Streetwise Professor

December 1, 2008


Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 9:01 pm

Today’s oil market, that is.   January Brent on ICE down 11.4 percent to $47.53/bbl.   January WTI on NYMEX down a mere 9.5 percent to $48.28/bbl.   And our favorite, Urals Med, down to $43.79/bbl in European trading.

The oil market continues its death ride strapped to the equity market.   This is historically unusual.   From 1985-2008, on average a 1 percent move in the SP500 was associated with a 0–yes zero–percent move in WTI.   That is, there is historically zero correlation between WTI and the SP.     In the summer of 2008, the correlation was negative–when the oil market went up, the stock market went down.   During this period, a 1 percent increase in the price of WTI was associated with about a .8 percent decline in the S&P.   This is consistent with supply shocks being the main driver of oil prices during that period.   An adverse supply shock raises oil prices and constrains economic activity, leading to lower stock prices.

What a difference a few months makes.   During October and November, oil and stock prices have been moving in the same direction, in a virtually unprecedented way.   A one percent change in the price of oil during these months is associated with a .85 percent change in the S&P   in the same direction, i.e., a one percent drop in the price of oil is associated with a .85 percent decline in the S&P.

In the past 20 years, the largest value of this coefficient is .4.   So, in the past two decades oil and stocks have never been even close to as highly correlated as they are now.

This all means that demand is now in the driver’s seat.   A decline in the S&P reflects bearish prospects for the economy.   Bad economy–low demand for oil–low oil price.

Today’s oil price bloodbath sure speaks volumes about the market’s assessment of the credibility of OPEC General Secretary al-Badri, who said today:

OPEC is ready to cut production by a significant amount when it meets later this month in Algeria, prompted by high oil inventories, the group’s secretary-general said on Monday.

“We are all geared toward a cut in Algeria,” Abdullah al-Badri told a news conference in Tehran, two days after the Organization of the Petroleum Exporting Countries decided at a meeting in Cairo to delay a decision on a new supply reduction.

Tell us another one, Abdullah!

Today’s plunge also speaks to those in Russia, and those bullish on Russia, who are counting on OPEC to ride to Russia’s rescue.   Don’t count on it, in other words.   To believe such is to grasp at straws in the tempest.

The market’s scoffing at al-Badri’s whistling-past-the-graveyard bravado reflects a clear-eyed appraisal of the realities facing OPEC.   As I’ve noted on SWP before, cartels in general, and OPEC in particular, face serious problems from cheating.   It is collectively rational to cut output to raise prices, but individually rational for each individual member country to produce more than its quota. This prisoner’s dilemma undermines cartel discipline, and means that cross-my-heart-hope-to-die promises to cut output are worthless.

Due to the sharp contraction in oil demand (as manifest in the decline in prices and the rapid growth of inventories), most OPEC countries are operating well below capacity.   This cushion would only increase were they to cut output in response to OPEC agreement.   They therefore have the ability and incentive to increase output beyond their quotas.   And believe me, they will.

This bodes ill indeed for Russia’s recovery.   The only somewhat gloomy World Bank report on the Russian economy, which predicted a slowdown in growth to 3 percent was predicated on an oil price of $74.45/bbl for 2009.   That is looking increasingly unlikely, meaning that the 3 percent growth number is similarly unlikely.

The first reliable indicators of damage to Russia’s real economy are also becoming available.   Manufacturing activity has declined more than in–wait for it–1998:

Russian manufacturing shrank more in November than during the 1998 financial collapse as the global economic crisis drove output and new orders to record lows and companies cut jobs, VTB Bank Europe said.

VTB’s Purchasing Managers’ Index fell for a fourth month to 39.8, its lowest level, from 46.4 in October, the bank said in an e-mailed statement today. The previous low was 43.2 in September 1998, a month after the government’s ruble devaluation and default on $40 billion of debt. A figure above 50 means growth, below 50 a contraction. The bank surveyed 300 purchasing executives.

“The sense of doom and gloom was only deepening,” in November, Tatiana Orlova an economist in Moscow at ING Group NV said by telephone. “The mood isn’t getting any better.”

