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Why you have to change your idea of ‘investing’ in the coming years to come

Wednesday, February 16th, 2011

The global economy is in a diabolical dilemma right now. If the world economy is paralysed by deflation (which is Bernanke’s nightmare), prices of many things will fall. For example, as we wrote in How to buy and invest in physical gold and silver bullion,

In the second half of 2008, the world experienced unprecedented asset and commodity price deflation. As noted earlier, oil prices fell from a high of almost US$150 to just over $30 over the space of months. Base metals and agricultural commodities plunged along with a panic in the stock market. The US dollar and US Treasury bonds surged (at one point, short-term US Treasury bonds had a negative yield). Statistically (in terms of price volatility), the panic in 2008 was worse than the crashes of 1929 and 1987.

Despite the mainstream commentary screaming “Disaster,” we believe such extreme deflation wasn’t that evil in the bigger scheme of things.

Why?

If you believe that burning fossil fuels causes climate change? or that Peak Oil is one of the greatest threat to humanity, wouldn’t such extreme deflation give planet Earth an urgently needed respite? Wouldn’t the collapse of global demand for goods and services save planet Earth for the sake of the next generation? Since 2008, the world witnessed a ‘recovery’ (that was brought about by massive money printing).

But what do we get out of that ‘recovery’?

Surging price inflation that threatens the poor with starvation and pushed many from middle-class to poor.

For example, as Food prices at dangerous levels, says World Bank reported,

The World Bank says food prices are at “dangerous levels” and have pushed 44 million more people into poverty since last June.

This, our dear readers, is just the beginning of a more serious global food crisis. Australia’s CSIRO scientist, Julian Cribb wrote a very sobering book, The Coming Famine: The Global Food Crisis and What We Can Do to Avoid it. As this New York Times book review wrote,

Like many other experts, he argues that we have passed the peak of oil production, and it?s all downhill from now on. He then presents evidence that we have passed the peaks for water, fertilizer and land, and that we will all soon be made painfully aware that we have passed it for food, as wealthy nations experience shortages and rising prices, and poorer ones starve.

This is the price that the this and the next generation will have to pay if we keep up the current way of exploiting planet Earth for the sake of economic ‘growth.’ Hardly surprisingly, a recent Wikileaks revealed that Saudi Arabia cannot pump enough oil to keep a lid on prices.

Dear readers, don’t you see that this economic ‘recovery’ is an illusion?

The ultra-rich, on the other hand, have less to worry about starvation and more to worry about how to preserve the purchasing power of their existing surplus wealth. Some of them will rush to hoard agricultural land and commodities, which will exacerbate the plight of the poor.

The middle-class will see their standard of living being eroded by rising food and energy prices. As we wrote in April 2007, Smart money in alternative energy?Part 1: current energy quandary,

The most important ingredient that drives the efficiencies, comforts, automation and wonders of today?s modern way of life is energy. The trains, cars, ships and aeroplanes that transport massive quantities of people and goods over vast distances quickly require energy in the form of fuel. The heavy machines that do heavy physical work far beyond the scope of human labour require energy too. The powerful computers that process and store vast amount of data and information as well as automate mental labour requires energy in the form of electricity. The heating in winter and cooling in summer of our abode requires energy too. Take energy away and our modern way of life will very much grind to a halt and bring us back to the hard life of our ancestors. In fact, contemporary life rests on the premise of abundant and cheap energy. Therefore, whoever controls the supply and provision of energy controls power and wealth.

When energy prices go up, the prices of everything else will go up. When the prices of everything else go up, your standard of living will go down.

Some of the poor, who are already spending a large portion of their income on food, will have to starve. But before that will happen, we will witness increased incidence of revolutions, wars and conflicts. What we see in Tunisia and Egypt is just the beginning- there will be more.

Dear readers, after reading all these, wouldn’t you come to the realisation that this will have grave implications on the idea of ‘investing.’ Normally, investing is associated with ‘making’ money. But in the context of surging price inflation, ‘making’ money becomes meaningless as the value of money diminishes.

In the next article, we will talk more about this implication. In the meantime, have a think about it.

