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- “I’d gladly pay you Tuesday to take this barrel of oil today”
- Oil contracts drop to zero, then to negative -$44.00
- Fragility in all debt ridden assets open to such catastrophic events
Tactical Short 1st Quarter 2020 Recap
Managing Short Exposure in an Unprecedented Environment – CLICK HERE TO SIGN UP
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Oil Goes Negative For The First Time In History
April 22, 2020
“Has this risk ever been modeled? It’s not a one in a hundred year event, it’s a first time ever in recorded history event. There is an underlying fragility in the financial system that leaves open anomalous and potentially catastrophic financial market developments. This is what we see happening this week in the oil markets. It is a reveal – a reveal of how fragile the markets are, and how weird things get when you are working on such high leverage.”
Kevin: Dave, Monday I texted you something that referenced Popeye. There was a character in Popeye that would say, “I’ll gladly pay you Tuesday for a hamburger today.” But the text that I sent you, because we saw something historic. I had never seen this. I don’t know if anybody ever has. But I said, “I’ll gladly pay you Tuesday to take this barrel of oil from me today.” Oil went negative on Monday.
David: (laughs) No, it really is amazing, and that is exactly what we went to talk about with Neil Cavuto. We were invited, and the Fox production crew likes me, particularly seems to comment on oil.
Kevin: What a day to be asked. You were already asked before that happened, to talk about oil.
David: Yes, so what a day to be on. We were on just before Mark Cuban, and we were discussing the contract swing from positive territory to, really, once in a lifetime, negative $40.32 on the May WTI West Texas intermediate contract.
Kevin: How does that even happen? I’d like you to unpack that as we talk today.
David: Yes, it’s down 321% for the day, and you just had to kind of pause and let those number ssink in – down 321%. Actually, you had the Friday close of $18.27, the Monday low of $40 below. That’s chilling.
Kevin: When something goes negative, it’s hard to understand that an investment can not only not pay you, but you actually have to pay to own that investment. I want to mention something before we on, though, Dave, because coming up this Thursday, Doug Noland, who is a master of understanding these markets, is going to be doing the Tactical Short call, and all are invited to listen. That is Thursday, April 23, at 4:00 Eastern time, and we really would like to invite the listeners to tune into that. How do they find that call?
David: Register in advance at mwealthm.com, that is, McAlvany Wealth Management dot-com, and there is a link in the show notes, as well.
Kevin: I want to mention something because you have talked about the zero bound on interest rates, and bankers and the IMF, as of last April, are trying to get us to think that zero is really not a bound, that zero if just another number. And what we saw with oil contracts on Monday, I guess they were right.
David: That’s right. So deeply negative is an area where we are now exploring and expanding our understanding in terms of interest rates. And as I told several of my co-workers earlier this week, zero is a level that you generally assume is as low as it goes, and imagination is what is necessary for the negative territory. And so, how much money can you lose owning an asset? Generally you think, “I can lose all the money I invested.” And of course, that’s different if you are leveraged. You can lose far more if you are in a leveraged position where the number can go higher. But zero is generally viewed as the bottom. And now, after this week, I think everyone has a little more imagination.
Kevin: The thing that you and I have even talked about is, it is really hard. You talk about imagination. How in the world do you imagine negative rates? That’s just a fancy word, I think, for people taking your money away from you. But what does that mean when you have negative oil? When you’re sitting there with a commodity that – I drove to the office today. With driving to the office to do this recording, I used oil. I didn’t have to have someone pay me to drive here. In a weird say, isn’t that what we’re talking about with these contracts?
David: Yes, absolutely. Driving to the office today, the other thing that really stood out to me is, the only people who are out and about are those working on construction crews. I looked around and I was in a sea of Ford and Dodge and Chevy pickups. It was like, “Hmm, why haven’t I noticed this before?” And it’s because, really, it is the only people who are out and about.
Kevin: I have been working remote for the last five weeks, Dave. Let’s face it, this is the first time I’m in the studio. We’ve been doing it remote.
