ENERGY PRICES WERE WEAK ON FRIDAY… the entire complex ended the week on a sour note. Led by gasoline, oil markets in New York and London tanked amid speculation U.S. refiners are ready to ramp up production. Meantime, gas futures in New York sank back towards the $4 critical point of reference.
The problem with all of these de rigueur StatArb models employed by Wall Street’s best-and-brightest [sic] when it comes to trading commodities is that they are great, great, great… until they are not great. And, depending on how great you think these systems are (or how desperate you are) when they are not great they can be catastrophic (think Amaranth). These systems are especially dangerous when they suggest strategies counter to underlying fundamentals.
Let that be a lesson to you… because it has been to us. Back in early May analysts from The Schork Reporttraveled extensively along the Gulf Coast speaking to clients that are involved on the supply and demand side of the market. The knowledge we accumulated from these clients was the same we received the other week when we spoke to clients in the Ontario Niagara market area… i.e. the underlying fundamentals –too much supply and not enough demand – was quite negative, especially for natural gas.
Be that as it may, at the time we said we liked owning natural gas… as long as we were selling the correct proportion of crude oil against it, i.e. our sexy, sophisticated mathematics suggested that the extant excursion between crude oil and natural gas values was such that a reversion to some arbitrarily concocted “mean value” was in order… regardless of the poor fundamentals for gas and regardless of the exogenous market fluctuations that impact crude oil, but not necessarily natural gas values (e.g. geopolitics, dollar value, politically savvy euphemisms like “green shoots”… and so on).
What saved us from our own mini catastrophe was the mantra of immediate gratification. That is to say, trading is all about immediate gratification. If you are not immediately gratified the moment you put money at risk, then what is the point of risking it?
In the case of the crude oil/natural gas reversion trade, not only did this strategy not immediately gratify, but it immediately gave us a case of angina. Thus, as if our irritable bowels were not enough to clue us in, the event that this trade continued to behave mathematically irrational certainly was.
Understanding the math behind the decision making is important, especially given Wall Street’s growing sway in the commodities arena. That is why we do employ these systems here at The Schork Report, but as the above anecdote implies, they are by no means our sole criteria. StatArb models can, and often do, influence the price path of a physical asset over a given timestep, but they are lacking in one crucial area; they do not capture shifts in the underlying fundamentals until it is too late.
In the case of gas, nearby fundamentals are poor. We all know it. On one hand we are seeing some life from steel (being from Pennsylvania that is one of our favorite metrics). Last week U.S. Steelannounced it was recalling workers at its coke works in Hamilton, ON and a blast furnace at its Granite City, IL works. That is positive. Also, recent economic headlines were also positive (which is code for, less bad).
Thus, we have no qualms with the argument that the Recession is in a bottoming phase. We do have qualms with the projected duration of this phase. Needless to say, we do not subscribe to the “V-shaped” recovery theory. We are partial to a “U-shape” recovery. And, if we do not see a material correction in energy costs, then we think this recovery could be “W-shaped” as rising costs choke off incipient consumer spending and we enter into a double-dip recession, à la 1980 and 1982 (see Chart of the Day in today’s issue of The Schork Report).
But, in the short-run that is neither here nor there. Last month the U.S. factory economy hit a record low for as long as the Fed provides records (since 1948). The United States has never come out of a recession without manufacturing. We could very well be on the cusp of that recovery, but given how far we have fallen, it is going to take time, a lot of time, for demand to rebound. In the meantime, we are still facing a glut of Btus, especially natural gas. In Friday’s report we talked about how the proliferation of unconventional gas drilling has offset the pullback in Baker Hughes rig counts. Thus, despite the decline in rigs, we have yet to see a commensurate impact to production. Therefore, as demand for gas falls or at best, stagnates, supplies continue to build.
This is the fundamental shift that the StatArb models could not detect. The market has changed. Thus, while crude oil has rallied, natural gas has stumbled. Therefore, the models suggested a reasonable probability existed that natural gas would either “catch up” to crude oil or that crude oil would regress to natural gas. That has not yet happened because there is no fundamental reason for natural gas to rally. Mind you, we do not think there is fundamental reason for crude oil to rally either, but because of exogenous forces in this market, it has rallied. Therefore, there is no immediate reason why it should regress.
Thus, when it comes to cross-market spreading, it is important to know the math, but it is as important to understand the underlying fundamentals particular to each asset.
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Stephen Schork is the Editor of, "The Schork Report"and has more than 17 years experience in physical commodity and derivatives trading, risk systems modeling and structured commodity finance.