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Trading Lessons

Can OPEC Beat The Black Swans ?

Commodities / Crude Oil Jul 22, 2010 - 11:15 AM GMT

By: Andrew_McKillop

Commodities

Best Financial Markets Analysis ArticleCheap oil doesnt help economic growth - Only about 10 years ago New Economists chimed that oil and gold are Sunset Commodities. So abundant, so low utility for the fastfood and finance derivatives based all-modern world of supermarket caddy wheelers and M&A guzzlers, that their price would just fade and drift away to nothing. Quite soon, they hinted, oil will be free and gold will be a harmless and cheap barbarous relic, just like Keynes always said.


Since then things have changed a little, and a lot from this farcical vision of the economy. More important, as both the IMF and the Federal Reserve Bank of NY have reported, recycling "windfall gains" from the unsurprising recovery of Sunset Commodity prices is now a key lifeline resource for increasing China's export sales - and bailing out the US and other debt-strapped OECD economies. The Fed Reserve of NY put it this way in a 2006 report: In recent years, oil-exporting countries have experienced windfall gains with rising oil prices.

A look at how oil exporters “recycle” their revenues reveals that roughly half the petrodollar windfall goes to purchase foreign goods, especially from China, while the remainder is invested in foreign assets. Although it is difficult to determine where the funds are initially invested, the evidence suggests that the bulk are ending up, directly or indirectly, in the United States.

Resource depletion, declining net energy yield, thermodynamic and environment limits, geopolitical crises, the rise and rise of China and India, and even OECD sovereign hyper-debt have yet to generate another 1929-style or 1979-style wipeout, although 2007-2008 was close. Today we therefore have graveside watchers and doomsayers arguing another Black Swan has taken off, and has winged its way into radar detection range.

Surviving Neoliberals still posture that the one trip throw-it-away throughput economy is now a No Alternative and that its phagocytic over-structure (not infrastructure) of a vastly oversized and dysfunctional finance casino system for compulsive gamblers actually lends credibility and extended life to the model. As Nassem Taleb pointed out, the real world proves this is far from the case. This suicide-prone economic model is not proof to surprise and shock but, even worse, generates endgame shocks.

Can OPEC save the economy ?

When it concerns old-time commodities like oil, metals, minerals, food and even paper bags, the average per capita consumption number for the "postindustrial" societies is always vastly above present Chinese or Indian per capita consumption, but Chindia is getting there. China has now edged above the USA as the world's biggest energy consuming nation, and Chinese car production is far ahead of US production, growing at a "slowed down" forecast 11% rate in 2010. India's car industry is growing even faster.

When or if the 1.3 billion Chinese and 1.2 billion Indians get to present per capita paper consumption of the OECD "postindustrial" societies, about 20 kilograms a year, how would this line up with world supply?

Their theoretical-only paper demand would be far above world total production today. Now try the same calculation for the Chindia car fleet and its oil demand.

To be sure, we can whistle electric car tunes, with lithium for their batteries supplied by tamed, ecology-conscious Talibans in Afghanistan, and admire the municipal frenzy to recycle anything and everything in most OECD countries today, marketing it as a struggle against climate change or for making streets beautiful. But the failed quest for food-based biofuels showed how hard it is to substitute and replace oil - and still eat. The oil price outlook is therefore normally bullish, and getting more so. Future prices should normally be higher than spot prices - called a 'contango' price structure. Other commodities also benefit from this supposedly 'Malthusian' outlook for hard asset supplies.

The simple question is whether rising oil prices and other hard asset prices, and their linked petrodollar-type surpluses can operate enough leverage in the real economy, and generate enough spinoff in the paper economy, to provide sure gains for investor-speculators and prevent another Black Swan.

If we take the second question, the road mapped by the equities finance industry for 'capturing value' from rising commodity prices is commodity backed ETFs and linked tradable commodity indexes. This provides a simple answer to the fond hope of rescuing equity plays by adding commodity ETFs to a portfolio. The simple answer is: no.