David: It’s great to have you back. We’ll, yes, after witnessing the phenomenon of negative rates, we should not be surprised to break into this unbelievable, unreal territory. Just because you haven’t seen something before, it doesn’t mean that it can’t happen. In the case of interest rates we are talking about a 5,000-year phenomenon in nominal terms. The oil markets are not as old as the interest rate markets, but with an understanding of the dynamics in play with a physical commodity contract, and apply to that a little imagination, I think you can get there.
Kevin: Dave, I think it takes a lot more than a little imagination. I’m not trying to correct you, but I was sitting in a meeting a week-and-a-half ago, it was a remote meeting, with Lila Murphy, one of the managers of the McAlvany Wealth Management platform. And Lila said, “We’re going to see oil contracts go negative.” I remember, it was like, “What’s she talking about?” I didn’t ask her the question but I thought – go negative?
David: Yes, that’s worthy of note. She is constantly looking at natural resources as an analyst and major contributor for the hard asset portfolios that we run. And you’re right. It was a couple of weeks back she was talking about negative rates, and she was there with all of her precious metals advisors getting the briefing – oil is going to trade negative. And I think what that is a reminder of, if you go back to Greek literature, you can ignore Cassandra, but you do so at your peril. It certainly has broader, more specific application than Greek literature. But you can ignore Cassandra, at your peril. And I love that Lila is always adding substance to the team.
Kevin: You’re going to have to help me with the Cassandra part. You have a higher education than I do, so Cassandra, explain a little bit.
David: Always for telling something bad that was going to happen, and it always happened. But there was always this encounter of disbelief when she was saying this, this and this is going to happen.
Kevin: Sometimes you can be painted as a negative person when you do that, but oftentimes it gives another person preparation.
David: Yes, there is a tragedy in reality, and again, this is not just literature. I kind of want to keep a sensitivity to this, but you have oil services which in the last downturn in oil saw an increase of about 30%, if you’re talking about unemployment, they lost about a third in the oil service sector. That was the 2015-2016 crunch.
Kevin: And then the banks came in.
David: Yes, so I think you’re talking about 50% or more is more likely, and these are some of the hardest working Americans you will find. And I feel for them. So as we see this unfold, you may blame the Russians, you may blame the Saudis, you may blame the politicians.
Kevin: What about blaming the bankers, Dave?
David: To a degree, I think all of the ire you can muster, if it were to those other categories, would be misplaced if you didn’t connect an expansion of supply within the oil space to the easy credit which was pushed into the system by the global central banks post 2008-2009, and accelerated since then. So no one in their right mind drills uneconomical projects, particularly when the cost of capital is high. That is one of those reminders that there is a severe nature within the financial markets. But you lower the cost of capital, and now you’re accommodating the marginal project. And that is where the greatest pain is now felt. You have the independent ENPs and the service companies sitting on debt that in a low commodity price environment is no longer serviceable.
Kevin: Something you have said over and over, and I remember we were sitting and having our Talisker. You actually were having a cigar when we were talking last night. And what you brought up was, someone always pays. I think we forget that in this society. I think we think we can just borrow and do these different things and leverage up and build bubbles. Somebody always pays, and in this particular case, people who owned barrels of oil didn’t own barrels of oil, they owed on barrels of oil.
David: Right. I think, too, before we move past politicians getting off Scot free, Congress has had the opportunity, and really has done nothing, to bring meaningful reforms to the derivatives market. Because when we think about the oil markets, what is most unhealthy, other than the credit-driven growth, is the way in which speculators engage that market through derivative products and derivative positions. You have no caps to position limits, no position limits and no caps. No limits to leverage. You have problems in the making. And yet, then there is this power law, which in the derivatives market takes a small momentum problem, and because of leverage involved, the small problem can create a blow-up, not just of the oil markets, but of the whole financial system.
Kevin: So for the person who doesn’t deal in contracts on a regular basis, explain what this contract market is.
