Thursday, June 5, 2008

What’s Wrong With This Picture?

Someone help me out with this one.

If, as the true believers in the purity of market forces say, the price of oil is a function of supply and demand AND considering the fact the US economy consumes more oil than any other country in the world, then how does one explain the accompanying chart from today’s Wall Street Journal?

Recently, before Saudi Arabia relented to political pressure, country leaders said that there is no need to increase their output as supply is meeting demand. Moreover, according to various sources, the cost of extracting oil from the ground ranges approximately from the mid teens to $60 per barrel, depending on various cost factors including the ease of access to the crude. Therefore, as I noted in my last appearance on the Business News Network, the fair value for oil seems to be somewhere in the $80 range, if one assumes an average exploration cost of $50 plus an extra $30 (60%) for all associated additional costs and reasonable profit margins.*

That said, perhaps the following excerpt from George Soros’ testimony before Congress yesterday might help shed light on the debate re a commodity bubble and help explain $120 oil:

"Madame Chairperson, distinguished members, I am honored to be invited to testify before your committee. As I understand it, you are seeking an explanation for the recent sharp rise in the oil futures market and in gasoline prices. In particular, you want to know whether this rise constitutes a bubble and, if it is a bubble, whether better regulation could mitigate the harmful consequences.

In trying to answer these questions, I must stress that I am not an expert in oil markets. I have, however, made a life-long study of bubbles. So I will briefly outline my theory of bubbles, which is at odds with the conventional wisdom and then discuss the current situation in the oil market. I shall focus on financial institutions investing in commodity indexes as an asset class because this is a relatively recent phenomenon and it has become the 'elephant in the room' in the futures market.

According to my theory, every bubble has two components: a trend based on reality and a misconception or misinterpretation of that trend. Financial markets are usually very good at correcting misconceptions. But occasionally misconceptions can lead to bubbles because they can reinforce the prevailing trend and by doing so they also reinforce the misconception until the gap between reality and the market's interpretation of reality becomes unsustainable. The misconception is recognized as a misconception, disillusionment sets in, and the trend is reversed. A decline in the value of collaterals provokes margin calls and distress selling causes an overshoot in the opposite direction. The bust tends to be shorter and sharper than the boom that preceded it.

This sequence contradicts the prevailing theory of financial markets, which is based on the belief that markets are always right and deviations from equilibrium occur in a random manner. The various synthetic financial instruments like CDOs and CLOs, which have played such an important role in turning the subprime crisis into a much larger financial crisis have been built on that belief. But the prevailing theory is wrong. Deviations can be self-reinforcing. We are currently experiencing the bursting of a housing bubble and, at the same time, a rise in oil and other commodities, which has some of the earmarks of a bubble. I believe the two phenomena are connected in what I call a super-bubble that has evolved over the last quarter of a century. The misconception in that super-bubble is that markets tend toward equilibrium and deviations are random.

So much for bubbles in general. With respect to the oil market in particular, I believe there are four major factors at play, which mutually reinforce each other.

First, the increasing cost of discovering and developing new reserves and the accelerating depletion of existing oil fields as they age. This goes under the rather misleading name of 'peak oil'.

Second, there is what may be described as a backward-sloping supply curve. As the price of oil rises, oil-producing countries have less incentive to convert their oil reserves underground, which are expected to appreciate in value, into dollar reserves above ground, which are losing their value. In addition, the high price of oil has allowed political regimes, which are inefficient and hostile to the West, to maintain themselves in power, notably Iran, Venezuela and Russia. Oil production in these countries is declining.

Third, the countries with the fastest growing demand, notably the major oil producers, and China and other Asian exporters, keep domestic energy prices artificially low by providing subsidies. Therefore rising prices do not reduce demand as they would under normal conditions.

Fourth, both trend-following speculation and institutional commodity index buying reinforce the upward pressure on prices. Commodities have become an asset class for institutional investors and they are increasing allocations to that asset class by following an index buying strategy. Recently, spot prices have risen far above the marginal cost of production and far-out, forward contracts have risen much faster than spot prices. Price charts have taken on a parabolic shape which is characteristic of bubbles in the making."

*I realize this is a rather simplistic analysis and that factors such as global growth have been strong. Nevertheless, the primary focus is on the "fair value" of oil, which is a function of overall supply and demand. And that of course includes the global growth story. The bottom line is simply this: if one can determine the fair value of any asset, then why can't one determine the fair value of a commodity? Unless, of course, one buys the bogus argument that the current market value is the fair value.

No comments: