Beware of Aftershocks

Jim Brown
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After the commodity flash crash last week the rumors are rampant that several macrofunds, commodity funds and even some hedge funds are in trouble. Maybe trouble is the wrong word but several are rumored to have lost between 5% and 20% for the week. Given their normal excessive leverage there could be some that lost more than that.

We may never know for sure how much the funds on the wrong side of the commodity crash lost unless some of them go belly up. Funds are notorious about keeping their trades secret and especially not disclosing when they had a really bad week. Showing weakness to your investors is not the way to entice more investments into the fund.

At one point on Thursday crude oil was down -$13. That is the largest drop on record and obviously something that traders are not used to coping with. Reuters interviewed two dozen fund managers and asked them why and who was responsible for the rout.

No clear reason surfaced as the culprit. Of the funds interviewed nobody was able to point to a specific bank or fund that was in trouble and may have been liquidating in a panic. Most simply believed the commodity markets had been overextended as a result of six months of QE2 pushing the dollar lower and the price of commodities higher.

There were numerous contributing factor including the wave of market calls in silver that required traders to close positions in other commodities in order to meet the calls. There were serious levels broken that would have triggered computer activated stop losses to liquidate positions and there was the computer generated selling programs that caught the decline and increase in volatility and launched waves of short sales to capture the drop.

Those funds interviewed said the massive amount of stop losses that were triggered was beyond comprehension. When prices for Brent were hovering in the $125 range and not moving materially higher for much of April the stops were moved progressively higher to protect profits. When the crash finally came the number of positions liquidated was staggering. As each technical level was broken it triggered more stop losses and more short selling to capture the drop.

Volume set a record high on Thursday. You would have thought with all the liquidating of positions the number of open contracts (open interest) would have declined. Instead open interest rose and that indicates a very high level of short selling. High enough to more than offset the number of contracts that were closed by the liquidation process.

Credit Suisse analysts said the high frequency and algorithmic trading accounted for about half of all the volume in the oil markets.

News that George Soros was liquidating commodity positions and Carlos Slim was short selling silver helped to fuel the decline.

As the commodities sold off the commodity indexes that are tracked by funds and commodity ETFs were also dumped. As the indexes moved lower it triggered further program selling in all the commodity baskets. Selling begets selling.

While the sell off was spectacular the build up ahead of the crash was even more spectacular. The short the dollar, long commodities trade had been the only game in town for six months. Prices finally reached blow off levels only a few weeks before that trade was scheduled to end. Funds don't wait until the last minute to change directions. With QE2 ending in late June their time was running short. Funds and individual investors had pressed their bets to the limit and the market rolled a seven.

In the game of craps when the shooter is hot the bettors can make a lot of money as roll after roll hits the numbers. With every win some bettors "press" their bets or increase their existing bet by a portion of their winnings. I have seen $25 bettors build up positions on single numbers to $200-$300 on a single hot roll. Every time those numbers hit it produces pure profit for the player because they got their original money back on the first win. Every successive win is a windfall profit and they reinvest a portion of those profits in pressing the bet.

In the silver market for sure and probably to some extent in the oil market as well, investors had pressed their bets over and over. In the market when "traders" have a winning position like silver they are so amazed by their good fortune they keep adding to the position. They may sell some off from time to time on minor dips but then they leverage up even more on the next move higher. Other positions are sold to apply the money to the winning trade. Everybody starts buying in to the "this time it is different" scenario and reason and common sense goes out the window. When the end arrives and it always does, many of those traders will give it all back and even lose money. They have been so sucked into the trade they are trading on emotion and not fundamentals or technicals. In silver the long term fundamentals are still strong and several brokers have said they still expect prices to set new highs. Time will tell.

In the oil market we have an ace in the hole. We know prices are going higher because oil supplies are shrinking and global demand is growing.

In my Option Investor commentary this weekend I listed comments from three major brokers and the common thread was tightening supply.

The major brokers were tripping all over each other to recommend buying the dip in oil. Goldman, who had been recommending selling oil just three weeks ago said oil should make new highs after the correction is over. They said prices will surpass recent highs by 2012 because of shrinking capacity and increasing demand. "It is important to emphasize that even as oil prices are pulling back from their recent highs, we expect them to return to or surpass the recent highs by next year." Also, "We continue to believe that the oil supply-demand fundamentals will tighten further over the course of this year, and likely reach critically tight levels by early next year should Libyan oil supplies remain off the market. The sell-off yesterday (May 5th) has likely removed a large portion of the risk premium that we believe has been embedded in oil prices, which could suggest further downside may be limited from here." They did not rule out a further short-term decline but suggested this was a buying opportunity.

Barclays said the current levels represented a good buying opportunity."While further downside weakness cannot be ruled out, the general trend should be higher rather than lower. Fundamentals have not changed. We have diminishing spare capacity, global demand increasing and supply side issues so the factors pushing prices higher are still there."

JP Morgan actually raised its estimates on Friday saying Brent crude will rise to $130 in the third quarter and that would restrain demand in the fall. JPM said, "While financial bushfires or perhaps a rapid resolution to the Libyan civil war could radically alter market dynamics, the balance of both risks and fundamentals still points to a supply-constrained world."

JPM said its current supply and demand projections show a supply shortfall of 600,000 bpd in Q3, even assuming OPEC increases output by 1.2 million barrels per day in the coming months. They believe that shortfall could narrow to 300,000 bpd in Q4 if Saudi can raise production to 9.5 mbpd, Angola 1.7 mbpd and Iraq 3.0 mbpd. That may be wishful thinking.

Driving season begins on Memorial Day and the hurricane season on June 1st. Those are just a couple more reasons why oil may not move lower.

We know oil is going higher. Eventually it will go much higher. We don't have to depend on the metal merchants to sell the public on why silver and gold will be the inflation hedge of the future. We know oil is THE inflation hedge because supplies are limited. Just like there were hundreds of aftershocks following the quake in Japan there will be aftershocks in the commodities market. Some funds were hurt badly. How they trade in the future and what steps they take to reallocate their capital are unknown but it could impact the market in the weeks ahead.

Remember the flash crash in May 2010 and the negative impact on market sentiment for months. We could see that same kind of negative sentiment on the commodity market in the weeks ahead although commodity traders are a different and more risk averse breed of trader than stock investors so the recovery should be quicker.

There will be future price cycles of highs and lows but I suspect it will be a long time before we see another $13 decline in one day. It won't be a long time before we see new highs.

Jim Brown

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