Crude Oil: The laws of supply and demand
by Philip Coggan/London/FT/February 06, 2006
The mystery so far is that oil has been above $50 a barrel for a long time without having any apparent adverse economic effects. But it might be foolish to assume that this would be the case if oil hits $80 or $90 a barrel.
It seems like the 1970s all over again. Commodity prices are booming, with copper and zinc reaching record highs and many other metals hitting their highest levels for 25 years. The world is fretting that oil supplies might be disrupted because of a dispute between the US and Iran, and that is keeping upward pressure on the crude price. And it is not just metals or oil.
The sugar price reached a 25-year high this week. This is not because we are putting more spoonfuls in our coffee. It is because sugar is a key ingredient of ethanol, which Brazilians are using to fuel their cars. With the oil price so high, drivers want to switch to ethanol or to ethanol/petrol hybrids. The standard explanation for this surge in prices is that booming demand, particularly from Asia, is clashing with stagnant supply. During the 20-year bear market for commodities, there was little investment in new mines.
There is certainly something to this argument and it helps explain why there is a long-term bullish argument for raw materials. But John Bergthiel of JP Morgan points out that some metals seem to be rising in price, regardless of their supply-demand mechanics. In copper, for example, inventory levels appear to be equal to just two weeks' demand, so a price squeeze is understandable. But in nickel, inventories are equal to 11 weeks' demand, and it is still being pushed higher. Something else is clearly going on. The answer seems to be that institutional investors are increasingly moving into commodities, having become convinced that they offer returns that are both attractive and, importantly, not correlated with other assets. When such investors do buy commodities, they tend to buy a basket rather than bet on individual metals. So as money flows into the sector, it tends to push all prices higher, regardless of the supply-demand position. Bergthiel points out that commodities such as coal, which are not in such investment baskets, have not been joining in the recent boom. The potential irony here is that if enough investors pile into commodities, the characteristics of the market will change.
One attractive feature of many commodities in the past has been "backwardation"; spot prices have been higher than future prices. Investors could buy in the futures market, and on average, expect prices to rise to meet the spot price, a return known as the "roll yield". The roll yield existed because so many producers wanted to hedge their output by selling it in the futures market. This overwhelmed the small number of raw material consumers who wanted to hedge against higher prices. But if enough investors try to exploit this market quirk, the roll yield will disappear. There is no backwardation in gold, the commodity most used as an investment vehicle, or in parts of the oil market. The backwardation in base metals has recently reduced.
Whatever its rationale, the surge in commodity prices creates dilemmas for investors. Low real yields on index-linked government bonds makes them look unattractive, particularly in the UK. Buying commodities is an alternative way of hedging against inflation, but there is the danger of being sucked in at the top of a market. Then there is the question of whether higher commodity prices are telling us something about the economy. Rising commodity prices are generally seen as a sign of buoyant global demand. Zinc has risen 23 per cent, and lead 29 per cent since the start of the year, according to Reuters. Does this mean the global economy is suddenly accelerating? For those who remember the 1970s, the fear must also be that higher commodity prices are an early indicator of a more general rise in inflation. Such a rise would require central banks to increase interest rates significantly to bring it under control. But this line of reasoning will turn out to be flawed if commodity prices are being driven by investment flows, rather than simple industrial demand.
Andy Xie of Morgan Stanley believes the recent slowdown in property prices may have diverted speculators into those asset classes that have been rising recently: Asian equities and commodities. If investors are really worried about inflation, it seems odd that the bond market has not taken greater fright. The US yield curve is flat (short rates are equal to long rates), normally a sign that investors are worried about an economic slowdown and relaxed about inflation.
Some will say that the bond market is distorted by Asian central bank buying but that Asian buying has been around for a while. For those banks to be offsetting the sales of rational, inflation-fearing investors, they must have substantially increased their purchases in recent months. It seems more plausible that high commodity prices are part of a liquidity-driven rally that is pushing up all asset prices. The Big Daddy of all the commodities is oil. While its high price may be a symptom of high global demand, some still fear that it acts as a tax on consumers, and thus a threat to economic growth.
The mystery so far is that oil has been above $50 a barrel for a long time without having any apparent adverse economic effects. But it might be foolish to assume that this would be the case if oil hits $80 or $90 a barrel, perhaps if the dispute with Iran escalates into sanctions or military action. If that happened, financial markets would be badly hit. and that would include other commodity prices, ironically done in by one of their own kind.
Very likely OIL is going to 100
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