Raging Bull (Market)
"A trend in motion, will stay in motion, until some outside force, knocks it off its course!" Crude oil prices have doubled from a year ago, resting at above $130 a barrel last week. Central bankers who underestimated the power and resiliency of the "crude oil vigilantes", are now praying for a bubble that is destined to burst under its own weight, and at a moment’s notice. Gary Dorsch explores…
In an interview with The Daily Telegraph, George Soros said that although a weak U.S. dollar, depleting supplies from aging oil fields, government fuel subsidies, and record Chinese and Indian demand could explain the parabolic surge in energy prices, the crude oil market is also significantly inflated by speculation. "Speculation is increasingly affecting the price, which has a parabolic shape, which is characteristic of bubbles," he said.
However, Soros warned that the oil bubble wouldn’t burst until both the United States and British economies slipped into recession, after which, oil prices could fall dramatically. "You can also anticipate that the bubble will eventually correct, but that is unlikely to happen before the recession actually reduces the demand. The rise in the price of oil and food is going to weigh and aggravate the recession."
It’s dangerous to pick a top in a raging bull market, since bubbles can inflate more than anybody could have imagined. On May 20th, T-Boone Pickens told CNBC he expected crude oil prices to keeping going up. "I think we’ll get to $150 this year," he reckoned. The next day, soon to be deposed Israeli PM Ehud Olmert called for a U.S. naval blockade of Iran, and if that happens, crude oil could hit $200/barrel.
Who is inflating the bubble in the global oil market? The Federal Reserve is the chief culprit, by slashing the fed funds rate 325-basis points to a negative -2%, after adjusting for inflation, and expanding the US-M3 money supply by 16.5% from a year ago, in a desperate effort to stop the slide in the sinking US banking sector. By slashing interest rates deep into negative territory, the Fed encourages speculation in commodities by pushing down the dollar, which in turn, is pushing up the price of dollar-denominated commodities, such as crude oil and gold.
So far, the Fed’s aggressive rate cuts haven’t found any meaningful traction in the S&P Banking Index, which is still languishing at the March lows, and -40% lower from a year ago, with banks posting hundreds of billions in losses from toxic sub-prime mortgage debt. The Fed’s single focus on rescuing the banking sector, with no regard for the inflationary consequences of its actions, has led to the emergence of the "crude oil vigilantes" who punish central bankers with sharply higher oil prices, whenever they become too abusive with the money supply.
In the past, a sharp slowdown in the U.S. economy, the world’s biggest oil guzzler, usually pushed the price of crude oil and other commodities lower. But the Fed was caught by complete surprise, after crude oil prices doubled, even as America’s economy slipped into a recession in the first quarter. "The current oil price has no relation to market fundamentals," explained Saudi oil chief Ali al-Naimi on March 5th. "It is linked to tremendous speculation in crude oil futures. There are even those who buy futures and speculate that oil prices will reach $200 in 2013," he said.
On April 28th, OPEC chief Chakib Khelil observed that crude oil prices were climbing, "even though supply is adequate, because the market is driven by the dollar’s slide. Each time the dollar falls 1%, the price of the barrel rises by $4, and of course vice versa. If for instance, the US dollar would strengthen by 10%, it is probable that oil prices will fall by 40%," he figured.
But such simple logic has its limitations. China, India, Russia and the Middle East combined, are now consuming more crude oil than the US, burning 20.7 million barrels a day, up 4% from a year ago, according to the IEA. The emerging economies are picking-up the slack in the oil market, more than offsetting a -1.3% contraction in U.S. oil demand to 20.3 million barrels this year. Thus, a mild recession in the Western economies and Japan might not weaken global demand for oil.
Economies of big oil-exporters in Russia, Mexico, and OPEC itself are growing so fast that their need for energy within their own borders will limit how much they can sell abroad. Internal oil demand in Saudi Arabia, Russia, Norway, Iran and the United Arab Emirates, grew 6% last year, and their exports declined 3 percent. Mexico’s oil output fell -9% in the first four months of 2008, from the same period a year earlier. If these trends continue, global crude exports could fall by 2.5 million barrels a day by the end of 2010, adding new strains to the global oil market.
