Mar 18, 2010
Betting the farm on oil
By Hossein Askari and Noureddine Krichene
In March 2009, when oil prices were at US$45 per barrel, if a speculator had made a bet that oil prices would rise by March 2010, he would have made a tidy gain of 82% as prices are now around $82 per barrel. But if a conservative retiree, who could not assume any risk, had invested his money in US government notes over the same period, he would have made 0.23%.
What a difference! Go back further in time. If in 2002, when oil prices were at $19 a barrel, a speculator had bet that oil prices would keep on moving up to $80 a barrel by 2006, he would have earned a tidy return of 43% per year compared with an annual
return of 1.5% on US Treasury notes. If in August 2007, when oil prices were at $71 a barrel, a speculator had bet that oil prices would accelerate to $147 a barrel in July 2008, he would have earned a whopping 117% per year, compared with 1.2% per year on US Treasuries.
Now, today in March 2010, if our speculator bets that oil prices will move up from the prevailing $82 per barrel to $100 per barrel, or a higher, in the near future, his bet would be consistent with observed trends. Let’s explain.
In the past decade, oil and other commodity price inflation have shattered records. Oil price inflation averaged 43% per year and commodity price inflation averaged 28% during 2002-2008, dwarfing commodity price inflation of the 1970-1981 period, a record for modern times with oil prices rising at 26% a year and commodity price inflation at 10% a year.
Why has the period 2002-2008 been so inflationary for commodities? Central banks, notably the US Federal Reserve and European Central Bank (ECB), have categorically denied any link between their monetary policies and oil and commodity price inflation during this period. Instead, they have blamed it on rapidly growing Chinese and Indian demand for oil and other commodities and on constrained supplies on the part of producers. Academics and the media have generally supported this view. The impact of expansionary monetary policy by the Fed during 2002-2005 and the impact of widening US fiscal deficits on oil and commodity markets have been simply ignored.
Despite a rejection by central banks of a link between commodity price inflation, record low interest rates and massive liquidity injection, a number of observers in the distant past, ever since the quantity theory of money, as well as contemporaneous analysts see monetary policy as a plausible explanation for sustained commodity price inflation. General price inflation could be plausibly explained as a monetary phenomenon. The monetary explanation for commodity price inflation lumps cost-push and demand-pull theories of inflation together as transmission mechanisms for monetary shocks and deals only with the accommodative or restrictive stance of monetary policy in fueling or retarding a general price increase.
The more monetary policy is accommodative, the more powerful would be the inflationary effect of monetary accommodation. Consequently, the present stance of near-zero interest rates and unlimited money injection by reserve currency central banks can only feed further commodity price inflation and a general rise in prices. The longer this stance is maintained, the faster the acceleration of inflation and the more predictable the rise of oil prices. In this unorthodox monetary policy setting, a forecast of oil prices going to $100 a barrel, or persistently moving higher, in the near future can only be a sound forecast.
In late 2008, equity and commodity prices crashed. Oil prices fell from $147 per barrel to a low of $32 per barrel in December 2009. Those who all along maintained that China and India were the cause of oil and commodity price inflation must have been embarrassed by this crash. Surely, they could no longer defend their view that China and India were the key determinant of oil and commodity price inflation.
If rapidly increasing demand from China and India was behind the explosion in oil and commodity prices, a student of economics would have had to infer that demand from China and India had crashed, or possibly supply had exploded. But this is not supported by the facts. Despite a fall in oil prices by 82% in less than four months, oil output and oil demand remained stable at 86 million barrels per day (mbd) during September-December 2008.
Similarly, the acceleration of oil prices from $71 per barrel from August 2007 to $147 per barrel in July 2008 would have made the same student think that oil demand had increased dramatically or oil supply had fallen dramatically. Neither event took place nor realistically could they have. Oil demand and supply remained stable at 86 mbd during August 2007-July 2008.
Are demand and supply models that economist use faulty? Certainly not. To answer the apparent puzzle, a student should be introduced to paper barrels, as opposed to oil in real barrels, traded in organized futures exchanges around the world that artificially increased the demand and supply for oil and to the role of speculation supported by the liquidity provided by central banks. The crash in oil prices in late 2008 was due to over supply of paper barrels in a stampede to sell long positions at a time when hardly anyone wanted to buy futures contracts when oil futures prices were collapsing; whereas the acceleration of oil inflation during August 2007-July 2008 was due to over demand for long positions when oil prices were confidently rising on the strength of abundant financial liquidity and low interest rates.
Organized futures markets were initially established for hedging as genuine commodity producers, such as wheat farmers, wanted to protect themselves against declines in prices and genuine consumers of commodities, such as bakers, wanted protection against a rise in prices. Nonetheless, futures markets have become dominated by speculation. Speculators are interested in profits from short-term changes in commodity and equity prices. Traders in oil futures could be commercial traders, non-commercial traders, or others. Non-commercial traders could include banks, hedge funds, commodity funds, pension funds, and a number of other institutions; brokers could trade for their own account.
Non-commercial trade may account for 60% to 80% of traded futures contracts. A seller of an oil futures contract does not need to be Exxon, British Petroleum, Shell, or any other oil company. A hedge fund that buys oil futures contracts would become a seller of a futures contract when it closes a position to reap gains or prevent losses from its futures contracts. In fact, futures contracts are settled in offset cash settlement and very rarely through actual delivery of commodities.
Why were oil prices stable during 1983-2000 at about $18-$20 per barrel? Does it mean that there were no speculators in the market during that time? Or similarly, why did the New York Exchange not crash during 1920-1929? Were there no speculators during that time? Speculators are always operating in the market.
