Oil supply predicted to exceed demand for two years, according to London based expert

Written by Ray Clancy

Monday, 06 September 2010 08:13

Oil supply is likely to exceed demand for around two years barring any unexpected economic upturn and the best trading strategy is to be short near term when prices will dip below $70, it is claimed.

London based fund manager Patrick Armstrong of Armstrong Investment Managers is predicting that US crude will fall below $70 a barrel by the end of the month, while gold could extend its bull run to reach $1,300 this year.

US crude has traded in a roughly $70 to $85 range for most of this year and last Thursday hovered around $74, pressured by record levels of US fuel inventories.

The obvious trading strategy for Armstrong was to be short near term, but to take longer positions further along the curve. ‘The no brainer trade is to be short front month and long further out. We have put on a significant short on the front month oil index and gone long four months out, rolling to the fifth month contract,’ Armstrong said.

By the front month oil index, he was referring to the S&P GSCI .SPGSCI basket of commodities, which is heavily weighted towards oil, and whose reliance on rolling positions from the front month to the second most prompt month has been challenged by a stubborn contango in the oil markets.

Contango, whereby oil for near-term delivery is cheaper than more distant contracts, is a function of oversupply and its persistence has drawn claims of super-contango, including from Armstrong. ‘Any time it’s costing you 2% a month to roll that qualifies as super-contango,’ he explained.

To roll contracts further along the curve is cheaper and the relative strength of less prompt oil implies an eventual recovery in demand to mop up surplus supplies. That will take time unless there is unexpected economic growth to drive fuel consumption.

‘It will be a couple of years before demand outstrips supply. There’s very little in the way of fundamentals to support near term oil prices where they are now,’ he added.

The impact of oversupply would continue to be exaggerated at the front end of the curve, also referred to as spot. ‘We expect on days when oil rallies, the entire curve will shift up, and on days of weakness it will be more pronounced at spot prices. We expect weakness in spot by month end, but we would not be surprised to see July 2014 stay in the $85 per barrel level,’ he explained further.

The net impact of long and short positions is that Armstrong’s portfolio of $350 million in assets under management has 0% invested in oil. Precious metals make up around 8% of the portfolio. Gold is already trading well above $1,200 an ounce after hitting a record of $1,264.90 in June.

It has some upside potential, Armstrong said, on the grounds that a struggling US economy will have to resort to further economic stimulus, with consequences of a weakened US dollar and upward pressure on inflation, although that might not be significant until around 2020.

‘The real value of gold in a portfolio context is the potential US dollar crisis, which we think is a significant possibility,’ he added.

Agricultural commodities have also delivered strong returns, with US wheat gaining more than 25% so far this year, and make up just under 2% of the Armstrong portfolio. Prices sprinted in July when worries about Russia’s worst drought in more than a century swept through benchmark grain markets.

‘We’re happy with 2% right now. We’re very bullish on agricultural commodities long term. Short term, it'’ run up quite a lot,’ he said.