Newsletters 2008 Newsletters The Oil Bubble (7/08)
Tuesday, 15 July 2008 00:00
At the end of 2006, the price of oil fell from $70 to $50 per barrel. By July of 2007, oil had climbed back to $70 and has not stopped rising since, reaching a high of just over $145 this month.
This increasingly steep price curve within such a short period of time is indicative of the type of parabolic price movement that has accompanied all past investment manias or “bubbles”, including the “Nifty Fifty” growth stock mania of the early 1970s, the gold bubble of the early 1980s, the Japanese stock market bubble of the late 1980s, the NASDAQ bubble of the late 1990s and the U.S. residential real estate mania of the current decade. The chart pattern for oil is alarming and clearly demonstrates an unsustainable increase in price. All previous asset manias and parabolic price increases are ultimately followed by price collapses that are equally as sharp on the way down as the rise was on the way up.
Unlike previous manias, the current oil bubble has significant negative consequences for consumer spending and consumer sentiment and therefore the overall economy. While spending on gasoline and other fuels accounts for only 4% of total U.S. personal expenditures, rising oil is inflationary and leads to generally higher prices for other goods and services, since oil is an important raw material and also impacts transportation costs. Whereas the ultimate bursting of previous stock market bubbles created a subsequent collapse in wealth that proved to have negative consequences for the economy, the ultimate bursting of the oil bubble will have significant positive consequences for the consumer and for the economy.
Price charts alone do not identify the existence of a bubble. While there are many good reasons why oil should be priced higher than it was just several years ago, there is little evidence that supports the doubling in price in just one year. Let’s examine the factors behind oil’s dramatic ascent and determine whether the fundamentals support such high prices.
Supply and Demand
According to the U.S. Energy Information Administration (EIA), total global production or output of oil is now 86.2 million barrels per day (mbpd). The EIA expects daily production to reach 89 mbpd by the second half of next year, due to increased production from Saudi Arabia and new oil fields that come into production by that time. The United States is by far the largest consumer of oil at approximately 21 mbpd. Combined, the 27 countries in the European Union consume just over 15 mbpd. Japan, the second largest economy in the world, is known for its energy efficiency and consumes just north of 5 million barrels per day. Canada consumes another 3 mbpd. These developed markets collectively consume 44 mbpd or just over 50% of global output. All of these markets are plagued by low or no population growth and slowing economies.
The emerging economies of Brazil, Russia, India and China collectively consume approximately 15 mbpd. Of these, Brazil and Russia are energy independent, while China and India have subsidized energy prices. Despite the popular notion that ever rising demand in China alone justfies the current price of oil, Chinese oil consumption has actually waned in recent years - the EIA now predicts that oil consumption in China will grow from 8 mbpd this year to just 8.4 mbpd next year. China just recently reduced its oil subsidy by 18%, amounting to China’s largest single price increase for gasoline in history. Further reductions in subsidies are expected not only in China but in other Asian countries such as Malaysia and Indonesia and will serve to further reduce demand.
It is important to understand that there is no direct or one-to-one correlation between a country’s growth rate and its overall consumption of oil. Since the last oil crisis in 1973, oil consumption in the United States has grown from approximatley 17 mbpd to the current 21 mbpd, a compounded annual increase of just .6% during a period when the U.S. economy has grown at an annual clip of approximately 3%. During the same 35 year period, oil consumption in the 27 European Union countries has actually declined from 15.5 mbpd to the current 15 mbpd.
And virtually all of the growth since 1973 in oil consumption in the United States has occurred since 1990. Americans actually demonstrated concern for efficiency and conservation after the oil shock of the 1970s and consumption remained flat for more than a decade until starting to rise again in 1990. The current price of oil has Americans once again focused on efficiency and conservation, a trend that will undoubtedly lead to reduced demand in the U.S. Indeed, there is mounting evidence of demand destruction due to persistently rising oil prices. For instance, the number of vehicle miles traveled in the United States fell during the first quarter on a year-over-year basis for the first time since 1979 and all major U.S. airlines have announced widespread capacity reductions. Demand for hybrids and other fuel-efficient cars is rocketing while sales of trucks and SUVs are plummetting. Sluggish economic growth and increased conservation efforts in the developed world combined with accelerated reduction of subsidies in emerging nations will curb demand for oil and ultimately help prick the oil bubble.