Industrial production has slumped and unemployment is rising as declining commodities prices and the seizure of credit markets prompt an outflow of capital. Investors withdrew $190 billion from the country since August, BNP Paribas SA estimates, as oil fell below the $70-a-barrel average needed to balance the 2009 budget.

“Driving the rapid contraction of the manufacturing sector in November was a record fall in incoming new work,” the bank said in the statement. New export contracts tumbled because of “fallout from the global financial crisis.”

(Not that things are rosy in the US.   Here manufacturing dropped by the largest amount in 26 years–that is, since the Reagan-Volker recession.)

But nonetheless, the Russia Central Bank continues its insane policy of supporting the ruble, thereby accelerating the erosion in its currency reserves:

Dec. 2 (Bloomberg) — Russia’s central bank probably doubled spending of foreign reserves to defend the ruble from its biggest weekly plunge against the euro in more than four years, according to the median of 10 analyst estimates.

Bank Rossii may have sold $5.75 billion of foreign currency last week, based on the average of predictions ranging between $2 billion and $6.5 billion. That’s likely to contribute to a decline of about $6.25 billion in Russia’s overall cash pool, compared with $3.6 billion in the previous week, the survey by Bloomberg shows.

Russia lifted interest rates twice last month and drained $148 billion from the world’s third-largest reserves since August to stem a 16 percent currency slide against the dollar. BNP Paribas SA estimates that investors withdrew $190 billion since August as oil prices below the $70-a-barrel average needed to balance the 2009 budget triggered Russia’s worst financial crisis since the government’s default a decade ago.

“The central bank is willing to use reserves daily to make sure the ruble falls at their pace,” said Elina Ribakova, chief economist in Moscow at Citigroup Inc., which forecasts a 15 percent fall in the ruble next year. “I expect continued declines in reserves until the end of the year and into the next.”

Bank Rossii buys and sells foreign currency to keep the ruble within a trading band against a basket comprised 55 percent of dollars and rest in euros. Policy makers widened the band three times last month as the ruble lost 3 percent versus the basket.

The Russian currency weakened 2.3 percent against the euro last week, its biggest plunge since August 2004. It traded near the weakest in 2 1/2 years against the dollar yesterday.

Currency Gains

The government may have deepened the reduction of its reserves from $449.9 billion last week by transferring cash to state lender Vnesheconombank, said Tatiana Orlova, an economist in Moscow at ING Groep NV.

A $1.8 billion loan to Evraz Group SA, Russia’s second- largest steelmaker, may also appear in the reserves data for last week, said Katya Malofeeva, an analyst in Moscow at Renaissance Capital.

An acceleration of purchases of rubles from the reserve combined with the fact that the ruble continued to fall last week suggests that a speculative attack against the currency is gaining speed.   And Russia is getting what for this, exactly?   Letting the ruble go to find an equilibrium level consistent with the dramatically weakening fundamentals (i.e., a plummeting oil price) would ease the drain on the reserves, and would also help the country’s increasingly desperate manufacturing sector.   But it would represent a very public repudiation of the Putin’s main economic argument.   So, expect speculators to make money at Russian expense, and for most Russians to see exactly bupkus from the summer’s oil windfall.   Easy come, easy go.

So, to tie everything together.   The price of oil is a hostage of the financial crisis in the West, with the linkage between the oil price and stock prices tighter than ever.   Russia’s economy is hostage to the price of oil, with the linkage again arguably tighter than ever.   With no end in sight to the West’s economic travails, this means that economic growth in Russia in 2009–even 1 percent–is likely a pipe dream, and that an economic contraction is far more likely.

The only question is what will be the broader fallout of a sharp decline in the ruble (inevitable, sooner or later) and a recession in Russia, against the background of unrealistic expectations stoked by a government controlled media.   Will Russians behave in the stereotypical, fatalistic fashion, and accept yet another disappointment with resignation?   Or will this spark another of Russia’s paroxysms of political chaos?   The latter is not a certainty, but it cannot be ruled out.   And the more severe the contraction becomes, the more likely that outcome.

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