Adviser Soapbox
Subprime Sullies Reputations
Martin Fridson, Leverage World 10.31.07, 11:00 AM ET

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True to form, underwriters and money managers blame wildly improbable, unforeseeable confluences of events for disastrous losses recently incurred by structured finance investors. Theory upholds their view that the circumstances leading to the losses could have not been predicted, as enlightened self-interest supposedly guarantees that assets can never become radically overvalued. One problem with this theory is that the penalties for exhibiting unenlightened self-interest are remarkably light.

Financial debacles such as this year’s subprime mortgage crisis and the backup of leveraged buyout loans generate predictable responses from individuals associated with large-scale wealth destruction. They customarily excuse themselves on the grounds that the latest collapse resulted from unprecedented and therefore unforeseeable events. This pattern has been followed recently by hedge fund managers whose limited partners suffered huge losses, and by investment banking executives who presided over massive write-offs, for which shareholders bear the brunt.

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Actually, the fact that an event is unprecedented does not automatically demonstrate that it was unforeseeable. Consider, for example, the lethal combination of dubious subprime collateral (including undocumented “liar loans”) and risk transfer via collateralized debt obligations. This particular mix of financial innovations was not prominent in any period prior to the present cycle, so by definition the form of the resulting explosion was unprecedented.

It does not follow that the possibility, or even the probability, of outsized losses was apparent only with 20/20 hindsight. Seasoned observers did in fact warn that the risks were out of line with investors’ potential returns. They made reasonable inferences from the presence of certain key elements that triggered busts in previous cycles. One example was the decline in underwriting standards made possible by risk transfer.

Much empirical work would be required to substantiate the claim that the risk of structured finance vehicles was recognizably out of line with their potential return. Such analysis is beyond the scope of the present article. Merely to suggest the existence of a market failure, however, imposes a duty to offer a plausible explanation.

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“Reputational Capital”

Market psychology is the solution to the problem of apparent inefficiency favored by self-anointed experts who are not bound by any standard of scientific proof. These include technical analysts and many pundit-visionaries based in the media. They assert that investors’ spontaneous swings from collective greed to collective fear and vice versa cause prices to lurch from one extreme to the other.

Why investors suddenly undergo violent mood swings is never explained. Neither is serious consideration given to an easier-to-swallow cause/effect relationship–namely, that rising prices cause investors to turn optimistic (and falling prices produce pessimism), rather than the reverse.

A more productive line of analysis focuses on the eminently rational behavior produced by offering someone a better-than-fair proposition. Suppose lenders can earn fees by approving loans but hand off the credit risk. Their sensible response is to approve as many loans as possible by the simple expedient of discarding all proven credit standards. Structured finance makes such a strategy feasible as long as unsophisticated investors can be induced to overpay for the deliberately complex, difficult-to-evaluate equity tranches.

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In the minds of financial economists who love markets without having actual experience with them, systematic pricing of this sort can never happen. The last line of defense for market efficiency, they say, is intermediaries’ concern for reputational capital. According to the textbooks, underwriters and asset managers will eschew “heads I win, tails you lose” behavior that disadvantages customers, lest they lose the trust of potential future customers. In practice, unfortunately, reputational capital is almost as great a delusion as market psychology.

Sensitivity to outcomes for the buyers is a logical consideration for investment banks, because they truly are intermediaries. Being perceived as an honest broker by both issuers and investors is an advantage, as they must deal regularly with both parties. There is an inherent bias toward the issuer’s interest, however. A corporate borrower is not obliged to deal with more than one lead underwriter and can therefore pit the investment banks against one another on the basis of willingness to foist unfavorable pricing and covenants on investors.

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Portfolio managers, on the other hand, must deal with all or at least most major underwriters if they are to construct adequately diversified portfolios out of the available primary supply. The buy-siders, consequently, are not in a strong position to force underwriters to compete by imposing investor-friendly terms on issuers. At best, a portfolio manager can put an underwriter into the penalty box for a month or two.