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Posted in Advertising/Affiliates, Commodities, Food, Looking Forward, Oil | 6 Comments »

Five potential emergencies- energy crisis

Tuesday, April 13th, 2010

As you have read from our series on the self-sufficiency theme, the modern complex societies that we live in is not as robust as it seems. The reason why it seems robust is that (as we wrote in our ?How To Foolproof Yourself Against Salesmen & Media Bias? report), we have the habit of falling into one of the mental pitfalls. When you see that the tap flows and lights turn on reliably day after day, this mental pitfall will lull you into complacency. Then one day, when crisis happens, it will hit everyone on the head that modern life is fragile.

One of the main potential emergencies that can quickly disrupt our modern way of life is this: energy emergency. As we wrote in An Achilles Heel of modern society- specialisation and division of labour,

The crucial question to ask is this: what is the ?glue? that stick together all these specialised and divided labour into a system that we called the ?economy?? The answer is: energy.

Today, we can have 99% (a figure that we plucked from the sky, but you get the idea) of the population not working and yet not starve. That?s thanks to the Green Revolution that allows more and more food to be grown by less and less people.

But this comes at a cost- energy. As Sean Brodrick wrote in The Ultimate Suburban Survivalist Guide,

Energy consumption by agriculture has increased 100 times, or more. According to 1994 data, 400 gallons of oil equivalents are expended annually to feed each American. The energy consumption breaks down as follows:

  1. 30% for the manufacture of inorganic fertilizer
  2. 18% for the operation of field machinery
  3. 15% for transportation
  4. 12% for irrigation
  5. 7% for raising livestock (not including animal feed)
  6. 5% for crop drying
  7. 5% for pesticide production
  8. 8% miscellaneous

These estimates don?t include the energy used in packaging, refrigeration, transportation to retail outlets, and cooking.

At the same time, the vast majority of Americans have gotten further and further away from their food sources.

The implication is clear. As energy prices increase (and they will), prices for our basic survival need- food- will increase. If you believe in the China growth story (i.e. the secular rise of China), you will have to seriously question whether the global energy production can keep up with the colossal demand of a rising China (see The Problem that can throw us back into the age of horse-drawn carriages). Since most of our energy comes from fossil fuels (especially oil), the question is this: how quickly can the global economy restructure itself away from using oil? To retool and reconfigure the entire economy away from using oil is not that easy and it takes time.

This is just the best-case scenario- a gradual rising in oil prices over the years, resulting in a gradual declining in the standard of living. There are other worse possible scenarios?

Now, consider these facts (source: The Ultimate Suburban Survivalist Guide):

  1. 81% of the world?s discovered and useable oil reserves come from just 10 countries.
  2. 30% of the world?s oil comes from just 3 countries- Iraq, Kuwait and Saudi Arabia.

Now, look at the second point more carefully. What is common among the three listed countries?

All three of them are close neighbours of Iran. The Iranians, who are Shiites Muslims, have ambition of dominating that region. They are steering the Shiites in these three countries into their sphere of influence. No doubt, part of their plan for domination includes acquiring nuclear weapons. If the Iranians (who are led by their mad President Mahmoud Ahmadinejad) acquire nuclear weapons, it will significantly tip the balance of power in the region away from the US.

If you see how Russia uses the supply of natural gas as a tool against its neighbours (e.g. Ukraine), we can imagine the Iranians trying the same on the Western world.

There is a worse scenario than that. That region is a potential military flashpoint. What if Israel miscalculates (see New urgency for action against Iran) and plunge the region into war? In any shooting war involving Iran, we have no doubt that they will find ways to block the Straits of Hormuz, one of the energy chokepoints in the world. As the US Department of Energy reported,

Chokepoints are narrow channels along widely used global sea routes. They are a critical part of global energy security due to the high volume of oil traded through their narrow straits.

?

The international energy market is dependent upon reliable transport. The blockage of a chokepoint, even temporarily, can lead to substantial increases in total energy costs. In addition, chokepoints leave oil tankers vulnerable to theft from pirates, terrorist attacks, and political unrest in the form of wars or hostilities as well as shipping accidents which can lead to disastrous oil spills.

A temporary disruption lasting not more than say, 40 days is manageable for the US because they can open up their Strategic Petroleum Reserve. But if the emergency last longer than that, then there will be a heavy price to pay.

