The Center of the Universe

With supply following demand, as with any monopolistic arena, it looks like the world crude oil balance remains very much neutral leaving the Saudis in full control as swing producer where they set prices and let quantity adjust to market demand.

Stable crude prices with 0 interest rates, high excess capacity and low aggregate demand should keep inflation at bay indefinitely, with productivity increases making deflation the greater risk.

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(an interoffice email exchange)

>   
>   On Fri, Sep 19, 2008 at 9:50 AM, David wrote:
>   So creating liquidity for toxic assets RTC style.
>   

maybe, jury is still out on how that might work

>   
>   Make the government a little money and inspire confidence in banks, ok.
>   
>   We are thinking that this is overtly inflationary for financial assets (maybe all
>   assets?)
>   

supports a lot of equity value by removing a large element of risk, but cost to shareholders still unknown

fixed income going higher in yield, prices there going down

>   
>   Should I expect this to re-inflate the commodity asset bubble in the medium
>   term???
>   

not directly. crude price up to the Saudis.

>   
>   Do you think the dollar’s rally will help cap any commodity asset price rise???
>   

yes, in the competitive markets. crude is not a competitive market. saudis merely set price and let quantity adjust

>   
>   PS- I expected to come in today to $110+ crude, $8+ gas, and $900+ gold.
>   

as above. crude up even with dollar up, but gold down.

warren

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Heard last night index funds have liquidated the equivalent of maybe 140 million barrels of crude.

Add to that trend followers who went from long to short, and it’s way more than enough to explain the sell-off.

Since the Saudis don’t want to make their price setting status obvious, they ‘get out of the way’ for these type of liquidations, and if they want prices back up, as I suspect they do, they start bringing them up after the smoke clears.

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(an email exchange)

>   
>   On Wed, Aug 6, 2008 at 4:45 PM, Craig wrote:
>   
>   It seems that the ‘right’ price for them to set oil at is not
>   necessarily the highest price possible.
>   

All the 911 passports were Saudi; so, they might have other agendas.

>   
>   If I were them it would seem like the best policy to maximize
>   the total value of their oil holdings over the life of those
>   holdings. By cranking the price up ‘too high’, they incent
>   substitution and potentially kill their sales in the long term.
>   

Right, classic monopoly analysis.

>   It would seem their goal would be to keep the price as high
>   as they could w/o setting off a chain of
>   substitution/invention/philosophy which would move the world
>   meaningfully away from oil (or towards increased oil exploration
>   or towards invading them). There is also the little matter of
>   how much money do they really need (a somewhat silly question
>   but this situation does create an embarrassment of riches/market
>   dislocations in excess of where a rational accumulation might lie).
>   

Yes, understood.

>   
>   It looks to me that on the highs they got everybody’s attention.
>   There may still be political responses towards
>   innovation/substitution/conservation at these levels, but it seems
>   likely that at or above the old highs, US folks will be making their
>   next car a hybrid, beating their government to get prices down
>   (including pluggables/nuclear – a long term threat to Saudi
>   dominance) and the like. Then there’s China’s slowdown and food
>   riots. I’d have thought quietly bleeding the world would be better
>   business than actually setting it on fire.
>   

Yes, but again, it’s their ‘political choice.’ There is no ‘market price’.

Also, with only 1.5 million bdp in total excess capacity, it might be too close to the line for them, and they might want to get prices high enough to build their excess capacity by a million or two bpd.

Otherwise they risk losing control of price on the upside, as happened a couple of years back when output briefly hit 10.5 million bpd when the funds were buying intensely enough to cause builds of physical inventory and a large contango as storage went to a premium.

>   
>   Of course, even if this is all true, they may be looking at it
>   differently.
>   

Worst case for us is they understand that they can hike all they want if they spend the extra revenues on imports of real goods and services. This keeps foreign GDPs muddling through in positive territory as they exact ever higher real terms of trade and they increasingly prosper at our expense.

And out leaders think more exports and less consumption is a good thing and are encouraging more of same.

Almost seems from the data this is exactly what they are up to?

Think they read my blog???

:)

warren

>   
>   Craig
>   

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Russel asks:

Any reason why the Saudi’s are allowing the price of oil to slide?

Just a guess. The futures liquidations were large enough such that holding spot prices up and letting futures free fall would have made it obvious the Saudis are price setter.

There also could be some liquidation of physical inventory going on in which case they would have to let inventories fall before resuming control of prices, or else actually buy in the spot markets which is out of the question of course.

It’s like if some pension fund had a hoard of NYC subway tokens and decided to sell them ‘at the market’. The price would go down from the current $2 price until that selling pressure abated. Then the price would go back to whatever NYC was charging.

