Concern Over Oil
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I have received many questions about oil recently.
Indeed, given its importance to the world's economy Mish pleads "guilty as charged" for failing to comment on this vital economic component. I hope to correct that oversight with this post.
Here are four typical questions from my blog and/or from the message boards I post on.
1) Mish, I've been wondering about oil prices and a common explanation we always hear as to why they are so high. I don't think I've ever seen this covered before so I was wondering if you'd take a shot.
2) Mish, I would also like to know what you think about the high oil prices. Andy Xie from Morgan Stanely believes oil prices are high due to speculation and are due to fall sharply in the medium term. See Asia/Pacific: Scary Oil
3) Mish, why are oil prices going up with oil reserves at 5 year highs and crude in contango?
4) Mish, Please respond to Noland's Thesis in a thoughtful, analytical and classy manner.
First off let me state that I am a firm believer in the concept of "Peak Oil". No meaningful discussion about oil can commence unless and until one has at least some knowledge about that concept.
Peak oil is the point in time when extraction of oil from the earth reaches its highest point and then begins to decline. We won't be able to say with certainty when we have reached peak oil until after the fact. Many experts say we have already reached the peak. Others say not yet, but within the next few years.
I am pretty sure most Mish readers are familiar with the idea, but if not here are three good sources:
Mish responds with a question: Are oil prices high?
At $60 a barrel, oil is priced at 18 cents a pint!
Yes that is correct: 18 cents a pint. You can not buy water for 18 cents a pint.
In fact can you get anything but oil for 18 cents a pint?
If so what, and does anyone want it?
Given peak oil and geopolitical concerns on top of it, one can make an easy subjective case that oil is bargain basement priced at $60 barrel.
My friend CalculatedRisk offers this perspective about oil prices on an inflation adjusted basis.
Let's now tackle Andy Xie's claim that speculators are pushing up the price of oil.
His claim is easily refuted by looking at actual stats.
Here are the current stats from the commitment of traders report (COTs) as of this writing on August 14 2005. Notes on the following chart for those not familiar with it.
- COT reports come out every week on Friday for every commodity and for currencies and major indices as well.
- By the time you click on the above link a new report might be out so don't expect to match the table below after 2005-08-18
- Although the report comes out on Friday it is based on data from the preceding Tuesday, in this case 2005-08-09
- Non-Reportable positions are the small specs (you and I)
- Non-Commercial positions are major players (hedge funds)
- Commercial positions are the producers (forward selling of oil delivery) and hedgers (e.g. airlines having a vested interest in hedging oil costs)
- The producers will always be net short
- Shorts and longs always balance out to zero
OPTION AND FUTURES COMBINED POSITIONS AS OF 08/09/05 |Looking quickly, one can see that small specs are net short. This is not surprising given that small traders are most often wrong. Big specs are indeed net long but the amount is not that huge. I have been following these reports for quite some time and the amount of spec long positions overall is not significant. It is well within normal patterns. Thus point blank, Andy Xie is wrong to be blaming speculators for huges rises in oil prices.
--------------------------------------------------------------| NONREPORTABLE
NON-COMMERCIAL | COMMERCIAL | TOTAL | POSITIONS
--------------------------|-----------------|-----------------|-----------------
Long | Short |Spreads | Long | Short | Long | Short | Long | Short
--------------------------------------------------------------------------------
(CONTRACTS OF 1,000 BARRELS) OPEN INTEREST: 1,452,515
COMMITMENTS
154,921 87,259 415,351 796,636 853,820 1366908 1356430 85,607 96,085
CHANGES FROM 08/02/05 (CHANGE IN OPEN INTEREST: 75,127)
18,337 9,999 20,930 28,155 35,582 67,421 66,510 7,706 8,617
On a fundamental basis, given a "Peak Oil" background of diminishing capacity, diminishing reserves, and a world population that is rising, with China and India coming of age causing increased demand at the margin (and in commodity pricing it is the nth margin that matters), it really should not be of shock to anyone that oil prices are rising. Thus Andy Xie has been wrong fundamentally as well. He has been bearish on both China and oil for as long as I can remember.
Andy Xie may eventually be right, but it will not be because of speculators throwing in the towel. This is what it comes down to: IF a slowing world economy decreases the demand for oil more than the "peak oil" pressures of diminishing supply over time are causing prices to rise, then and only then will prices drop.
Personally I think that will happen at some point but there is a huge wildcard. What happens if Islamic fundamentalists overthrow the Saudi government? What happens if terrorists in Saudi Arabia blow up refineries? What happens if Iran shuts off oil supplies? Quite frankly oil will skyrocket on any of those. Regardless of my fundamental beliefs that the world economy is about to go to hell in a hand basket, oil is a very tough short (and oil bears have indeed been carted out in wheel barrows). Should a huge unsustainable spike come on horrific geopolitical news, I might be inclined to short that spike via puts with a known risk. We will see when the time comes. A second caveat is that should a worldwide recession reduce oil demand enough to cause prices to drop, it will be a temporary drop only. Coming out of the recession, demand will pick back up and we will be further along the peak oil supply curve as well.