That?s not all the Iranians can do in a shooting war. Since the oil fields of 30% of the world?s oil is so near Iran, our guess is that it would not take them too much to take down these oil fields? productive capacity. Back in 1990, Saddam Hussien sabotaged the oil fields of Kuwait by setting fire to them. An irrational Iranian President will surely think of trying something worse with missiles, artillery shells, ground troops or worse still, nuclear missiles. Although the Iranian may not have military technology as sophisticated the US (although the gap is probably closing with Russian help), they have a large pool of manpower to call up as canon fodder. During the Iran-Iraq war, the Iranians used human wave techniques to beat back the Iraqis.

Therefore, a second oil crisis (the first one is in the 1970s) is definitely possible. The question is, are you ready?

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Posted in Advertising/Affiliates, Oil, Self-Sufficiency | 1 Comment »

Is the world really running out of oil?

Sunday, November 15th, 2009

Many of us would have heard of the threat of Peak Oil to our way of life. To put it very simply, according to the Wikipedia, Peak Oil is the

Peak oil is the point in time when the maximum rate of global petroleum extraction is reached, after which the rate of production enters terminal decline.

Unfortunately, there is a lot of misunderstanding as to what Peak Oil is. For example, in our quote of the news article in our previous post, it reported that

The world is much closer to running out of oil than official estimates admit, says a whistleblower at the International Energy Agency…

This is an example of how the mainstream news media can oversimplify things and subtract knowledge from their readers’ minds. Please note that we are not saying that the news media is useless, but it pays to be careful with what you read, especially with so much vested interests wanting to control public opinion through control of the media.

To add to the confusion, the debate on Peak Oil is as polarising as the inflation/deflation debate with both sides having different motives and vested interests. There are some experts who do not believe in Peak Oil (we are not geologists here, so we shall not get involved in this debate). For example, one of our readers forwarded us this news article by an expert (Leonardo Maugeri, the senior executive vice president of the Italian oil company Eni, and a visiting scholar at the MIT), who believes that there will still be plenty of oil in the 21st century and we need not fear losing our way of life as we know it.

First, let us understand what Peak Oil is not. It does not mean that the world is running out of oil. There are still plenty of oil on this earth. The last drop of oil will not be used up any time soon. But there is a problem. The cheap and “easy to get” oil is getting harder and harder to find and extract.

The best way to understand this problem is to use an analogy. Imagine we have a fruit tree that has plenty of fruits. We have been consuming the low hanging ones for quite a while and are realising that our daily supply of fruits are in decline. No doubt, there are plenty of fruits on the tree. But the problem is, the low hanging ones are getting fewer and fewer and the ones left are hanging higher and higher. That means, we have to expend more work (e.g. using a ladder) to get those higher hanging fruits if we want to maintain or increase (with China & India coming) our daily supply of fruits.

The point of contention is what is means by “low hanging” fruits. Critics of Peak Oil believe that new technologies will help us to extract the higher hanging fruits more easily than before. They believe that mankind will find new ways to extend the lifespan of existing oil fields, extract non-conventional oil (e.g. get the oil from the tar sands), find new oil fields in previously infeasible locations (due to technical and economic reasons) and so on.

As usual, we have to cast a skeptical eye on whatever we read. For example, the news article by Leonardo Maugeri is full of optimism with regards to mankind’s ability to pluck the higher hanging fruits. Perhaps he is a little too optimistic? As we read his article, we can’t help but notice that he is using some kind of turkey thinking- mankind’s ability to innovate in the past with regards to oil-related technologies will see that further innovations is the default result for the future (see Failure to understand Black Swan leads to fallacious thinking). For example, he wrote,

But when new exploration technologies do take root, the results are remarkable.

…

Fifteen years ago, all this was simply unthinkable.

Of course, being an oil industry executive, he has to walk the talk and be optimistic. We are not saying that he is lying or wrong. We are just exercising our skepticism. We certainly hope he is right. If not, this is a BIG problem for mankind.

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Posted in Oil | 33 Comments »

Aborted correction?

Thursday, November 12th, 2009

Eleven days ago, when we wrote Stronger signs of a coming major correction, it looks as if the long-awaited major correction was on its way. It turned out that it was a very shallow correction. Gold prices, on the other hand, are hitting record highs in US dollar terms. Commodity prices are in a much weaker up-trend than gold prices. Even silver, gold’s sister, are not as strong as gold.