David: Here is the dynamic, and this is how we have an appreciation for what was going on earlier this week. We are talking about a contract to deliver the physical asset, and that entails, first, an obligation – second, an asset – and third, a price structure. Ordinarily, the obligation for West Texas Intermediate is to deliver a barrel of oil at a particular time, in a particular place. That is Cushing, Oklahoma. That is where the West Texas intermediate contract is delivered. So ordinarily, oil is produced, sold, delivered. Sometimes it is sold before it is produced, but that’s the nature of the futures contract. But delivery is the final aspect of this obligation.
Kevin: But in this particular case – I remember reading before the movie came out, the book, The Perfect Storm, which by the way, is one of the greatest books ever written. It was about converging the worst case scenario of two, or three, of four things, all converging at once. That is what happened Monday in the oil market.
David: What occurred for the May contract has a few unique aspects. We covered some of this in recent commentaries, but I think I will briefly go over it. The OPEC Plus blow-up – that is, OPEC and Russia here in the 1st quarter – is kind of a distinct, but complementary issue. You have Russia and Saudi Arabia who backed away from production cuts. That had been in place for some time, a couple of years, again going back to 2015-2016, arranged in 2016. They were supporting the prices of oil through these production cuts.
Kevin: Right. And you brought that up, whatever it was, six weeks ago, and it brought oil down 10%.
David: 10% straight off the bat, where all of a sudden Russia said, “We’re not going to play ball.” And the Saudis said, “If you’re not going to play ball, we’re not going to play ball.” And so prices immediately fell 10% to $41 a barrel for the West Texas contract.
Kevin: And that felt like a big number at the time.
David: That’s right. And Brent was still about a $4 difference. Brent is another contract. It was trading at $45. The timeframe here was Friday, March 6th. We had overnight trading Sunday, that weekend, and oil was selling off 20% in the overnight markets, and by the end of Monday, March 9th, it was down 30%. I remember I was getting tri-bike fit. I was supposed to go in that day and get it fit, and I had to call and say, “Oil is down about 30%. It doesn’t happen every day. I think I’d better reschedule.” But at that point you had speculation from Goldman-Sachs that we would see $20 a barrel. That was – wow – low side estimate.
So why would Lila conclude we were going negative? From March to the present, the implications of a voluntary global economic shutdown have been building. If you eliminate the demand side of the equation, that is, eliminate all the uses of oil throughout the economy, and the supplies keep flowing, the price is going to suffer. And here is where she nailed it. The contract is unique. It is not that oil this week had no value. This is an important distinction between the physical commodity itself and the contract. The contract has its own unique constraints. The commodity has, and will in all likelihood, always have value. But the constraints of the contract are that the oil is delivered by date X at location Y.
And here’s the rub. We’ve spent enough time with both global and domestic economies being shut down and demand for oil being lowered by between 20% and 40% — the most recent figures were 29 million barrels a day not getting used. That is out of the usual 100 million barrels produced and used. That’s on a daily basis. If the oil isn’t getting used, it’s going to stack up somewhere.
Kevin: And that is one place in Oklahoma, isn’t it? It’s one place for that particular contract.
David: In the case of WTI, contract delivery is Cushing, Oklahoma.
Kevin: So the oil is flowing over Cushing, Oklahoma.
Kevin: We’ve seen the same type of thing in physical metals and other types of contracts, so in this particular case, it is related to logistics, right? It’s delivery logistics.
David: And so you could argue, just manage the logistics, pay the transport costs, and get that oil to another location to have it stored. You can arrange to have it sent to another storage facility, unless those facilities are topping out, too.
Kevin: Which is what is happening, right?
David: That’s right. So as rare as it is, with demand on its keister, there is no place to put the oil contractually being delivered.
Kevin: So what is the price of real oil versus paper oil?