The fact is that while overall global demand for oil has grown at approximately 2-3% over the last several years, overall global production has kept pace with demand. With oil demand perhaps peaking and even predicted to decline on a year-over-year basis by the fourth quarter of this year as production is increasing, there must be something other than supply and demand causing oil prices to escalate.
Oppenheimer analyst Fadel Gheit recently surmised that “there is a total disconnect between supply and demand”. Gheit notes the historical relationship of the price of crude oil at three times the price of extraction. Since oil companies can profitably replace oil at between $15 to $20 per barrel, Gheit argues that oil should trade between $45 and $60 per barrel. “Any oil company that can’t replace reserves at $15 a barrel shouldn’t be in business, so anything over $45 a barrel is all fat”.
The U.S. Dollar
The dollar has depreciated approximately 40% against the euro during the last 6 years. Since oil is priced in U.S. dollars, the argument is that oil producing countries demand more dollars for the same amount of oil, driving the price upward. Also, many investors buy oil as a hedge against inflation when the dollar falls. Finally, a weaker dollar makes oil less expensive to investors dealing in other currencies, perhaps spurring additional demand. Many analysts believe the dollar's protracted decline is a major factor behind oil's doubling in price over the past year.
However, the dollar reached a tentative low in March of this year and has been able to stabilize at slightly higher levels. Since the dollar has stopped going down, it is highly unlikley that “dollar weakness” can explain why oil has rocketed $40 per barrel since March. There must be something else at work.
To the extent dollar weakness does play a role in the rising price of oil, the Fed’s renewed focus on inflation with a slight bias towards raising rates should help bring the price of oil down. Additionally, there is growing speculation that the U.S. Treasury may intervene to help prop up the dollar.
On June 5th, ECB President Jean-Claude Trichet signaled that the European Central Bank might raise interest rates. With the Federal Reserve keeping U.S. interest rates on hold, the fear of further dollar weakness caused oil to surge $10.75 on June 6th, it’s largest one-day rally in history. This type of wild one-day move in oil based on currency prognostication offers a clue as to perhaps the most important culprit for rising oil prices – speculation.
Index Speculation
On May 20th, Michael Masters, Managing Member of the hedge fund Masters Capital Management, testified before the Committee on Homeland Security and Governmental Affairs for the U.S. Senate on the impact of index speculation by institutional investors (such as pension funds, endowment funds and sovereign wealth funds) on the rising price of oil and other commodities. Masters distinguishes between “index speculators” that allocate a percentage of their portfolios to commodities futures according to popular indices such as the S&P Goldman Sachs Commodity Index and the Dow Jones AIG Commodity Index and “traditional speculators” that use the futures market to hedge their actual economic interest.
Driven by stock market losses in the severe bear market of 2000-2002 and the search for new “uncorrelated asset classes”, institutional investors began to “buy and hold” commodities futures for the first time. The appeal of commodities as a distinct asset class has risen dramatically as the perception of oil as a hedge against the weak dollar and terrorism has grown. Masters claims that index speculators now collectively “account for a larger share of outstanding commodities futures contracts than any other market participant”. The numbers are staggering.
With the proliferation of commodity exchange traded funds, “commodity index trading strategies have risen from $13 billion at the end of 2003 to $260 billion as of March 2008”. According to a recent article in Barron’s, the total contract value on all domestic commodity exchanges is $960 billion, so the approximate $260 billion invested since 2003 in commodity indices is very material and accounts for roughly 27% of the total domestic exchange contract value.
This incredible sum invested through regulated domestic exchanges pales in comparison to the value of so-called “swap dealings” of hedge funds and commodity index products traded on the over-the-counter (OTC) market. Index speculators circumvent position limits otherwise imposed by the Commodity Futures Trading Commission (CFTC) by “hedging” through dealers (investment banks and commodity brokers) that belong to the International Swaps and Derivatives Association. The CFTC has granted these “swap dealers” an exemption from speculative position limits when they hedge OTC swaps transactions, thereby qualifying the trade as “commercial” versus “non-commercial” and opening a “swaps loophole” for unlimited speculation. The swap dealers effectively serve as market makers for the index funds and issue derivative swaps to index speculators, yet they do not take possession of the actual physical commodity. According to the Bank for International Settlements, the value of OTC commodity swap contracts totaled $9 trillion as of December 2007. This compares to $7.1 trillion at the end of 2006 and only $1.4 trillion in 2004! With oil contracts representing as much as 70% of these swaps, ISI Group estimates that “OTC oil trading could be as much as 18 ½ times larger than the total bets outstanding on the main regulated energy futures market, the New York Mercantile Exchange”.
