I am overdue on a write-up of a great panel discussion hosted by the folks at RGE Monitor (Nouriel Roubini’s blog/news service). It was all fundamentally oriented, so with the coming holiday weekend and lack of new news, you will not be any worse off for my delay (although I am annoyed that I haven’t gotten round to it). Do check back for it.
In the meantime, a lovely post by Tim Price (of The Price of Everything) on the perversities of markets:
One of the innumerable problems with Wall Street and the City is that they never do seem to learn from their mistakes….Each generation seems obligated to re-experience the errors of its predecessors. There is little or no ‘race memory’ that might at least mean that this year’s crisis is brand new rather than a tired retread of past embarrassments.
And while Wall Street typically shies away from overly intrusive questions, it certainly seems to have all the answers. Where is the oil price headed ? $141 a barrel during the second half of 2008, according to Arjun Murti of Goldman Sachs. (Could Goldman Sachs possibly have any material interest in oil trading ?) Because Mr. Murti was also behind a prediction for higher oil prices in 2005, his apparent ability to foresee the future has led to his universal resource market canonization in the financial press. Actually, the target is $150, says T. Boone Pickens, another presumably disinterested oil trader. The last time we saw this kind of easy momentum-chasing and price target leapfrogging was during the dotcom boom….and it did not end well. As the analysts at McCall, Aitken, McKenzie have suggested, welcome to “dot.oil”.
The difficulty with commodities prices, as Bloomberg’s Caroline Baum recently pointed out, is that unlike more traditional financial instruments such as stocks or bonds, there is no fundamental yardstick of value:
“..metrics that allow us to quantify the degree to which prices have strayed from their fundamental moorings. Stock prices have an historical relationship with underlying earnings. House prices don’t stray too far from their “earnings” stream, or rental value.. With commodities, no such quantifiable ratio exists.”
So in assessing the valuation of commodities and natural resource prices, we are all left orienteering in the fog. Patrick Perret-Green of Citigroup has at least tried to square this circle using behavioural finance techniques. In his occasional ‘Chart of Shame’ he archly compares markets that have experienced classic booms and busts with contenders for the Emperor’s new clothes. Back in January he cheekily overlaid a chart of the Nikkei (grotesque peak in 1989), Nasdaq (grotesque peak in 2000), the Saudi Tadawul All Share Index (grotesque peak in 2006) and the Shanghai Composite (grotesque-looking peak in, erm, late 2007). Chinese stocks have obediently collapsed since then. One swallow, of course, doesn’t make a Murti. Last week, Patrick somewhat ominously updated the ‘Chart of Shame’ but with the FTSE 350 Mining Index as the ‘bubble’ candidate.
As anyone who holds mining stocks will confirm, the sector dutifully collapsed, albeit in the short run….
What makes markets so intriguing today is that equities seem largely immune to a combination of $120+ oil, softening housing markets and a likely collapse in western consumer spending. Arguing that several trillion currently either sheltering in money market funds or rapidly accumulating thanks to petrodollar wealth in sovereign wealth funds will ride in to support stock markets (a.k.a. greater fool theory) only logically goes so far in the face of such sizeable challenges. But some confusing short-term resilience on the part of stock markets does not invalidate the need for caution, it rather reinforces the need for patience. On a separate note, James Ferguson of Pali asks whether it might be time to commit heresy and talk, not of $200 oil (or $1000 oil, has anyone on Wall Street tried that yet ?), but merely $100 oil ? “The last three times, in the 7-year bull run that West Texas Intermediate (crude) has enjoyed, that the oil price got more than two standard deviations above trend, it precipitated an almost immediate profit-taking that resulted in an average -28% drop.” Wall Street’s venal salesmanship and management of subprime goes some way to underpinning its credibility in other markets, so its bandwagon-chasing on oil can be largely discounted on fundamental trustworthiness. The bigger question is how long equity markets can hold their poise in the face of the world’s mounting unbalances, and that question touches on government bond valuations too in the face of the smoke of the battle around inflation.
Sir Francis Bacon once wrote:
If a man will begin with certainties, he shall end in doubts; but if he will be content to begin with doubts he shall end in certainties.
In the face of almost insurmountable doubts (over likely economic slowdown, the impact on consumer confidence of softening residential property prices, the robustness of Asian fundamentals in the face of the ongoing commodity rally, the impact of $130+ oil, and the health of government bond markets given growing doubts over the under-reporting of inflationary pressures) it makes absolute sense to assume ongoing and substantial macro uncertainties….Unfortunately, an especially discredited Wall Street establishment now has peculiarly weak authority in either recommending appropriate strategies or taking advantage of the resultant dislocations in markets. Happily, evolutions in financial products and the rapid democratisation of more sophisticated investment vehicles make it easier for independent asset managers and private individuals to try and resolve these questions for themselves, rather than simply overpaying to engage with a mountain of conflicted interests.
