal GDP. Even a quick view shows that compared to Fed Funds, oil contango should be much flatter. Further more, there are signs in long term markets - primarily the forward interest rate swaps and the the long dated interest rate swaps - that return to trend growth will be much slower than these Fed Funds expectations indicate, and the chance of Japanese long term stagnation is real.

Even if the "peak oil" argument holds it looks like the pricing of the oil contango has to adjust to both a longer time getting back to trend nominal GDP growth and that the trend nominal GDP growth or potential is now shifted down from 5% to 3%. If "peak oil" argument still holds it means the front crude price may not have completed the necessary adjustment and we could see a 20 handle and the contango must also flatten. All this and yet still maintain the "peak oil" thesis validity.

But an adverse technical situation may exist where some who reloaded trading positions for 2009, and with remaining legacy positions, which plan to take advantage of the contango by "rolling down" the term structure of oil, may have to be unwound in swift order if current pricing spot and forward do not match reasonable nominal GDP expectations. In that case not only does front oil drop more, but the contango might actually go to "backwardation", at odds with the Fed Funds term structure and cause even further pressure on the front oil.

Now if we enter a Japanese like "lost decade", even with "peak oil", much in oil pricing adjustment would occur. And if there is no such thing as "peak oil" just some theory chasing a market a la Malthus - then we have yet to see the completion of the oil crash and we will see sub $20 oil and even worse, a backwardation of oil. If the last 6 months didnt clip a hedge fund - this scenario likely would.

The following shows a regression of the one year oil contango versus the 10 year interest rate swap 10 years forward (a good quick way ot see what market expectations are for nominal GDP for the long run):

1/17/07 to 1/14/09

I think "peak oil" is hog wash - by the way.

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