The Inflation Dragon is Sleeping, Not Slain


A 50% gain in around two weeks is a very tidy lift in anyone’s book. Anyone holding shares in Anadarko Petroleum has this very warm, fuzzy feeling right now.

That’s because the stock is the subject of two competing takeover offers.

I told you about the first one last week. Major energy giant Chevron came out and said it would pay US$33 billion to acquire Anadarko.

This week, another firm called Occidental came out and upped the ante to US$38 billion. We might have an old-fashioned bidding war on our hands.

Do you care? Probably not, as it’s unlikely you own any of them.

However, something tells me we’re going to see more mergers and acquisitions across the energy sector in both the United States and Australia.

That means it could be an ideal time to be hunting for likely candidates like this one.

It’s certainly not unreasonable to suggest so. Brent crude is up 40% for the year. That gives any existing producer than can take advantage of it some nice cash flow to do deals.

It also helps when US President Donald Trump is putting sanctions on two major energy-producing countries: Venezuela and Iran. That means the market is more likely to tighten than not.

You don’t have to believe me on that, either. That’s what the futures market is saying right now.

Market traders bet big on oil rising

Let me explain. Crude oil is the most traded commodity in the world.

You can buy it for months out into the future. For example, you can buy a contract for June delivery of Brent oil at US$74 a barrel.

If you can wait a little longer, say to December 2019, you’ll pay just under US$71 per barrel.

Fast forward in your mind for a moment and imagine we’re heading into Christmas for 2019.

If you happen to own a contract with the right to buy oil at US$71 (you bought it in April) and the current price of oil (we’re imagining we’re in December 2019) is US$100, you’re holding a very valuable piece of paper. You can pocket the difference.

This is what the game of futures is about. It’s also how hedge funds and traders speculate on the price of oil.

So their buying and selling decisions throw off clues as to where they think the price is going. And they’re placing big bets, in terms of money, on being right.

What’s the market saying right now?

When the price of oil for delivery in the short term is higher than dates further out, the market is said to be in ‘backwardation’. This is the inverse of the normal market structure.

Oil is in the deepest backwardation currently since early last year. What’s the clue? It means the market is putting a premium on oil available now and pricing in shortages to develop in the second half of the year.

Naturally, this could all change tomorrow if new information causes traders to reposition.

But we can pair this with offers from Chevron and Occidental to spend billions to acquire Anadarko to see that the players closest to the oil industry see the price more likely going up than down.

That puts the market at odds with statements from the US and Saudi governments that the oil market is in balance.

When faced with this kind of choice, I’ll always go with the market first…unless a very compelling reason says otherwise.

Then we have another indicator that just popped up on my radar…

Another howler in the eyes of history?

Financial history contains a couple of howlers that only became apparent in retrospect. In 1979, for example, Businessweek magazine ran a cover with the headline ‘The Death of Equities’.

History was not kind to this. US stocks were on the cusp of their biggest boom of all time over the next 20 years.

The point being is that magazine covers can offer a wonderful contrarian signal.

What’s that today, though? I’d suggest that it’s the outlook for inflation. Prices for most things (except houses and financial assets!) have grinded along for nearly 10 years now.

Central banks keep undershooting their inflation targets. That means investors have priced in a world for low inflation.

It’s why there’s US$10 trillion in negative-yielding debt floating around the world.

This recent cover — courtesy of my colleague Dan Denning — captures the current zeitgeist…

Source: Bloomberg

Inflation may seem benign even with oil at US$75. But what about US$150?

My fear is that we’re going to find out the answer over the next 12 months. That’s because there’s multiple pressures building up in the oil market.

It’s why I have a select few oil stocks on the Small Cap Alpha buy list.

If I’m right, the inflation dragon could breathe its fire and light them up.

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Callum Newman Signature

Callum Newman,
Editor, Profit Watch