Shareholders theoretically constitute a second line of defense. They can punish an investment bank’s management for bad decisions that lead to multibillion-dollar write-offs by “voting with their feet,” i.e., by selling their shares. Senior managers may be well compensated enough to be indifferent to the resulting decline in the value of their own holdings, but shareholder dissatisfaction can conceivably lead to their ouster. The more usual outcome, however, is that the second-level managers most directly responsible for the losses get the ax, and the chief executive officer expresses regret about the underlings’ irresponsibility.

Not surprisingly, this allocation of blame tends to be upheld by securities analysts. They have little to gain and much to lose by pointing the finger at canny executives who have risen to the top in large part through their survivorship skills.

As for hedge fund managers, the record indicates little need to worry about reputational capital. Far from decreeing lifetime banishment for managers who inflict huge losses on the limited partners, investors insist on their right to a second chance. Phoenix-like, the spectacularly underperforming portfolio managers raise new funds, often after remarkably short periods of dust settling. The theory seems to be that the greater the assets under management they were in a position to blow away, the greater must be their ability.

Famous examples from the past include John Meriwether of Long-Term Capital Management and Brian Hunter of Amaranth Advisers.

In Pictures: 12 Top Chinese Gainers

Market Inefficiency

In theory, financial markets have built-in, self-correcting mechanisms that keep valuations at least roughly in line with intrinsic value. Rational self-interest prevents knowledgeable investors from willingly accepting more risk than the associated, expected return justifies. Concern for preserving reputational capital prevents professionals from placing unknowledgeable investors in an unfavorable risk-reward position. Professionals who violate that trust are eliminated from the field.

So much for theory. If investors are too willing to give unskilled speculators a second chance, the controls break down, assets get overvalued and impossibly large losses become possible. By all appearances, this is not merely a theoretical problem, and there is no particular reason to suppose it will disappear. Regardless of the lessons investors may have learned from the subprime crisis, we should expect to see many more financial debacles in the future.

Martin Fridson, CFA, is editor of Leverage World. Visit www.fridsonvision.com or e-mail Martin@FridsonVision.com.

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  Are Wall Street Chiefs Worth Their Pay?

October 31, 2007, 8:04 am

When he retired from Merrill Lynch on Tuesday, E. Stanley O’Neal left as one of the highest-paid chief executives of a Wall Street investment bank, having earned $46.4 million in the 2006 fiscal year. But was he worth it?

An analysis by The New York Times seeks to answer that question by comparing the paychecks that Wall Street chieftains took home last year to the total stock return of their firms over the past year and a half. After the jump, check out a graphic with our findings.

Only three investment-banking chief’s have presided over rises in their firm’s stock prices from Dec. 31, 2005, to Oct. 30. And according to data provided to The Times by Equilar, which tracks executive compensation, they aren’t necessarily the highest-paid ones.

It’s worth remembering that investment banks’ sky-high profits over the past two years have been built in part on risky trading bets on mortgage-backed securities. Those are the same wagers that collapsed this summer, leading to multibillion-dollar write-downs from many firms.

(We should note that Goldman Sachs‘ Lloyd C. Blankfein, who earned the most last year, became chairman and chief executive only last summer. Every other executive on this list has been in the top spot for the entire time period listed in the chart.)

The New York Times’s editorial board, for its part, asked Wednesday whether more Wall Street chiefs should be losing their jobs as well.

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Are Hedge Fund Indexes the Answer?

October 31, 2007, 7:41 am

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Indexes have long been used as a gauge of performance for stock and bond investors, but, Investment Dealers’ Digest wonders, can they be used within the hedge fund industry, and could they supplant the role of funds-of-funds that many institutional investors have come to rely on?

Indexes serve as barometers for an industry or an asset class, and in recent years Wall Street firms such as Credit Suisse and Barclays Capital have introduced hedge fund indexes. These indexes look to measure the returns of a broad pool of hedge funds to establish an overall peer group performance benchmark.

Proponents of hedge fund indexes believe they can be cost-effective and save time for investors. But, notes I.D.D., there has been a mixed reaction among investors to these indexes, some whom believe that basing investments on the index can only generate average returns.

Go to Article from Investment Dealers’ Digest »

http://dealbook.blogs.nytimes.com/2007/

10/31/are-hedge-fund-indexes-the-answer/

Can Hedge Fund Indexing Work?
Jessica Papini
October 29, 2007

Indexes have long been used as a gauge of performance for stock and bond investors, but can they be used within the hedge fund industry, and could they supplant the role of funds-of-funds that many institutional investors have come to rely on?

Indexes serve as barometers for an industry or an asset class, and in recent years Wall Street firms such as Credit Suisse and Barclays Capital have introduced hedge fund indexes. These indexes look to measure the returns of a broad pool of hedge funds to establish an overall peer group performance benchmark.

According to a recent Credit Suisse report, institutional investors will measure a hedge fund’s performance by measuring it against a risk-free rate of return such as cash plus a certain number of basis points. Another way to gauge how well a hedge fund is doing is to measure its performance against public equity markets. Now, though, hedge fund indices look to measure performance of a hedge fund by measuring how well it does against its peers.

“Over the last decade, funds-of-funds were widely popular with investors because they were overwhelmed with the choice of which hedge funds to invest in,” says Philippe Schenk, director at Credit Suisse. “Within the past three years, more and more investors are looking into indexed funds, and the strategy is starting to establish itself in the marketplace,” he says.

According to Ferenc Sanderson, senior research analyst at Lipper, a debate is ongoing among large institutions as how to best invest in hedge funds. Institutions like endowments or pension funds can invest “passively” using a hedge fund index or they can do the research themselves and find a fund with an investment strategy they like. Or, they can hire a fund-of-funds to put their money to work for them.

Proponents of hedge fund indexes believe they can be cost-effective and save time for investors. “It is difficult for investors to pick from a universe of over 10,000 hedge funds,” says Schenk. He adds that finding top managers in the industry requires resources and time because of a lack of transparency in the industry and the variety of trading strategies.

Using a hedge fund index, “allows for smaller fees, greater diversification, and stronger risk adjusted returns,” according to Schenk, who is with Credit Suisse’s alternative investment group, and co-author of the bank’s recent report “Gaining Efficient Hedge Fund Exposure through Passive Investing.” “It also eliminates the subjectivity of actively managed funds providing consistent return patterns,” he says, conceding that some investors will always prefer to actively manage their investments within hedge funds.

Credit Suisse unveiled its Credit Suisse/Tremont Hedge Fund index in 2003. The index tracks 455 funds with a combined $656 billion in assets under management.

According to that recent report published by Credit Suisse, “with an indexed portfolio, an investor ‘buys’ the entire market, creating safety in numbers. Should an individual hedge fund experience management or trading problems, the impact to the overall portfolio is minimized.”

Hedge fund indexing, though, has encountered some skepticism. There has been a mixed reaction among investors to these indexes, says Sanderson, who points out that “there is no specific universally recognized benchmark for hedge funds.”

Charles Gradante, managing principal and co-founder of New York-based investment advisory firm Hennessee Group, believes that hedge funds indexes “can be overly diversified to the point where it generates average returns.”

Gradante is not convinced that putting money to work in hedge funds using indexes is the most effective way to use capital. Also, he would not allocate more than 10% of a portfolio using a hedge fund index. “Hedge fund indexing is a great idea and works on paper, but hasn’t worked in the marketplace to any effective degree,” he says.

For investors managing over $1 billion, Gradante sees some benefits in using hedge fund indexes. But, “if an investor has $100 million, a better option is to leave money in funds-of-funds where the portfolio can reflect their opinions of the market easier,” he said.

(c) 2007 Investment Dealers’ Digest Magazine and SourceMedia, Inc. All Rights Reserved.

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Crude Oil Reaches Record $95.80 on Decline in U.S. Stockpiles
By Angela Macdonald-Smith

Nov. 1 (Bloomberg) — Crude oil rose to a record $95.80 a barrel in New York after a U.S. inventories unexpectedly fell to a two-year low.

U.S. crude stockpiles dropped 3.89 million barrels to 312.7 million barrels last week, the lowest since October 2005, according to the Department of Energy. A 400,000-barrel gain was expected in a Bloomberg News survey. Petroleos Mexicanos, or Pemex, resumed some oil exports and revealed that a storm caused more output to be halted than had been assumed.

“The shock of the data is understandable when you consider the news from Pemex that they shut in something like 1 million barrels a day, not 600,000,” said Chris Mennis, owner of oil broker New Wave Energy LLC in Aptos, California. “Most of that would have been going to the U.S.”

Crude oil for December delivery gained as much as $1.27, or 1.3 percent, to $95.80 a barrel in after-hours electronic trading on the New York Mercantile Exchange, the highest since trading began in 1983. It traded at $95.34 at 8:19 a.m. Singapore time.

Yesterday the contract surged $4.15, or 4.6 percent, to settle at $94.53 barrel. Oil is up 62 percent from a year ago.

Prices plunged 3.4 percent the previous day after Goldman Sachs Group Inc., which said in July oil may reach $95 a barrel, told clients it was “time to take profits.”

Economic Growth

Oil also rose yesterday as a government report showed economic growth in the U.S. unexpectedly accelerated in the third quarter after increases in exports, consumer spending and investment made up for another plunge in home construction. Gross domestic product grew at an annual rate of 3.9 percent in the quarter, the most since the first three months of 2006.

The economic data is “definitely supportive for prices,” though the strength in exports isn’t surprising given the weakness in the dollar, said Rowan Menzies, an analyst at Commodity Warrants Australia Pty in Sydney.

The dollar sank to an all-time low of $1.4504 against the euro after the Federal Reserve’s second interest-rate cut in two months.

The economic factors added to the “nasty surprise” of the stockpile numbers, Menzies said. Momentum seems to be building for an increase to $100, yet oil may be down to about $85 within a month in the absence of more supportive news, he said.

Crude-oil inventories at Cushing, Oklahoma, the delivery point for New York futures, fell 17 percent, the energy department report showed. Stockpiles dropped to 15.1 million barrels in the biggest decline since November 2004.

Pemex resumed crude-oil exports at a rate of 800,000 barrels a day and will add another 300,000 by the end of Wednesday local time, Carlos Morales, chief of the company’s exploration and production, said yesterday at a Mexico city press conference. Pemex previously said that 600,000 barrels a day of production had been halted.

Brent crude oil for December settlement rose 57 cents, or 0.6 percent, to $91.20 a barrel on the London-based ICE Futures Europe exchange at 8:20 a.m. Singapore time. Brent reached $90.94 a barrel yesterday, a record intraday price.

To contact the reporter on this story: Angela Macdonald-Smith in Wellington at amacdonaldsm@bloomberg.net

Last Updated: October 31, 2007 20:24 EDT

Investors faced with rush of downgrades

By Saskia Scholtes in New York

Published: October 31 2007 20:05 | Last updated: October 31 2007 20:05

As the subprime mortgage debacle claimed another boardroom scalp this week – Merrill Lynch chief Stan O’Neal – investors were counting the cost of a string of downgrades on complex mortgage securities issued by investment banks such as Merrill and others.

In October alone, rating agencies Moody’s, Standard & Poor’s and Fitch Ratings delivered a heavy drip-feed of downgrades or reviews for downgrade that affected more than $100bn in so-called collateralised debt obligations (CDOs) and the mortgage securities they contain.

EDITOR’S CHOICE

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Many of the downgrades took the CDO securities from investment grade directly to high-yield. In one case, Moody’s cut the Aaa-rated slice of a CDO deal called Vertical CDO 07-1 by 14 ratings notches to B2, and still left it on watch for further downgrades.

Domenico Picone, analyst at Dresdner Kleinwort, said: “What is astonishing, and at the same time particularly worrying, is that Moody’s gave a AAA rating to this security only back in April this year.”

This has potentially serious consequences for market prices, which have already suffered precipitous drops this year. Some investors are constrained by rules that force them to sell securities rated below investment grade.

The cuts come as the major rating agencies have been criticised for granting high ratings to complex mortgage securitisations that failed to take account of signs of looser lending standards and slowing house price appreciation in 2005 and 2006. Late payments and defaults on the underlying mortgages have far exceeded the agencies’ initial expectations, and investors and analysts say this month’s rating actions lag far behind where prices have already fallen.