David: That’s the question. And it’s complicated by the contractual nature of this. Those with the contractual obligation to deliver now have to do something, sell the contract, go through the delivery process, or roll the contract into the next month. But you are creating – it’s weird for a producer, in this instance, pay to get rid of the product, either through paying outrageous storage costs or outrageous transportation fees. In this case, they don’t have those as options, so paying to deliver your own product is a very upside-down world.
Kevin: But this isn’t just Oklahoma. We’re not in Oklahoma only on this. Is this a national, or even a worldwide problem?
David: The problem is global because the nature of demand destruction over the last several months has been global. And so the alternative, or sort of makeshift storage facilities can’t take the product either, because this has been building. It just happens to be at sort of a flashpoint in Cushing. So to the degree that these dynamics are left unresolved over the next 30 days – again, these are supply and demand dynamics, supply is going to continue to flow, and we have the Texas railroad commission who is meeting this week and are determining what exactly it is they are going to do to help mitigate this. This is where, again, there are things that from a policy standpoint you can put in motion. And so, pro rata cuts to current supplies, that is what the Texas Railroad Commission is going to put in motion.
Kevin: So if I dug a big hole and I had the ability to transport oil, I could get a lot of oil right now for free and they would be happy to give it to me. There is another contract coming up here soon, isn’t there? This isn’t just a one-day problem.
David: That’s what I mean. You’re going to deal with this 30 days from now because then you have the June contract. All of this drama is related to the May contract.
Kevin: That’s what you said on Cavuto. You were saying this isn’t just today.
David: It’s a one-day problem, and it’s a 30-day problem. You now have 30 days to figure out how to deal with demand destruction and over-supply.
Kevin: So are there places that people could put oil right now if they could get it there?
David: Theoretically, but this kind of cropped up on us pretty quickly, and so it wasn’t done in time. So yes, if you went to the Caribbean, you have St. Croix, you have Aruba, sites that once were run by Exxon Mobile and Hess, and they were mothballed years ago. But they could take product. Now, that assumes that you have tanker availability and the willingness to pay transport costs. But with West Texas Intermediate at a negative number versus the Brent contract, those are costs that any trader would absorb.
Kevin: So repeat again what you were talking about on Cavuto as it was happening. The one-day versus the 30-day problem. Just repeat that.
David: In the interview with Cavuto my first comment was that you have a one-day problem and you have a 30-day problem. The price action this week reflected the time constraints. It is the time constraints of the penultimate and ultimate expiration of the May contract, Tuesday the 20th, and Tuesday the 21st, which ultimately this all settles and everything has to be delivered by the end of the month. You can replay this same drama 30 days from now if the dynamics don’t shift.
Kevin: Can the traders fix this, though? Trader’s always try to figure out a way to make a profit on something like this.
David: Absolutely, and 30 days is a lot of time for risk-takers and oil-traders to solve the problem and be in a position to capitalize on those negative numbers, or to create other arbitrage opportunities. The market can solve this problem, and it wants to. Trust me. But supplies are still coming. And the only thing that will shift the equation in a major way is if demand comes back. That is now a political decision. Yes, it is in the category of public health and safety because we are talking about Covid-19, but that is why I say it is political. You have constraints that have been put in place against normal business activity and they have to be removed or demand may even deteriorate further.
Even if you solve the supply issue, this is again where it doesn’t matter that we have had, in the interim, an agreement between the Russians and the Saudis and the U.S. encouraging this, to cut back supply by 10 million barrels a day. The math doesn’t work. If you are over-creating by 30-40, but only reducing by 10, you still have too much coming in. So you would have to cut supplies so drastically.
This is, again, where Texas Railroad Commission is going to do everything that they can, but the real answer is not managing supply. Yes, that is going to take care of itself, and you are going to have a lot of players that go broke, you are going to have a lot of shut-ins in terms of the wells, and they will continue to do that in Midland until they run out of caps (laughs). It’s really an interesting dynamic. But if we don’t solve the demand side of the equation those variables are going to replay themselves, just like groundhog day, 30 days out.
