How the Hedge Funds Are Calling the Tune on Oil

Watching the gut churning $22 plunge in crude (USO) has been fascinating, and gives broader insights into the state of global capital markets as a whole.

Just as the Gulf disaster threatens to cap one third of America's least politically risky oil supply, prices have been heading downtown on the Lexington Avenue Express.

The environmental disaster equals another Hurricane Katrina in terms of impact on the local economy. The spill could reach Scotland, where the Gulf Stream ends, before it is finally contained.

It tells you how meaningless the real physical demand for Texas tea has become in price discovery, and that it is carry trade demand from hedge funds that is really calling the tune. It hasn't helped either that the economic outlook has softened, the contango (the premium that far month futures contracts are trading over front month contracts) has widened enormously to $10.10/ barrel one year out.

That is an incredible 14.6% over the front month, giving traders a huge incentive to take delivery of crude, store it, and simultaneously sell it forward. Leverage this up a few times and you are talking about some serious coin.

When this happened two years ago, you could walk across the Gulf, jumping from tanker to tanker, without getting your ankles wet. This explains why shipping rates have been on an absolute tear.

A month ago, when crude was still rising, you could charter a Suezmax tanker for $15,000/day. Today, the same ship costs $50,000.

As long as the world is in risk reduction mode, crude will continue heading south, no matter how many long term supplies we blow up. Get the S&P 500 back to 1,050, and the low sixties per barrel are a chip shot.

Bring on the risk of a double dip recession, and we visit the fifties.

Get the actual second recession that China and Europe seem hell bent on delivering, and the forties come into play.

I say all of this still honoring my long-term target of $300/barrel that peak oil will eventually deliver, and then $10/barrel when all of the alternatives and conservation finally kick in. And you wonder why they call the crude contract a bag of snakes.

Courtesy of: Mad Hedge Fund Trader