It is very important to understand the difference between traditional speculators and index speculators. Masters explains that “traditional speculators provide liquidity by both buying and selling futures, while index speculators buy futures and then roll their positions by buying calendar spreads – they never sell. Therefore, they consume liquidity and provide zero benefit to the futures markets”. Masters continues that index demand “arises purely from portfolio allocation decisions” and “their insensitivity to price multiplies their impact on the commodity markets”. Masters further explains that “commodities futures prices are the benchmark for the prices of actual physical commodities, so when index speculators drive futures prices higher, the effects are felt immediately in spot prices and the real economy”.
So, we have a market where trillions of dollars are driving up the price of physical commodities - without having to take physical delivery of the commodity - through derivative swaps. Furthermore, the phenomenon of long-only bets by institutional speculators has become the unintended equivalent of hoarding. It is estimated that index speculators occupy 40% of all long contract positions, compared to 27% by traditional index speculators and 33% by physical commodity hedgers – this is amazing when one considers that commodity index speculation barely existed only several years ago! Masters estimates that index speculators have “stockpiled, via the futures market, the equivalent of 1.1 billion barrels of petroleum, effectively adding eight times as much to their own stockpile as the U.S. has added to the Strategic Petroleum Reserve over the last 5 years”. As this new commodity asset class continues to outperform, more institutional money gets allocated which further drives the price of oil higher. It is interesting to note that Morgan Stanley and Goldman Sachs, the two largest institutional swaps dealers and arguably the most vested players in the commodity game, recently predicted that oil would reach $150 and $200 respectively.
Solutions
Masters offers three specific solutions to immediatley reduce index speculation:
- Congress should modify ERISA regulations to prohibit commodity index replication strategies as unsuitable pension investments.
- Congress should act to close the “swaps loophole” by looking through the swaps transaction to the ultimate counterparty and hold that counterparty to the regulated position limits.
- Congress should compel the CFTC to reclassify all positions in the “commerical” category to distinguish between “bona fide” physical hedgers and those controlled by Wall Street banks.
It is worth noting that, on June 26, the House of Representatives voted 402-19 in favor of a bill that requires the CFTC to more aggressively police the commodity markets it oversees. In addition, both John McCain and Barack Obama have targeted commodity speculation as part of their overall energy policies.
We are convinced that index speculation is the single largest factor behind the parabolic rise in oil prices. Oil may not return to the $45 to $60 range as Oppenheimer’s Gheit recently suggested, but there seems to be very little economic reason to support the sharp move above $100.
While the price of oil may move short-term due to speculation, we need to take actions to secure sustained long-term access to affordable energy. Since the United States currently imports 70% of the oil we consume and all Western oil companies combined (Exxon Mobil, Chevron, BP, Shell, ConocoPhillips, Total) today control only 7% of the world’s oil reserves, it is abundantly clear that we need to work dilligently towards energy indepedence. Here are potential solutions:
- Expand investment in alternative energy sources such as wind, solar, hydrogen, biofuel, coal, nuclear and natural gas. Alternative energy can be America’s next great technological frontier.
- Consider lifting the moratorium on drilling domestically off the Atlantic and Pacific coasts. (Petrobras’ Tupi oil field discovery two years ago off the Atlantic coast may contain as much as 8 billion barrels of oil and would boost Brazil’s reserves by more than 50%).
- Open up Alaska’s Arctic National Wildlife Refuge (ANWR) for exploration. It is estimated that ANWR contains half of the proven oil reserves in the U.S. at 10.4 billion barrels.
- Open up shale exploration in the Rockies. The Rand Corporation estimates that the sedimentary rock where Utah borders Colorado and Wyoming holds about 800 billion barrels - that's three times the size of Saudi Arabia's oil reserves.
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