This is one of the better analysis of oil prices I've read in awhile. From Charles Schwab:
Black Dog: Is the Mania Around Oil Set to Wane?
by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
May 2, 2008
* Demand is less of a factor than many believe in driving oil prices.
* Long-term supply problems are drivers, not "peak oil."
* Speculation and geopolitics are the real culprits.
* Is a reversal in the cards?
I wrote earlier this week on food inflation and the crisis it's inflicting on many emerging economies, and this is the promised follow-up on oil prices.
As I noted in my previous piece and in other commentaries, I believe the characteristics of the latest bubble (or mania) in commodities are quite the opposite of the past two bubbles (housing and tech stocks). As the housing and tech bubbles were inflating, it was largely to the benefit of consumers, investors and the economy … whereas those bubbles did their damage as they deflated. Conversely, the commodities mania is inflicting its damage on the way up (other than for investors playing commodities on the long side) and will create an economic tailwind if and when the air comes out.
Of course, inflation is always a monetary phenomenon, so we can't discount the impact on commodity prices of easy monetary policy by the Federal Reserve. In fact, if you price oil in gold vs. U.S. dollars, the price is barely changed over this decade so far. We'll get to the dollar's impact on oil later in this report, but we'll begin with demand, supply and speculation as other drivers.
There's demand …
We are all familiar with the demand side of the story for the parabolic rise in commodity prices of every variety, including oil. We certainly feel it every time we go to the supermarket or the gas station. And of course, there's a relationship between the two: It takes fuel to transport grains and food, and as fuel costs increase, they get passed through to the price of grains and food, too. But there's more than just demand at play in the commodities story, and the speculation we discussed around food commodities is very much a factor in the energy segment as well.
There is a laundry list of factors at work in the run-up in oil prices, including of course increased demand, geopolitical uncertainties in key producing regions, speculative activity in futures markets and investors' frantic efforts to both chase performance and/or hedge against increases in dollar-based assets like oil. However, from my perch, I don't view the demand piece as the biggest contributor. Yes, there has a been a marked shift in demand away from the industrialized world toward the dominant emerging regions, including China, India, the Middle East and Russia. However, the pace of demand growth in these areas has NOT changed significantly and in fact, has actually slowed a bit. In other words, we are not experiencing a demand shock.
In fact, demand from the world's biggest oil consumer (that would be us here in the United States) has been declining quite sharply as you can see in the charts below. Even over the early part of this year, the period during which oil prices jumped from $85 to $110 per barrel and retail gasoline prices inched up toward $4 per gallon, demand looks to have imploded relative to initial estimates.
Oil demand estimates shrinking
Gasoline demand estimates shrinking, too
As of February 29, 2008. Source: Energy Information Administration.
There seems to be a disconnect between $4-per-gallon gasoline and the chart below, which shows that vehicle miles have fallen to a level not seen since the late-1970s energy crisis! (The blue bars represent recessions.) In other words, "demand destruction" (from higher prices) is alive and well.
Vehicle miles fall into negative territory
As of January 31, 2008. Source: FactSet.
… and there's supply …
A bigger contributor than demand has been supply, but this problem has been developing over time … it's not a supply shock. The tightening between supply and demand, now viewed as chronic, has been a long time coming. However, today's problems are not a result of "peak oil." In fact, over the last 10 years, global oil reserves have increased by 140 billion barrels, to 1.2 trillion barrels. If you add Canadian oil sands to the total, the increase was 300 billion barrels. Over that same span, the increase in world oil demand has been a benign 45 billion barrels.
… then there's politics and the fear factor
Where we have really faced problems is at the political and investment level: OPEC's production capacity has been relatively flat over the past 10 years thanks to underinvestment, while outside of OPEC, production capacity growth is barely registering. On top of that, nearly three billion barrels per day of existing production has been lost due to war or investment failures in countries like Iran, Iraq, Nigeria and Venezuela.
The net effect is that there is little if any spare capacity to match any supply disruptions. This exacerbates the fear factor and drives the speculation and frenzied hedging by consumers, investors, corporations and governments that has become this cycle's big driver at the margin.
Reversal of speculation?
Might we be finally seeing a reversal in some of these trends? It's been our contention for a little while now that this was likely to unfold, hence our recent move to recommend underweights to both the energy and materials equity sectors (yes, we were early). The price of wheat has already dropped 37% from its March 2008 high. Gold is down a sharp 15% from its high at the pinnacle of the credit crisis in March. Lead, nickel, copper and aluminum are also struggling. In fact, only oil, rice and corn-related agricultural products remain near or at all-time highs.
It does appear commodity prices are now being driven at the margin by speculation and panic buying, and a much-needed shift may be underway. As we learned the hard way during the bursting of the last two bubbles—housing and tech stocks—market and investor behavior during the manic phase results in major price-overshooting when prices become determined largely by momentum investors, speculators and hedgers. To put some numbers behind this trend, take a look at the chart below which shows the huge jump in the amount of over-the-counter (OTC) commodity derivatives held globally.
