Thursday, 22 May 2008

Somebody make it stop

With each passing day, the price of oil increases further. On Thursday, prices jumped by four dollars in a single day, to $135 a barrel. Here in the UK, the average price of a litre of unleaded petrol is now approaching ₤1.14.

What would it take to bring the price of oil down? In order to answer that question, we need to understand why it is rising in the first place. Under normal circumstances, the price of any good will rise when either demand increases, supply falls, or some combination of the two. Over the last decade or so, demand for oil has risen dramatically, as many developing countries have industrialized.

However, this increase in demand can hardly explain why the price of oil rose from around $90 a barrel in December last year to $135 today. If anything, the growth in demand is slackening off, as advanced countries begin to slow down. In turn, this slowdown reduces demand for goods produced by emerging market economies.

Can we find an explanation on the supply side? There has been the odd disruption here and there, but nothing that can explain the magnitude of the recent surge in prices. In fact, most oil-producing countries have maintained production levels.

If the conventional explanations for a price increase are lacking credibility, where do we look for an answer? We have to go back to demand, but not the usual demand for oil as inputs to production or as a source of energy for transportation. We have to see oil as an asset price, traded in financial markets.

Oil prices are merely responding to interest rates. As short-term rates have come crashing down, and investors have suddenly realized that most asset classes are much more risky than previously thought, commodity prices, particularly oil, have been the only asset class offering significant rates of return. Lower interest rates also drastically reduced storage costs of oil, which has encouraged many suppliers to store oil rather than sell it. In other words, as interest rates have fallen, speculative activity in the oil markets has taken off.

Ironically. Central Banks in advanced countries could bring the price of oil crashing down in just 24 hours. All that it would need is one massive hike in rates. Although central banks would like to burst the oil bubble, they fear something more than inflation. It is a systemic banking crisis.

Banks in the US, the UK, and many parts of Europe are hopelessly exposed to one horrifically overvalued asset class - real estate. Although property prices are falling, a large increase in interest rates threatens to send property prices into a double-digit slide into the abyss.

This collapse would unleash an unstoppable chain reaction. As house prices go down, so does the value of collateral. Default rates on mortgages would also rise, banking losses would accumulate, and bank capital would be wiped out. In other words, higher interest rates threaten to bankrupt financial systems on both sides of the Atlantic.

Can oil prices just keep on going upwards? Oil is the last great bubble, and in the fullness of time, it will burst. The adjustment mechanism will come through long-term interest rates. The oil price bubble is pushing up inflation across the world. Gradually long-term interest rates are beginning to reflect that fact.

So far, the yield curve has only steepened marginally. Nevertheless, give it time, and it will fully reflect higher inflationary expectations. Long-term interest rates will rise further, and as they do, the world economy will slow. The oil market will be faced with declining demand, which will eventually put a brake on this speculative behaviour.

However, that day could be some way off. In the meantime, prices could keep on rising for months to come. The day of $200 oil could shortly be upon us. It is doubtful whether it would be with us for long, but by the time it shuffles off, it will leave the world economy in a deep recession.


Roy said...

₤2 a litre by xmas?

Simon said...

If one looks at the global increase in money supply plus the advance in China/India etal, then the price of oil is not in a bubble.

It is merely adjusting to an industrialized world's demand.

aSteve said...

Nice analysis, Alice.

I think the key here is that the oil price may have been driven primarily by long futures positions... essentially a bet that prices will continue to rise... the oil being bought is oil yet to be delivered... it is bought almost entirely on credit - and it requires no storage until it is scheduled for delivery... usually in 3 or six months from the time at which contracts are drawn up.

According to the document Nick posted here, positions are growing exponentially in spite of growing supply and diminishing demand.

$30bn in futures contracts, I work out to have been >250,000,000 barrels. Let's just hope they have somewhere to put all this oil when it is delivered and can't be sold immediately at a profit in 3 or 6 months' time.

From my textbook on commodity derivatives, I understand that it is normal practice to sell the future/option before it expires in order to avoid taking physical delivery... so, I anticipate fear of spiralling future cost of oil until this winter - when the futures price will collapse... but not until the cost of retail fuel (retail prices being quickly adjusted to take account of future raw material costs) significantly damages the wider economy.

The current oil situation looks *remarkably* similar to Enron's dabbling in the US-East-Coast's electricity supply. Given how similar Enron behaved to an investment bank / hedge fund, it isn't hard to imagine that some similar player is again attempting to game the system today.