Indeed, this is a very trying period for investors. In the US, with short-term interest rates at zero, it has become very difficult to value your investments. If cash is yielding nothing (and losing value due to price inflation), how different is it from gold, which also yields nothing? In fact, with gold prices in such a strong up-trend, it is doing much better than cash. In fact, anything is better than cash (US dollar) right now and it has become a very crowded trade, with speculators shorting it into a gigantic bubbly carry trade (Return (and potential crash) of the great Aussie carry trade).

Today, China is hinting that it is allowing the yuan to appreciate (see China hints at resumption of yuan appreciation). Speculators who are already betting on a yuan appreciation will be well rewarded. Very likely, more latecomer speculators will try to squeeze its way into this carry trade too as this sure-profit trade looks too tempting to miss.

Meanwhile, there is a danger ahead- peak oil. As this recent news article reported,

The world is much closer to running out of oil than official estimates admit, says a whistleblower at the International Energy Agency who claims it has been deliberately underplaying a looming shortage for fear of triggering panic buying.

Assuming that the world is past its peak oil production and what follows is a downward sloping decline, it can only mean one thing- more price inflation ahead.

And this will break the global economy once again. Meanwhile, be alert for a currency crisis.

Posted in Currencies, Oil | 9 Comments »

Fighting for resources in the Caucasus

Thursday, August 14th, 2008

As we know, on the day of the Beijing Olympics 2008 opening ceremony, a war was brewing between Georgia and Russia. We do not know what the quarrel between Georgia, Russia and the disputed provinces of South Ossetia and Abkhazia was all about. Claims of genocide by Georgia on South Ossetia were made by the Russia, while Georgia claimed that Russia was trying to bully its tiny neighbour. Who is in the right?

We do not know.

But as we said before in Are we in a long-term inflationary environment?,

The implication is extremely unpalatable: some nations will have to rise at the expense of the others, which may result in armed conflicts (touch wood, heaven forbid!).

We believe the conflict was at the root about jostling and pushing for the influence and control of natural resources. Russia is an energy rich nation- much of Europe is dependent on Russia for its gas supplies. It also has abundant reserves of oil too. And disturbingly, Russia has shown to have no qualms in using energy to bully its neighbours and settle disputes.

In terms of natural resources, the Caucasus is a very strategic region. As this map in the Wikipedia shows,

Detailed map of the Caucasus region (1994), including locations of economicaly important energy and mineral resources: South Ossetia has reserves of lead and zinc, Abkhazia has coal, and Georgia has oil, gold, copper, manganese, and coal.

In terms of oil, this article from The Age explains,

While Georgia does not produce oil itself, US and European energy firms have counted on the pro-Western country – sandwiched between Russia and Iran further south – to host a conduit for oil and gas exports from Azerbaijan.

…

Since President Mikheil Saakashvili took power in 2004 two new pipes have been built, and the explosion of violence between Georgia and huge northern neighbour is threatening those, notably the Baku-Tbilisi-Ceyhan (BTC) pipeline.

…

Transporting oil through the Caucasus is designed to make the West less dependent on supplies from Russia, which has shown worrying willingness to close the taps in disputes with other ex-Soviet states in recent years.

Make no mistake about this: in the years to come, countries that own and control energy reserves (and natural resources in general) will be the ones calling the shots. As we said before in The Problem that can throw us back into the age of horse-drawn carriages,

… supplying environmentally sustainable energy indefinitely at a rate fast enough is a colossal global problem that must be solved. If not, the latter generations will not live better than the current generation.

Many of the oil fields located in US-friendly oil producing nations are in decline. The implication is that as the years goes by, more and more of the world’s energy are produced in nations that are not so receptive to the US and its Western allies.

It is no coincidence that we are seeing conflicts in such regions of the world.

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Posted in Geopolitics & Politics, Oil | 10 Comments »

Can rising oil prices undermine the benefits of globalisation?

Tuesday, June 3rd, 2008

Right now, there is much talk about price inflation. As you read the news media headlines, you will get to see a lot of talk about the soaring oil and food prices. There are rumours that the Fed is going to raise interest rates to fight inflation. Some people are comparing today with the infamous stagflation of the 1970s. We have heard of inflation in the Middle East, China, Singapore, South Korea and even Japan. It seems that the world is infected with the inflation bug.

