Posts Tagged ‘OPEC’

A resemblance of the beginning of Weimar-style inflation

Monday, June 9th, 2008

As we can all learn from the news media, inflation seems to be infecting every nation in the world. Despite the destruction of credit (deflation) in the United States through asset write-downs, bad debts and wealth destruction through home price deflation, price inflation is still turning into a more and more serious problem not only in the United States, but also in the rest of the world. Most notably, with the prices of oil (which is an input for many stages of production, for example, see Can rising oil prices undermine the benefits of globalisation?) in an upward warpath, government ministers are murmuring of the threat to global growth, as this Bloomberg article, Soaring Oil Price `Dangerous’ for Growth, Steinbrueck Says, reported:

Soaring oil and food prices will spur inflation and could imperil economic growth, German Finance Minister Peer Steinbrueck said.

“We are facing a very dangerous situation caused by these tremendously increasing prices for commodities, food and oil,” Steinbrueck said today at the St. Petersburg International Economic Forum.

Here in Australia, our Prime Minister is putting the blame on oil producers, as this article reported,

As the bowser price of petrol climbs towards $1.80, the Prime Minister, Kevin Rudd, and the Treasurer, Wayne Swan, have blamed a lack of supply from oil-producing countries.

Can increasing production really solve the problem? Based on the simplistic supply-demand curve taught at first year economics courses, it is easy to conclude that rising prices is due to rising demand without the corresponding rise in supply. But there is far more than meets the eye in this problem.

Here we must make one point clear: There are indeed fundamental reasons why the prices of commodities, food and oil are rising (see The Problem that can throw us back into the age of horse-drawn carriages, Why are the poor suffering from food shortages? and Example of a secular trend- commodities and the upcoming rise of a potential superpower). But monetary inflation accentuates price inflation and distorts the price signals for demand and supply. As we explained 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 [and other fiat money e.g. Australian dollars, Euros, etc] can be expanded [inflation] and contracted [deflation e.g. credit contraction] at will by the Federal Reserve, how useful do you think it is as a calibration for measuring the value of oil?

The presence of index speculators in the commodities futures market (see Who is to blame for surging food and oil prices?) is an example of how prices are distorted by monetary inflation. As we explained before in How to secretly rob the people with monetary inflation?, such price distortions ultimately harm societies (and by extensions, nations) in the end. Today, it is the poor nations that are bearing the brunt of commodities price inflation as the richer ones hoard them (see Price fluctuations and hoarding), which lead to even more price inflation, which further encourages even more hoarding. Ultimately, all these will result in further global mis-allocation of resources for production. As we said in The economics of inflation, that was what happened in Weimar Germany in the 1920s:

In the acutest phase of the inflation Germany offered the grotesque, and at the same time tragic, spectacle of a people which, rather than produce food, clothes, shoes, and milk for its own babies, was exhausting its energies in the manufacture of machines or the building of factories.

Our fear is that the world may be embarking on a similar path. Countries like China and Middle East are embarking on massive investment spending sprees as they spend their hoard of rapidly depreciating US dollars. This is probably the answer to the question we posed in What to do with US$ raised from dumped US Treasuries?. Soaring commodity prices may induce massive mal-investments into the commodity producing industries. For example, massive amount of capital could be further poured into the extraction and refining of lower quality oil in hostile terrains. Wars may even be fought for the sake of securing commodities (well, we wonder whether the root of Iran’s war rhetoric and US invasion of Iraq related to the fight for commodities?). Meanwhile, investments into alternative energy are languishing and dragged slowly by other seemingly more urgent agendas.

If this hyper-inflationary crack-up boom continues, all of us here know where the root of the problem begins: lack of honest monetary system (see Why should you invest in gold?).

What to do with US$ raised from dumped US Treasuries?

Wednesday, January 24th, 2007

Recently, in Bloomberg, we saw this news: OPEC Dumps $10.1 Billion of Treasuries as Oil Tumbles. In our previous article, Awash with cash?what to do with it?, we asked this question: What would these countries [mainly China and Middle Eastern oil-producing nation] buy to replace their US dollars [of which a significant proportion are parked in US Treasuries]?

This is significant.

While this news is hardly surprising, it serves as an indication of what is likely to be a long-term trend. What would those OPEC nations buy to replace the proceeds of their sale of US Treasuries?

We do not really know the answer. But if we are them, we will steer clear away from stocks, bonds and real estates. Other than investment expenditure, if we still need to find a place to park our surplus US dollars, the most logical place, in our opinion, will be to buy gold. This is what we will do if we are them. But we are not them.

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?

How much lower can oil prices fall?

Thursday, September 28th, 2006

For the past couple of months, oil prices had fallen to a 6-month low, even undershooting the US$60 mark. There has been talk of it going even further down. The question is- how much lower can oil prices fall?

While we profess not to know the exact answer to this question, we suspect there isn?t much further for oil prices to fall. Why? There are other vested interests by the other big boys (OPEC) in town to ensure that oil still remain at favourable high enough price for them.

OPEC has pricing power on oil. If they don?t like the low prices of oil, they can easily put a floor to it by cutting production. No, they don?t even have to cut production- all they need to do is just talk about doing it!

Today, oil prices jumped by a couple of dollars- just through talk.