So most likely they just let this inventory liquidation run its course, and then work prices higher again.

Much like happened in Aug 2006 with the massive Goldman liquidation and again in a smaller way at year end back then.

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Lehman cuts oil demand forecast

by Richard Valdmanis

(Reuters) Investment bank Lehman Brothers (LEH.N: Quote, Profile, Research, Stock Buzz) said Wednesday it slashed its forecast for 2008 world oil demand growth due to a steeper-than-expected slowdown in energy consumption in the United States and other OECD countries.

Lehman added it believes the oil market is “approaching a tipping point” with prices expected to decline to an average of $90 a barrel in the first quarter of 2009.

“We now forecast annual oil demand for 2008 at 86.3 million barrels per day, a growth of 790,000 bpd from 2007. The growth has been revised down from projections of 1.5 million bpd in December,” Lehman said in a research note titled ‘Demand Demolition’.

If true, and non-Saudi supply remains about flat, Saudi production might fall to about 9 million bpd and the price would still remain wherever the Saudis set it.

There has been some talk that the Saudis may have agreed to lower prices after the last round of meetings with US officials. Could be, but with their output running within a million or two bpd of their total capacity, it seems doubtful they would do anything to increase demand before they have the excess capacity to meet it. But there could be other factors (including the US 7th fleet and concerns about a united Iran/Iraq threatening them) that might be influencing their decision. Only time and prices will tell. Should be more clear in a week or so.

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(an email exchange)

>   
>   On Sun, Jul 20, 2008 at 10:46 PM, Russell wrote:
>   
>   Brad Setser, at Follow the Money, presents a couple of graphs on changes in
>   oil export revenue: The Oil Shock of 2008.
>   
>   The following graph shows the Year-over-year change in oil exports as a
>   percent of world GDP (and in billions of dollars).
>   
>   

>   
>   Year-over-year change in oil exports
>   
>   This calculation assumes that the oil exporters will export about 45 million
>   barrels a day of oil.
>   
>   Each $5 increase in the average price of oil increases the oil exporters’
>   revenues by about $80 billion, so if oil ends up averaging $125 a barrel this year
>   rather than $120 a barrel, the increase in the oil exporters revenues would be
>   close to a trillion dollars.
>   
>   Assuming oil prices average $120 per barrel for 2008, the increase in 2008 will
>   be similar to the oil shocks of the ’70s.
>   
>   

Right, the notion that oil is a smaller % of GDP and therefore not as inflationary was flawed to begin with and now moot.

Two more thoughts for today:

First, the second Mike Masters sell-off may have run its course. The first was after his testimony in regard to passive commodity strategies which I agree probably serve no public purpose whatsoever. The second was last week as markets expect Congress to act to curb speculation this week, which they might. Crude isn’t a competitive market (Saudi’s are the swing producer) so prices won’t be altered apart from knee jerk reactions, but competitive markets such as gold can see lower relative prices if the major funds back off their passive commodity strategies.

Second, just saw a headline on Bloomberg that inflation is starting to hurt the value of some currencies.

Third, the Stern statement will continue to weigh on interest rate expectations up to the Aug 9 meeting.

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Seems like a sale ahead of possible Congressional action to limit ’speculation’.

Not sure how big the dip might be, but yet another buying op as the choice remains – pay the Saudis their asking price or shut the lights off.

The price only goes down if the Saudis cut price, or if there is a supply response of more than 5 million bpd that dislodges them from being swing producer.

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Bank deputy chief warns of market trouble to come

by Ben Russell, Political Correspondent and Sean O’Grady

Britain is facing the risk of renewed turmoil in the financial markets, the new deputy governor of the Bank of England warned yesterday.

Professor Charlie Bean, the deputy governor for monetary policy and a former chief economist at the Bank, raised the prospect of a slowing global economy triggering a new round of problems with corporate loans and said that the impact of the credit squeeze could be greater than Bank projections.

Yes, but unlike the Eurozone, the BoE is permitted to ‘write the check’ as in the treasury.

National solvency is not an issue in the UK as it is in the Eurozone when weakness is addressed.

He told members of the Commons Treasury Select Committee that Britain faced “major conflicting risks” threatening the Government’s inflation target from the problems of a slowing economy and rising commodity prices.

Yes, the twin themes of weakness and inflation.

In a memorandum to the committee, Professor Bean warned that the “dislocation” in the financial markets “probably has further to run, especially if a slowing economy here and abroad generates a second round of write-downs, this time associated with corporate loans. Moreover, the impact of the tightening in the terms of availability of credit could prove greater than is embodied in the central case in our most recent set of projections”.