If crude oil speculators on the Nymex were buying "black gold" as a hedge against the U.S. dollar’s slide against the euro, the #2 reserve currency, then perhaps, traders in London were buying North Sea Brent as a hedge against the British pound’s devaluation against the Euro. The Bank of England engineered the British pound’s sharp devaluation against the Euro, by joining the Fed’s rate cutting spree last November, with three quarter-point rate cuts to 5 percent.
The euro soared 17% to 80-pence, while at the same time, North Sea Brent crude oil prices doubled to $130 /barrel. Flipped the other way round, the British pound buys around ?1.25, down from ?1.50 last summer, making European imports considerably more expensive. For Ivory-Tower economists, the euro’s ascent against the British pound and U.S. dollar, which closely tracked North Sea Brent was just a statistical coincidence. But for crude oil speculators, the sharp devaluations of the pound and U.S. dollar translated into enormous windfall profits in their brokerage accounts.
When riding the waves of a bubble, it’s always good to have the basic fundamentals are your side. Oil production is shrinking in 54 of the world’s top-60 oil producing nations, including Britain’s North Sea, where output peaked in 1999, and has already plunged by half. The United Kingdom began importing liquid gas, for the first time in history in July 2005, and its North Sea oil reserve is dwindling at an -8.5% annual rate. The curtain might fall on North Sea Brent by 2012, if enough isn’t done to maintain development and exploration, according to the U.K. Offshore Oil Industry.
But political pressure on the BoE for more rate cuts could intensify, after British home prices dropped for the eighth straight month in May, down -2% from a year ago. The average selling time for U.K. homes has climbed to 9.8-weeks, compared to 5.8-weeks in May 2007. A further slide in home prices could topple the U.K.’s asset based economy into recession, and deepen losses for British banks. Another round of BoE rate cuts could renew selling pressure on sterling and buoy oil prices.
Currency devaluations do not fully account for crude oil’s dramatic rise to as $135 /barrel last week. "Peak Oil" theorists have a better explanation, and Saudi Arabia’s threat to ramp-up oil production by 2012 is sounding hollow. However, currency swings do magnify the volatility and price trends in the crude oil market, the same way the "yen carry" trade magnifies swings in the global stock markets.
No market travels in a straight line forever, and shakeouts in the crude oil market are designed to wipe-off the speculative froth. However, a British and U.S. economic recession would not necessarily burst the oil bubble, if the net result is another sharp devaluation of the British pound and U.S. dollar in the foreign exchange market, which would support high oil prices.
for The Daily Reckoning
May 29, 2008
This article is just a preview of what’s available in the Global Money Trends newsletter.
GMT filters important news and information into bullet-point, easy to understand analysis, featuring "Inter-Market Technical Analysis" that visually displays the dynamic inter-relationships between foreign currencies, commodities, interest rates and the stock markets from a dozen key countries around the world. Also included are charts of key economic statistics of foreign countries that move markets.
Oh la la, dear reader…the vigilantes are back!
Those happy trends of the Great Moderation period – roughly, the 15 years before 2007 – have turned for the worse.
Globalization, for example, helped keep prices down in the United States. Americans could reach for all the imports they wanted without getting rapped on the knuckles by the usual consumer price inflation. That is, like a drunk who never gets a hangover, they could enjoy an inflationary boom without ever having to pay higher consumer prices.
Now, the screw has turned a full 180 degrees…now they can cut back…spend less…and still have to pay higher prices! The world was such a benign, forgiving place before 2007. Now it has turned wicked.
Let’s begin our exploration of this nasty turn of events by looking at the oil market.
We are out of oil; at $130, we regard it as too speculative. But that doesn’t mean that the oil bubble is going to burst anytime soon…or that the real price of oil won’t be even higher 10 years from now than it is today.
The Big Picture in the oil market is one of the most confusing and complex we have ever seen. It is like a painting by Hieronymus Bosch, where there is so much going on you can’t quite tell what it all means.
On the one hand, there is the background of supply and demand. Even here, the picture is not a clear one. Oil supplies seem to be running out. Of the world’s 60 top oil producers, 54 report declining output. Indonesia announced yesterday that its production had slipped so much, it was no longer an exporter; the country had to withdraw from OPEC, since it has become an oil importer.
On the other hand, Brazil has recently reported huge new finds. New technologies offer ways to get more oil out of existing fields. And more and more alternatives to petroleum are being developed. Brazil is also the world’s leading producer of biofuels, mostly from sugar cane, and is ramping up production as fast as it can. Solar power is hot.
