Oil bear who won big in 2014 says prices can still fall further
11 Sep 2015
In the spring of 2014, hedge-fund manager Doug King decided weak demand for natural rubber, a key industrial ingredient, meant global economic growth would be slower than many expected. That helped seal a decision to make a big short bet on oil futures, which contributed to a 59% net return for the Merchant Commodity Fund last year.
King, the London-based chief investment officer and co-owner of RCMA Asset Management, which manages the fund, moved Merchant to the market’s sidelines after late-August volatility saw oil futures jump 28% in three sessions and left the fund down around 10% for the year.
But with rubber prices near six-year lows, King remains bearish on oil and says the fund could make further short bets when market volatility subsides. Persistent oversupply and uncertain demand should lead the U.S. oil benchmark to test the 2009 low at $32.70 a barrel, according to King.
“My bias is still that the world economy is struggling—that the demand we’ve seen in the first half of the year will prove transitory,” King said in an interview with MarketWatch.
Questions about both oil oversupply and slowing demand
Pressure on emerging-market currencies means producers in those countries have incentive to keep producing oil and other commodities even as the price of oil declines, King said.
Meanwhile, demand is set to take a seasonal hit in the near term as refiners head into what is known as the “fall turnaround season,” in which refiners shut down in September and October to retool equipment and switch from making summer- to winter-grade fuels. That could take 1 million barrels of daily demand out of the market, analysts say.
Oil is unlikely to see a lasting recovery, King said, until there are signs of true capitulation on the supply side, such as a decision by the Organization of the Petroleum Exporting Countries, or OPEC, to cut production. OPEC late last year opted not to cut production in the face of falling prices in a move widely viewed as an attempt to drive higher-cost producers, particularly in U.S. shale regions, out of business.
Analysts at Goldman Sachs on Friday are also maintaining a bearish outlook on oil prices, warning that crude could drop as low as $20 a barrel on persistent OPEC production growth, resilient supply from non-OPEC countries and doubts about demand.
OPEC production in August saw its first monthly decline since February, but continued to surpass the cartel’s production ceiling. U.S. shale production is slowing, but didn’t decline as quickly as many analysts anticipated. Saudi Arabia, the world’s swing oil producer, continues to resist calls for an emergency OPEC meeting to discuss a production cut.
Crude oil’s plunge was one of the top business stories of 2014, as the U.S. benchmark ended the year at less than half of the June high of around $107 a barrel. Ahead of the collapse, strong demand from China and a litany of geopolitical flare-upshad buoyed oil. High prices encouraged production.
The shale revolution in North Dakota, Texas and elsewhere was the biggest factor, with U.S. oil producers adding nearly 4 million barrels a day in production between 2008 and 2014.
Before oil’s crash, the impact of surging U.S. crude production was muted by a litany of problems in the Middle East and North Africa, including Libya’s civil war, which weighed on production outright or made market participants nervous about potential output losses form the region.
“All of this incremental supply from the States was getting absorbed because there were so many problems elsewhere, but it was still there,” King said.
The hedge-fund manager grew doubtful in the spring of 2014 that the market could continue to absorb that supply, particularly as he and his colleagues became increasingly convinced that the outlook for oil demand wasn’t so robust.
‘Lackluster’ demand for rubber was a clue
That’s where rubber comes in. King has a strong window into the underlying global economic picture through RCMA Group, a privately-held physical commodity-trading business. King is the chairman and largest shareholder of the firm, which deals in rubber, cotton, coffee, sugar, fertilizer and other commodities.
“We spend a lot of time data crunching,” King said. “We spend a lot of time chatting with real physical commodity people, and we spend a lot of time modeling on what we think is best way of approaching good risk-reward trades.”
That offered a crucial clue last spring.
“Rubber is a big [gross domestic product] proxy,” King said. “Our rubber deliveries globally, and whether in the states or China or in Europe, were just lackluster and declining.”
While the consensus at the time was for global economic growth of 3.5% to 4% in 2014, King’s firm pegged it closer to 2% to 2.5%. That suggested oil demand of 500,000 to 600,000 barrels a day rather than 1.3 million—which, in turn, meant crude-oil inventories were set to grow quickly, King said.
And they did. A rising tide of crude oil supply in the U.S. even stoked fears of a shortage of storage space in early 2015. Crude inventories, while seeing a seasonal drawdown in the summer, remain near levels last seen eight decades ago for this time of year, according to the Energy Information Administration.
The oil rout carried on through the first quarter of this year, with oil touching a six-year low below $44 in March.
Then came a rebound, driven in part by a seasonal pickup in demand that took some bears, including King, by surprise. The bounce took the U.S. crude benchmark back above $60 a barrel in June. Oil came under renewed pressure late this summer, with the U.S. crude benchmark hitting lows below $40 a barrel for the first time since February 2009.
Oil’s rebound hurt, but King still sees poor commodities demand
But after dropping to lows in August, crude snapped back like an overstretched rubber band—jumping 28% in just three trading sessions, the biggest three-day rise since 1990.
That price action wasn’t friendly to the still-bearish King, even though both West Texas Intermediate US:CLV5 and Brent UK:LCOV5 futures, the global benchmark, are both down more than 14% since the end of last year.
King admits the fund got the demand outlook wrong in the first half of the year. Low prices spurred stronger demand for oil in the U.S., Europe and other developed markets. But he argues that the price action across a range of physical commodities, including rubber, are now telling the same tale they told in early 2014.
“They’re telling us that in the world in general, consumption demand for commodities is lackluster,” King said.
Rubber hit new lows in early September. And when oil did manage to rally at the end of August, other commodity markets and shares of natural resources companies didn’t enjoy a sympathy bounce.
King sees no obvious catalyst for crude’s end-of-August jump. “I think it can only be put down to huge volumes, people getting out of positions, algorithms and whatever you want to talk about,” he said. Much of the recent volatility was driven by factors that have little to do with oil-market fundamentals, such as China’s stock-market plunge.
It’s no secret that commodities can be volatile. Even on the way to a winning performance in 2014, the fund faced a rough patch after it started building short positions in May of that year. A round of Middle East turmoil, including ISIS gains across Iraq, provided crude-oil bulls with a final hurrah that temporarily wrong-footed the fund.
Near-term volatility aside, King said, until there are convincing signs of capitulation on the supply side, the bears are likely to prevail.
“When we last bottomed in commodities in 2001-2002…you saw people cutting down rubber trees,” he said. “I don’t see capacity being taken out of the commodity world today. Until we see some proper supply-side reaction, I don’t think you can call the bottom.”
Merchant was the top performing fund in the macro strategies category in 2014, according to hedge-fund data firm Preqin Ltd., and the sixth best performing fund overall.