Posts Tagged ‘Iraq’

363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy?

Thursday, February 15th, 2007

Recently, this news report came up in CNN: Lawmaker: U.S. sent giant pallets of cash into Iraq. In this report, 363 tons of cash (worth $4 billion) were loaded into pallets and transported via military transport aircraft into Iraq ?shortly before the United States gave control back to Iraqis.? Needless to say, much of the cash went unaccounted for.

As we said before in A brief history of money and its breakdown- Part 2, when much of the world was under the gold monetary standard, nations only go off that standard under exceptional circumstances, such as war. This is because war is always prohibitively expensive and thus, can only be financed if fiat money is used. Today, we look with disbelief at such a gross abuse!

Back in Liquidity?Global Markets Face `Severe Correction,? Faber Says, we mentioned that when money is ‘created’, the ?outcome is a pyramid of ?money,? with hard cash at the apex and derivatives at the bottom.? Imagine what this $4 billion of cold hard cash is eventually going to do to global liquidity! To see what will become of these monies, let us examine how this massive quantity of physical cash is going to swell the total money supply, which includes bank deposits. Today, we live in a time of fractional reserve banking system. Put it simply, if you deposit $100 into a bank account, the bank is going to lend out a large proportion of your $100 and keep the rest as reserves, in case you decide to withdraw some of your money as cash. The proportion that the bank is going to keep as reserves is the reserve ratio. Let’s say the reserve ratio is 10%. After depositing $100, the bank is going to keep $10 and lend out $90. The $90 that someone borrowed from the bank will again be deposited, resulting in $81 being lent out and $9 keep as reserve. At this point time, how much money has you original $100 multiplied into? In terms of the amount of bank deposits, there are now $100 + $90 + $81 = $271 of ?money? in the financial system. This can go on and on, until the quantity of money swell to the theoretical limit of $1000 (based on reserve ratio of 10%). Thus, for example, a ratio of 5% can swell the quantity of money up to the theoretical limit of 20 times.

The next question is: what is the reserve ratio? We took a look at the Federal Reserve?s requirements on reserve here. Depending on the amount on deposit, the ratio ranges from 0% to 10% (a ratio of 0% means that money can be created by the banks to a theoretical limit of infinity). Anyway, whatever the answer to this question, $4 billion of physical cash will eventually spawn many more times worth of liquidity into the financial system. It certainly would not help in the ?fight? against inflation.

Analysing recent falls in oil prices?real vs investment demand

Saturday, January 13th, 2007

In November last year, we explained our opinions on the future of oil prices (see Is oil going to be more expensive?). Recently, oil prices had been falling very rapidly to even below US$53. Were we wrong?

Before we answer this question, we have to understand the distinction between the real and financial side of the economy. The real side where you find the physical market for goods, services and labour. The financial side is where you find the flow of financial capital, assets and payments. For example, the stock, debt and derivatives markets are part of the financial side of the economy. As Ross Gittins said in his article, Two sides to the story of nation’s rising prosperity, as the financial side grows in importance, it balloons and crowds out the real side. In Australia, with hundreds of millions more of superannuation money seeking to find a home, we can expect the financial service industry to grow even more, which means the financial side of the economy will rise in further prominence in the future.

Now, let?s go back to oil. What makes up the demand for oil? There are basically two types of demand for oil: (1) The physical demand where the real side of the economy uses for its everyday needs and (2) The investment demand where the financial side of the economy shifts the money here and there from one asset class to the other. We need to ask ourselves the following question: Has the physical demand for oil changed? Will it change in the long run?

From the International Energy Agency (IEA), we can see that world oil supply exceeds world oil demand by just around a couple of millions of barrels per day (or around 2.5% of demand). From the US Department of Energy (DOE), we learnt that,

In the AEO2006 reference case, the combined production capacity of members of the Organization of the Petroleum Exporting Countries (OPEC) does not increase as much as previously projected, and consequently world oil supplies are assumed to remain tight. The United States and emerging Asia?notably, China? are expected to lead the increase in demand for world oil supplies, keeping pressure on prices though 2030.

World oil demand is expected to increase to around 120 million barrels per day in 2025, from 84.5 million in 2006, with developing nations (notably China) capturing a mounting slice of the increase. World oil supply is expected to barely keep up (assuming that Peak Oil is not true) with the demand.

These forecasts are based on a fundamental economic assumption: ceteris paribus, which means ?everything else being equal.? But as we know in real life, things rarely happen nicely according to plan. Unexpected surprises often do happen. The biggest wild card is the geopolitical situation in the Middle East. Would the Israelis or the Americans strike Iran, resulting in Iranian retaliation by disrupting the global flow of oil? Will the US succeed in creating a viable state in Iraq or will Iraq descend into chaos, thus removing a major oil-producing nation from the equation? Would war break out in the Middle East again, destroying and damaging oil infrastructures in the region?

As we can see, the fundamentals of oil are still intact. Therefore, from what we can see, such a rapid drop in oil prices is mainly due to the change in investment demand?asset managers (we prefer to see them as ?money shufflers?) shifting their preferences from one asset class to another.

Some of the reasons given by the financial media to ?explain? the recent falls in oil prices are nonsense. For example, they blamed the warmer than expected weather in North America for the price fall. In reality, oil demand is primarily driven by transportation needs, not by winter heating needs.

One more thing: as oil prices fell because of the fall in investment demand, guess what will happen to the real demand for oil?