While the price of oil is rising, demand for the physical commodity is in retreat. Problems with Iran are only part of the story as a geopolitical risk premium is built into futurescontracts, inflicting higher fuel costs on consumers. Ben Hunt reports.
The recently issued statement from HSBC that “oil is the new Greece” – pun intended or not – must have raised a smile or two in financial markets. Underneath, of course, lies a more serious concern.
With the European Union (EU) embargo on Iranian oil, the various other American and EU trade sanctions that are protests against Iran’s nuclear programme, not to mention Iran’s threat to close the Strait of Hormuz, through which 18% of global oil passes - the price of oil has risen again in recent months.
The period from October 2011 to March this year witnessed a rise of about 20%, with the price of Brent – the global benchmark for crude oil – hitting highs of about $125 a barrel.
Many wonder if the price will creep up again to the record high of July 2008 – $147.
The surge in prices, which has generated debate in the financial media, comes at a fragile time for the world economy. Many feel that the associated rises in petrol and other costs are the dominant headwind to an economic recovery – again. (Cover story continues below)
Given the situation with Iran, Nouriel Roubini, a prominent economist, recently warned that another spike in oil prices is the leading risk for the world economy. “You see a substantial geopolitical risk premium built into the oil price,” says Tim Evans, an energy analyst with the Citi Futures Perspective team of Citigroup, the American financial services firm.
“It has become a one-issue market. We are essentially seeing long-side bets based on expectations of a loss of Iranian oil supply.”
Evans says that a volatile mix of factors is in play. There is an appetite for risk, he says, but based around demand for a futures position, the buying of paper contracts, not the physical demand for petroleum. Real economic demand for oil, by contrast, is in retreat, and a thin support for current prices.
”It has become a one-issue market. We are essentially seeing long-side bets based on expectations of a loss of Iranian oil supply”
For America, the world’s largest consumer of petroleum, total petroleum demand in the four weeks ending March 9 is down 5.4% year-on-year. Gasoline demand is down 7.2% for the same period. Production, however, is 4% a year higher than a year ago.
More generally, the International Energy Agency (IEA) has forecast shrinking demand for oil from developed nations for 2012, and modest growth in the developing world of 2.8%.
“We are seeing a bit of a bubble, understandably connected to the take on Iran and the embargo,” says Evans.
Imagine the unlikely scenario of Mahmoud Ahmadinejad, the Iranian president, suddenly being invited to the White House for talks, he suggests.
“That would probably spark downside chaos in the oil market.”
While the issue of supply disruption related to Iran has come to the fore, however, it is hardly the only one to be preoccupying policymakers and the global oil industry.
The last decade has set in motion a peculiar new direction that the industry is still trying to get to grips with. This involves not only developments specific to oil but also macro trends that have driven what has been called the largest commodities boom in history.
As is well known, China and other developing nations provide huge demand for commodities as part of their drive to industrialise, urbanise and develop economically. In the context of rising commodity prices set off by this, the financial sector in the western world in turn has sought to profit from this development by marketing commodities as a new asset class – a term some refer to as a “financialization” process.
Since, in the case of oil, the price is set in the futures market where new investment has gone, the extra liquidity has in turn has driven up oil prices.
Evans has pointed out that in 2007, money managers held a net long position of 160,000 West Texas Intermediate futures contracts on the New York Mercantile Exchange. By March of this year, that number had risen to 272,000 contracts.
The positions are larger than the past, he says. In turn the potential for volatility is higher.
“The question you have to ask yourself,” he says, “is what impact would selling a large number of those contracts have on the price?”
You can make the general point, says Tom Kloza, the chief oil analyst for Oil Price Information Service, that global demand for physical oil has increased from roughly 80m barrels a day a decade ago, to about 90m today. However, demand for oil through futures trading has increased at a much faster rate.
A more intangible but equally important factor that helps explain price appreciation – whether you agree with it or not – is the concept that oil is becoming a more scarce resource, with supply gradually falling relative to demand.
”There is a fairly convincing argument that the aggressive loosening of monetary policy everywhere has seen authorities shooting themselves in the foot”
The popularity of the Peak Oil theory, attributed to the American geoscientist Dr M King Hubbert, is one expression of this. For some observers, this has helped to bake-in continually bullish expectations about higher prices. In other words, it has helped create an ongoing foundation for speculation.
Government intervention in the form of monetary policy also seems to have played its role in higher prices. As part of a strategy of “reflation” of asset prices after the 1990s equity collapse and economic downturn, Alan Greenspan, the then Federal Reserve chairman, lowered interest rates to record lows, leading in turn to a new phase of dollar value depreciation from 2002 to the present.