Today, we read a news article, China, Starbucks and inflation, of which one of its paragraphs caught our attention:

“In many rural economies, you have farmers who go in their trucks with the produce they grow to the market to trade it,” said Lawrence Eagles, head of the International Energy Agency’s oil industry and market division. “But if it no longer becomes profitable because of the cost of gas, they’re going to simply return to subsistence farming, which would be a significant development.”

It is obvious that if most of these rural farmers return to subsistence farming, the price of food will rise, thanks to the rising price of oil. This led us to mull about the inflation problem.

Nowadays, we live in the modern age of globalisation. One of the characteristics of globalisation is specialisation. Countries specialise in producing things that they are particularly skilled at or can do so at a relatively lower cost than the others (see the theory of comparative advantage). Individually, our jobs are becoming more and more specialised. We see more and more experts at narrower and narrower fields of discipline.

No doubt, globalisation can bring about a lot of prosperity and wealth (and a lot of other negative side effects as well). For example, we have a case whereby Australia grows macadamia nuts (because it has a comparative advantage), ships them to China for packing (where the low cost of labour allows packing to be done at a much lower cost) and them ships them back to Australia for sale. Producing and packing macadamia nuts in either country alone will result in higher costs. But thanks to the globalisation, we can enjoy lower prices than otherwise.

But we see a weak point in globalisation. In the above example, it only works if the cost of shipping things is not prohibitive. As oil prices rises, the cost of shipping increases. As shipping cost increases, the benefits of specialisation and comparative advantage cannot be exploited just as easily.

Using the quote from the above-mentioned news article, we can imagine that with specialisation and comparative advantage, the farmers specialise in growing food for the city dwellers, while the city dwellers specialise in producing white goods in the factories for the farmers. Both benefits. But as the price of transport shoot up, this cosy arrangement can potentially break down.

So, as we can all see, this is another example of to show that much of the prosperity and comforts of modern life depends cheap and abundant energy. Take that away, and the good life as we know will be under threat.

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Posted in Economics/Finance, Oil | 8 Comments »

How the rich make their killing from soaring oil prices?

Sunday, June 1st, 2008

Take a look at this article from the news media: Opportunities in crisis as oil stocks dwindle,

A new oil shock that is sweeping the world has sent airline tickets soaring, car drivers reeling and retailers bemoaning the shrinking purses of customers. It is an oil shock of rare proportions.

It is in such events that investors thrive: surely there is an opportunity here for an investor to make a profit from the rising oil price?

Well, how would the rich profit from the soaring oil prices?

There is one rule of thumb that all investors, especially the budding ones, should take note: by the time you get to read about profit opportunities on the media, the biggest and most lucrative killings have already been made. What remains are the leftover scraps. The best investors hop on to the long term major trend long before the mainstream media screams about it. As early as the end of 2006, we had already whispered about the future of oil prices at Is oil going to be more expensive?. The world-class investors who are making a killing from soaring oil prices now would have made their move two years ago.

So, now that mainstream media are talking about how to profit from soaring oil prices, what will the world-class investors be looking at right now? No doubt, they will be thinking steps from the crowd. We believe they will be casting their eyes on alternative energy.

Back in April last year, we examined the idea of alternative energy- see our currently evolving guide, How to profit from rising energy prices?. In particular, take a read at Part 3 (Centralised or Distributed Power) of the “Smart money in alternative energy” series to see how the future of energy will look like in the long run. Regardless of whether you believe the former model (centralised power) or the latter model (distributed power) will be the outcome of the future, there is one problem for the investor: currently, there is no certainty on which forms of alternative energy (e.g. wind, solar, geothermal, nuclear, clean coal, biofuels, etc) will be implemented or commercially successful in the future. By the time the world work them out, the most lucrative profits would have already been made.

But how would the best investors invest in alternative energy? Remember the concept of the asymmetric pay-off strategy in our guide, How to profit from a stock market crash?? The same applies to alternative energy. We do not know which alternative energy will be the winner, but we know that the winner (or winners) will probably win a whopping big victory (or victories). The losers may end up discarded and forgotten (we believe ethanol will probably go the way of the losers). Therefore, the way to invest in alternative energy will be to allocate fractions of your capital into each and every alternative energy candidate that you believe will have good chances of winning. Eventually, one or more of the candidate will win so big that your combined losses on the losers will pale in comparison to the combined wins.