Agreed. And while ‘writing the check’ can readily address these issues with no risk to government solvency, it will also support the higher prices he next discusses:

He said that increasing oil and other commodity price rises would lead to higher inflation becoming “embedded in the economy”, warning that people might seek to offset price increases by making higher wage demands. He said: “There is no doubt that the UK economy presently faces the most challenging set of circumstances since at least the early 1990s and probably earlier.”

Professor Bean said oil prices could continue to rise for another two years and cautioned that Britain faced the danger of a pay-price spiral if workers tried to compensate by pushing up wages. He said: “It certainly poses a significant challenge. There is no doubt about that at all. It may be a relatively unlikely event but it could be particularly unfortunate if it happened, if households and businesses start losing faith in the idea that inflation will stay low, round about the target, they start building it into their pay and prices and inflation becomes much more embedded into the system… Provided pay growth remains subdued, the current pick-up in inflation will be temporary.”

Living standards, the deputy governor stressed, will inevitably be lower because of the global inflation in commodity prices.

Agreed. It’s all about real terms of trade, which have also been declining rapidly in the US as evidenced by the drop in growth of GDP and the drop in non-oil trade deficit.

My guess is the most likely political response in the US and the UK is proactive deficit spending from the treasury to address the weakness and higher interest rates to address the inflation.

Unfortunately the deficit spending that supports domestic demand will also support crude consumption (as well as housing) and ‘monetize’ the ever higher crude prices being set by the Saudis, thereby supporting ‘inflation’ in general.

And this will trigger ever higher interest rates from the Central Bank as inflation trends even higher.

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Saudi Oil Production

This does not bode well for oil prices.

Increased Saudi output means demand has increased at current prices, and the Saudis (and Russians, etc.) remain firmly positioned as ‘price setter’.

The Saudis continue to have the only excess supply, with about 1.5 million bpd excess capacity.

The Mike Masters sell off seems to be over. Actual legislative effort could cause a subsequent temporary sell off but will not dislodge the Saudis from total control.

The only thing that can dislodge their ability to set price is a net supply response in excess of 5 million bpd, which is highly unlikely in the near future.

Any efforts to increase aggregate demand to support growth will also function to support prices.

My twin themes remain:

1. Weakness (low domestic demand supported by exports) as GDP muddles through. No recession yet, but could happen down the road should exports falter.
2. Higher prices as Saudis remain as price setter, continuously hiking prices, and inflation continues to march higher, and our real terms of trade and standard of living continues to deteriorate.

‘Solutions’ remain:

1. pluggable hybrids – this switches demand from crude to coal, and dislodges the Saudis from being price setter.
2. dropping the national speed limit to 30 mph for private ground transportation. (Just heard JKG dropped the national limit to 35 mph during WWII)

Biofuels continue to link crude to food, and the political response to food shortages and markets allocating life by price is likely to continue to be ‘cash’ payments regardless of inflationary consequences. The body count is likely to exceed that of WWII over the next few years and is probably already in the millions.

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Maybe the weak USD is causing him to have second thoughts on preventing CBs and monetary authorities from accumulating USDs to keep their currencies low and support their exporters?

Ending dollar peg won’t solve Gulf inflation: Paulson

by David Lawder

(Reuters) U.S. Treasury Secretary Henry Paulson said on Saturday the dollar peg for currencies in the Middle East had served those countries well and any changes to the peg would be a sovereign matter.

Paulson, on a visit to Saudi Arabia, Qatar and the United Arab Emirates, also told a news conference the current level of oil prices were a burden on economies and consumers around the world.

Asked about the dollar peg, Paulson said:

“That is a sovereign decision … The dollar peg, I think, has served this country (Saudi Arabia) and this region well.”

Paulson earlier met Saudi Finance Minister Ibrahim al-Assaf to discuss a range of issues including the oil market, the U.S. and Saudi economies and issues related to foreign exchange.

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Saudi Pumps More Oil

(Reuters) Top oil exporter Saudi Arabia has boosted supply to help meet the world’s need for fuel and may further increase output later if needed, a senior Gulf OPEC source said on Wednesday.

Yes, they set price and then sell all that’s demanded at their price. The fact that they are pumping more means demand has increased at current prices.

OPEC’s 13 members, especially core Gulf producers, are taking their output cues from global oil demand rather than sticking to production targets, said the source familiar with Saudi thinking.

“Whenever there is demand it will be met by OPEC,” he said. “The majority of OPEC producers definitely don’t like this high oil price because it is neither in their interest nor in the interest of the global economy, and it’s especially painful for the developing world.”