Enron went to the lengths of orchestrating artificial blackouts - I wonder if we're going to get more terrorism scares relating to the near-East?

Alice Cook said...


"From my textbook on commodity derivatives, I understand that it is normal practice to sell the future/option before it expires in order to avoid taking physical delivery..."

I think this is a key part of the story. Very few people actually need to buy and hold stocks.


Simon said...

When I took economics A level (many years ago), one of the first things my teacher said was,

"if everyone in China had a moped the world would be thrown into an energy crisis"

guess what?

aSteve said...

My textbook tells an interesting urban legend about a junior futures trader who had a contract for thousands sides of beef... and forgot to sell it... then received a phone call telling him that his cattle needed to be shifted from the market within 24 hours... whereupon he was forced to fly out and arrange emergency fields and feed while suited and booted for the city. The author explains that he is not aware of anything similar to this actually happening, but investors are well advised that someone, somewhere, always does take possession of the physical commodities... and in an extreme situation what happened to the fictional junior trader could happen in real life.

It is my personal belief that the vast majority of all of our economic problems boil down to the effects of derivatives today - just as the malaise of the 1930s can be pinned primarily on the stock markets.

My take is that derivatives are exceptionally powerful market manipulators. They're pitched as being a mechanism by which market forces are stabilised... but I think the converse. I think options, futures and derivatives act in different ways - depending upon the type of entity the derivative acts upon...

1. Some entities have flexible supply and flexible demand. The price and margin on these entities are driven down by improved forecasting of demand. The suppliers are marginalised and the consumer benefits... especially if consumers are free to alter demand patterns. This effect has definitely marginalised first-world farmers - placing supermarkets, for example, in a commanding position to profit at the expense of their suppliers. "Investing long" in such derivatives is suicide - unless you have specific information about an entity-specific crisis... or you're having fun playing roulette with someone else's money.

2. Some entities have fixed supply... this makes little difference except that the derivative now represents only demand speculation - not supply. With only one free variable, this is just a degenerate form of (1) and prices are likely to fall as a result of decreased demand. (If I *knew* I could "hire" the community lawnmower on Sundays, the only day I'm free to mow, I'd not likely buy my own - hence driving down demand.)

3. Here's the counter-intuitive notion: credit derivatives. Credit derivatives drive down the cost of credit - just like the derivative of entities above. They drive down the cost of borrowing - which dramatically increases the amount of money that can be borrowed against any given income stream... which drives up the value of all assets suitable as collateral... including debt... hence a virtuous/vicious cycle (depending upon whether or not you own real assets to start the ball rolling.

Credit derivatives can be though of as insurance for lenders. I don't worry about my car being torched while parked - because I'm insured... I park anywhere I like. In a sense it makes me reckless... and the same effect could be found with all forms of lending... Once a credit derivative is obtained, there is no further need to worry - or so you might think.

The problem, of course, is how can the risk of the credit be mitigated? I could underwrite a £100 loan made by a loanshark to "friend" by putting £100 in a secure box and promising that to the loan-shark should my "friend default" - or maybe do the same with a £200 watch - if I didn't have the cash. But, of course, if I have sufficient capital to underwrite the loan, why should I let the loanshark profit/take advantage of my friend? Why don't I lend my friend the money, or borrow it on their behalf... at favourable terms... because I've assets and (s)he hasn't? Therein lies the nonsense in the proposition of credit derivatives.

How does it really work? Well, the loans aren't underwritten at all... the issuer of a credit derivative just promise to make good any defaults - because they have sufficient assets to pay off a tiny proportion of defaults - and, historically, there have only been a tiny number of defaults... and miraculously - in the looser credit conditions that happily coincided with initial expansion of credit derivatives (cheaper borrowing) defaults tended to zero. [Which is logical, why would anyone default if - on running out of cash - they could always borrow more against the same assets? No-one who owned a house - no matter how much debt was secured on it - could logically default... so, it followed that giving cheap mortgages to the credit impaired made sense.] Another "benefit" also rapidly arose: the debt of borrowers was perfectly suited as collateral to underwrite credit derivatives (virtual circle/vicious cycle - depending on your perspective - again.)

