Oil speculation

The Economist leader this week is about oil. Clearly, at $135 a barrel the world is suffering a serious oil shock. Equally clearly, everyone is looking around for someone to blame. One of the favorites is those-evil-speculators. The Economist puts it thusly:

Stuck for answers, politicians have been looking for scapegoats. Top of the list are the speculators profiting from other people's hardship. Some $260 billion is invested in commodity funds, 20 times the level of 2003. Surely all that hot money has supercharged the demand for oil? But that is plain wrong. Such speculators do not own real oil. Every barrel they buy in the futures markets they sell back again before the contract ends. That may raise the price of “paper barrels”, but not of the black stuff refiners turn into petrol. It is true that high futures prices could lead someone to hoard oil today in the hope of a higher price tomorrow. But inventories are not especially full just now and there are few signs of hoarding.

Of course, as useful and intelligent as The Economist is, it sometimes suffers from over-compression an idea in order to fit it into their bite-size chunk type of format. If you actually look at it the facts, there is every reasons to believe that speculation is in fact contributing substantially to the run up in oil prices. This is not to say that the entire move over the last four years from $35 to $135 has been caused by speculation. There is certainly a broader supply and demand trend. But to ignore the contribution of changes in the financial markets is foolish, no matter how well it sits with your market fundamentalism faith. On top of that, The Economist, while mumbling a bit about inflation, does nothing to explore the role that negative real interest rates have in all this.

In reading over this question, I often feel it can be reduced to a case of the all-powerful force and the unmovable object. On the one hand, The Economist and a lot of other people claim that there is no possible way that the money coming through index funds into futures can effect the spot market. They claim that this is just "paper oil" we'd see a huge rise in inventories, which we don't. This is impeccable logic. On the other hand, when the fund inflows into commodities are as large as they are and you can see long-time industry participants complaining about the distortions that are happening in the markets, you have to assume that this amount of new money is going to have some effect on the price.

So, in sum, there absolutely must be commodity speculation, and there can't possibly be.

Of course, as happens with most speculative manias, both are partly correct. There is always a long-term story, and it always gets over-hyped. In this case, the conclusion is that the days of $35 a barrel oil (the marginal production cost) are over, but that neither is there any reason to believe that the price will stay above $100 for very long. Half of the story is the growing demand and long lag time on new supply of an ultimately finite resource, and half is a financial bubble -- "peak oil" meets peak oil frenzy. So let's not beat around the bush. The price of oil will stabilize around $75. That's my story, and I'm sticking to it.

Second life

In a funny coincidence I just finished writing an e-mail about this very topic of what's going to happen with globalization (and of course, how to profit from that). Here is Philip Stephens in the Financial Times with Uncomfortable truths for a new world of them and us.

The world has been turned on its head. Consumers in the wealthiest nations are struggling with the consequences of the credit crunch and with the soaring cost of energy and food. In China, retail sales have been rising at an annual 15 per cent. I cannot think of a better description of the emerging global order.

In another interesting coincidence, I found this link via Naked Capitalism, who mentions a place dear to my heart in his commentary.

But the ugly fact is that the US (and the UK) has the potential to go from first world to third world on a relative basis. We've already have one developing economy trait: the emergence of a super-rich cohort that lives in splendid isolation, often with considerable security.

If you think that's impossible, remember that Argentina had a spectacularly rapid fall. Bad leadership can destroy an economy in a surprisingly short period of time. Again, the US will hopefully escape that fate, but no matter what happens, our economic strength is ebbing as others are moving forward. A severe crisis in the advanced economies could lead to a bad outcomes even in emerging economies, but that scenario has perils of its own.

I don't think there's any reason to believe that the US will be destroyed in the long-run by these changes in globalization. After all, it is beginning with a remarkable secular head-start, even if the cyclical tide is against us. But avoiding this -- avoiding becoming Argentina -- will require a certain political will. 8 more years of George Bush would probably be America's undoing.

Argentina and the US are a little bit like twin colonies separated at birth. Someday I hope they are re-united, but I definitely hope it's because Argentina comes to resemble the US, warts and all, rather than vice-versa.

Bear bottoms

One hears an awful lot about what bear market bottoms look like historically, and most of it tends to seem a bit silly to me. But the idea this Morgan Stanley analyst had to read all the WSJ copies surrounding a bear market bottom seems interesting. A couple of his points:

1. Valuations get very very low indeed. The cyclically-adjusted PE, aka the Shiller PE, represented by the latest price divided by the average earnings of the last 10 years, reaches 10 or even less at bear market bottoms, while Tobin’s Q, the price divided by the replacement value of assets (or price over net worth defined as assets minus liabilities), gets as low as 30% or less. These valuations are the biggest problem with today’s market, as the Shiller PE is more than twice that. Today’s message: Shiller PE is above 20 still, while true bear markets tend to end at less than 10 times. Equities are not cheap enough and need to decline by at least 50 percent.

2. Equities become cheap slowly. The average duration of bear markets has been 14 years, with the much more rapid 1929-32 episode, when equities went down 89%, the exception. Today’s message: we are in year 8 of a 14 year bear market.