U.S. crude hit a record above $135 a barrel last week, prompting consumer countries such as the United States to renew their plea for more oil from the Organization of the Petroleum Exporting Countries.

OPEC’s leading producer Saudi Arabia has been adjusting supply to match demand since August last year when prices were around $60 and it was pumping around half a million barrels per day (bpd) less than now.

Saudi Oil Minister Ali al-Naimi said earlier this month output would rise by 300,000 bpd and hit 9.45 million bpd in June. Riyadh is pumping about 9.1 million bpd this month, the source said.

Global demand is likely to increase this year by about one million bpd, with demand picking up in the third quarter, the senior Gulf OPEC source said, which explains the current Saudi production increase.

Last September OPEC agreed a 500,000 bpd increase in its formal output targets, with Saudi Arabia providing the greatest share. The group holds its next official conference on Sept. 9 in Vienna.

That’s a long way off.

Most OPEC members would like to see lower prices, but there was little they could do as the market was responding to factors beyond supply and demand, the source said. If those fundamentals dictated the price, oil would cost around $60 to $70 a barrel, the source said.

And the pundits believe this ’source’.

The world oil market balance is similar to that in 1999, when the price was less than $20, he added.

The oil market has risen in large part because of increasing doubt over production capacity and global oil reserves, the OPEC source said.

That concern was unwarranted, he said, but helped to explain a roughly $5 premium for crude prices for delivery in 2016 compared with the prompt contract now trading at about $126 a barrel.

A wave of investment activity has also been fueled by the weakness of the U.S. currency and lower U.S. interest rates, which adds to the appeal of dollar-denominated commodities.

“This big rush to oil futures is definitely leading to higher and higher prices,” he said. “So adding more or taking less oil from the market will not change the oil price since the sentiment of investors in the futures market is pushing for higher prices.”

Everything but the obvious: Saudis are swing producers, setting price and letting quantity adjust.

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Saudi Oil Production

Still in full control of price.

(an email exchange)

>
>   On Mon, Apr 21, 2008 at 9:23 AM, Scott wrote:
>
>   Backed by high oil prices, Saudi Arabia is embarking
>   on a massive spending program focused predominantly
>   on infrastructure projects. The value of announced
>   investment projects so far is $862 billion.
>

Thanks, looks like maybe they’ve figured it out as suspected (jack up price and spend the USD) which improves their real terms of trade while hurting ours and keeps US GDP higher to please policy makers who think it’s all a good thing.

I’ve been thinking that when the Fed turns its attention to inflation it will find itself way behind that curve, which it is by any mainstream standard, and that the curve then gets negative from a year or two out as markets anticipate rate hikes followed by falling inflation and rate cuts.

Didn’t know exactly how it would get from here to there, how long it would take or exactly when it would happen.

I never thought the Fed would let it go this far. Especially Governor Kohn, who has been through this before in the 1970s with Burns, Miller, and Volcker. This FOMCs inflation tolerance lasted a lot longer than I expected, even with a weak economy and perceived systemic risk.

Won’t be long before the mainstream comes down hard on this FOMC for letting the inflation cat out of the bag with a high risk, untested, counter theory strategy of aggressively cutting into a triple negative supply shock. The mainstream will see it as a ‘hail Mary’ move. If it works, fine, if not it was a foolish error with a major price to pay to fix it.

Maybe they just got what will turn out to be overconfident in their inflation fighting ability. Kind of a ‘we know how to do that and can do it anytime’ attitude.

Wrong. They will soon find out it is not so easy.

Maybe they got confused and saw the tail risk as that of the gold standard era when there were real supply side constraints to money to deal with.

Also, they probably blamed the whole 1970’s thing on labor unions; so, maybe they got blind sided this time because they thought without unions wages would be ‘well contained’ and therefore there would be no inflation.

Wrong on that score as well. It was about oil before, and it is about oil now.

And the fact is, they have no tools for fighting inflation. They think they do (hiking rates), but higher rates just make it worse by raising costs and jacking up rentier incomes. (Incomes of savers who do not work or produce = more demand and no supply)

The inflation broke in the early 80’s only because of a supply response of about 15 million barrels of crude per day that buried OPEC and caused prices to collapse for almost 20 years. (And even during the 20 years of low oil prices and falling imported prices inflation still averaged around 3%.)

That kind of supply response is not going to happen in the near future. I expect the Saudis to keep hiking and inflation to keep getting worse no matter what the Fed does. It is payback time for them from being humiliated in the 1980s, and they are also at ideological war with us whether we know it or not.

Markets might have a false start or two with the interest rate response and flattening curve, just to not make it too easy.