In concrete terms, the name of the most popular credit derivative is a CDS "Credit Default Swap". These are traded but not in an open market, as such. Total nominal contracts in CDS have been expanding exponentially in recent years - and vastly exceed global credit... making it clear that issuers of CDS have become nervous about the risk and tried to hedge that by buying a CDS to offset the risk of the CDS they sold... a frantic game of pass-the-parcel... with the parcel getting hotter by the second. Some non-conclusive evidence exists that nominal outstanding CDS contracts are in excess of $40 trillion (yes, that's the units!) or about 10 times world GDP at the time of the leak.

The most alarmist of responses is to look at the CDS markets and have an epileptic siezure at the size of the numbers. This misses the point... however... many of these contracts will cancel out - and represent insured amounts rather than realistic losses... but it is still alarming for two reasons:

1. In an unregulated market it is impossible to determine which CDS contracts have substantial default risk and which do not. This means that most companies that hold financial instruments which depend upon CDS contracts have accounts that can't be independently verified in any meaningful way.

2. The same lack of regulation gives rise to another risk... where the assets used as collateral form a cycle of dependency - and, hence, are all worthless. This bears an uncanny resemblance to the "Split Cap" fiasco of 2004 where "Split Cap Trusts" (details unimportant here) saw they were beating the markets... so, rather than invest in the markets, they decided to invest in each other to keep the party going. It is interesting to note that the Spit-Cap fiasco was the most recent scandal before Northern Rock... and one where John Tiner (then head of the FSA) intervened to get the perpetrators off with a fine for a small fraction of their ill-gotten gains... It is anecdotally interesting that Tiner quit the FSA just before Northern Rock hit the headlines... and went to work for New Star asset management... the fund managers he helped out after their "Spit Cap" scandal came to light.

One thing we can conclude from the seizure of the credit markets is that they'd become too 'optimised' to cope with any unexpected shock – such as subprime defaults or falling house prices. The upshot is that – when lending re-starts, it will not bear any relation to previous lending – for at least 10 years – and that the value and supply of financial assets is entirely uncertain at present... but almost definitely vastly over-stated in financial accounts.

From the perspective of a fellow angry renter, one awfully clever idea I've just had is that we should set up a derivative market for rental contracts and house prices. That would put the cat among the pigeons, wouldn't it?

VADO said...

Oil at $200 - that should be enough to cause a world slow down.

Unregulated markets, excessive greed, and mispriced risk - what a mess!!!!!

aSteve said...

Simon: of the first things my teacher said was, "if everyone in China had a moped the world would be thrown into an energy crisis" guess what?

Your teacher wasn't especially bright? Your teacher wanted to say something shocking to start a contrary debate? Your teacher, even back then, was drawn in by the peak-oil conspiracy theories?

I remember a "business studies" teacher when I was doing my GCSEs - about 1989/1990 - who said that "House prices can't fall; they just can't - that's all." Guess what happened next?

powerman said...

I'd be interesting in comparing the price of oil to other commodities like gold.

Anonymous said...

If petrol keeps on rising, I will have to start getting the bus to work.

Vodka drinker said...

I read somewhere that gold was crashing right now.....

Josh said...

Oil isn't called black gold for nothing.

aSteve said...

Gold has fallen back some way from its recent highs, while the price of oil is still rising.

It is important to note that the price of oil is a future price, whereas the price of gold is a spot price. Brent crude at it's recent record ($135) is for July delivery... the spot (now) price for gold is $912 - which is about 10% down from its recent peek.

Mark Wadsworth said...

Global temperatures, house prices and oil prices will keep rising at the same rate for ever! By 2020 an average UK home will cost £1 million; oil will be £100 a gallon and the Greenland glaciers will have melted!

aSteve said...

Good choice of 2020. This is exactly what 14% year-on-year uniform inflation would bring over a period of 12 years.

By the same metric, average wages would be £120K and a beer would cost £15. Council tax would be about £6K for a modest house and heating it might well cost £10K. Get ready for some *very* poor pensioners.

aSteve said...

Oh, and I've just found... George Soros agrees that we're in a futures driven bubble. ;)

Simon said...


My very astute teacher introduced me to the concept that oil may well be abiotic.

The point was that with a relatively small increase in individual demand aggregate demand could well overstretch supply.

I believe we could now be close to this situation.

Anonymous said...

"This collapse would unleash an unstoppable chain reaction"

Change 'would' to 'will' and you have my prediction.

I'm still calling bubble in oil, rather than real supply/demand issues. There would be supply/demand issues soon if not for the global recession.