OTC commodity derivatives held globally (U.S. and foreign banks)
As of June 30, 2007. Source: ISI Group.
Note that this is a seven-fold increase (to $7 trillion) in less than three years. As noted by ISI Group, if we assume that only 50% of the open position of $7 trillion currently is oil, the exposure as of the last data point equated to 48.5 billion barrels of oil—or about 20 times the size of the NYMEX (NY Mercantile Exchange) market!
OPEC's hands tied?
OPEC officials have weighed in lately with their thoughts on speculation, too. Kuwait's acting oil minister Mohammed al-Aleem said in an interview in Kuwait earlier this week: "You cannot control the price; you cannot predict it, because there are reasons controlling the market other than the fundamentals of supply and demand … speculation, a weakening U.S. dollar, and insufficient refining capacity are influencing oil prices." Qatari oil minister Abdullah bin Hamad al-Attiyah said, in an interview the same day: "What I hear today is panic about the oil price, nothing about supply. There is nothing we can do because we are not seeing any shortage in physical oil. We don't have the tools to do anything."
Even global organized crime's getting in on the trade
An even more troubling sign of speculation was noted in remarks by Attorney General Michael Mukasey on international organized crime1 on April 23, 2008 and published in a recent ISI report:
"The first threat we identified was that international organized criminals control significant positions in the global energy and strategic materials markets. They are expanding their holdings in these sectors, which corrupts the normal functioning of these markets and may have a destabilizing effect on U.S. geopolitical interests … The criminals operating these schemes are willing to move money for anyone who needs to hide the source, ownership, or destination of the funds- no questions asked. They corrupt banking officials and exploit lax anti-money-laundering protections around the world to inject illicit funds into the global money stream. By all estimates, such schemes move billions of dollars every year through U.S. financial institutions…"
Speculative phases have their limits
We know these momentum-driven phases can't last forever if only because speculators can't indefinitely inflate (or depress) the price of something. If speculation worked over the long-term, then it would only require a sufficiently large amount of money to corner any market. Particularly encouraging currently is that the present commodity mania has coincided with similar momentum speculation in three other financial markets: the U.S. dollar, U.S. Treasury yields and U.S. corporate bond yields. We may be seeing simultaneous reversals in many of these momentum "trades." At the time of the engineered rescue of Bear Stearns, the market for investment-grade credit began to improve. Just following that, the yields on U.S. Treasury bills and bonds began to reverse and trend higher, while most recently, the dollar has staged a reasonably good rally as you can see in the chart below.
Dollar staging a meaningful rally?
As of May 1, 2008. Source: FactSet.
Oil is denominated in dollars, so if the dollar becomes cheaper relative to, say, the euro, oil producers need higher prices if their global purchasing power is to remain the same. The opposite can be said as well.
Much-needed relief for gasoline as per hedger activity?
Finally, there's another sign pointing to lower energy prices- this one in the form of gasoline (what a nice tailwind lower pump prices would bring to our economy!): SentimenTrader looks at commercial hedger positions for gasoline futures as you can see in the chart below.
Commercial hedgers betting against rising gasoline prices
As of April 25, 2008. Source: SentimenTrader.com.
Their current position is a net short 75,000 contracts. That is an increase of 10,000 contracts from the prior week and is by far a new all-time extreme. In the past, when hedgers had more than 50,000 contracts net short, gasoline tended to back off, at least temporarily. It's not a perfect indicator by any means, but it's one factor suggesting that the "big boys" are betting against another sustained run higher in gas prices, according to SentimenTrader’s data.
That's the "smart money" side … what about public opinion?
Again, according to SentimenTrader, its Public Opinion gauge is 84% bullish on unleaded gasoline, the highest level since August 2005. Gasoline has entered a "danger zone" in the past when the public opinion has reached 80% or more, so it's well into caution territory (i.e., pointing to lower gasoline prices). Since the early 1990s, whenever SentimenTrader's Public Opinion gauge has been this high, two months later gasoline was down an average 10% in price (while up only 5% of the time), albeit with wild swings during the span.
Mind your P's (profits) and Q's (quotas)
It's my contention that we are now going to see a reversal in the commodity trade with some speculation coming out. We may be wrong about this view and/or early. And, we're not suggesting any major portfolio shifts as a result. As always, we urge investors to review their long-term strategic asset allocation (especially if it includes commodities) and make sure your risk profile hasn't gotten out of whack due to the recent, outsized appreciation of the commodities-driven asset classes.
1. Michael B. Mukasey's report on international organized crime at the Center for Strategic and International Studies at the U.S. Department of Justice website .
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Past performance is no guarantee of future results.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
Now, we all know we can't control oil or gas prices, and some of us understand that boycotting Exxon would not have an impact, and some of us can't get over not blaming the oil companies.......and some of us concentrate on Peak Oil,,,,,,,So here are some real facts and insightful analysis for all of us to chew on awhile....Enjoy, complements of Charles Schwab. I am not employed by CS, and Liz Sonders is not related to me either. LOL