Let’s turn our attention to question #3:
Why are oil prices going up with oil reserves at 5 year highs and crude in contango?
That is a good question.
First off let’s define "contango".
In futures or options trading, a market in which longer-term contracts carry a higher price than near-term contracts. The premium accorded to longer maturities is a normal condition of the market and reflects the cost of carrying the commodity for future delivery.
Hmmm. Given that contango describes a state in which prices are cheaper now than expected prices in the future, it sure seems logical for one to be filling reserves now doesn't it?
Thus we have rising reserves.
Or do we?
Enquiring Mish readers want proof.
The August 11th edition of Futures and Commodity Market News reported the following:
"Gasoline stock falls are providing some support to prices, but overall the rises in crude and distillates are bearish for prices which the bulls are ignoring," IFR senior analyst Tim Evans said.Wow that sure looks like hugely rising reserves does it not?
Further, US crude stockpiles are now 8.4 pct above their five year average. "This is not just a token surplus but a genuine glut."
"The gamesmanship continues as traders try to push the price to even more high's, ignoring the fundamentals, which suggest there is no imminent shortage," he said.
Enquiring Mish readers do not give up so easily and fire further questions.
This one just came in telepathically just now.
Is there a genuine glut or is there more to this story?
I have not heard of Tim Evans before but we have already discredited the nonsense about "gamesmanship" pushing prices higher. Perhaps Andy Xie reads Tim Evans. Who knows? We have also already proven (hopefully anyway) that 18 cents a pint is a reasonably cheap price, so now let's turn our focus on the "genuine glut" theory.
If crude stocks are 8.4% above the 5 year average does that mean there is a glut?
What if demand is 10% higher than 5 years ago? How about 20% higher? 40% anyone? The point I am trying to make is that anyone that thinks they can define a "glut" on the sole basis of a 5 year average of inventory without looking at a 5 year average in increasing demand is foolish.
Mish is there any evidence of increasing demand?
First off let me say that increasing demand should be obvious to anyone given all the sales of gas guzzling Hummers and SUVs in addition to the obvious rise in demand from China. That said, enquiring Mish readers deserve better answers than that, so let's consider the concept of "days of forward cover" .
OPEC research shows that days of forward cover is a far better indicator of oil prices than current inventory levels. Enquiring minds might wish to check out the graphs on page 3. While inventory levels may be at 5 year highs, the days of forward cover at current demand levels relatively low.
In short there is no current glut in oil inventory levels, although there might be later if demand falls off the cliff in a worldwide recession.
NEXT!
We have one last question to tackle.
I saved it for last because it is the most subjective.
I was asked to "Please respond to Noland's Thesis in a thoughtful, analytical and classy manner."
For starters let me point out that the article behind the credit bulletin link given above is subject to change. If you click on the above link, it it might be for a different date on a different topic. What the reader (from Silicon Investor) is asking about is Noland's Global Inflationary Boom Thesis. Following is the pertinent section:
"There is no better evidence to support the Global Inflationary Boom Thesis than $67 crude. And there was today news from China that July retail sales were up 12.7% from a year earlier (4-month high) and that China’s M2 money supply expanded last month at the fastest pace in a year (16.3%). Also today, India reported a stronger-than-expected 11.7% rise in industrial production. The Wall of Global Liquidity – much emanating from U.S. mortgage borrowings and speculative leveraging - continues to fuel the Chinese boom, as it does to only somewhat lesser degrees throughout Asia, India and elsewhere."
Let me say a couple of things. I like Noland. He generally does a credible job in pointing out the imbalances in the global economy. He is well aware of the "credit bubble" that is driving this train wreck to be. He is 100% correct about the existance of a mammoth "Credit Bubble". However, I think he is just plain wrong with his statement "There is no better evidence to support the Global Inflationary Boom Thesis than $67 crude". I will give him a chance to take it back. I propose there is no better evidence of a Global Inflationary Boom than housing bubbles on multiple continents.
That said, the global housing bubble is starting to collapse. A housing collapse is well under way in Australia, housing is starting to collapsing in the UK, and housing seems to be on the brink of a collapse in the US. One can make a case that something stronger than "Baby Steps" was needed to halt the credit bubble, but that case was stronger before these cracks in housing started to appear. Also, please bear in mind that the real problem was slashing interest rates to 1% in the first place, not the "Baby Steps" unwinding of it all. Those 1% rates fueled housing bubbles everywhere at a time when our economy already had an election stimulus, huge tax incentives for businesses, a firm housing market to begin with, and a huge war stimulus with money pouring into companies servicing the war effort.
Noland also proclaims "These days, analysts mistake the effects of massive global manufacturing investment (a Credit Inflation Manifestation!) for a continuation of the nineties 'disinflationary' environment. This is a major analytical error."