Kevin: Let’s try to think creatively. I was reading a letter from Jim Deeds. He was talking to a friend of his, and his friend said, “You know, Jim, you are always sort of negative.” Jim said, “You know, I’m really not negative, I’m just a contrarian. In other words, I try to find opportunity the opposite direction.” So think this through for a second. If you can buy oil at negative $40 – let’s just pretend, like that contract – and you can figure some things out, it seems to me that oil, which is really $20 a barrel right now, or $15, or whatever you want to call it – there seems to be some opportunity for somebody sitting out there. Or am I wrong? With the lack of supply is there no opportunity?
David: Well, I think one thing that should not come as a surprise to listeners is to see a bump in the price of oil. We were negative $40. For it to trade positive again within a 48-72 hour timeframe is normal, because a part of the constraints were contract-related, specifically to the May contract, which by April 22nd is now in the rear-view mirror. So now we get to look at new dynamics, new timeframes, new constraints, new contract – the June contract.
But yes, if you can buy at negative $40, theoretically, sit on the product, pay for storage, and then sell at a positive $10, $20, $30, $40 a barrel, remember we were at $40 a barrel just 45 days ago, you’re talking about minting money. There is a fortune there. And traders have been playing this dynamic to a lesser degree in recent days and months. Anywhere there is storage product has already been shoved.
Kevin: But there is the perfect storm. In other words, they ran out of time, they ran out of space, they ran out of people who will use oil. They ran out of everything all at once.
David: We ran out of time and space simultaneously, and that is a unique thing to experience in the world of contracts. So the result? A trade to negative $40 a barrel. That wasn’t the global price. That wasn’t the price for Brent crude, an alternative contract, but given the dynamics of the WTI contract, that is what gave us the drama.
Kevin: We have been experiencing, in this industry many times, something like this, except for it is on the other side. Everybody wants a certain type of gold or silver. And we probably have access to over a million ounces of silver. If you want to have a 1,000-ounce bar. It is the size of shoebox. It’s 70 pounds, it’s heavy, but you can buy silver in 70-pound bars. If you want to buy coins you have to pay a premium. And so, contracts and spot price and the real item, like in this particular case, the oil that goes to Cushing, Oklahoma was the wrong kind of oil to own at the time, right? Why don’t you explain a little bit the difference between the physical market and the contract market?
David: I think, looking at that going forward, number one, we have to remember that there is a difference between a contract and the underlying asset. Price is one of the elements in a contract, but the other stipulations that are embedded in it are key, so pricing on the contract may be completely disconnected from the value of the physical asset. It doesn’t matter if it is oil, soybeans, gold and silver. That’s what it is. Secondly, should the sanctity of the contract come into question, you are talking about all hell breaking loose in the financial markets.
Kevin: I thought the derivatives were there to keep us from that problem.
David: This is one of those strange developments. It is not unexpected, given the kind of creativity that we generally see on Wall Street. But the derivatives – futures are a derivative product. And they allow a producer to hedge production. So let’s say I’m going to go dig in the dirt for iron ore, or for gold or silver, or to see if I can discover some oil. Or I’ve discovered it, and now I know that I am going to produce X amount of ounces or barrels in a year. I can go ahead and lock the price now for a product that I am going to deliver in the future. And it means that for all the risk that I am taking to operate and produce, I can take one element of risk out of the equation. That is, by the time I deliver it to the market, what is the price I am going to receive? I can lock that up now if I know what my production is going to be for the year.
Kevin: So in a way you are insuring yourself.
Kevin: But in this case the insurance is what kills the market.
David: It’s for hedging. It’s for hedging production.
Kevin: Not for ruining the price of the market.
David: Right. And so that’s what you have is when you can take very little capital, leverage it up 4-5 times, and if you have borrowed the capital, then leveraged it up 4-5 times, now what are your leverage ratios? That is how people have played the futures market. Derivatives are, by nature, a derivation, or a segmentation, kind of a loosely related product to the underlying asset.