“The rating agencies’ ability to accurately assess the risks have been in question since the beginning of the year, so downgrades do not really tell us whether the securities are worth more or less,” said Don Brownstein, chief executive of Structured Portfolio Management, a hedge fund. “But they are important because they can trigger forced selling for some investors and some structures.”

Widespread sales of such securities could cause further acute losses for banks and investors, even if they are not subject to forced selling rules, by providing dismal market prices for portfolios of mortgage-backed securities and CDOs. Losses for such securities forced Merrill Lynch to take a $7.9bn writedown in the third quarter alone, raising serious concerns about the outlook for the fourth.

Mr Brownstein said this complicated the rating agencies’ work because, while the existing ratings were not an accurate reflection of the likelihood of default for subprime-linked securities, wholesale downgrades could also destabilise the market.

“From a purely intellectual perspective, since the truth will come out, then the sooner the better,” he said. “But from a macro-economic standpoint, the question is how much shock is too much, given that we don’t know who owns what.”

The problem is particularly acute, given the ratings cuts are affecting not just the riskiest tier of securities, but also those with the highest AAA ratings. These are typically held by investors with low risk appetite, who could be forced to sell in large numbers, or may have leveraged their holdings based on the “safety” of the AAA rating.

According to a Bank of America analysis of recent Moody’s and S&P downgrades, while most affected classes were rated A or below, still about one quarter of affected ratings were AA or AAA.

In one set of rating actions earlier this week, Fitch placed $24bn of AAA-rated CDO securities linked to subprime mortgages under review for downgrade.

Meanwhile, the rating agencies are already trying to catch up with the scale of late mortgage payments and defaults on securities issued in 2007, when problems in the subprime mortgage market were already evident. S&P this month downgraded $23.35bn of US residential mortgage-backed securities issued in 2007.

But while the rating agencies admit that losses in the subprime mortgage market have eclipsed their initial assumptions, they say it is not unusual for rating actions on such structured finance securities to occur in such a wholesale manner.

“When structured finance [ratings] move . . . they move in groups more than company ratings do,” said Ray McDaniel, chief executive of Moody’s, in a recent video interview with the Financial Times. “It’s not surprising that they do, because they are packages of assets that are quite homogenous – a pool of mortgages, for example – and they are often originated at a very similar point in time.”

As a result, said Mr McDaniel: “It is reasonable to anticipate they are going to experience more correlated behaviour, and so in times of strength more of those securities will be upgraded across the board and in times of weakness more of those securities will be downgraded across the board.”

The rating agencies have announced reviews of their structured finance ratings for the coming weeks and months, all while conditions in the housing and mortgage market continue to deteriorate, leaving investors steeled for further losses in an already stricken market.

Additional reporting by Stacy-Marie Ishmael

Copyright The Financial Times Limited 2007

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One Pay Gap Shrinks,
Another Grows
November 1, 2007

There’s a new myth percolating about the U.S. economy: Female workers are doing great. So are educated men. The only ones hurting are male high-school dropouts. So, the argument goes, cut the whining about globalization and technological change hurting the American middle class, fix the education and training system, and get on with it.

FORUM

Why do you think women are gaining on men in the labor market? How do you think the typical American family is faring these days? Discuss.

It’s a nice story. Unfortunately, it isn’t true. Women are closing the pay gap with men and are outpacing men in the race to get college diplomas. But the fact is that the remarkable burst of productivity of the past decade has not been widely shared with the women or men living at the middle of the American middle class.

“Women are doing better than men, but still not good — in the sense as not as good as from 1947 to 1973 and not as good given the strength of productivity growth,” says Lawrence Katz, a Harvard University economist who has become the arbiter of arguments about the American labor market. “If men had done as well as women, things would look much brighter, but people would still be questioning why the median worker hasn’t earned more.”

Justifiably uneasy about Democratic politicians’ demonization of globalization, labor economist Stephen J. Rose of the centrist Democrats’ Progressive Policy Institute is the latest to raise his voice to argue against what he calls the “dark vision” that “the American middle class is disappearing.”

