Wednesday, May 21, 2008

Market Watch: Will the oil bull cause its own downfall?

The US dollar has been hammered since late last week, falling to a 24-year low against the Aussie dollar, a 1-month low against the euro and a 2-month low against the Canadian dollar this week. Although US interest rates appear to be on hold for now, the recent rally in the greenback has hit a wall and the currency has reversed course, as rising inflation across the globe cuts off the prospect of rates cuts by the world's Central Banks. Indeed rate hikes across the globe are back on the agenda as oil prices have hit $130 a barrel. Oil prices are 100% higher than they were this month in 2007 and 160% higher than in January of last year. Oil prices are now a huge risk to the health of the global economy and the frenzy-like price spike underway poses a policy dilemma for Central Bankers, let alone governments. The Fed won’t be thanked by many for their contribution to the commodity price bubble, a bubble which took off in earnest when the Fed embarked upon its aggressive rate easing cycle last September. This policy track, primarily for the benefit of financial markets, was not reciprocated by the ECB or most other Central Banks. It is plain nonsense to suggest rocketing oil prices are merely the result of an economic supply and demand imbalance. Demand growth for oil has slowed since oil prices were trading at $50 a barrel in early 2007. The global economy was booming back then but global GDP is expected to slow to a paltry 1.8% in 2008, according to the latest IMF forecast. If oil demand was kept in check at $50 during boom times, why must it fetch $130 during the bad times, which have arrived only 16 months later? US inflation is running at 3.9% over the past 12 months, euro area inflation at 3.3% and oil price inflation at 100%.

Oil demand relative to the oil price is also distorted as governments of many of the emerging economies (from where the bulk of global growth in demand originates) shield the end consumer by subsidising all imported oil and gas. Were consumers in China to be burdened with the massive inflation seen in oil and gas prices, it is not possible the growth in Chinese demand for these commodities could be sustained at current prices. In a sense, the subsidising governments are doing global consumers a disservice by interfering with the normal supply and demand mechanics of a free market. But the governments of emerging economies are not alone in price tampering as some governments in the developed world traditionally load domestic taxes on oil and gas, while wealth creation funds (hedge funds), that have no interest in buying the actual physical product let alone helping the end consumer, are allowed to push the price around significantly, generating exaggerated price movements through applying loosely regulated risk leverage to their bets. And it is worth noting that hedge funds don’t tend to short commodities in a bull market. A glance at last week’s non-commercial trades on the New York Mercantile Exchange reveals there is approximately two long positions against every short position on Nymex for non-commercial traders and in terms of volume, there is 5 times as much funds invested in non-commercial Nymex positions than there is in the euro currency. Looking in more detail, up to last week, there were more speculative shorts than longs on the euro, thus traders were net short on the euro. This confirms that the often referenced correlation between EUR/USD and oil prices has disappeared for immediate term because the bullish run-up in oil failed to pause, after we saw a temporary stabilisation in the dollar.

So what are the options and how can economic reality be brought to bear on oil prices? There are a few considerations to ponder:

1) OPEC announces it is increasing production output before the scheduled September meeting. This has been tried and tested many times before and previous token gestures to increase output have been met by higher oil prices. How come? There is not a supply shortage and there is no logic in rising output if it widens the gap between supply and demand. Politicians who believe the route to lower oil prices is taking a trip to the Middle East to plead for some announcement of a marginal increase in output, need to be brought into an economics class for a reality lesson.

2) China announces it is lifting its oil and gas subsidies and recent price increases are passed onto the consumer. This would definitely work and the very threat of subsidies being lifted would force a mass sell-off of those speculative long positions on the futures and options markets. Were other emerging economies to follow suit, oil prices could tumble dramatically and crude could easily fall to below $80 a barrel by the end of the third quarter. Of course a well-coordinated campaign on the part of the emerging economies to lifting subsidies could be a major triumph for these governments, because a dramatic fall in oil prices would essentially mean the end consumer does not pay any more anyway while the governments save themselves a fortune on subsidy costs. The risk associated with this strategy is that if oil prices did not fall, the removal of the subsidies would see substantial additional costs loaded onto the consumer and it would seriously dampen the pace of growth in those emerging economies. In any case, even if the governments fail to act now, they will not be able to afford to subsidise oil at consistently escalating price levels indefinitely and the price burden will eventually be passed onto the consumer.

3) A strong US dollar rebound would slow oil price inflation. While crude may have outperformed all other commodities over the past 9 months, the rapid run up in commodity prices over this period is directly related to a plunging dollar. Many commodities, including oil and gold, act as a hedge against a falling dollar and were the dollar to bounce back significantly, the heat would be taken out of the bull market in oil. The question remains as to what might force a dollar recovery strong enough to deter the commodity bull. The funny thing is it will probably be the runaway bull itself which will ultimately lead to some marked appreciation in the dollar. Why so? Inflation is rising everywhere, not just in the US, at a time when broad-based demand is slowing, which poses something of an economic contradiction. The real reason for the spike in producer and consumer prices is that hyper-inflation has entered dollar-denominated commodities, including industrial metals and soft commodities, although the principal contributor to hyper-inflation is the run-up in oil prices. If the dollar continues to fall indefinitely and commodity prices rise at the same disproportionate rate as seen in the past year, the world economy is set for a major recession, characterised by hyper-inflation and rising interest rates. It was the Fed’s unilateral policy that led to this commodity bubble in the first place and it may be that only the Fed can reverse it. A sudden downturn for the euro area economy should help the Fed, albeit by proxy, as this would trigger dollar appreciation, but failing this, further rises in commodity prices on the back of a weakening dollar will mean inflation (headline and core) comes knocking hard and the Fed will eventually be forced to answer its own door.

Ted B - May 21

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