I completely agree with Noland that there is a "Credit Inflation Manifestation". I also agree that there is a major analytical error but that error is on behalf of Noland. From my perspective Noland fails to correctly analyze the aftermath of what will happen to those malinvestments and overcapacity once the global housing bubble collapses. K-Cycle theory (as well as actual historical outcomes) says that the end of a credit expansion cycle is a K-Winter deflationary credit collapse, not an inflationary inferno. I have not yet seen a valid set of reasons as to why this time will be different.
In the meantime, attempting to target inflation by focusing on the price of oil when
- Demand for oil is hugely inelastic
- Supply of oil is subject to peak oil concerns
- Supply of oil is subject to geopolitical factors
- Oil has naturally rising demand simply because the world's population is growing
Specifically, interest rates hikes are a rather broad brush method at controlling demand. Given the relative inelasticity of oil demand, attempting to control oil prices with such measures would likely not work until major economic activity dramatically slowed across the board. It would even be conceivable that we would be headed for economic depression before such a mechanism "worked". In short, it would be very poor economic policy to even think about attempting to control demand for "peak anything" via broad brushed interest rate policy decisions.
What nearly everyone fails to understand is that this is not 1970. Oil price increases are not in general being passed along with the exception of prices the gasoline pump. Gasoline prices will at some point have the affect of dampening consumer spending, at least at the margin. It is probably already starting. At any rate, rising oil prices are not exerting the same inflationary pressures that we saw the last go around. To paraphrase Dorothy, “Toto I don’t think this is 1970 anymore”.
Right now, rising oil prices are more of an economic drag on the economy as opposed to a massive inflationary force to be reckoned with. Unless and until wages rise to compensate for increased gasoline prices, it will likely stay that way. Given there is little evidence of either wage growth or job growth and given a collapse in demand when the housing bubble collapses, inflationary pressures of rising oil prices will likely be minimal for the foreseeable future.
Some people are focused on the CRB commodities index as opposed to just oil prices. That too, is just another red herring. The CRB is extremely skewed by energy prices. Consumer spending, a zero% savings rate, the housing bubble, and reckless extension of credit are what economists should be focusing on. When the housing bubble pops, its all over, regardless of what oil prices do. It does remain to be seen how many more "Baby Steps" are necessary to crash housing, but I think not many given the cracks that seem to be appearing all over the place.
If one accepts the notion that peak oil can not effectively be reined in by broad brushed interest rate policy, then how should one attempt to control it? I think peak oil is better addressed by specifically targeting oil demand as opposed to reducing the demand for everything. In that regard, taxes on oil, credits for low mileage cars, taxes on "gas guzzlers", mandates for higher gas mileage cars and trucks, taxes on oil company profits, and just plain "market forces" would all be better than firing a missile at demand in general on account of rising oil prices. Please not that I am not saying that a missile should not have been fired, I am saying that firing a missile because of rising oil prices is bad policy. There is a difference.
Thus I contend that Noland missed the boat twice: once by focusing on oil, second by accusing others of making a "major analytical error" when it seems that he is the one failing to see the deflationary aftermath of a housing bubble collapse. Even in such an aftermath, it is entirely possible that oil prices will still be "high" because of peak oil issues.
Regardless of what oil prices do, this house of cards is so shaky that it will eventually collapse on its own accord. All credit bubbles eventually collapse. This one will not be different. The moral implications of letting this bubble get so far out of hand lie with Greenspan and the FED. Greenspan’s idea that bubbles are best addressed after the fact is the very reason why each bubble he blows is bigger than the last. In excessively fighting every economic slowdown with ever increasing liquidity, he has repeatedly bailed out his banking buddies at the expense of someone else. That someone else is typically the average taxpayer who was sucked into one of his bubbles or was punished by it for long periods of time by staying out while everyone else played the greater fool theory. Greenspan will easily go down in history as the worst FED chairman ever on both a moral and results oriented basis. If I have ever said anything that Puplava and Noland both agree with, that is probably it.
Mish notes: This article first appeared in Whiskey and Gunpowder.
In that version I listed oil at 24 cents a pint. I had it correct in the temporary holding version in my blog. It seems I failed to get that correction to W&G. This was my error. I received the following email early this evening.
"In the latest Whiskey and Gunpowder you say:
At $60 a barrel, oil is priced at 24 cents a pint!
Yes that is correct: 24 cents a pint. You cannot buy water for 24 cents a pint. In fact, can you get anything but oil for 24 cents a pint?
By my math 60 divided by 42 is 1.42857, and that divided by 8 is about 18 cents a pint. It seems you used 31 gals. per barrel -- which is right for a fermented beverage but not for oil".
The responder provided a link to the correct defination of barrel. Thanks for that correction Bill. I need people to keep me on my toes. So for those of you that think oil is high priced at 24 cents a pint it is actually only 18 cents a pint at $60. Is that cheap enough?
Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/