18 comments
Comments are closed.
Dear Madam,
Does it seem to you that this is indicating a threshold for “real” capital in the world?
And since we have created excess capital – it manifests itself in two ways.
Part of the capital that has managed to permeate through the income classes shows up as inflation. Thus the value of the capital is reduced.
Part of it still with the top income class – manifests as increases in prices of asset classes – to the extent this class decides to invest. So when these burst there is capital destruction reducing total capital in the world!
It is as though these tools are systematically un-doing our excess capital creation.
Rahul
Rahul raises an essential point with additional ramifications. Note Caroline Baum’s comment about housing not ‘straying too far” from rental streams. Hello? Ms. Baum has evidently been in hibernation for the last decade plus. (And, please don’t hide behind ‘in the long run….’).
The ‘excess, non-real capital’ suggested by Rahul acts like swarms — invading, poisoning, destroying and abandoning for a new target. Behind the swarm are intermediary players whose ‘real capital’ is not at stake and who rake in fees and bonuses based on the size of the swarm.
Ben Bernanke and his fellow blind men and women don’t call this a ‘swarm’. They call it liquidity. And, when the swarm masters choose to exit for new targets, they appeal to the blind folks for more liquidity to extend their profit taking opportunity and soften the blow of withdrawal.
The effects on the ‘real’ economy of excess, swarm capital are the reverse of real capital. Instead of investment in strength for growth, swarm capital is an extraction operation that works in the reverse: find a strength, figure out how to extract immediate value from it, and use the indebtedness left behind as the honey to attract the swarm.
Bernanke and the blind folks call this ‘financial innovation’. Others might characterize it as blood sucking.
Just one of the many essential elements to all this is too much excess-, swarm- and blood sucking- capital in the hands of too few.
Bernanke and the blind folks might call this ‘meritocracy’. And others, who are critics, might liken it to aristocracy or oligarchy.
But all that would miss the point. It’s not who they are. It’s how they act.
And the action is that of the casino. It’s not for nothing that the symbol of America in the 21st century is neither the steel mill nor the Silicon Valley nor the Statue of Liberty. It’s Las Vegas. And the Predator’s Ball.
It’s just complete b.s. that there is no fundamental yardstick of value for commodities. Take oil, for example, which is the commodity I know the best. If you want to increase supply at this point, it means things like difficult deepwater wells and production costs of $90 (and that was the cost a few months ago–it’s surely higher now). Add a profit to that and you’re talking a base price of roughly $100 unless you cut demand to the point that you don’t need this expensive deepwater production.
Now you add up demand and you add up supply and you see where you are. At a base price of $100, every 1% of demand greater than supply is worth roughly $15–that is the price rise it takes to knock out that 1% of demand. That number has been going up, by the way, not down. It’s taking more and more of a price increase to knock out 1% of demand, probably because the users who are left have more money to compete for the product, and because efficiency is up since the 70s and continuing to rise, so we get more bang out of the oil we buy, making it worth paying more.
There are a number of ways to calculate demand to confirm that the price is pretty close to reality–the IEA, for example, uses models based on the number of cars on the road, the number of power plants that burn petroleum products, mile of new highway constructed, etc. The number of cars on the road in China, India and Russia has been soaring. Russians are moving out of the city to new suburbs. China is building highways, yada yada yada.
So, no way we’re in a fog. Do you really think that oil companies are making decisions about long-term investments in expensive, high-risk production completely in a fog?!?!?!? Au contraire.
The average consumer may be in a fog, and the average blogger or Bloomsberg columnist may be in a fog, but not the oil companies and not good oil traders.
And you can expect Asian fundamentals to decline all you want, but until the markets actually see it happening, they’re not going to bet on it.
Moe Gamble
“The difficulty with commodities prices, as Bloomberg’s Caroline Baum recently pointed out, is that unlike more traditional financial instruments such as stocks or bonds, there is no fundamental yardstick of value:”
Something about that statement seemed odd to me, and it took me a while to figure out what it was. Stocks, of course, have no intrinsic value. Because of that, we need a model to value stocks. Then we can “mark to model” stock prices and have an idea what they “should be” worth.
We do not have a model for commodity prices, because we do not need one. Commodities are “marked to market” every day on the spot market and monthly on the futures markets. The idea that we need a model to mark them to strikes me as perverse.
In a world where both supply and demand are relatively elastic, commodities follow a cyclical pattern. When prices are high, supply expands and demand contracts. Prices go down, so supply contracts and demand expands.
To call that behavior a “bubble” is a misuse of the term. Has there ever been a bubble in commodities (at least real, usable commodities like copper & oil, as opposed to something like gold)? I think not, precisely because commodities are continually being marked to market.
