Gotti is wrong on oil

But should be congratulated for staking out a position, a rare event in today’s world of commentary flip flopping.

As Deus Forex Machina likes to say, disagreement makes a market so let’s rip in. Gotti asks:

Why should oil prices rise in response to the latest turn of events in Libya? We are already seeing Middle Eastern countries, lead by Saudi Arabia, the UAE and Kuwait, lift production to compensate for Libya. The big oil producers are enjoying the higher prices and production which, in the case of Saudi Arabia, will help fund the extra spending being used to quell unrest. There is going to be no shortage of oil unless the Middle Eastern unrest spreads to the major oil producers lead by the Saudis.

The simple answer is that speculators see a danger in Saudi Arabia and other oil producers so they are currently driving the market upwards.

That’s true. Gotti is describing a risk premium that’s been built into the supply of oil. And no doubt speculators are playing a major role. But Gotti doesn’t ask what the signals are that these speculators are following. The FT’s Javier Blas described the return of the oil risk premium in January:

After a two-year hiatus, the oil market has rediscovered the geopolitical risk premium.

For most of 2009 and 2010, traders ignored sparks in the Middle East, as global production spare capacity was more than enough to cover any potential shortfall. But as demand hits record levels, the market is paying more attention to geopolitics.

To be sure, the market’s anxiety about the Middle East – which accounts for 30 per cent of global oil production – or other potential hotspots, including Nigeria, is not near the panic levels seen between 2005 and 2008. The cushion of spare crude oil production capacity is still large enough to handle most disruptions.

Opec’s idle production hit a record low of 1m barrels a day in early 2006 as global demand surged. Then, the oil market reacted with panic to geopolitical events as spare capacity was not enough to cover even small disruptions in supply.

As the financial and economic crisis reduced oil demand worldwide, the cartel’s effective idle capacity surged to a peak of more than 6m b/d in early 2009, cushioning the oil market. Since then, however, spare capacity has started to drop as demand has risen. Oil demand surged by nearly 3m b/d last year, the second largest increase in 30 years. The International Energy Agency, the rich countries’ oil watchdog, estimates spare capacity fell last month below the key 5m b/d mark for the first time in two years.

So, the premium is not about how much oil is being pumped but how much that can be pumped.

Moreover, the notion that the MENA crisis itself is subsiding is problematic too. Bahrain is likely to settle, or, at least, be settled. And I do not foresee trouble coming from Iran. But the blood is still up across North Africa and a multitude of power vacuums have opened up in Tunisia, Egypt, Libya and Yemen. We don’t yet know who is going to fill them.

The West’s involvement in Libya is another risk variable that might inspire further rebellion, for democracy, or against it.

On top of that, look at the below index from Reuters, which lists countries at risk:

You can take or leave the parameters of the list. But it’s hard to ignore the fact that oil a key export of 8 of the top 10.

Back to Gotti:

Meanwhile the so-called “safe haven” money which rushed to the US on the back of Japanese nuclear threat and Middle Eastern turmoil is now flowing back into world markets. These flows have put downward pressure on the American dollar but have also propelled Wall Street and boosted the Dow Index once again above 12,000.

As part of that trend the Australian dollar is again above parity with the US currency. On top of all of this, there is takeover speculation in the US that is fanning activity.

In other words it’s “back to normal”.

To adversely change that pattern will require a serious deterioration in one or two of the current trigger events – the Middle East, China, the Japan nuclear situation, European banking or the US economy.

The sharemarket speculators cannot see that happening at the moment although the oil price speculators are still punting that Middle Eastern troubles are far from over.