As new capital sought to hedge against a depreciating dollar and inflation, a paradox was created, some argue. As commodity prices rose, capital inflows created the inflation it sought to avoid as a certain amount of passive “buy and hold” money entered the market and rolled over contracts on a regular basis.
Whatever the precise contribution of all of these factors, which of course are heavily debated and contested, like all areas of economics, the results were clear towards the end of the “noughties”.
According to Anthony Boeckh, an investor, the main commodity indices were still up 80% from the beginning of the decade, even given a 35% fall after the 2008 peak. The S&P index by contrast had delivered zero returns over the same period.
Frederic Neumann, the co-head of Asian economic research for HSBC, says that the three factors of supply and demand, financialisation and geopolitical risk are generally driving the rise in the higher oil price.
“In practice, however, it is difficult to tease out the exact contribution of the different drivers,” he says.
“The uncertainty regarding the Middle East has overshadowed the oil market for the last 24 months”.
It is “hard to see a quick solution, and the geopolitical risk premium will be in the oil price for some time”.
Neumann says “there has been a general commodities bubble to some extent, driven by demand growth, but it is not really sustainable in its present form”.
For HSBC, the important role of the extra liquidity provided by the world’s central banks is not so much that it has gone into commodity futures markets, but rather that new investment has been driven more to emerging markets.
Greater credit there has driven growth, in turn driving up demand for raw materials and commodity prices.
“However, there is a fairly convincing argument that the aggressive loosening of monetary policy everywhere has seen authorities shooting themselves in the foot,” says Neumann.
Consumers in the countries where quantitative easing (QE) has been introduced face higher petrol prices and inflation, for example. More generally, it is not difficult to see why rising oil and therefore petrol, fuel and heating costs, and inflation in general, are causing concern.
With stagnant or declining real wages, and high unemployment in many parts of the developed world, living standards are already coming under pressure. Inflation adds to the cost of living and, of course, has a more serious impact on the poorest of the world in the developing nations.
At the same time, higher oil prices mean higher production costs for a whole range of industries – agriculture, transport, manufacturing, and so on – which, to one debatable degree or another, may be passed on to consumers via higher prices.
Not surprisingly in this context, analysts and economists are trying to quantify the impact of certain oil price levels on economic growth more generally.
For investors, however, there are differential effects of oil price gains on firms, sectors and economies, quickly creating a variety of winners and losers.
”Prices may fall for oil because of the supply of substitutes that have not been introduced at a rapid pace until now”
Oil producers and their shareholders are the winners, having enjoyed huge profits for a while. The picture is more mixed for refiners. Institutions that enjoy profits from taking speculative positions, and financial intermediaries who benefit from greater trade in commodity derivatives markets and new types of investment products, are also obvious winners.
Losers might include companies that heavily rely on fuel products in areas such as agriculture and transport.
Oil prices can also be pivotal to countries’ balance of trade and currency values. Norway has been improving its fortunes with its oil revenues, and its currency is seen as a relatively new haven. A country like Turkey on the other hand, with a trade deficit based around oil imports and a vulnerable currency, is in the opposite camp.
More specifically, given investors are not a homogenous bunch, higher oil costs can either be viewed as a short-term opportunity or a long-term irritation.
A complicating factor is that oil prices seem to play a paradoxical role in the global economy. While a high price punishes consumers and other producers, it also incentivises new capital to invest in new exploration, technology and extraction.
Each type of crude oil – ranging from the heavy varieties in the Middle East, which can be easily extracted, to the lighter North American types – needs to sell for a certain price for profits to be made. The costs of producing a barrel of Canadian Tar Sands oil before profit are thought to be about $40-50.
In this context a higher sale price for oil is likely to have encouraged rising production in America, where production costs are high.
If bullish forecasts are to be believed, America is on the verge of energy self-sufficiency within a decade, given the huge shale oil deposits it has, and the possibility of using the same technology developed for shale gas – hydraulic fracturing, or fracking.
An estimate is that such oil deposits contain two trillion barrels of oil. For comparison, America consumes roughly 19m barrels of oil a day.
The story for oil might not be to do with production, says Neumann of HSBC, but it might involve the counterweight from natural gas.
“The US commercial vehicle fleet could be switched to natural gas. That would take away a lot of the demand for oil. Prices may fall for oil because of the supply of substitutes that have not been introduced at a rapid pace until now,” says Neumann.
For the economy as a whole, high prices might not be a problem in themselves – unless they are excessively high. A distinction is between nominal and real prices – that is, the latter adjusted for inflation.
The key is whether costs take up a greater proportion of overall consumer income compared with the past. If they do, this could indicate deeper problems with the economy or an industry – that is, a failure to make proper productivity gains, use technology or a failure of competition to drive down prices in markets.