Now we are entering a period in which the supply of some commodities is no longer elastic (at least not such that it can expand; it can, and will, contract). These commodities are still being marked to market. It is just that the market is going to get progressively more expensive. People who write this off as a bubble are impeding our ability to deal with the new reality.
Something like a bubble in commodities occurred with cotton in the 1850’s. The price of cotton rose steadily even in the face of increased production, peaking in 1858 (I think). In the final stages something like a buyer’s panic set in, and when the Civil War started the average English cotton mill had a 21 month inventory of raw cotton on hand. The profits accruing to Southern cotton producers was a major cause of their hubris going into that war. Ironically, those large inventories in England were also a major reason why that country was relatively immune to Confederate diplomacy and efforts at economic blackmail. See James McPherson’s “Battle Cry of Freedom”.
Let me pile on to the negative comments. Oddly, we’ve had a number of reports about the “mystery” of oil prices that completely skips the pesky reality of, uh, war. War in Iraq. The threat of war in Iran. Now, I know futures dealers only point to these things, and they could be lying, but on the other hand, maybe they are speculating on American foreign policy continuing to impede the international flow of oil, and – as stupidly – getting behind laws to return oil production profits to a fifties model – with the oil companies taking most of the profit, a la the Iraqi oil laws – when in 80 percent of the oil fields today, that ain’t how it is done. It ain’t going back, either.
Really, you get a price on a barrel of oil by the same method that you get a price on a widget – you learn how much it costs to produce one, firstly. On the other hand, cost of producing a piece of paper on which is written “stock certificate” is close to zero.
One of the stupidities of the past decade is in looking at the whole economy through the perspective of financial speculation. But guess what? There is a real world out there.
Moe Gamble said:
“It’s just complete b.s. that there is no fundamental yardstick of value for commodities. Take oil, for example, which is the commodity I know the best. If you want to increase supply at this point, it means things like difficult deepwater wells and production costs of $90 (and that was the cost a few months ago–it’s surely higher now). Add a profit to that and you’re talking a base price of roughly $100”
Moe,
One thing I have noticed in this debate is the amount information that is false, and easily proven to be false, that somehow manages to make its way into the discussion. And not just in web discussions, but published in some of the nation’s leading newspapers and magazines.
I’ll cite just one example. In my exhaustive reading on the subject during the past month or so, numerous commentators have stated that oil can be extracted from the Athabasca tar sands in Canada for $40 or $50 per barrel.
Now that is a figure that is fairly easy to check. All one has to do is go and take a look at the latest financial statement of one of the major players in the oil sands, Suncor Energy.
What we find is that in 1Q08 Suncor’s oil sands segment produced 248,000 BOPD or 22.5 MMBO. Operating expenses for the three month period were $1.274 tillion dollars, or $56.45 per barrel.
Also, during the first quarter, its board of directors approved an expansion in capacity of 200,000 BOPD to be completed in 2012. The cost is estimated at $23.98 billion dollars, or about $120,000 per BOPD of added capacity.
That’s an investment of $120,000 to make 365 barrels of oil per year. If the investors want a 15% rate of return on their money, that’s $18,000 per year or $49.32 per barrel.
So the current total cost to produce a barrel of oil from the Athabasca sands is $105.77, allowing a reasonable return on investment.
I think we have a large number of energy analysts, perhaps even a majority, who 1) don’t know what they are doing or 2) will bend the facts to make whatever point it is that they want to make.
Moe,
One more thing and I’ll shut up.
Even conventional is not that cheap to produce any more. A couple of stocks I follow:
1Q08 XTO’s production costs were $4.46 per MCF, a 22% increase over 1Q07 of $3.66.
1Q08 Swift Energy’s production costs were $43.18 per barrel of oil, a 47% increase over 1Q07 of $31.98.
These costs include Production expense, severence and ad valorem taxes, gas gathering costs, DD&A and G&A.
Like I stated before, it is rather obvious that a large chunk of the “analysts” and “experts” the media employs to comment on energy issues do not know how to read a financial statement.
Rahul, yes, that could be called an overproduction of fictitious capital which, contrary to its owners beliefs, can never be fully disconnected from surplus value creation in the real, productive, parts of the economy. Sure, as even the Minneapolis Fed mentioned in its 1974 annual report, credit can act as a substitute for wages and capital investment. But a ‘substitute’ which, with its accumulation, can only but contradict itself and must unevenly give way.
Differently, a rentier capitalism can only progress so far; as with other forms of capitalism, limits demand/generate their overcoming but as claims to value increasingly gap away from that available and as substitution hits more difficult barriers, the rentier form fails. Price retreats to value which has less to do with physical supply/demand than the production of supply and labor productivity of such. Rising productivity can reduce unit value even as unit price rises.
Yes, far too conceptual, even 19th century, but then I’m not of the opinion that neoclassic econ has earned more than, perhaps, a ‘C’ curving towards an ‘F’.
