Streetwise Professor

April 20, 2009

What the Oil Market is Saying

Filed under: Commodities,Economics,Energy,Financial crisis — The Professor @ 8:42 pm

Oil was down almost 10 percent today, following the decline in equities.  But that’s not what I find intriguing.  What I find intriguing is that the price of oil was able to rise above $50/bbl, and stay there for awhile, despite extremely weak fundamentals.

These two FT Alphaville blog posts set out the story in detail.  They document continuing increases in inventories.  Specifically, both crude inventories and refined product inventories have been continuing their increase even as prices have inched upwards.  The increase in US refined plus crude stocks is a 4 standard deviation move–bigger than observed in almost 30 years.  Tanker rates are falling even as firms are chartering both clean and dirty tankers to store products and crude.  Refinery capacity utilization is at very low levels.

In a conventional theory-of-storage model, the increase in inventories would reflect a decline in demand/increase in supply that would also result in lower prices; the accumulation of inventories would slow, but not stop, the decline in prices.  Given that supply has actually dropped (due to OPEC output cuts), this would mean that demand has continued its precipitous drop.  

In the past I’ve argued that inventories and prices can move in the same direction when fundamental uncertainty increases.  An increase in fundamental volatility leads to increases in precautionary inventory holding.  The only way to accommodate this demand for higher inventories is to raise prices.

But that doesn’t seem to be a plausible explanation of what’s been happening in the last couple of months.  Some indicators of fundamental uncertainty, such as the VIX equity volatility index and credit spreads have actually eased in past months while the oil price was rising.  

So that leads me to another explanation, similar to the one advanced by the Diapason Commodities guy quoted in one of the FT pieces: Inflationary expectations.    

So what was behind the recent strength in crude prices? According to Corrigan most likely the same thing that was behind the equity rally – people investing in commodities and ‘real assets’ as an inflation hedge. As he explains:

This inflationary policy is already beginning to push people towards increasing their exposure to real assets — hence the rise in commodities and stocks   – a phenomenon very similar   to that which took place after the American devaluation of 1933, well ahead of the recovery in real output.  

Given the dismal news about the real economy, that’s the only thing that makes sense to me (in both the equities and commodities markets).  (Though Chinese strategic inventory accumulation is probably playing a role too.  That could be seen as inflation related too, however, as it involves the Chinese exchanging nominal claims, US dollar denominated securities, for real commodities.  That is a reasonable response to inflationary expectations; tends to reduce the demand for dollars; and cause an appreciation in the dollar prices of real commodities.  It is a Chinese contribution to quantitative easing.)  

You might say: “But the CPI and PPI actually dropped last month.  Inflation is the least of our worries: deflation is a more pressing concern.”  I would argue that these price measures are backwards looking; asset and commodity markets are forward looking.  And looking forward, there are many signs pointing to a potential spike in inflation.  It is not a probability one event, but the huge monetary overhang poses acute challenges to the Fed, and other central banks that have engaged in quantitative easing.  If they do not walk a very fine line, inflation could very well flare up.  And the line will be very hard to walk, because of the politicization of the Fed and other central banks, and the inherent credibility problem in anti-inflation policies as economies pull out of recession/depression/banana (a reference to Alfred Kahn’s quip in the 70s).  Therefore, it is not surprising to me that the dollar value of equities and commodities has strengthened somewhat recently.  

I will be keeping an eye on the connection between commodity prices and measures of fundamentals, especially inventories and capacity utilization.  Bearish fundamentals plus firming prices are a strong signal of potential stagflation.

A brief comment about today’s equity selloff.  I was actually surprised at the rally in stocks in recent weeks on bank earnings news.  I was surprised because I thought these earnings announcements said nothing about the main issue involving banks–the values of the assets in their portfolios.  Making money trading in an illiquid environment with wide bid ask spreads (because many competitors have exited the market), and intermediating in a market with a relatively steep term structure, is no surprise.  But what inquiring minds want to know is whether the banks are really solvent or not, and the answer to that question depends on the performance of all the bad assets.  It appears that today’s decline was related directly to inferences about the continued, and perhaps increasing, severity of this problem.  Inferences derived from reading between the lines in various bank earnings statements.  

For my part, I am paying little attention to bank earnings.  I am looking for clues about solvency.  And today suggests that the market is adopting a similar approach.

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  1. I like this post mainly because it answers my long standing question of which asset classes the markets (and in particular the Chinese government) would favor over the dollar. Given the cut loose inflationary policies of the Fed, it was obvious that the Chinese would want to reduce their dependence on Treasuries and bonds. My question is whether we observe a similar uptick in prices of other commodities such as copper, silver etc – to get more insight into this behavior.

    And it certainly does look like the market is looking beyond the attempts of banks to throw sand over its eyes by playing the 3 month card trick :-D.

    The problem of increasing inventories and increasing commodities prices in the context of easing volatility seems like a good puzzle to investigate. But why would anyone consider oil as a long time inflation hedge? On the basis that its supply is limited to some extent and that the demand would in fact really increase in the long run? But a long stagflation hypothesis in my opinion wouldn’t really be consistent with a rising oil prices scenario. May be it is just the market’s current guess that the uncertainty induced by oil suppliers (Putin and OPEC) would in fact help keep oil prices higher versus investments in bonds whose yields are bound to dip in the medium term……

    Comment by Surya — April 20, 2009 @ 10:34 pm

  2. You forgot to mention hopes of recovery in China. The Shanghai index as increased by more than 40% in the last 3 months. If indeed this is an early sign of a world recovery on China and the other BRICs then no wonder investors are pilling on commodities…

    Comment by Christian — April 21, 2009 @ 3:35 pm

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