Kevin: But the derivatives markets have grown larger than any market in the world.
David: Sure, the derivations now dwarf what the underlying assets are. We have hundreds of trillions of dollars in derivative assets within the financial markets, and what is unique now is that no one has – again, we go back to this idea of imagination. Who modeled a profit and loss statement and looked at risk, assuming the kind of disconnect we saw this week in oil? You can apply the same type of thought process or thought experiment to any asset class.
Has this risk ever been modeled? It is not a one-in-a-hundred year event. It is a first-time ever in recorded history event. So circumstances had to be just right. Granted. And we discussed the WTI dynamics earlier. But what we have on display is confirmation – Doug Noland’s opinion, mine too – that there is an underlying fragility in the financial system that leaves open anomalous and potentially catastrophic financial market developments. This is what we see happening this week in the oil markets. It’s a reveal. It’s a reveal of how fragile the markets are, and how weird things get when you are working on such high leverage.
Kevin: One of the things we talked about was having limited storage space and having sort of a consolidation of where that oil needed to be. That with the problem with Cushing, right? Don’t we have the same thing with banks? When we talk about the banking industry and all this expansion of leverage we’re not talking about thousands and thousands of little home town banks. We’re talking about seven, or six. How much exposure do these guys have when the debt starts coming due?
David: One of the things we have to thinking about is economic growth that we have seen over the last several years, or even decades, has been tied to an expansion within financial assets. So the financialization of everything has been a part of the growth thematics that we have seen for a couple of decades now. And that is the credit bubble thesis that Doug has run with for a long time. Now you have five banks, not unlike Cushing, Oklahoma, that are topping out. They have so much in terms of derivatives on their books, the question is how can we continue to see the kind of economic growth we have had when the financialization process is reaching limits?
Kevin: So what percentage do the five banks hold?
David: The Bank of International Settlements gave us the numbers back in June of last year. Five top banks, globally, have 95% of all of the derivatives. You are talking about 640 trillion dollars in derivatives and this is what sits embedded in the balance sheets of five banks. So again, if we go back to normal, what does a post Covid world look like going back to normal? Well, everything is normal again, right? We were actually in a topping out process anyway in terms of the amount of leverage and embedded risk you can have within a portfolio – 640 trillion dollars? Do we get to a quadrillion? Is that our next destination? Is that how we define “date with destiny?”
Kevin: But this is insurance, derivatives, that got out of hand and then grew to be – you used the word Leviathan for the government, and that’s true, Leviathan just continues to get bigger. But this is Behemoth. If you’re going to use biblical terminology, you have Leviathan and Behemoth. This is Behemoth. 640 trillion.
David: According to the Bank of International Settlements. I don’t know what the changes have been from June 2019 to the present, but here is where you find the greatest potential for counter-party failure. Derivative products have allowed for speculation to occur on products that have an end use. So no longer are futures contracts the sole domain of the producer and hedger, like we talked about earlier, but now you have the leveraged speculative money – hedge fund money, private investor money, bank money – all of it is re-leveraged in the context of derivative betting, and there is no asset class that is exempt.
So we can talk about inflation and deflation, but the reality is, with the amount of asset price inflation we have seen because of derivative betting, of course you can expect to see asset price deflation. Is that broad economic deflation? That has yet to play out. But again, leveraged speculative money re-leveraged in the context of derivative betting, that coming unwound. I think, if you reflect on the oil market, what oil gave you was a shot across the bow for what asset price deflation can look like in an age of leveraged contract speculation.
Any asset that trades on a contract can have anomalous behavior. It doesn’t have to repeat exactly what we saw with WTI, but it can have anomalous behavior. By that, I mean where prices are disconnecting from any intrinsic value in the asset because of – again, this is the distinction – the nuances in details of the contract obligation. And in essence, anything that is encumbered behaves differently than the same thing that is unencumbered and free to be itself.