As for oil itself, there is only so much available…and many experts believe the maximum annual extraction level – Peak Oil – is coming up soon. From that point onward, the world will just have to make do with tighter supplies and higher prices.
Looking at the demand side, we see the opposite picture – a curve rising from here to eternity. A few years ago, millions…maybe billions…of the world’s people lived almost without fossil fuel of any sort. They tilled rice paddies, for example, with water buffalo, cooked their meals on a wood fire, and traveled on bicycles. Now they’re moving to the city, living in apartments heated by oil, eating commercial food grown with plenty of petroleum-based inputs, working in heated, energy-absorbing factories, riding on automobiles and buses, and buying things that take energy to make and energy (usually oil) to deliver.
It used to be a sure thing that if the United States had a recession, oil consumption – and energy prices – would go down. But in the last year, oil consumption in the United States has gone down 1.3% – even as the price of it soared. How is that possible? It is partly explained by that giant sucking sound coming from the emerging markets, the BRICs (Brazil, Russia, India and China) and the Middle East. These countries are all using a lot more energy – partly because they are getting a lot richer, and partly because they tend to keep internal energy prices low (which helps explain why they are growing so fast). Both China and India have refused to allow their large oil companies to raise domestic prices in line with world market prices, encouraging greater consumption. In the BRIC nations, oil use went up 4% during the last 12 months.
But how come investors didn’t see it coming? A man of 30 may be unprepared to die in a train wreck; but a man of 90 typically has a Last Will & Testament. These trends in demand and supply are well known…and they happen slowly. How could investors miss them? How come the price of oil stayed so low for so long? How come it more than doubled since the beginning of ’07…and went up more in the last 6 months than the entire oil price prior to 2005?
*** Let’s look again at this remarkable tableau of the oil market. In addition to the supply and demand pictures, there is a lot more going on. Over on the side are the central bankers – led by Ben Bernanke and the U.S. Fed. What are they doing? Let us look hard…oh yes, they seem to be printing money! Yes, the Fed – the guardian of America’s financial integrity – is lending money at 2% below the official inflation rate (probably more like 6% below the real inflation rate). And it is permitting the supply of money to increase at an estimated 16% annual rate. Remember, when the supply of money increases faster than the supply of goods and services (GDP), prices rise. With GDP flat or barely rising at all, a 16% increase in money supply represents a huge inflationary push.
And look! Prices are rising, just as they should. Want proof? Just drive to a filling station…or go to the grocery store. As reported in this space, the ingredients for a typical Memorial Day cookout rose by double digits in the last 12 months.
And look at this. Over on the other side…what’s this? A group of vigilantes!
Yes, dear reader, they’re back…the vigilantes…ready to mount up and ride out whenever they think the Fed is being too inflationary. Back in the ’70s and ’80s the vigilantes won their spurs in the bond market. As soon as they saw the money supply figures creeping up on them, the vigilantes strapped on their guns and shot the bond market to pieces. Bond prices fell…forcing up yields…and thereby forcing the authorities to back off. It was bond market vigilantes who convinced the feds that the jig was up in the late ’70s. They still had the power to inflate the money supply as they had during the ’60s. But they couldn’t get away with it anymore. When the vigilantes dumped bonds and drove up interest rates, the economy went into such a slump, it just wasn’t worth it.
We’d been wondering what happened to the vigilantes. The feds have been increasing the money supply twice, three times…and now infinitely…faster than GDP growth. How come the vigilantes let them get away with it? How come the bond market didn’t crash? Why did they still buy bonds…didn’t they know they were going to lose money?
We still don’t know the answer. Maybe the vigilantes have grown old and too tired to strap on their six-shooters… maybe they’ve gotten Alzheimers and no longer know how things work.
But lo and behold…here they are again – in the oil market! They’ve found a new way to bring some financial discipline and monetary rectitude to the feds.
The sharp upward move in oil began at just about the same time the Fed began printing more currency, bailing out investment firms, and cutting its key rate. The supply and demand situation hadn’t changed; but the monetary situation had – and the vigilantes saw it. Rather than sell bonds…they bought oil!
