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By Robert Rapier on Oct 19, 2007 with no responses

Herding Behavior

The bandwagon on $100 oil filled up very quickly. I thought we were likely to see $100 oil next year, which is why I have consistently said I wouldn’t make that bet on oil prices for 2008. But, if you look back just a couple of months ago, nobody was calling for $100 oil this year. In early August, WTI was hovering in the low $70′s. That’s when you need your financial advisor to step up and say “$100 oil is coming fast.” That would be a gutsy call. Yet it would be a call supported by pretty much the same fundamentals that are in place now (with the exception of Iraq/Turkey). After all, supply and demand projections are pretty much on target from what they looked like in August. Nothing has dramatically changed. If anything, the supply picture looks a bit better with OPEC cracking the taps a bit.

So why did oil have to go through $85 with a bullet before the chorus for $100 oil became loud? $100 oil by the end of the year is now conventional wisdom. The experts on CNBC are telling us to brace for it. We are given this information as if we can’t deduce for ourselves that the chance of $100 oil this year is much higher after the rapid rise into the high $80′s.

This herding behavior is sort of comical to watch. We saw it on Black Monday. I noticed it when ethanol stocks were riding high in the first half of 2006. I thought most were overvalued. In fact, I wrote my first article on overvalued ethanol stocks in June 2006 in response to an article the previous week that urged investors to embrace ethanol stocks. As ethanol stocks drifted lower and lower, the herd started to defect. But they didn’t defect until the slide was well underway. Why didn’t they defect early, based on the fundamentals? Because that’s not the way a herd behaves. (I grant that there are lots of exceptions). I sometimes wonder about the ratio of people doing fundamental analyses to those just parroting the work of others and getting paid for it.

Finally, ethanol stocks were down 60% and the remainder of the herd awoke from their slumber. Ethanol stocks became a poor investment, and the remaining holdouts finally said “Perhaps we should downgrade ethanol stocks from hold to sell.” It’s the same kind of herding behavior that pushed some tech stocks from $5 to $150 to $2 in the late 90′s.

Back to oil prices, there was a very funny column in yesterday’s Houston Chronicle that explains oil prices are so volatile:

A day in the life of an energy trader

Here are some excerpts (OK, extensive excerpts!) that capture the gist:

It was just another day on the trading desk at Flippum Energy Partners. I decided to drop by and see what the traders thought about crude oil prices, which closed above $89 a barrel Thursday, setting a record.

“The prices have consumers worried. What does it all mean?” I asked Lefty Dollarhyde, the head trader. “It means oil is going to $100 a barrel before Thanksgiving,” Lefty said. He spoke without taking his eyes off of the bank of computer screens in front of him. Their glow bathed him like a tanning bed. He hammered furiously on the keyboard.

“What can we do?” I asked feebly over the clacking.
“Go long oil. That’s what we’re doing. We’ve maxed our position.”
“If oil keeps rising, doesn’t that mean gasoline will soon follow?”
“Nah, we’re short gasoline. Nobody’s driving.”
“OK. If nobody’s driving, then won’t demand for oil eventually fall?”
Lefty’s fingers froze over the keys. He paused for a moment, then leaned back in his chair and called to another trader sitting in the next row.

“Hey, Slick! Check the stockpiles. Whatcha got?” Slick responded with a litany of numbers and place names, but he talked so fast I couldn’t write them down. Lefty returned to the screens. He picked up the phone and punched in a few numbers, cradling the receiver on his shoulder. If I understood his staccato instructions, he was placing an order for January puts, a bet that prices would fall. I was confused.

“Didn’t you just say oil was going to $100?” “Nah,” he said, the phone still against his ear. “Stockpiles are fat. It’s going down. It’s nuclear winter, baby. A major glut. We’re shorting crude big time.”

As Lefty typed furiously, I looked around and saw a group of traders gathered around a television across the room. They appeared to be ogling Maria Bartiromo. Suddenly, one of them turned away and shouted in our direction.

“Lefty! Turkey’s amassing troops at the Iraqi border. It looks like an invasion.”
Geopolitical scares Lefty unleashed a string of profanity so foul it singed the pages of my notebook from 2 feet away. He shook his head. “See? Geopolitical conflict. That’s what it’s all about. We got a new war. No oil’s getting through. Bundle up, baby, we’re all burning trash to stay warm this Christmas.”

He was on the phone again, going long on crude. As he put the receiver down, Herb Flippum, the firm’s founder, walked up. We chatted a few minutes as Lefty continued to stare at his computer screens. Flippum patted Lefty on the shoulder.

“Hey, Lefty, remember my neighbor who bought that huge SUV, the Ford Subdivision? He told me this morning he’s selling it and getting a Yaris.”

Flippum walked off shaking his head and chuckling to himself. Lefty was already on the phone. “That’s what makes us different. I factor anecdotal evidence into my positions. If a guy’s selling his SUV for an econo-bug, that tells me demand is falling off. Prices will hit $75 before they hit $100.”

He leaned back in his chair to catch his breath. He looked at me, as if he just realized I’d been sitting with him all morning. “So, what do you want to know?”
“Well, I was hoping to explain to my readers what’s happening with oil prices.”
“Oh,” he said with a shrug. “You just have to understand the markets.”

Don’t get me wrong. I obviously believe the underlying fundamentals strongly favor higher oil prices going forward. But I know what’s going to happen if the herd now spooks in the other direction. Monday is the last day for trading the November WTI contract. I think you will see a lot more volatility with the December contract, which becomes the front month contract on Tuesday.