Kevin: This is why it is so important to understand the difference between price, because back in 2008, remember, Dave, when the crash started happening in October of 2008, gold went down about 30% on contract. But if you remember, also, the coins that we were selling were actually skyrocketing and we had supply problems.
David: At one point we were limited to 1 kilo bar per client per day. We could not provide any more than that. It was on an allocated basis because supplies were so tight. And that was right in the middle of a price collapse. And you think, “Well, what is this?” The price collapse was – again, you are talking about an encumbered asset. This is so important. Anything that is encumbered behaves differently.
Kevin: You have said, “Own what you want.” You have ended the program a couple of times here recently. “Own it now. Don’t worry about the price.”
David: And don’t own it in a way where someone else has a claim to it, or could potentially change the rules of how that contract is operating, in their favor, and against yours.
Kevin: One of the things that you and your dad have taught all through the years is, if you have liquidity – he calls it keeping his powder dry, and you have inherited that because you say the same thing. But a person who keeps their powder dry stays out of debt, keeps their powder dry, can buy things for pennies on the dollar.
David: What we have advised, and pounding the table on this for two years, is raise some liquidity. Yes, I say yes to cash. Reduce some equity exposure. So that is a no vote to high valuations and momentum-based insanity, much of which is derivative-driven. Add some physical gold and precious metals. That is a yes to an asset that is not encumbered, that is outside the financial system, that is removed from counter-party risks. In essence what we are saying is, do some de-risking because the debt and derivative dynamics to be revealed, not only this week but in the years ahead, are going to scare the whiskers off a cat.
Kevin: And you want to be early. This is something that Jim Deeds also talks about. He says, “Always think two years ahead. I try to think what somebody is going to be buying two years from now.” And he has been very, very successful for eighty-eight years. The guy was a stock broker when I was six, and I’m 57 now. So I usually take his advice.
But your dad is the same way. One of the criticisms that people will make is that they say, “Ah, he is just always early.” You can laugh all the way to the bank when you’re always early.
David: I think one of the things that we saw this week is an example of what it means to be late.
Kevin: That’s true.
David: You’re playing with time, because time is a part of the contract. And the folks who closed out of the May contract settled on very different terms a week ago, ten days ago, a month ago, three months ago. This is an active contract that people have had access to and could trade for a long period of time. The people who really got in trouble are the people who waited until it was too late. So the advice to be early is because when you are trying to take any of those actions, whether it is raising cash, reducing equity exposure, adding to a physical metals position – in essence, de-risking – if you’re trying to take those actions in the heat of the moment you’re going to find that the terms involved are not favorable to you. And we just saw an example of what the terms can be, how ugly they can be. Be early, don’t be late. Or you can be stuck and screwed because the obligations stacking up against you – again, all of your options are limited in that moment of stress.
I think this is a perfect case in point. WTI. If you just want to sear this into your brain, April 2020, WTI. Don’t be late. And don’t be afraid to be a little early.
Kevin: And it’s not just West Texas Intermediate. If you think about it, there are unintended consequences worldwide. How would you like to be a Canadian right now?
David: Sure, this is where the most pain is, because you have transportation costs and logistics which are very expensive, so if you take your Canadian heavy crude, as an example, they have to get it to market and their costs of transportation are much higher. So you find that Canadian heavy has been selling at a $15 discount to West Texas Intermediate.
Kevin: So, we were $40 negative on WTI. Does that mean $55 negative on Canadian?
David: Sure. As we were heading toward zero they were already zero. They were already zero, we played catch-up and basically pushed them into deeper negative territory. The contract obligations struck the price penultimate day for April. That leads into the June contract. What does that mean? You have Canadian producers – I guess, a speculator, if you were betting on that kind of oil – and they were writing a check for as much as $55 a barrel for someone else to take that oil from them. They are writing the check, you take the oil. They are paying you to take the oil at $55 a barrel. Contracts of contracts.
Kevin: But I wonder, if contracts were made to be broken, can contracts actually default?