Higher oil prices, of course, depress economic activity. They, along with falling house prices, are the two things pushing the United States into a slump. Usually, a slowdown would bring pain…but some relief too. Prices, notably the price of oil, would fall. But now globalization – which had been such a delight during all those years of the Great Moderation – kicks us in the derriere. Americans are forced to cut back on energy use. But the foreigners take up the slack…and then some. The oil price refuses to fall.
And the feds try to make up for it by cutting rates and increasing the money supply. They’re desperate to try to get the party going again. But then along come the crude oil vigilantes. In just seconds, they’ve pulled the plug on the amplifier and turned off the beer machine. Oil goes higher, and the economy sinks further.
*** The latest news from the U.S. housing market is bad. New house sales are still near their lowest level in 17 years. And the New York Times reports that even the best markets – like Seattle – are beginning to sink. The Times mentions a guess that prices could fall another 10% before stabilizing.
*** Rising consumer prices, combined with stagnant incomes and falling house prices, has the U.S. public in a squeeze. The "middle class is struggling to stay in the same place," says a report on CNNMoney.
This has to result in lower consumer spending – and an economic slump in the United States. We got evidence of sharply lower spending in yesterday’s driving figures.
Now, we’re going to see it in other areas. Yesterday, for example, Dow Chemical announced price hikes of 20% – which will feed into a whole range of consumer goods, from diapers to detergent.
*** The BRIC nations held an historic meeting in Yekaterinburg, Russia, last week. They’re growing very fast…with rising markets, rising incomes, rising currencies, and rising GDPs. Together, their percentage of total global growth grew 50% between 2000 and 2008.
The BRIC meeting seems intended to remind us that it is a big world…with a lot more going on it than we realize. Economies rise and fall. Nations and empires too. And here is colleague Byron King’s explanation of how the U.S. dollar came to be the world’s reserve currency. (It helps us look ahead…to when the U.S. dollar will no longer be the world’s reserve currency.)
"I have long tried to imagine the discussion at Bretton Woods in July 1944. US, British & Canadian troops had just landed in France. Germany was bleeding white on the Russian Front. The Japanese Empire was dying in the Pacific. Everyone knew that there was hard fighting ahead. But everyone also knew that the Axis was going to be defeated, and the Allied nations would win the war.
"So 730 delegates from 44 Allied nations gathered in New Hampshire to chart the future course of the world monetary system.
"There are, of course, reports and summaries of what people said for the record. But what did the US delegates REALLY say at Bretton Woods? Let’s just imagine…
"’OK, everyone. Nice to see you all. Hey, did you see the invasion force at Normandy last month? Can you do that? No? Oh. Well, we did that. And we can do it again.’
"’How about that industrial base back home, eh? Those Rosie the Riveter girls sure can knock out the old landing craft. How’s your industrial base? Oh. Well, that’s OK.
"’And it’s a good thing we had all those bombers in the 8th Air Force in England, huh? Yep. Those bombers just turn the sky black, don’t they? And how about that steel rain when the bombs come whistling down? You want area bombing? We have area bombing. On a good day, we can do precision bombing too. Can you do precision bombing? No? Oh.’
"’And we have 200 submarines in the Pacific. Do you have 200 submarines? No? Oh, gee.’
"’Overall, we have a 2,000 ship navy, with over 100 aircraft carriers. Do you have a 2,000-ship navy, with over 100 aircraft carriers? No? Oh. That’s OK. Not everyone can have a 2,000-ship navy. Or 100 aircraft carriers.’
"’And have you heard about the B-29? It’s an intercontinental bomber. Yep. Takes off from the U.S., and bombs another continent. We’re going to build a lot of those B-29s. Do you have B-29s? No? Oh.’
"’And I can’t get into details, but the U.S. has this really big program to develop the next generation of weapons. It’s all classified, so I can’t talk about it. But we have all the best physicists and chemists and mathematicians working on it. Really, there are so many brilliant minds working on it that you just can’t find a decent physicist or chemist or mathematician any more. Do you have one of those programs? No? Oh.’
"’And how about all that gold in the U.S. government vaults? Back in 1933, President Roosevelt collected all the gold from every person in the United States. All of it. The whole national treasure. It’s all under our control now. The Supreme Court said it was OK, so it’s even legal. Now we have just thousands of tons of gold. Do you have thousands of tons of gold? No? Oh.’
"’OK everyone, let’s get down to work. I propose that we make the U.S. dollar the world’s reserve currency. Any questions? No? Oh.’"
The Daily Reckoning