In my view, this is a misunderstanding of exactly what constitutes “normal”. As Gotti intimates, the new normal is one in which Bretton Woods II is slowly unwinding via a weak $US. The US can no longer rely upon consumption alone to grow and is growing its exports very strongly. In such a circumstance, the $US must continue to to be weak at best and fall if possible , as Gotti says. But that is an intrinsic upwards pressure upon the entire commodity complex, including oil. This has been clear since September last yearwhen QE2 became a certainty:

Back to Gotti:

Global economies are far stronger now than they were when the oil price last reached its current levels so the impact of the current spike will be much less. Nevertheless higher oil prices act like a tax, diverting spending from discretionary areas. Higher inflation over the longer term can cause central bankers to lift interest rates to lower inflation which creates a double taxation on the discretionary spending of people with high mortgages.

But it’s manageable unless there is really an oil shortage rather than speculator driven price rises. The key to global market swings in the current environment is what is happening in those trigger areas. As long as they remain relatively benign (including no oil shortages) markets will be robust.

As we know events in these trigger areas can change rapidly. But in the normal course the next crisis is due when the current round of stimulus measures in the US end around June. With the Dow above 12,000 the markets clearly expect a gradual wind down and no sudden impact from the withdrawal of stimulus.

I would say rather that the jury is still out on whether the wind down of QE2 will go smoothly. If it goes badly, QE3 will be back the moment the market tank effects growth.

However, my guess is that it will go better than many think. If it does, the US will still have its zero interest rate policy and the great unlikelihood of raising rates until at least 2012. In today’s newly liberated AFR, Glen Mumford points to an OECD report that advises against hurrying to raise rates into the oil spike.

Anyway, it’s a near certainty that other nations will raise rates ahead of the Fed, such as the ECB, which will keep downwards pressure on the dollar, and upwards on oil.

We could see an oil pull back as the struggles in Japan hit growth and if the Libyan campaign goes well. But the only thing I can see correcting oil for any period is a marked slowdown in China. And that would hit everything.

Houses and Holes
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  1. Deus Forex Machina

    Dead right HH, Gotti is far too sanguine. He also misses the point that Oil has lagged the broader rally in commodities and that the spot price might get all the attention but it is the curve that matters. What are the second, third, fourth and fith contracts telling us? Brent is bid above $112 out to Jan 2012 so its not just a spec bubble which is Javier Blas’ point.

    As the Saudi’s face off against Iran over Bahrain and Yemen looks set to be the next area destabilised its hard not to want to trade the signals infront of you. At least I would.

    Another great post HH

  2. FYI: The link to Gotti’s piece is broken.

    I don’t get this bit:

    Global economies are far stronger now than they were when the oil price last reached its current levels so the impact of the current spike will be much less

    Is he saying global economies now are far stronger than they were in mid-2008? As in before the GFC? If so, what is he smoking?

    The US, Europe and Japan are all still on life-support with zero interest rates and direct infusions of cash. If Gotti thinks these economies are “far stronger” than they were in 2008, then why aren’t interest rates far higher than they were in 2008?

    To the question of oil: With spare capacity so tight, and getting tighter, a series of oil spikes and crashes are almost inevitable over coming decades. While resource and energy intensive economies like China and India continue to grow, oil prices will grind higher until the world economy breaks, and prices crash again. The financialisation of oil and commodities markets amplifies this cycle.

    The only long term solution is to cure our addiction to oil, and there’s Buckley’s chance of that.

    • “To the question of oil: With spare capacity so tight, and getting tighter, a series of oil spikes and crashes are almost inevitable over coming decades.” This is similar to my argument about the housing market. That is, restricted supply leads to price volatility and boom/bust cycles.

  3. Oils ain’t oils, Sol. Libya produces light sweet crude, where as Saudi swing capacity is heavy sour. Then its onto refining capacity and product mix, plus seasonality. Yes, we have no bananas.

    Also read an OPEC report on oil costs in the West. E.g. By the time oil is lifted in Saudi, transported, refined and delivered to end user, more than 50% of price is TAX from Western governments, i.e. Western governments take is higher than OPEC’s.

    As for partial self sufficiency of oil product in Australia we will be at less than 25% in 2015, down from 75%.

    Tonight, Tapis-Minas-Singapore hub, where Australian imports are priced the range is US$119.93-121.37.