David: It depends who is writing them. Treaties, like pie crusts, are made to be broken. Well, contracts – this is something that in the Western world we put a lot of confidence in because of the history of the rule of law and the sanctity of contract. Now, when you look at a contract you also know that there are stipulations and wiggle room at certain points and default is a possibility, default is an option. And I think the breaking, or the default, on a commodity contract is something you have to kind of run the traps on.
The system assumes a certain degree of normality. In fact, in order for it to function, it has to have the normality. When you have dysfunctional behavior which becomes the norm, then I think you have to look at contract security and the potential for default in a different light. And again, the stipulations, the expectations of a contract, might not be as secure as previously assumed. And that is partially because politics can get involved.
Kevin: We saw that back in 2008. The bankers caused the problem and then the bankers seemed to get rich.
David: And you really saw it with the Hunt brothers silver debacle. For anyone who understands the details of that silver trade and having the government literally step in and say, “There is no buying today. There is only selling. And we’re just going to allow the silver price to drop, and drop, and drop, and drop.”
Kevin: That was a huge betrayal to the Hunt brothers, and to the futures markets.
David: It was your first lesson that there is a game, and at certain junctures, if the pressure is great enough you might discover it’s rigged. So there will be winners and losers, and we will continue to witness the selection process. And some of it is natural selection, a la evolution – going the way of the Dodo bird. And some of it is political selection. And it all depends on what moneyed interests are blowing up, who is under pressure, how deep the ties to power are.
Again, there are legal ramifications for defaulting on a contract, but let’s be real. The closer you are to power the greater the likelihood of preferential treatment. That may come in the form of contracts being upheld, but maybe you are the first in line for the bailouts, the handouts, basically what we have been parading since the Covid-19 lockdown. And of course, you have the Treasury and the Fed fiat frolic. It doesn’t end.
Kevin: Yes, you have the political side. You have these announcements coming out as to what state is going to open. You have the monetary side, how much in trillions certain people are going to get. And then, of course, you have the fiscal side, when you have Trump saying, “Yes, we have a virus so it is now time to rebuild bridges.” That’s the fiscal side.
Kevin: You’ve been calling for that for the last few years. He said he’s going to have to step up and start spending fiscal money when the monetary policy isn’t adequate.
David: Yes, and this is the excuse. They have the excuse to spend anything they want.
Kevin: So desperate times?
David: Desperate measures. That’s right, you know the tune. Kevin, there is so much more to talk about. Obviously, in a week where unprecedented things have occurred, there is a million implications and unintended consequences from policy choices and investor choices, and whatever else. We have a lot more to talk about and we’ll have to push it to next week.
Once again, I think the concluding illustration we had in this week’s market action is the illusion of control being smashed once again, and it happening in real time. We believe we have the tiger by the tail. We believe we can determine outcomes, and then the tiger turns and the game is up.
Kevin: I was sitting and having lunch with my wife yesterday, and she said, “You know, Kevin, just about everything that we have held as maybe even a false idol is being challenged right now, whether it is sports as a false idol, or money, or our health. All these things are being challenged. There is an unknown right now, and actually, I read an interesting headline. It said, “We’re not really fearing Corona virus. We’re fearing the unknown.”
This illusion of control, I’ll tell you when it really hit me was about a month ago when the Federal Reserve lowered interest rates by half a point and that normally, every other time, would have caused the stock market to go up. But if you remember, that Monday it went down a couple of thousand points. That’s illusion of control is being popped, and it seems like there is a leveling going on right now where everyone – there are no experts, are there?
David: No experts. And I think this is only fair. Does anyone know the future? No. No one does. And this is what I think is fascinating. We go to WTI and this contract again. The futures market is a pure play, speculation on something that is not set in stone, can’t be predicted, and will give and will take away without remorse. So today, we have one of the pillars of finance in the derivatives market, and today what we see is it severely cracked, and tomorrow it may, in fact, crumble.