During 1983-2000, interest rates were relatively high, liquidity was scarce, and government bond yields were high in the range of 6%-8% per year, making bonds more attractive and less risky than commodities. Speculation flourishes when interest rates are exceptionally low and liquidity plentiful. When interest rates are very low and liquidity is abundant, the cost of margins becomes very low. That is, speculators can borrow from their brokers at very low interest rates as they did prior to the stock market crash in 1929, and price trends become unmistakenly upward moving.
It is cheap liquidity that fuels speculation. When central banks generously provide very cheap liquidity, speculation is fired up. The speed at which equity, commodity, and asset prices rise would depend on the speculative euphoria and the real economic activity. Buoyant real activity would accelerate the speed at which speculative prices rise. Nonetheless, a drop in real activity would not necessarily preclude a rapid rise in prices when interest rates are very low and liquidity abundant. For instance, oil prices rose from $32 per barrel in December 2008 to $82 per barrel in March 2010 even though oil demand declined from 86 mbd in December 2008 to 85 mbd in March 2010. In 2009, major banks posted large profits from trading in commodities and equities in spite of a sluggish economy and rising unemployment.
The intensity of speculation also varies depending on the specifics of the commodity market in question. Even though all commodity markets are under a common speculative trend that could be rising as observed during 2002-2008, stationary as during 1983-2000, or crashing as in the last quarter of 2008, the intensity of speculation depends on the characteristics of each market.
For instance, a recent drop in sugar supply sent sugar prices skyrocketing by 160% from $295 per ton in December 2008 to $767 per ton in January 2010, with powerful inflationary effect on sugar-based products. Oil markets have characteristics that are different from agricultural commodities. More specifically, oil output has very low variability in the short-run and is almost fixed; similarly, oil demand is highly inelastic and cannot change in the short-run. These characteristics rule out short-term changes in real oil demand and supply and bring oil prices under stronger inflationary pressure compared to many other commodities. As for any commodity, speculative increases in oil prices are instantaneously transmitted to consumers. Oil price inflation continues to weigh on economic activity and contributes to a general rise in energy costs until it becomes disruptive as it did during 2007-2008 or during the 1970s.
Commodity markets rapidly transmit the inflationary effects of US Fed and other major reserve currency central banks monetary policies. Commodity prices are very sensitive to interest rates and availability of liquidity through borrowing. Cheap money policies have operated through a number of channels, including credit channel, exchange rate channel, and commodity channel. The commodity markets channel operates faster in comparison to other channels with instantaneous impact on consumer prices. For instance, while US banks are at present awash with $1.175 trillion in excess reserves, which they could not lend profitably and with reduced risk, futures markets have been on a speculative rise as illustrated by large rebounds in gold, oil, food, and many other commodity prices. At present, bonds are offering very low yields and would suffer large price losses if interest rates started rising; whereas commodities are offering a significantly higher and safer return under prevailing unorthodox monetary policy environment.
Who is in a position to determine whether oil prices move to $100 per barrel, $147 per barrel, or even higher? It is not the Organization of the Petroleum Exporting Countries, China or India. It is not even the speculators. Speculators are simply microstructures that are risk-averse and seek to profit from opportunities for gains; they were not able to prevent a sharp decline in oil prices from $41 per barrel in 1981 to $8 per barrel in 1986, nor were they able to push oil prices beyond $18-$22 per barrel during 1985-2000.
The late Milton Friedman stated that there was inflation only because the US Fed had decreed so. By setting interest rates near zero bound, the US Fed as well as other reserve currency central bankers are igniting oil price inflation. By creating fictitious liquidity, that is, liquidity that has no real counterpart, major central banks are providing the fuel for speculation and for driving oil prices to $100 per barrel and higher.
In fact, extremely low interest rates and fictitious liquidity created by US Fed and other reserve currency central banks pushed credit to excessively high levels that resulted in a meltdown of subprime credit. Not only did private sectors become over-indebted, governments also availed themselves of very cheap credit. The financial crises in Iceland and Greece have demonstrated the distortive and disruptive effects of excessively expansionary policies. Most disturbing, European leaders have yet to grasp the underlying cause of the crisis they face and the unsustainability of excessive public debt. Recently, European leaders have expressed anger against speculative attacks and credit default swaps (CDSs) for causing the financial crisis in Greece and making the financing of Greek debt more expensive. Likewise, the US Congress blamed oil companies and oil producers for the oil crisis in 2007-2008. If one were to believe the logic of European leaders, if CDSs are banned, Greece and other European countries could borrow more cheaply and the debt crisis would be resolved. Simple logic indeed.
Fictitious money creation by reserve currency central banks was conducive to high oil and commodity price inflation. Since the US Fed could not push oil output above 85 mbd nor could it prevent a sharp drop in sugar output, its fictitious money creation has amounted to a real redistribution of purchasing power in favor of borrowers and speculators and imposed a heavy tax on workers, pensioners, and other fixed-income groups – and a cut in real incomes for millions of consumers around the world. By paying threefold to fourfold more for basic commodities, consumers are cutting dramatically their real consumption of these goods and at the same are being taxed directly through commodity price inflation by central banks.
Today, major central banks may have become a powerful destabilizing force. If US banks had deployed the excess liquidity ($1.75 trillion) created by the US Fed, they would have triggered the worst commodity price inflation. Would economic recovery become sustainable and companies go on a hiring spree when oil prices are back up to the $147 per barrel mark? If you are the US Fed or the ECB and believe that commodity price inflation is irrelevant, then economic growth would be strong regardless whether oil prices exceed $147 per barrel or hit newer records. However, if you remember the 1970s and 2007-2008 with high oil and other commodity prices, then you would realize that persistent increases in oil prices could become disruptive and could dissuade hiring and undermine economic growth. It would appear that the world economy may be locked in a vicious circle of loose monetary policy and spiraling oil and commodity price inflation.
Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist with a PhD from UCLA.