Historically, these are the areas that commodities in agriculture and energy have excelled in, as real prices have fallen alongside productivity gains.
Jeremy Grantham, an investor and the co-founder of GMO, an American asset management firm, published a report last year that examined some of these trends. In the paper, he reminded that “the history of pricing for commodities has been an incredibly helpful one for the economic progress of our species”. Goods such as food and energy have managed to come down to a smaller and smaller portion of overall income and our cost of living over time.
In broad terms this is because of productivity gains and using less labour in relation to technology.
Grantham says this process has come to an end. Costs for food and energy are grabbing a bigger part of our income, our cost of living. Real prices in commodities are rising.
Referring to the commodity boom, he calls this “the most remarkable price rise, in real terms, ever recorded”.
The culprit, he thinks, is China. He says it has “caused an unprecedented shift in the price structure of resources”.
Although a welcome contribution, however, Grantham does not make clear why there cannot be further innovation and productivity gains with new technologies, energy products and labour processes to bring prices down further.
The reason why agricultural, energy and other commodities traditionally have not been seen as an asset class in the world of finance is that it was understood that they offer poor returns precisely because of falling values over time. According to Boeckh, writing in his book The Great Reflation, a buy-and-hold strategy in commodities is the equivalent to simply “chucking money away”, precisely for this reason.
He notes that huge demand increases historically have not led to rising prices in the long term. “Commodities have proven to be a disastrous long-term investment.” For him they are only a hedge against inflation in the short term.
It is not difficult to see that a financial markets approach that drives up prices of commodities such as food and energy is going to be at odds with producers and consumers who have an interest in keeping those prices down. This may reflect a broader problem with how financial markets have developed.
As many investors and analysts fully recognise and are discussing, “financialisation” attempts to get general economic growth through reflation of assets, rather than greater investment, economic growth and productivity growth that leads to real wealth creation and lower costs over time.
For example, there is criticism that housing has been viewed too much as an investment rather than as a place to live. In the worst-case scenario after a bubble, the value falls below the total loan value and the owner falls into negative equity.
High prices and costs in the economy, equating to high profits for particular interests, have been generally seen as acceptable, but in a context where they can fall over time and capitalism gets continual “churn” or “creative destruction”. That is, as costs come down, new products are created with initially high costs (luxury goods are yet to become mass market items) that in turn come down when faced with new innovation or competition.
There seems to be a parallel with the energy industry: a necessity to get cheaper-cost alternatives. It may happen with shale oil or gas, and of course, the big question is how to do it with clean technology.
”Commodities have proven to be a disastrous long-term investment”
One of the paradoxes about the oil and broader energy market is that, in economic, operational and technological terms, the market has been relatively successful at the basic in supplying half of the world with the energy it has been demanding to raise living standards. The future does not seem too terrible, either, for technological breakthroughs and further development.
According to the US Energy Information Administration, there is enough oil worldwide to meet demand for the next 25 years.
This is not to downplay the considerable problems around global warming, but on the bright side it does provide space to develop more sustainable, cleaner and cheaper alternatives.
Of course, an alternative view is that oil needs to be made much more expensive for its use to be discontinued and cheaper resources to be used.
If anything, it seems instability in the market is more being introduced from the financial and geopolitical sides.
Discussions about reform in the financial area are underway. The US Commodity Futures Trading Commission is considering ways to stop excess liquidity and speculation in futures markets from distorting price discovery and affecting the physical market and real economy.
It plans to implement “position limits” in the futures markets, for example. Ex-futures traders are some of the most strident critics of the system. In his book, Oil’s Endless Bid: Taming the Unreliable Price of Oil to Secure Our Economy, Dan Dicker, an energy analyst and ex-oil trader, explores how financial markets have become more divorced from the practical and productive activities in the physical oil industry.
The problem might be broader still. A further analysis might look at what is happening with broader money creation, the excess liquidity and price instability problems stemming from the central bank objectives of “reflation”, and their impact on the oil market.
On the geopolitical side, the oil industry and many other interests would be thrown into turmoil if a new conflict in the Middle East breaks out. The future in this area is far from visible and is driving considerable speculation with the oil price.
On the positive side, perhaps, is China’s long-term role. Its demand for commodities is seeing it make a contribution in areas of the developing world such as Africa. It has the potential to become a major energy innovator in clean-tech.
Of course, much is motivated by self-interest and resource security problems. But as some observers have pointed out, why not give it a chance to promote development in new ways, where older western interests have failed?
Will Dale Nicholls do a better job than Anthony Bolton running the Fidelity China Special Situations trust?