Obviously, this strategy will work only for those who have large enough capital.

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Posted in Alternative Energy, Commodities, Oil | 10 Comments »

Who is to blame for surging food and oil prices?

Thursday, May 22nd, 2008

Imagine you are standing in a typical petrol station in 1974 on a typical day (there was an oil shock in 1973). This is what you may see back then:

Cars queued for hours to get petrol in 1974

Now, imagine you get sucked into a time warp and time-travelled to today on 2008. This is what you may see:

A typical petrol station in 2008

So, let’s say a passer-by told you that petrol price had doubled more than 2 ½ times over the past 2 years, would you laugh at the passer-by? “Yeah right!” you may say. “Where’s the queue and rationing?”

Indeed, this is what has happened. As we said before in The Problem that can throw us back into the age of horse-drawn carriages, there are good reasons why the oil price rose over the past decade. In fact, this is true for commodities in general (e.g. base metals, food). As we explained before in Why are the poor suffering from food shortages? and Example of a secular trend- commodities and the upcoming rise of a potential superpower, there are good reasons for this. Already, we are hearing of food riots in the Middle East and Asia.

Yet, strangely, these upward price movements seem unreal. Where’s the queues and rationing? How do we explain this?

Two days ago, in the U.S. Senate Committee on Homeland Security and Governmental Affairs hearing, this question was put forth: Financial Speculation in Commodity Markets: Are Institutional Investors and Hedge Funds Contributing to Food and Energy Price Inflation? Here, we must give special thanks to one of our readers, Zoo for highlighting this piece of information at Picture of a fiat money.

Here, let us zoom into the testimony of Michael Masters, who is the Managing Member and Portfolio Manager, Masters Capital Management, LLC. As our reader Zoo said, “It seems it is the testimony of Michael Masters, a hedge fund manager, which made all the Senators sit up and take notice (sic).” This is Michael Masters’ introduction in his testimony:

Good morning and thank you, Mr. Chairman and Members of the Committee, for the invitation to speak to you today. This is a topic that I care deeply about, and I appreciate the chance to share what I have discovered.

I have been successfully managing a long-short equity hedge fund for over 12 years and I have extensive contacts on Wall Street and within the hedge fund community. It’s important that you know that I am not currently involved in trading the commodities futures markets. I am not representing any corporate, financial, or lobby organizations. I am speaking with you today as a concerned citizen whose professional background has given me insight into a situation that I believe is negatively affecting the U.S. economy. While some in my profession might be disappointed that I am presenting this testimony to Congress, I feel that it is the right thing to do.

You have asked the question ?Are Institutional Investors contributing to food and energy price inflation?? And my unequivocal answer is ?YES.?

That’s a strong categorical statement. Unlike many mainstream financial commentators, Michael Masters did not fluffed around with the “on-the-other-hand” and “having-said-that” types of answer. It is as clear as you can get, backed up by evidence, charts and numbers.

So, how do we explain such a spectacular rise in commodity prices without the queues and rationing? Michael Masters answered,

What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets

Just who is this “new category” of market participants? Is it China and India? No! The rising demand of these two giant nations had been gradually brewing and simmering over the past decade and will continue to the next decade and beyond. Their demand are hardly a shock. Michael Masters pointed the finger at:

Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.

To give you a sense of scale of their share on the commodities futures contracts, Michael Masters gave an example:

According to the DOE, annual Chinese demand for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels. Over the same five-year period, Index Speculators’ [institutional investors’] demand for petroleum futures has increased by 848 million barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China!

There are a few more examples given by Michael Masters in his testimony. What happened was that these institutional investors hoarded commodities through the futures market, affecting futures price, which in turn affected the spot prices (i.e. the real world market price). The spot prices are the prices that we all face in our daily life.

