Market update and the oil predicament
On May 11, Wall Street’s most bullish analyst raised his year-end S&P 500 target from 7700 to 8250, the highest forecast on Wall Street. He did so because of the strength and breadth of S&P 500 earnings during the Q1 earnings reporting season.
Citing Fabulous Earnings Momentum (FEMO), Yardeni expects this year’s stock market melt-up to be more sustainable than a FOMO (Fear of Missing Out)-led rally.
However, even Yardeni has turned more cautious in the near term.
In another non-consensus view, Yardeni believes the resilient U.S. economy, stable labour market, and rising inflation mean the U.S. Federal Open Market Committee (FOMC) is turning hawkish and could possibly shift from an easing bias to a tightening bias as early as this month, followed by a rate hike in July. The consensus view doesn’t expect a rate hike until late this year at the earliest.
Finally, it’s worth remembering there are three epochal Initial Public Offerings (IPOs) coming to market this year (SpaceX, Anthropic and OpenAI), which might add volatility. Even though there’s more than enough liquidity in the market to invest in these companies (they’re listing only small proportions of their total shares), their early inclusion in the major indices will increase thematic concentration.
Oiling a problem
The war in the Middle East appears likely to linger, even as oil giants Exxon and Chevron warn that global oil inventories are dangerously low and that oil prices, which are trading calmly around US$100/bbl, could soon spike to US$150/bbl or higher.
Why?
Strategic Petroleum Reserves (SPR).
There’s some merit in the idea the U.S. government is employing financial shenanigans to manipulate near-term oil prices lower, and that will eventually backfire.
At its peak, the U.S. Strategic Petroleum Reserve (SPR) held over 700 million barrels of oil. Its current maximum capacity is said to be 714 million barrels.
In March this year, the U.S. began releasing 172 million barrels through a series of term exchanges or repo-loans, as part of a coordinated international effort to reduce pressure on prices and economies.
- The Repo-Loan scheme or oil swap
Normally, when the U.S. wants to lower petrol (‘gas’) prices, it just sells oil from its SPR. But today, the SPR has hit its lowest inventory level in 40 years – bottoming out at 243 million barrels. Direct sales aren’t an option.
To understand the use of “term exchanges” or “repo-loans” instead of a direct sale, imagine lending your neighbour a dozen eggs, but at steep interest.
The U.S. government ‘lends’ 172 million barrels of oil to Exxon or Marathon today, and instead of paying with cash, Exxon and peers repay by returning physical oil in the future, plus a steep 25 per cent premium (interest in the form of additional barrels of oil). If they ‘borrow’ 100 barrels from the strategic reserve today, they have to return 125 barrels later.
The SPR will actually hold 460 million barrels. Physically, the tanks are much lower, but on paper (the ‘forward curve’), those companies legally owe the government 215 million barrels of oil over the next couple of years.
- Backwardation
Investors might notice that Crude Oil WTI futures for July 2026 delivery are currently trading at US$95.40/bbl, while October 2026 futures are trading at $85.77/bbl, November 2028 delivery is trading at $71.08/bbl, and, all the way out, September 2034 futures are trading at $57.61/bbl. Clearly, oil traders believe the oil price will fall in the future, and the futures curve is said to be in backwardation. Oil today is more expensive than oil in the future.
This dynamic creates a massive profit incentive and arbitrage opportunity for oil companies. They borrow the government’s $96 oil today, sell it immediately into the market for a high price, buy cheaper $70 futures contracts for 2028 delivery to lock in the oil they owe back to the government, and pocket the price difference as profit – even after paying the premium.
- Gold’s historic warning
Back in the 1990s, central banks lent physical gold to mining companies. The miners sold the gold immediately to finance operations, flooding the market and keeping gold prices artificially low for a decade.
However, it created a massive trap: if gold prices suddenly spiked, those companies wouldn’t be able to afford to buy back the gold they owed the banks. In 1999, an ill-executed gold price hedge led by Goldman Sachs caused a major mining company, Ashanti, to lose US$190 million in 1999 and collapse because it couldn’t cover its massive loans. The crisis triggered a merger with AngloGold to create the world’s second-largest gold producer, AngloGold Ashanti company, and it also caused a crisis in the gold market.
Gold prices bottomed at US$256/oz in July 1999 before commencing an almost uninterrupted rise to US$1,826/oz in August 2011.
- A predictable outcome?
Just as we saw with gold in the 1990s, today’s borrowing and selling of oil are said to be artificially suppressing near-term prices. By flooding the market with paper contracts and loaned physical oil today, the U.S. government effectively caps oil prices. Oil companies are strongly incentivised to increase the short-term velocity of oil trading, thereby keeping the market artificially supplied.
The issue is the U.S. has traded physical, ready-to-use emergency or ‘strategic’ oil for a promise of oil years from now.
The risk is that a true geopolitical emergency occurs between now and 2028.
With strategic reserves depleted, the U.S. can’t pump paper contracts into a domestic refinery during a crisis.
Between now and late 2028, oil giants will have enter the open market to buy up more than 200 million barrels of oil just to pay back their debt to the government. This massive, mandatory buying pressure could drive global oil prices way up in the future. If oil production fails to grow aggressively to meet this hidden demand, the market will suffer a severe supply shock.
The concern should be that the U.S. government is trading temporary fuel price relief today for the high risk of an oil shortage and a price spike tomorrow.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
He is also author of best-selling investment guide-book for the stock market, Value.able – how to value the best stocks and buy them for less than they are worth.
Roger appears regularly on television and radio, and in the press, including ABC radio and TV, The Australian and Ausbiz. View upcoming media appearances.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