Oil has gone up for 3 reasons:
- more money printed that's chasing it;
- money ditching other asset classes to chase it, especially the index speculators;
- speculators borrowing to buy oil futures on margin.


powerman said...

It sounds like you have similar economic views to me Nick, but the reason I'd like to see oil priced in terms of gold (over, say, the last 10 years) is that I think it would give me an insight into whether there had been a real shift in the end consumer demand for oil (or supply), or whether we were seeing the result of currency devaluation, capital flight to commodities etc..

As was pointed out above, whilst Oil and Gold are both much more expensive than they were 5 years ago, Oil is currently going up in price, whilst gold has been declining and this trend seems to have held for several months.

Anonymous said...

It's hard to price things in gold when gold is in a bubble of it's own.

I think that article linked is a good approximation of how much is real supply/demand and how much is temporary speculation that must reverse.


aSteve said...

Simon: "My very astute teacher introduced me to the concept that oil may well be abiotic."

While I hope I'm not being too abrasive... I consider the abiotic case somewhere less credible than unproven.

I also refuse to believe the idea that there is going to be a tipping point with dramatic consequences. There is absolutely no financial incentive at present to find alternatives to oil.. when such incentives arise, I'm very optimistic that technological advancement will rise to the challenge. I'm looking forwards to significant improvements in battery technology, for example - and for greater efficiency of transport systems and freedom to travel in more pleasant ways. I don't want to sit in a traffic jam for 2 hours every day; I don't want to sit in a cramped plane... I want to see electric cars used sparingly - mainly for liesure; commutes to walk; occasional use only of planes... rather than fly short-haul to holiday... why not enjoy a 2-day plane and boat journey on a longer holiday? I can't wait for us to find motivation to avoid over-use of oil.

powerman said...

"It's hard to price things in gold when gold is in a bubble of it's own.

I think that article linked is a good approximation of how much is real supply/demand and how much is temporary speculation that must reverse.


It's the comparison of the two bubbles I'm interested in. If oil and gold had more stable 'prices' relative to each other than they did compared to, say, the US dollar or Sterling, that would tell me something.

Oil/Gold stability (they seem to be disparate commodites with no particular industrial or actual usage relationship between their respect supply and demand) would suggest to me that the prices were financial artefacts. Whereas oil clearly soaring away relative to gold would suggest to me that there really has been a substantial shift in the supply/demand fundamentals of oil.

aSteve said...

Powerman, I think the problem with your suggestion is that while oil is consumed, gold is merely held...

I think it would be a huge mistake to compare prices unless you also compare traded volumes. To ignore the volume of transactions in favour of the price alone plays into the hands of speculators. It is the dual error to that made by those who are sucked-in by ponzi schemes and multi-level-sales strategies. Reality can only be found by looking at consumption and solvency... to do otherwise is to fall victim to false valuations.

The fact that gold (bullion) is not consumed is exactly why I reject its subjective supposed value. There is only speculative demand for bullion - so it has the least stable price of any commodity.

powerman said...

It's true that oil is consumed (voraciously) whilst gold is mostly (but not entirely) held as an investment or made into jewelery.

But.. we don't consume currency notes either. They have no use at all except as money.

Gold's price relative to a range of other goods has a remarkably stable history.

I don't think volume traded necessarily matters here.

But, there's no reason Gold has to be the commodity compared. Pricing oil in some other commodity (doesn't have to be an 'investment' commodity like an imperishable precious metal or gemstone, could be wheat or cotton), or a basket of them, could still tell us something about the real nature of oil's supply and demand fundamentals.

aSteve said...

We don't consume currency notes, I agree, but they are extremely heavily traded. Their use is to pay duty and taxes while avoiding imprisonment and other penalties.

I disagree that Gold's price relative to other commodites has a remarkably stable history. The price of consumer electronics, for example, has plummeted over the past 5 years, while the price of gold has rocketed. The price of gold is only stable if you have a mindset that values everything in gold... wages are not priced in gold; taxes are not priced in gold – etc.

Volume traded does matter for gold – just like shares. Where either gold or a share is thinly traded, the price can not be trusted... the price represents a speculation – usually by those with insufficient funds to pay for a meaningful proportion of the asset. It allows traders to “move the markets” in order to inflate the accounted values of their assets and appear to make profits.