In additional, these institutional investors (which Michael Masters called “Index Speculators” are a completely different breed from the traditional speculators. The latter were relatively small fries who (1) had limited supply of money, (2) specialised in certain commodities and (3) price conscious (i.e. they are careful with what price they pay for). The Index Speculators are poles apart. They have vast amount of money (fiat money in US dollars) to be distributed among “key commodities futures according to the popular indices” and are not conscious about the price they pay. They think in terms of portfolio asset allocation, which means that if they decide to allocate, say 2% of their assets into a specific commodity, they will “buy as many futures contracts as they need, at whatever price is necessary, until all of their money has been ‘put to work.’ ” Unlike the traditional speculators who buys and sells, Index Speculators never sell because they treat commodities as some kind of quasi-assets. You can expect such behaviour to have colossal impact on commodity prices.

How did all these Index Speculators came about? Michael Masters explained,

In the early part of this decade, some institutional investors who suffered as a result of the severe equity bear market of 2000-2002, began to look to the commodity futures market as a potential new ?asset class? suitable for institutional investment. While the commodities markets have always had some speculators, never before had major investment institutions seriously considered the commodities futures markets as viable for larger scale investment programs. Commodities looked attractive because they have historically been ?uncorrelated,? meaning they trade inversely to fixed income and equity portfolios. Mainline financial industry consultants, who advised large institutions on portfolio allocations, suggested for the first time that investors could ?buy and hold? commodities futures, just like investors previously had done with stocks and bonds.

The value of assets devoted to commodities by these Index Speculators grew from just US$13 billion in 2003 to US$260 billion as of March 2008. Over these 5 years, the prices of commodities grew by an average of 183%. In 2003, they were small fries in the commodities futures market. Today, they are the largest force in the market.

Why is it that no one seems to know about this phenomenon? Michael Masters believes that (emphasis in the original testimony):

The huge growth in their demand has gone virtually undetected by classically-trained economists who almost never analyze demand in futures markets.

To compound the effect of Index Speculators on commodity prices, it must be noted that the commodity futures markets are much smaller than the capital markets. For example, it is 240 times smaller than the global equity market. Thus, every dollar on commodity futures has a much greater impact on prices than the same dollar on equities. To compound the problem even further, it was observed that their demand increases prices, which in turn increases demand even more. That is, hoarding begets more hoarding.

So, let’s return to the petrol problem. Let’s say OPEC increases production in an attempt to help bring down the price of oil. Or the world decides to to embark on an oil fast. Will that work? You can see that these Index Speculators can easily pour more money into the oil futures sink hole.

Sad to say, through a loophole, the US Commodities Futures Trading Commission (CFTC) allows such speculators “unlimited access to the commodities futures markets.” As Michael Masters explained,

The really shocking thing about the Swaps Loophole is that Speculators of all stripes can use it to access the futures markets. So if a hedge fund wants a $500 million position in Wheat, which is way beyond position limits, they can enter into swap with a Wall Street bank and then the bank buys $500 million worth of Wheat futures.

In the CFTC?s classification scheme all Speculators accessing the futures markets through the Swaps Loophole are categorized as ?Commercial? rather than ?Non-Commercial.? The result is a gross distortion in data that effectively hides the full impact of Index Speculation.

So, whose fault is this? We can blame these Index Speculators. But as we said before in Connecting monetary inflation with speculation,

Thus, by further inflating the supply of money and credit in the financial system at such a time, there comes a situation whereby there are excess liquidity without adequate avenues for appropriate investments.

Is it surprising to see the arrival of the Index Speculators?

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Posted in Commodities, Economics/Finance, Food, Oil | 41 Comments »

Can “weak US dollar” be partially blamed for rising oil prices?

Thursday, May 8th, 2008

Yesterday, we questioned the validity of using fiat money as a unit of measure for the value of a commodity. Today, we will look at idea that the “weak US dollar” is one of the scapegoats for rising oil prices.

Frequently, we hear from the media explaining that one of the ’causes’ of rising oil prices (and by extension, inflation) is due to the “weak US dollar.” But notice one thing: oil prices had been rising in all currencies, not just in terms of US dollar. This leads us to one basic principle: everything else being equal, a falling US dollar has no effect on oil prices measured in non-US currencies. Of course, in the real world, everything else is not equal- oil prices rises to different degrees in terms of other currencies too, including the Australian dollar. In that case, can the rising in oil prices in terms of non-US currencies be attributed to supply/demand fundamentals?