3. Sentiment is not hugely negative at the bottom of the bear market. The popular myth that there are no bulls left at the bottom of the bear market is wrong. Many market commentators are correctly bullish right at the bottom of the bear market. Popular myth has it that talk of ‘equities are dead’ and ‘there is no future for equities’ should be widespread and are classic signals of the end of the bear market. This is far from the truth, it turns out. In related fashion, there is no climactic last and final sell-off on high volumes. Quite the contrary, the final slump is on lower and lower volumes. Subsequent higher volumes at higher levels confirm the bear market is over, with hindsight. Today’s message: do not take any ‘contrarian comfort’ from the fact that many people are quite bearish on the macro outlook, contrary to conventional wisdom, that is not a classical sign of a bear market trough.

4. Patience! Equities do trough during economic recessions, but they do not anticipate economic recovery by 6-9 months. The lead time is much shorter, and often equity and economic recoveries are coincident, and sometimes economies bottom before equities do so. Patience is key. Today’s message: indeed, this is consistent with our finding that one should be patient in bear markets as there is not much discounting of the upturn going on at the end of the bear market, after numerous failed rallies and false hopes.

7. There are some consistent early signs of economic improvement. The three best are the copper price bottoming out, auto sales improving (or at least getting less bad), and inventories being very low. Today’s message: the copper price has not even fallen yet, so we are far away from the bear market trough.

Good trading idea

I'm reading an interesting paper by Brad Delong on international capital flows, and I come across this brilliant story:

A huge amount of industrialization in the resource-rich, temperate periphery
before 1913, was financed by the willingness of British investors to commit
their capital overseas—not just to build up Britain’s capital stock, but to
build up capital stocks abroad as well. (Let’s pass over for a moment the
fact that the British investors in the Erie Railroad found that Jay Gould stole
two-thirds of their money, not least by taking a huge leveraged long position
in the stock and then announcing his retirement from the company. He
retired, the stock price boomed, and he pocketed something like 50 percent
of the present discounted value of the fact that he would no longer be around
to loot the company.)

I love it when people are willing to pay you to stop robbing them.

Friday Afternoon Phase Transition

I wonder what it will be like to look back on my life in 2042, just as the world starts to settle down into a new state. We will not even be the same species we were 100 years ago. I also wonder whether we are in the process of boiling or freezing. Probably freezing given the increasing density.

Oil Fundamentals

With all the debate over commodity speculation, it's also good to revisit the real story that got the bubble rolling. Jim Hamilton reviews the fundamentals for oil. Basically they imply consistently high oil prices. What price? I don't know that anybody has come up with a convincing way to say. But I do take seriously his point that there is simply not enough oil in the ground for China to consume as much per capita as the US.

To summarize, I think we will see some net production gains this year, and expect this to bring some relief for oil prices. But I cannot imagine that the projected path for China above will ever become a reality. Oil prices have to rise to whatever value it takes to prevent that from happening.

So yes, I do believe that speculation has played a role in the oil price increases, particularly what we've observed the last few months. But it's a big mistake to conclude that speculation is the most important part of the longer run trend we've been seeing.

Markets and oil

A few snippets from this recent post express my own consternation:

What makes markets so intriguing today is that equities seem largely immune to a combination of $120+ oil, softening housing markets and a likely collapse in western consumer spending. Arguing that several trillion currently either sheltering in money market funds or rapidly accumulating thanks to petrodollar wealth in sovereign wealth funds will ride in to support stock markets (a.k.a. greater fool theory) only logically goes so far in the face of such sizeable challenges. But some confusing short-term resilience on the part of stock markets does not invalidate the need for caution, it rather reinforces the need for patience ...

In the face of almost insurmountable doubts (over likely economic slowdown, the impact on consumer confidence of softening residential property prices, the robustness of Asian fundamentals in the face of the ongoing commodity rally, the impact of $130+ oil, and the health of government bond markets given growing doubts over the under-reporting of inflationary pressures) it makes absolute sense to assume ongoing and substantial macro uncertainties. That argues, in turn, for nuanced and highly selective exposure to equity market risk, to capital preservation strategies in bond market terms, and to a healthy degree of ‘absolute return’ (quality hedge fund) as opposed to long-only market positioning, not to mention further asset diversification. Markets may not yet be flashing red, but there seem to be more than usually strong headwinds about.

I think that pretty much sums it up -- the market does not make much sense right now in the face of what's happening in the real world. Stocks seem like they're on prozac. I would have only a couple of comments on this post.

First, I haven't quoted it, but that article mentions a Citibank analyst who has overlaid the charts of various bubbles (Japan 89, Nasdaq 2000, Saudi Arabia 2006, Shanghai 2007) with the current prices for commodities. I agree that it is difficult to value commodities and so difficult to know how much of their current valuation is speculative. I also agree that financial markets should be the subject of ethological study -- capitalism is a fascinating animal behavior pattern. But you've got to be kidding me if you think you can convince me that something is a speculative bubble merely by overlaying its chart on that of other speculative bubbles. This is supposed to be the grand new "science" of behavioral finance? Give this chart overlay stuff a rest. It's about as useful as technical analysis, or reading entrails generally is.

Second, my own experience investigating funds that bill themselves as "absolute return" is that their not. Maybe funds like this really do exist, but I think they are few and far between, and not the ones that everybody normally gets excited about because by remaining "market neutral" they get lost in the dustbin of under-performance during the good times. Now that times are tough, suggesting that investors take these guys out and dust them off is a bit ingenuous -- they've already been driven out of business by all the performance chasing redemptions during the good years. So if you don't already have some money allocated to this type of thing, I'm not sure I would rush to do it now.