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Macro Economic Trends and Risks
Oil & The Law of Unintended Consequences

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By tomk0508
May 27, 2008

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Oil could well be considered the king of commodities. And, while all commodities have been seeing healthy price increases for the past few years, none is more spectacular or painful than the current trend in oil prices. There has been a lot written about the current trend in oil prices and most of the articles I have seen have put forward a theory that competition for resources with emerging economies is the primary driver. A popular alternative theory is that the current drop in the value of the dollar is behind the up-trend. Here is yet another alternative view to consider.

"If it has not popped yet, is it still a bubble"

Over the past ten years we have seen bubbles in the equities markets as well as the real estate markets on pretty much a global scale. There is a healthy debate going on regarding the current price movement in the oil market with some using the "b" word and others saying confidently that it is different this time. If you are looking for evidence of a bubble one of the first things you can and should do is look for the presence of the "bubble makers" otherwise known as Wall Street Investment Banks. Indeed, if we survey the last decade we find that Wall Street was actively promoting commodities as an investment class to institutional investors (think pension funds and insurance companies) Research from the early 90's done at a few top academic institutions suggested that commodities had two favorable traits as investments: they were negatively correlated to equities and the absolute historical return on commodities was better than equities.

By 2004, the institutional investors finally bit on the idea and started buying commodities en masse to hedge their portfolios of equities. So what, who cares, can't the pension funds own some oil too? Ah but it is never that simple is it. You see, as funds flowed into the oil market, prices tended to increase as stocks of oil were set aside in storage against the investment made by the institutional investors. For example, from 2004 through the end of 2006, world stocks of oil in storage rose by about 70 million barrels, a 20% rise (Source: US Dept of Energy) At the same time that more oil was being held in storage, the price of a barrel of oil was rapidly increasing. Rising stocks and price per barrel at the same time is a clear indicator that there is a net inflow of money into the oil market and the source of the inflow was the institutional investors trying to increase their returns and diversify their portfolios.

Oil companies became fabulously profitable in this environment and the bubble was born. Remember that these new investors are the longest of the long term investors. They tend to buy and hold and they fully collateralize their contracts. So, when they buy 10,000 barrels at $60 per barrel, they put aside $600K in US Treasuries or similar low risk security against the oil purchased. But wait, storage capacity can't increase forever can it? No it can't but it could continue to increase as long as investors were willing to pay ever higher prices for the oil so I don't think that storage is the last straw to this destabilized market. More likely, a slowing in the net inflow of new investment capital or any move to sell oil out of their portfolios will be the last straw.

How close are we to the point of inflection? That's a tricky question because it has a lot to do with relative returns across asset classes as well as the inherent unpredictability of a destabilized investment market that is far from equilibrium. For the oil market right now, small changes in initial conditions will lead to massive changes in price. A few things are certain, Asia's growth in demand is decelerating and the West's demand is falling and the relative return on other classes of financial assets appears to be rising though the dust has not settled yet. In any event, somewhere in the next 12 months, we are likely to see a point of discontinuity in the price of a barrel of oil to the downside. When, how far and how fast are not knowable but if the investors exit like they entered the market (as a group over a relatively short period of time) the drop in price will be sizable. I think it is reasonable to expect a fall to $70 is highly possible while a 30 day average price bottom of $50 is pretty likely. No doubt that the impact will be felt in other asset classes as the underlying collateral (US Treasuries) is freed up and assets are reallocated to new investments.

At the end of the day, this is another example of Wall Street creating demand for an asset class based on historical analysis of the asset class that is rendered irrelevant by the success of Wall Street's sales pitch. The inflow of massive net new investment dollars destabilizes the market, changing it's correlation to other asset classes and destroying its historical absolute return. It's been done to Internet stocks, mortgage securities, asset-backed securities and, now, commodities. Whether it peaks at $140, $150 or $200, hold onto your hat because the correction will be swift as excess stocks of oil flood into the market in a very short time frame.