Notes from Jim Haughey

Nov 1 2007 12:56PM | Permalink | Email this | Comments (0) |
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The price of crude oil has been labeled overpriced in economic models for several years with quick, substantial declines predicted.  However, the price of crude oil keeps rising and is now over $90/bbl. for the high quality blends that serve as industry price benchmarks. How does this happen? How long can it continue?  And could it derail the expected improvement in economic growth and the accompanying rise in demand for building space and facilities?

Yes, it could but it probably will only slow the pickup in the economy and construction spending.

What the forecast models can not capture it that oil has become a financial commodity. Investors have traded oil for several decades, often very profitably.  Remember Enron?  But it is only recently that investor activity has scaled up enough to dominate the oil futures markets and thus also set the spot prices you see quoted in the news. The buying and selling of futures contracts by investors speculating on price movements dominates the buying and selling of contracts by oil refineries hedging against adverse price movements.

When futures trading is dominated by the activity of hedgers who will take delivery of the commodity, prices are stabilized.  But prices become more volatile when trading is dominated by price speculators who will not take delivery of the commodity. Physical demand and supply changes are still important is setting the price of oil but strictly financial developments have become more important in short-term price changes.

The economic models are assuming that the financial considerations in the oil futures market will eventually be overwhelmed by the underlying physical demand-supply balance for oil.  But eventually is turning out to be a long time. Both the sinking $US and real demand and supply trends have supported some rise in crude oil prices since January, permitting price speculators to profitably bet on further price rises.

Some of the price speculators are the same investment funds that used cash bonuses to encourage brokers to generate more variable rate subprime mortgages. The high yields were very profitable. Investors bet that home price inflation would postpone foreclosures long enough for them to earn a large profit and then get out of the market. We now know that these people can miscalculate and drag the economy down with them.

The oil trading market is now dominated by the same irrational attitudes that dominated the real estate market in 2005.  Home prices — now oil prices — will keep rising simply because they have been rising and there is always a buyer who thinks you are selling too low.  This can continue for a year until the first instance of a price decline catches an overleveraged investor with a cash shortage, forcing a panic sale to raise cash and setting off a chain of price declines as more and more investors have to liquidate holdings to raise cash.

This process should be familiar since we saw it happen in the mortgage market in July.  It also happened in August 2006 in the oil market when price speculators were forced to liquidate their holding setting off a more than 50% plunge in prices in the following five months.

This will happen again soon in the oil market.  The ongoing rise in prices is approaching an unusually long ten months. The pace of price rises has increased recently with prices becoming more detached from underlying demand and inventory trends. Both of these developments usually signal that the end is near. But it could take as long as 4-5 months before the panic liquidations sales begin.

Every piece of bad news about the oil demand-supply balance give additional encouragement to those who think the price will rise indefinitely. Turkey threatening Iraq. Iran hinting at a supply boycott. Russian energy supplies reverting back from commercial to political control. Venezuela becoming a socialist dictatorship using oil to reward and punish.  China unable to rein in over-heated economic growth. And the $US falling rapidly.

The price could peak in the low $90’s making the current consensus economic outlook too pessimistic.  Or it could peak later well over $100 making the current consensus economic outlook too optimistic. Even in this case the shock to the economy will be less than that delivered by the mortgage crisis last summer. The economy will probably escape the maximum possible damage.  But if the price is well over $100 at thanksgiving forget that you read that here.