This is a bit off topic, but since you mentioned it, and I’m not an american – is memorial day this weekend or next weekend ? (wikipedia says 30th of may.
Thanks, Moe, shargash, and anonymous, for your insights on oil markets.
To 8:35pm poster: Memorial Day is observed this Monday
Thankyou Tom for clearing that up
Roger Said: Really, you get a price on a barrel of oil by the same method that you get a price on a widget – you learn how much it costs to produce one, firstly. On the other hand, cost of producing a piece of paper on which is written “stock certificate” is close to zero.
Great observation. Ironically, producing oil futures contracts, derivatives — certificates, if you will — drives up the underlying current spot price. This is were fundamentals separates from value.
The only difference between a futures and a spot is storage, transporation, insurance and borrowing costs. Anything between is an arb profit. Regardless of what’s causing Oil to rise, if the futures are rising, the spot has to rise by arb theory alone.
So Moe and Shargash, there seems to me a fundamental misconception of what demand really constitutes here. _Whose demand?_ That’s not a trick or silly question. Demand of those using petroleum derivatives is not directly linked to producers’ supply, it’s linked to the supply controlled by futures’ buyers. Now, were producers’ supply and consumers’ demand truly elastic, middlemen get whipsawed. Since as we see consumers are increasingly inelastic (and some of them are subsidy buffered from price), and producers’ supply is tight and more subject to downbounce niggles than upbounce new production, the real demand in the process IS FROM FUTURES BUYERS. If they pay more, the ultimate consumers have very little option but to pay more on the cost pass through unless the price level in futures fragments. And that is in the interest of _no one_ buying futures contracts, and very much against the open interest of those buying with leverage in bulk. Demand in the equation is a function of middleman demand at this point. And _that_ is the definition of speculation, whether bubble level or not.
Richard, very well put.
What I worry about is if both the fundamental demand/ marginal cost of production case laid out by anonymous at 14:19 and 14:39 and the Speculation meme brought up by Richard (and M. Masters) are accurate.
So lets say the marginal cost of production for a barrel of oil today is $105, however due to Speculative demand on the futures market we hit $150 this year. Then the bubble bursts and the price overshoots to the downside as everyone runs for the exits. Do the projects we need to come online to meet demand 10 years out get scotched because of the collapse in prices? The IEA is already turning pessimistic on the prognosis for new projects coming online in the next few years. What happens to prices once they find equilibrium again with less future supply? Bet the marginal cost after a 2 year hiatus will be higher.
I grew up in the oil bust and remember wells we would love to have now being filled with concrete.
Hoosierdaddy,
Where did this marginal cost of production is $105 come from? Goldman, who we all know is bullish, says here the marginal cost is $70:
http://investingforincome.blogspot.com/2007/10/goldman-sachs-on-price-of-oil.html
Now new sources cost more, that’s why they aren’t in use now.
Brazilian ethanol (using sugar?) is also cheap but it is controversial, and probably not enough to have a huge impact. This is probably way too bullish, but it was in the FT:
“First, technology is bound to deliver a biofuel that will be competitive with fossil energy at something like current prices. It probably already has. Brazil has been exporting ethanol to the US at an average delivery price of $1.45 for an amount with the energy equivalence of a gallon of petrol. It is doing so profitably and in increasing amounts, in spite of a 54 cents a gallon tariff to protect American maize-based ethanol producers. Many countries are following suit.
But ethanol is an inconvenient chemical compound that is corrosive and soluble in water, thus limiting its immediate market to that of a gasoline additive. However, this is just the Betamax phase of the industry. There is plenty of private venture capital money being poured into finding more efficient ways of extracting energy from biomass and delivering it to transport and power systems. Over time, the technology will also become more flexible, allowing more crops to be used as feedstock, not just the current choice of sugarcane, maize and palm oil. New technologies will be able to extract energy from cellulose, allowing the use of pastures such as switch grass as well as the refuse of current food production. The cheque is in the mail.
Second, the world is full of under-utilised land that can grow the biomass that the new technology will require. According to the Food and Agriculture Organisation, the world has a bit less than 1.4bn hectares under cultivation. But using the Geographic Information System database, Rodrigo Wagner and I have estimated that there are some 95 countries that have more than 700m hectares of good quality land that is not being cultivated. Depending on assumptions about productivity per hectare, today’s oil production represents the equivalent of some 500m to 1bn hectares of biofuels. So the production potential of biofuels is in the same ball park as oil production today.”
There’s more, see
http://www.ft.com/cms/s/0/ad770a0c-8c7d-11dc-b887-0000779fd2ac.html
Retread, I was responding to Anon’s post about the tar sands, which summed up
So the current total cost to produce a barrel of oil from the Athabasca sands is $105.77, allowing a reasonable return on investment.