Equity trading of commodity futures doesnt work

Oil-based ETFs show this best. Since the 2008 crash of both equities and commodities, physical oil, and oil futures have rebounded even stronger than other tradable paper. Oil ETFs are however able to go exactly the other way to the underlying commodity, whenever its price structure is in contango, despite this being, like we said, logical and normal. Traded like equities, managers of ETF paper have to sell their contract before the contract close - or accept physical delivery - and then buy a new contract. Whenever forward prices are above current, this loses money. For the Goldman Sachs commodity index run with Standard & Poor's (S&P GSCI), the rollover date for selling one contract and buying the next is between the 5th and 9th day of each month. If the forward price is high in that period, then falls after the 9th of the month, the investor-speculator will have a guaranteed loss. If the forward price then recovers during the month, and is high at end-month, the loser cycle will repeat.

This is a basic and simple invitation for commodity index owners and operators, and ETF managers to ensure the related commodity prices move that way - the ETF managers being able, for example, to run 'other way bets' on their own paper, but of course not for the Average Joe buyer of their products and promises. Checking how oil prices move, each day of the month, is therefore a good way to highlight the in-built financial Black Swan, or kiss of death hiding beneath the ETF route to apparent sure profit from real asset appreciation of commodities, anytime the economy is not in rout.

Unequal combat

We can be sure the contango price structure for oil reflects a simple reality for all hard asset commodities: only cheap energy can beat resource depletion. Finance markets are however insulated from this depressing reality because of the magic that printing promises confers, 'creating value'. The more interconnected and larger the bubble of future assets, for equities the hoped-for earnings growth of the 'underlying security', the company or corporation whose stock is traded, the easier it is for Black Swan deniers to pretend this generates visibility, transparency, predictability, resistance to shock of any kind - and assured future value.

One key real world factor always raising the credibility of Black Swan events is structural low visibility of equity markets, getting worse in accelerating fashion as market cap, derivatives proliferation and geographical market linkage rises. To be sure this is no static picture, because net energy study of resource and asset choices provides hard-edge data for rising commodity values, but this is trashed by the equity-type financial deadweight channeling commodity ETFs to regular and predictable loss of value.

Black Swan events feed off the same leverage which drives equity asset creation, but most important leverage works both ways. Taking the subprime lever for a sequence including the fall of Lehman Brothers, the actual (that is nominal) amounts in play, in the multibillion USD range, were vastly outclassed by the estimated 20 - 25 trillion USD impact of the global financial crisis, in terms of (nominal of course) market capitalization losses, and secondary impacts such as "lost growth", debt growth, and so on.

Seismic tremors

Trader tremors, and especially equity trader tremors are a key signal, as with consensus view forecasts from media-approved experts, that are almost overnight trashed by the real economic world, and preceded by telltale volatility - as global equity markets show each day at this time. A glaring current example is claims the Eurozone's euro has to sink near parity with the US dollar before slowly recovering to perhaps 1.25 USD, late in the year. This sequence played out in a few weeks, from late June. Exactly the same applies to consensus view forecasts on oil prices: these supposedly have to fall as low as US 60 a barrel before recovering late in the year, while long dated futures tell a very different story.

Another is the sure and certain 'hyperbolic' gold price explosion to new heights, itself needing a Black Swan meltdown on equity and bond markets. Without the Black Swan meltdown, no hyperbolic priced gold.

Black Swan events are always more likely when players get frightened by how far out of line their playtime world has drifted from its only underlying security - the real economy. Equities fully fit the bill as agents of this change, and are first in line for heroic write downs in nominal value.

Taking oil and by late this year 2010, nothing prevents the present 'Peak Oil plateau' of around 88 Mbd maximum capacity (including about 1.4 Mbd "well-to-wheel" losses in production, transport, storage) from breaking. We would then find that producing any more than around 88 + 1.4 Mbd is already the limit: the only way out of this is another crash dive into global economic recession, courtesy of the Black Swan.

How Opec can Save the Global Economy

To be sure, OPEC and Russian oil revenues are relatively small change, compared with nominal or notional equity market losses and gains through 2008-2010 to date, but leverage explains the real economy role of commodity exporter revenues. Certainly since the great oil price crash of 1985-86 (about equal to the 2008 oil price crash, around -70%), OPEC acts like a price taker in recession and a price setter or hawk, when the global economy is growing fast. Its main decisional method is simple: deciding nothing. It wants backwardation of future prices in recession, but accepts contango prices in

By Andrew McKillop

gsoassociates.com

Project Director, GSO Consulting Associates

Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

© 2010 Copyright Andrew McKillop - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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