The problem with all commodities is this: they're commodities, and – as such – have futures markets... which are dominated by speculators rather than consumers. Where speculators engage in the commodity futures markets, it should not be surprising to see price bubbles. I strongly suspect that the primary difference between relative commodity inflation will be the time-scale over which the futures markets trade... the shorter the time-scale to alter production, the greater the risk for speculative investors that there will be chronic over-supply and they will create commodity mountains that cost them dear. We had commodity speculation initially because the risk free rate of borrowing fell below perceived inflation... the returns on futures indices then lured speculators who inflated a speculative bubble. By comparing relative changes in commodity price, all you're really doing is comparing the lead time for increased capacity.

Nick Drew said...

FYI, not all derivatives settle physically - for example, the most heavily traded oil contract, the Brent futures, can be (and usually is) cash-settled (see here)

Brent is a complex market where the front-month futures contract plays almost the same role as what would be called the 'spot' contract in other commodities. But speculators are generally punting on futures, not physicals / spot.

Oil production costs (on average) less than $40/bbl. Speculation alone couldn't drive the gap between 40 and a spot price of 135: it is mostly just froth on top.

In addition to genuinely high demand, the real issue is ACCESS: marginal production is no longer controlled by IOCs, but increasingly by NOCs / countries that have little or no incentive to respond to price signals.

A sharp downturn in Chinese industrial output will cause a major downward correction - if it hasn't happened already by then.

powerman said...

"I disagree that Gold's price relative to other commodites has a remarkably stable history. The price of consumer electronics, for example, has plummeted over the past 5 years, while the price of gold has rocketed."

That's an example of exactly what I'm talking about. Consumer electronics are cheaper precisely because of a change in supply fundamentals (i.e. production switching to cheaper labour).

aSteve said...

Nick Drew: Interesting stuff about cash settled crude futures... I was wrong - I'd assumed they would all be physically settled. Can you offer some indication as to what proportion is physically settled and what proportion is cash settled?

Powerman: My point is that it depends what is valuable to you. A PC is far, far more valuable to me than an ounce of an inert shiny metal. Your perspective on wealth is rather old fashioned (N.B. I'm not saying wrong - just different.) In saying that gold represents value (i.e. that its price is stable) you reject that technological advancement improves wealth. I disagree with this view.

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Nick Drew said...

asteve - the greater amount, by far, is cash-settled

Traded volume of Brent is sometimes getting on for 100 times the underlying: so approx 99% is either closed-out before settlement, or cash-settled

taking delivery of Brent, in particular, is very complex - only for oil co's or seriously competent trading-house players. No bank would take delivery

hedge-funds etc tend to trade through banks, they like to avoid an overt market presence

(WTI is easier to take delivery of, because there is storage available)

powerman said...

"My point is that it depends what is valuable to you. A PC is far, far more valuable to me than an ounce of an inert shiny metal."

No argument with that. If somebody gave you an ounce of gold, you'd sell it and buy something useful to you. I'd use mine to pay off more mortgage debt.

"In saying that gold represents value (i.e. that its price is stable) you reject that technological advancement improves wealth. I disagree with this view."

Ah, this isn't what I think. Technological improvement certainly does improve wealth. I probably shouldn't have picked gold as the initial commodity in my example because that spins things off into a seperate 'gold standard' argument.

What I was trying to get at was this:-

The price of an individual commodity in cash fluctuates not just in terms of the real supply of and demand for the commodity, but also as a result of monetary distortions and speculative activity.

I was looking for a way to try and filter out these distortions to look at movements in real supply and demand, by comparing commodities relative values to each other.

aSteve said...

Nick, I see a massive distinction between derivatives settled in cash, and those which are closed-out before settlement. Derivatives which are, ultimately, physically settled (it doesn't matter to whom) determine prices; those which are cash settled amount primarily to insurance. This is why I'm interested in the distinction... Sure it makes no difference to an individual speculator's positions, but it will affect the overall market from a systemic stance. Cash settled futures are not subject to supply constraints.

Powerman, I like your idea to compare different "stuff" - but the problem is that you intend to compare commodities... and commodities are a very specific type of stuff. For your plan to work, you also need to consider assets... but... assets, by their very nature, have uncertain value... and therein lies the problem.

As far as I can tell, the only way that it is reasonable to address supply and demand is to consider sustainable supply and consumption. This, of course, is extremely difficult to establish.

Nick Drew said...

asteve - not sure which Nick you're addressing but

Cash settled futures are not subject to supply constraints

... is an important idea to explore. Not on a bank hol, though !

I shall return