Posts Tagged ‘Middle East’

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?

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Posted in Commodities, Oil | No Comments »

More Chinese and Middle Eastern money heading Down Under: recipe for inflation?

Saturday, December 23rd, 2006

In our previous article, Awash with cash?what to do with it?, we asked the question of where the vast amount of surplus US dollars reserves (from China and the oil-producing Middle Eastern nations) will be recycled to.

Today, this news article caught our eye: The rush is on, the ride is wild. From this article, we learnt that according to the ANZ chief economist Saul Eslake, the private equity boom (we are more inclined to call it a ?bubble?) is funded by ?an absolute flood of money coming out of Asia and the Middle East. There is a huge amount of money looking for homes, and some is going to risky areas.?

It is forecasted that in Australia, the pace of takeover and leveraged buy-out activities by private equity will accelerate in 2007. We can imagine that with more flood of liquidity (money) heading for Down Under, we can expect price inflation to become more of a problem as these money permeate to the rest of the economy (see our article, Cause of inflation: Shanghai bubble case study, for our discussion on the Austrian School?s view on inflation).

The world is still flooded with too much liquidity (money). Just like in 1929…

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Posted in Economics/Finance, Looking Forward, Market Observations | No Comments »

Awash with cash?what to do with it?

Tuesday, December 19th, 2006

Not long ago, an Australian executive went to the Middle East to promote one of his company?s software systems to potential Arab clients. In his sales pitch, he sprinkled the words ?low-cost? all over to stress the cost effectiveness of the product. After a while, one of the Arabs pulled him aside and growled, ?What do you mean by ?low-cost?? We don’t care about the cost! Just cut the nonsense and give us what we want now!? Upon returning to Australia, that executive remarked that the Middle East is ?just awash with money.?

Just where do all these money come from?

The answer, as you would have guessed by now, is the United States. The US, being in the enviable position of having its money as the world’s primary reserve currency, is not subjected (for now) to the same rules as the other countries?it can spend more than it earns simply by printing its own dollars to pay foreigners. Thus, it can sustain greater trade deficits than would otherwise be tolerated by foreigners.

For years, the US has been running a ballooning trade deficit?its imports, which is paid by its own printed dollars, has been exceeding its exports by an ever-widening margin. From China, the US has been importing consumer goods and from the oil-producing nations, oil. The US dollars that are used to buy oil are nicknamed ?petrodollars? (the money in the above-mentioned story is such dollars).

Today, those foreign countries that account for the vast majority of US imports (namely the oil-producing Middle Eastern nations, Russia, China and Japan) are sitting on so much US dollars that they do not know what to do with it. Therefore, they recycled much of those dollars by purchasing US Treasury bonds. As a result, the long-term interest rates in the US are being artificially suppressed by those purchases.

As we said before in Will the US dollar collapse?, some of these countries are murmuring about diversifying their reserves away from the US dollars because they see that such state of affair is increasingly unsustainable. With the US continually inflating its money supply (printing money), their reserves of US dollars are increasingly become more and more worthless. In fact, we believe that given the swelling amount of US dollars in the world, its current price is overvalued.

Now, here comes a problem. Countries like China and Saudi Arabia are sitting on a massive pile of US dollars parked in US Treasuries. They also know that the US dollars are overvalued and are becoming more and more worthless as each day passes. On one hand, they would not want the US dollar to collapse to its intrinsic value because that would mean the purchasing power of their US dollar reserves would be crunched. On the other hand, they would not want to continue maintaining their holdings of US dollars because they lack confidence in its value. Selling their US Treasuries at once and using the proceeds to buy alternatives to the US dollars will be unacceptable because by virtue of the magnitude of their US dollar holdings, such action will have an immediate and significant impact on the market prices. This will have a very disruptive and destabilising effect on the global financial markets. Thus, the only sensible solution is to quietly and slowly diversify away from their holdings of US dollars so as not to disturb the market prices unduly. This would take a long period of time.

The next question is, what would these countries buy to replace their US dollars?

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Posted in Economics/Finance | No Comments »