But wait a minute! What is the meaning of “weak US dollar?” Can we interpret the meaning of “weak US dollar” to mean that the supply of US money and credit has been expanding at a faster rate than the supply of its non-US counterparts? Well, consider this fact: the supply of non-US money and credit has been expanding at an arguably greater rate than the supply of their US counterpart. For example, Australia’s money supply increased 21.6% (see Australia?s monetary growth update?February 2008) while the US money supply was estimated to be significantly below that figure (the US no longer publish figures on their M3 money supply). Putting aside the argument of which nation’s money supply has been increasing at a faster rate, this is the basic point: the supply of fiat money and credit of all nations have been increasing. In other words, high oil price is not just a problem of the “weak US dollar.” As we said before in What if the US fall into hyperinflation?,

Now, in this age of freely fluctuating currencies, the currency?s value is a relative concept. For example, a falling US dollar implies a rising Australian dollar. Therefore, one way to ?maintain? the value of the US dollar relative to the Australian dollar is to devalue the Australian dollar. Perhaps this is the route that central bankers will concertedly take to instil ?confidence? in the US dollar in order to create the illusion that the US dollar is still a reliable store of value? Well, they can try, but growing global inflation and skyrocketing gold price relative to all currencies will be tell-tale signs of such a dirty trick.

We can include oil prices in the last sentence of the above-quoted paragraph. Thus, we believe that global monetary inflation is one of the major contributing factors in accentuating the rise in oil prices, in addition to the fundamental supply/demand factors. It is an error to blame it on the “weak US dollar.”

In the next article, we will connect monetary inflation with oil price speculation.

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Posted in Economics/Finance, Oil | 16 Comments »

Oil at $40 or $200?

Wednesday, May 7th, 2008

Yesterday, Goldman Sachs analysts predicted that oil can hit US$200. As this news article, New ‘super-spike’ might mean $200 a barrel oil, reported,

With $100-a-barrel here for now, Goldman Sachs says $200 a barrel could be a reality in the not-too-distant future in the case of a “major disruption.”

Goldman on Friday also boosted by $10 the low end of its 2008-2012 projected range for crude to $60 a barrel — significantly lower than current prices, to be sure, but a possible mark for oil if “normalized” trends return to the marketplace.

Mind you, those Goldman Sachs guys predicted US$100 a couple of years ago and no one believed them. This time round, people take their forecasts more seriously.

At the same time, Citigroup analysts predicted that oil will hit US$40 within 2 years.

Why is there such a vast difference in the price forecast of oil?

Is it possible for oil to fall in demand so drastically that its price falls to US$40? Can its demand surge so hight till its price hits US$200? If one asks such questions, it shows a fundamental error in thinking. You see, the underlying assumption behind these questions is that the US dollars is an immovable yardstick of measurement. The truth is, the US dollar is as elastic and twang as rubber band. With deflation, the US dollar shrinks, and with inflation, the US dollar stretches (see What is inflation and deflation?). As we said before in How is inflation sabotaging our ability to measure the value of things?,

If you want to measure the length of a box, you may use the ruler to do it. The reason why a ruler can do such a job is because its length is reasonably consistent for the foreseeable future. Now, imagine that ruler is as elastic as a rubber band. Do you think it is still a useful tool to measure the length of the box? An elastic ruler is useless because you can always make up the measurement of the box to whatever you please just by stretching the ruler such that the edge of the box is aligned to any intended measurement markings in the ruler.

Now, let come back to measuring the value of oil. Since oil is priced in US dollars and if the supply of US dollars can be expanded and contracted at will by the Federal Reserve, how useful do you think it is as a calibration for measuring the value of oil?

Can oil fall to US$40? Yes, it will take an acute deflation of money and credit in the global financial system to result in that. If you wonder how such a deflation will look like, the Great Depression is the best template. Can oil surge to US$200? Sure, other than Chinese and Indian demand (see The Problem that can throw us back into the age of horse-drawn carriages), monetary inflation can lubricate the upward slide of oil prices.

If you notice, the mainstream media is catching on to this understanding too. They are starting to blame rising oil prices on the weak US dollar. Speculators and ‘investors’ are also blamed. But there are a couple of things they do not see. What are they? Keep in tune!

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Posted in Oil | 12 Comments »

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