Speculative component to oil price not near enough to call a bubble.
Editor’s note: The following piece by Jason Moschella first appeared on the blog Jason’s Market Thoughts (view the original blog entry). Moschella’s piece is the second of two formal responses to F. William Engdahl’s article “Perhaps 60% of today’s oil price is pure speculation.” A response by gabrielgray entitled “Oil speculation theory taken to the woodshed” is also live on Stockhouse.
Rob from Stockhouse found an intriguing article by F. William Engdahl wherein the author argues that 60% of oil prices are due to speculation (suggesting that oil is really only worth $55 a barrel). You can consult the piece here.
I read Engdahl's piece several times, and, although I agree with him that there is a speculative component embedded in oil prices, it is not anywhere near the 50% or 60% of the price that he is referring to. I found his insight into the political backdrop and relationship intriguing, but began to question his methods upon using the words "compelling evidence" without even presenting said evidence. As with any piece that anyone in financial markets writes, Engdahl likely has a view and has framed his story to fit it. He may be right in that oil can drop 60%, but the key issue is timing. Two key issues in the analysis that I strongly disagree with:
1) U.S. crude inventories (ending stocks) ARE at higher levels than in 2000, but have been virtually flat since 2005 (source: EIA). It is worth noting that at this time oil really started to rise. Engdahl claims that inventories have risen "at a steady pace" for eight years. Maybe China's hoarding oil, but they need it as infrastructure investment is material- and energy-intensive.
2) Chart crude in other currencies (EUR, RMB, CAD, BRL) and the price of oil has not risen to nearly the same degree as it has in U.S. dollar terms. Other countries are structurally stronger and thus have been able to absorb the increased costs more readily via currency appreciation (vs. USD). In fact, the dollar is still overvalued on a long-term basis (make a price-parity chart with John Edwards' inflation data and you'll see what I mean). From a balance sheet perspective, the country is insolvent! Persistent current account deficit, massive leverage, unfunded liabilities, and monetary inflation are the recurring themes.
In addition, the rise in global commodity prices reflects a massive flood of liquidity that has been forced into the system following the Asian crisis and tech stock bubble bursting at the turn of the century. Money growth in developed countries has outpaced nominal GDP growth by 15% in the last 8 years, yet crude stocks have only grown in line with population growth. Stocks shouldn’t matter over the long term because they are a short-term, cyclical measure. Proven reserves should be used to calculate supply, not inventory on hand (from what I have read, proven reserves are shrinking). This leads me to the issue of increasing marginal costs of production. My former colleagues have estimated that it now costs almost $80 for non-OPEC entities to find and extract a new barrel of oil. If anything, this cost is higher because of a 30% decline in the U.S. trade-weighted dollar since 2002. Add on the 15% “excess liquidity” premium and you get a “fair” price somewhere between $92 and $115 a barrel. The key is that fair value keeps rising, and that it takes a long time to find and make a new barrel of oil, so the extra $20 you are paying in the spot market comes from the convenience of having the barrel now, rather than later.
Finally, I was upset with the fact that Engdahl’s unwillingness to distinguish between “speculators” and “investors.” I do not think that he understands the difference in time horizons that these two groups face. As in every market, there are players who try and take advantage of short-term price gyrations to make a quick buck. These quants and hedge funds only really add volatility, as evidenced by the increased amplitude of price changes in the past couple of years in the crude market, but on a rate-of-change basis, oil prices are increasing only at a slightly higher pace than before (this is a better representation of speculative activity, so although there is more gambling now, it is not yet bubbly).
On the investor front, the appeal of commodities as an asset class by large, long-term investors such as pension funds really didn’t make sense until recently because of falling commodity prices from 1980 to 1998. Now, commodities have regained appeal as the secular winds have shifted, and the fact of the matter is that the size of the pool of money controlled by these funds dwarfs the size of the physical market. There is obviously a link between this and the excess liquidity story I outlined above and it partially explains why prices are going up. It is worth noting that many of these large entities are pension funds which have invested in commodities as strategic (long-term), as opposed to tactical (short-term) bets.
To conclude, oil prices DO have a speculative component to them, but a rough back-of-the-envelope calculation suggests that at present they comprise too small of a portion of prices to infer that oil is a mania about to go bust.
This article was written by a member of the Stockhouse community.