Part of his case, expressed in a PPI monograph adapted for an op-ed piece in this newspaper, is this: “For three-quarters of the American work force (women and the top half of male earners), economic growth [between 1979 and 2005] translated into earnings gains….For the clear majority of the work force, then, the job market has become more welcoming.” He does, however, offer a rather significant admission: “The last six years have seen very little wage growth for the bottom 80% of the work force.”

A few caveats: (1) The choice of years to compare, the particular wage measure used and the way one adjusts for inflation can tilt the data toward a brighter or gloomier picture. (2) Men and women tend to live together, so when wages for one go up and wages for the other go down, they share the pain or gain. (3) In many ways — cleaner air, healthier children, amazing technology — the middle-class American family is far better off than it was 35 years ago.

A few facts:

Women are gaining on men. Women who worked full-time, year-round earned less than 60% of what men earned until the early 1980s, when social attitudes changed and women moved into high-paying jobs once reserved almost exclusively for men. As recently as 1970, more than half the 30-something working women with college degrees were teachers; now it’s less than one-fifth. In 2006, the Census Bureau says, the typical woman earned 77% of the typical man’s wage.

But, as the accompanying chart demonstrates, the men and women at the statistical middle of the middle haven’t done all that well. The typical man earned $42,261 last year, which is 2.7% more than the typical man earned in 1996, adjusted for inflation. For women, it’s $32,515, up 7.1% — better, not great. In the same decade, output per hour of work, known as productivity, climbed nearly 30%. (Yes, some of this discrepancy is because employers spent more on health insurance and had less left over for wages, but a lot is because the gains of recent growth have gone to the very best-off.)

Women are getting more education. In 1960, there were 1.6 men graduating from four-year colleges for every woman, according to Mr. Katz and his Harvard colleague, Claudia Goldin. By 1980, there were as many women as men graduating. Today, there are about 1.35 women graduates for every man.

But the noteworthy gap is between workers with education and workers without, regardless of gender. The payoff for getting a diploma traditionally has been greater for women (in the past, some men got high-paid blue-collar jobs), and that’s still true. The bigger story is how much more valuable a college diploma is than it was 30 years ago, and how much of a penalty a worker pays for not going to college.

The gap between women’s wages and men’s is narrowing, but the gap between economic winners and losers of either gender is widening. And the patterns of inequality among women are more similar to than different from the patterns among men: Earnings at the very top are growing much faster those at than at the middle or the bottom. Everything else is detail.

Former Treasury Secretary Lawrence Summers puts it sharply. If the distribution of income in the U.S. today were the same as it was in 1979, and the U.S. had enjoyed the same growth, the bottom 80% would have about $670 billion more, or about $8,000 per family a year. The top 1% would have about $670 billion less, or about $500,000 a family.

The bottom line: The economy treats female workers more like male workers than it did a generation or two ago. That’s a welcome fact. But it doesn’t obscure the unwelcome reality that the fruits of America’s prosperity aren’t being widely shared.

Write to David Wessel at capital@wsj.com

“I wouldn’t attribute oil’s current rally all to backwardation. This is strong market on a fundamental basis which has caught the attention of speculators,” said Sarah Emerson, director of Energy Security Analysis Inc in Boston. “But the backwardation reinforces the move up in price.”

http://www.msnbc.msn.com/id/21565232/

MSNBC.com

China pushes up fuel prices

By Jamil Anderlini in Beijing and Javier Blas in London

Financial Times

updated 6:42 p.m. ET, Wed., Oct. 31, 2007

China raised the price of petrol and diesel by almost 10 per cent on Wednesday as crude oil prices hit a record above $94 a barrel.

The move, the first increase since May 2006, came in spite of a promise by Beijing not to put up state-controlled prices before the end of the year in an effort to keep inflation at bay.

Inflation in China exceeded 6 per cent in the third quarter amid rising food-price increases that some fear could lead to social unrest. The fuel-price rises are the latest sign that record oil prices are affecting the global economy at a time when some central banks are considering interest-rate cuts to boost economic growth after this summer’s credit squeeze.

Vitor Constancio, a member of the European Central Bank governing council, warned on Wednesday that higher oil prices could “create stagflation conditions”. His comments came after eurozone inflation jumped to 2.6 per cent in October, the highest level in more than two years.

The US and China, the first and second world’s largest crude oil consumers, this week called on the Organisation of the Petroleum Exporting Countries to boost its supply to replenish oil inventories ahead of the winter peak season.

US crude inventories on Wednesday dropped to the lowest level since October 2005, when the oil industry was recovering from the impact of damaging hurricanes.

The unexpected fall triggered a price rally that saw West Texas Intermediate crude oil surge to a fresh nominal record of $94.56 a barrel.

The retail price rise in China could stimulate demand in the short term as refiners resume production, and is unlikely to dampen long-term demand, analysts said.

The price of petrol, diesel and jet fuel in would be raised by Rmb500 per tonne, effective from Thursday, said the National Development and Reform Commission, China’s powerful state planner.

Copyright The Financial Times Ltd. All rights reserved.

URL: http://www.msnbc.msn.com/id/21565232/
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Backwardation “vortex” fueling oil’s rally

Wed Oct 31, 2007 4:01pm EDT

By Richard Valdmanis and Robert Campbell - Analysis

NEW YORK (Reuters) - Falling crude inventories and the shape of the futures curve will likely continue to feed back into each other and boost oil prices further until there is a meaningful change in the global supply picture.

Since July the market has been “backwardated,” where the price of oil that is about to be delivered is higher than for later deliveries. Backwardation encourages the sell-off of stocks and is seen as a sign of supply tightness or even shortages, which further boosts prompt prices.

The current rally will likely go on until oil supplies rise or demand falls enough to reduce the incentive to sell off oil in storage, energy experts said on Wednesday.

“Given the economics of storing oil, it makes no sense to hold on to inventory right now. Storage owners are taking the economically prudent step and dumping inventories,” said Stephen Schork, editor of the Schork Report.

U.S. crude futures for delivery in December hit a record of $94.74 a barrel on Wednesday and were running more than a dollar higher than those for delivery in January and more than $5 higher than those for delivery in May.

“We’re in a hamster wheel right now,” Schork said. “This can only end when there is not enough prompt demand to sop up supply on the spot market.”

U.S. commercial crude oil inventories fell nearly 4 million barrels last week, spurring another rally in crude prices which hit a record above $94 a barrel. Much of the drop came at the delivery point for the New York Mercantile Exchange’s (NYMEX) crude oil futures contract at Cushing, Oklahoma.

“Backwardation in the NYMEX futures curve remains steep, and today’s eye-catching decline in crude stocks held at Cushing will help to entrench the current curve structure in the near term,” said Harry Tchilinguirian of BNP Paribas.

SUMMER STOCK SLIDE

U.S. crude oil inventories have tumbled by 41.4 million barrels or 11.7 percent over the four months since the end of June, according to U.S. government data.

The drop has been even more pronounced at Cushing where stocks have plunged by 36.5 percent to 15.05 million barrels.

A lot of the majors are cutting their imports into the Midcontinent and are running down stocks held at Cushing and other inland storage points,” said a U.S. crude oil broker.

Shipments of crude oil up the 350,000 bpd Seaway pipeline, which brings imported crude from the U.S. Gulf Coast to Cushing, slumped to 104,000 barrels per day in the third quarter compared with 239,000 bpd a year ago, according to TEPPCO Partners LP, which holds a 40 percent stake in Seaway.

Energy experts said oil’s 35 percent rally since August is due largely to slipping inventories in big consumer nations amid OPEC’s reluctance to hike output.

“I wouldn’t attribute oil’s current rally all to backwardation. This is strong market on a fundamental basis which has caught the attention of speculators,” said Sarah Emerson, director of Energy Security Analysis Inc in Boston. “But the backwardation reinforces the move up in price.”

“The thing about backwardation is if you have a rally in the prompt contract, you get into the backwardation vortex. It is a self-reinforcing cycle,” she said.

OPEC producers agreed to hike output 500,000 barrels per day starting in November, but many oil analysts have said the move is not enough to ease the tight market.

OPEC ministers are expected to discuss the supply situation at an informal meeting in Saudi Arabia in November.

(Additional reporting by Janet McBride in London)

© Reuters 2006. All rights reserved.

http://www.reuters.com/article/reutersEdge/idUSN3145897620071031