Also, as before, there could be an equity pullback when it is sensed the Fed is going to seriously fight inflation with hikes designed to keep a sufficient output gap to bring inflation increases down.

And along the way everything goes up, including housing prices, during a major cost push inflation. Even with low demand. Just look at all the weak emerging market nations that have had major inflations with weak demand, high rates, etc. etc.

Saudi Oil Production

Looks like even at current prices and with a relatively weak economy demand is holding up.

Tells me they probably keep hiking prices and spending the proceeds.

Comments people emailed me and my responses:

Bob Hart wrote:

http://www.wtrg.com/prices.htm

This graph supports your statement below:
Prices fell from a high of maybe $40 per barrel to the $10-15 range for the next two decades

Thanks!

“So, there is nothing the US can do to keep core inflation in check? Only the Saudis (and other oil producers) control US inflation?”

In this case, yes. If the Saudis keep hiking cpi goes up and an inflation begins via the various channels that connect energy with other prices. And in this case exacerbated by our pension funds.

right: previous high inflations have always been: energy, food, and shelter costs. I haven’t looked at shelter costs this time around.

Great piece. I’ve been thinking along the same lines over the last few weeks. I wish I had been a lot shorter the long end but think that trade still makes sense, especially given future deficits over the next 3-5 years. Having been born in the 1980s and not lived through oil embargos, stock market stagnation and hyper inflation, I am not exactly sure what the play is over the near-term and longer term. If you were to set up a portfolio that couldn’t be changed over the next 3 yrs / 5yrs / 10yrs what do you think the mix should be?

I like AVM’s current mortgage construction: buy FN 5’s versus tailored swap at LIBOR plus 25 basis points with a ‘free’ embedded put. Put it on and sit tight for Fed hikes. Worst case you get LIBOR plus 25.

Call your AVM salesman ASAP before the spread vanishes!!!

Do you buy TIPS / Broad based commodities indices (DJP) / Gold / Stocks / short end / long end?

‘Raw’ TIPS imply a low real rate. If the Fed decides to rais the real rate, you lose.

You could do a 10 year break even bit, especially in Japan, but I like the mortgage trade better.

Think that you could get killed owning bonds but input prices have already run so much its hard to buy commodities in a potentially declining demand environment. Do you buy stocks hoping they simply stay inline with inflation or do you just hold cash?

In the medium- and long-term the S&P will probably more than keep up with inflation, but help to get the right one and to get the right entry point.

Thanks for the help. I know you are busy but any insight would be much appreciated. thanks.

I agree entirely with the view that the 1970s was a question of energy prices, a supply-side phenomenon rather than anything else. The implications for policy are important; we might produce a problem where it does not exist if policy is predicated on the wrong interpretation of the problem.

(an email)

> On Feb 19, 2008 10:03 AM, Mike wrote:

> Warren, note spec comments and dollar issues, a big hurdle to overcome
> if they go the other way …
> Mike

Hi Mike,

Agreed the dollar may have bottomed. Seems to have reached a level where exports are now growing at about 13% which maybe is the right number to accommodate the pressure from the non resident sector to slow it’s accumulation of $US financial assets.
However I continue to conclude the price of crude is being set by the Saudi’s/Russians acting as swing producer, and that there is sufficient demand to keep them in the driver’s seat. Quantity pumped keeps creeping up at current prices, with Saudis last reporting 9.2 million bpd output.

Crude at 98.70 now. Note crude goes up on news a refinery is down, when refineries are the only buyers of crude, so in fact it’s going up for other reasons (price setting by the swing producer?). Also, WTI is now ahead of Brent, indicating whatever was causing the sag in WTI vs Brent is over. WTI would ordinarily trade higher than Brent due to shipping charges.

Warren

Saudis are selling more oil at the higher prices, as they continue to function as swing producer, setting prices and letting quantity adjust.

Iraqi Oil Minister Sees No Output Change from OPEC

(Reuters) Iraq’s oil minister Hussain al-Shahristani said on Thursday there was no sign of any shortage of oil in international markets and he did not expect OPEC to change its output levels at a meeting this week.

Saudis might like letting prices sag in front of meetings to stave off production increase talk.

“Quite frankly, the data we are looking at do not show any shortage of oil on the market. The prices are not really affected by any fundamental market forces,”

Right, just the Saudis (and probably Russians as well) setting price and letting the quantity they pump adjust, aka acting as swing producer.

Shahristani said ahead of the meeting on Friday of OPEC oil ministers in Vienna.

Twin themes continue – moderating demand and inflation.

So far, the Fed is directing all its efforts to the demand issue, including support for the coming fiscal package.