Fundamentalism and oil markets
Tony Curzon Price
June 14th 2008
In 1990, Jim Rogers, famed biker-trader, set off to circumscribe the globe astride a large motorcycle and with a leggy blond. He returned in 1992 having pondered the deep realities of life and came to the conclusion that the answer was "Commodities". With some capital and a pretty good credit record to his name, he did not have to do anything so practical as to go out and find oil or platinum. He started a Long Only Commodity Fund instead--essentially a gigantic bet that commodity prices will rise and rise. He and his co-investors have become hugely wealthier for it.
As the price of oil rises, watch Hummers grind to an expensive halt, bankers fawn over the managers of Sovereign Wealth Funds (where most of the oil profits end up before being re-invested in whatever looks as if it might pay some return), but listen, also, to the sound of market ideologies creaking under a weight they can hardly bear. A particularly loud creak came out of the Economist's lead editorial, which argued that oil is not in a speculative bubble, because:
[...] speculators do not own real oil ...[They] may raise the price of Òpaper barrelsÓ, but not of the black stuff [...] inventories are not especially full just now and there are few signs of hoarding.
Jim Rogers and his many imitators are off the hook, says the Economist. Before explaining why even the hard-headed Economist can't shake its faith in markets, let's see why it is so wrong-headed about the speculative bubble in oil.
We've all just come out of the housing bubble, and one thing we understand well is that when prices are expected to rise, everyone selling a house wants to hang on to their house a little bit longer and everyone buying a house wants to do it a little bit sooner--naturally, because simply holding the house for a period of time earns you money. But when everyone delays a sale or tries to precipitate a purchase houses are hard to come by. So, a belief that house prices will go up makes actual house prices go up. This is the essence of "irrational exuberance", where the expectation of high prices creates high prices. We've all now seen this effect pretty close up. (The converse effect, of course applies, and the ride down will be rougher than the ride up: when everyone expects prices to fall, you want to sell early and delay buying ...watch the glut of unsold inventory and boarded-up estate agencies).
In the case of oil, if someone is holding back on selling, waiting for the price to rise even further, can't we see them at it, just as we watched great-aunt Gladys waiting to downsize until the last possible moment during the housing bubble? The Economist asks to see the oil market's equivalent of housing's downsizing elderlies, those holding back on selling. If you look in the gulf, you will find them.
First, look at Saudi Arabia, who, like Gladys, sits on assets of great value and needs to decide when to sell. At some point between 2007 and 2009, the Saudis had planned to bring on two large new fields--Khursaniyah and Shaybah. Between them, these fields will add almost 3/4 of a million barrels per day to world production capacity--almost the whole additional oil that China used in 2007. The taps are ready to be opened. Aramco (the Saudi oil company) has over 2 million barrels a day of spare oil capacity. Oil already is a stock. Inventories are held underground, in Nature's own great depots. The question is the rate at which you allow it to gush out. (It really does gush--just look at Werner Herzog's extraordinary film of Red Adair capping the Kuwait well fires after the First Gulf War). And Saudi Arabia, the producer no one can do without, doesn't have the taps on at full flow.
For more spottings of Gladys, look at the full oil tankers bobbing about the Gulf. It costs about $150,000 a week to hire a super-tanker. But they are hard to get hold of right now, because a popular flutter amongst the gambling rich recently has been to charter a tanker, fill it with oil (you can get 2 million barrels in), park it in front of a refinery and watch the price rise. When you loose your nerve or you've made enough (if there is such a concept today), you cruise into the dock and sell your cargo. If the price of oil rises by $1 in a week, you walk away from this game almost $2m richer. Tankers are being used as oil storage. Veterans from the 1979/80 oil shock tell the story of 30 loaded tankers moored off Manhattan. Their owners watched prices rise, and spied on each other for any sign that someone else was moving. Market spirits fell quite suddenly, and the thirty behemoths all raced to the dock at once.
So the Economist's view that all is well in the land of market fundamentals is wrong. As long as the taps are not at full flow, the claim that high prices are due to limitations in supply cannot be right. Does this mean we can blame the Sheiks rather than the shakers on Wall Street? No. Jim Rogers is not off the hook yet. When Aramco decides whether to let the oil gush, it has to decide whether the oil will be worth more later. As it sees Jim Rogers continuing to buy paper oil futures, it encourages a belief that the price is still rising. When Goldman Sachs talks of $200 oil by year-end, and Gazprom talks it up to $250 for next year, then, just like Gladys with her house, Aramco is tempted to wait before flicking the on switch at Khursaniyah or Shaybah. And it's not only the future price of oil that matters--it's also what to do with the cash once you've sold. If the best the Wall Street wizards can offer you when you deposit money with them is to give the money back to Jim Rogers, why not by-pass the fees, the risks of a falling dollar and all that and just keep your spare oil in the ground?
Saudi Arabia knows that oil prices will eventually return to about $75 per barrel pre-tax. That is the price at which you can profitably make liquid fuel from coal. The technique is well known--it was developed by German industrialists during World War II. Coal reserves are so plentiful and so widely distributed that oil cannot sustain a price above that for long.
From Aramco's point of view, there is something inevitable about this eventual fall in price. Between 1981 and 2003, OPEC and especially the Saudis worked hard to keep oil prices just below the point at which alternative technologies would pay. The break-up of the Soviet Union and the opportunistic, oligarch-serving fire-sales that ensued created the glut of the 1990's (remember, not so long ago, when The Economist forecast $5 oil for years to come ...) that took prices well below that point. Eventually, the increased demand from China over these past ten years has been absorbed almost barrel for barrel by increased Former Soviet Union production. For all the peak-oil buzz, the truth is that supply has no fundamental trouble keeping up with demand. The Iraq war has taken 600k barrels per day out of production, but even that has been absorbed by Angolan, Nigerian and Azerbaijani increases. At will, Aramco could take us back to physical production levels that once delivered oil under $30 per barrel.
The emerging markets bubble ended in 1998 and led into the tech bubble that ended in 2001, leading into the long real estate bubble of 2002-6 that has tanked with a weakening dollar, world inflation and low real interest rates on US Treasury bonds--the default asset of choice for commodity-rich central banks and Sovereign Wealth Funds. Dealing with that last bubble has set the scene for the next: bringing commodities out of natural storage makes little sense when returns on Treasury Bonds are so low.
Jim Rogers has had a great 6 years, and the long only commodity funds have now been a natural place to channel liquidity looking for returns. When you buy commodities, you have a feeling that you are getting to something real, something that the world will always want. They are a hedge against inflation and a vote for the potential of the world to imitate America and create decades of "catch-up" growth. So there is a second way in which the real-estate bubble sets the scene for the next: hot money left the complexities of credit derivatives, and looking for a home, pushed commodity futures up, which has only encouraged producers to moderate their gushing wells.
Now back to the original conundrum--why does The Economist find it so hard to admit these simple interpretations? Because to do so drives a tanker through the faith in minimal regulation. Oil prices are high because of a series of self-reinforcing beliefs that have nothing much to do with fundamentals. Physical flows and investment levels are consistent with oil prices half where they are today. George Soros, who has successfully put more than his credibility as a writer on the line interpreting the bubbles of the recent past: backing commodities now, he says, is "intellectually unsound, potentially destabilising and distinctly harmful in its economic consequences." We are living through linked bubbles that will bury for a long time the notion that financial markets can benevolently look after themselves. But after the funeral, where where will the market fundamentalists get their moral compass from? The fear of being bereft of one, ultimately, is why ideology creaks as the oil price balloons.
tony curzon price2008-06-23