By Andy Xie

Oil is making new highs again and again, reaching almost ＄100/barrel and up 60% this year, even though the biggest consumer of oil-the US is heading for recession, and the International Energy Agency (‘IEA’) has revised down oil demand four times this year to reflect demand destruction due to high price. I am quite sure that oil is a bubble. But, it seems to have nine lives. At the beginning of the year, I predicted that the bubble would burst in 18 to 24 months, the normal price should be around 40, and the price would undershoot when the bubble burst. Should I change my mind now? I still believe in the ending. But, timing may have to be pushed out by six months.

Global stock and credit markets are declining due to the US subprime crisis. The Crisis would slow credit flow to the US consumers that have been dependent on borrowing for increasing consumption. The US economy-one fourth of the global economy is the biggest in the world. It depends on the debt financed consumption for growth. The credit crisis aims squarely at its growth engine. Hence, the odds of a US recession are high and rising. It would lead to slowing or even declining retail sales and corporate earnings in the US. Hence, global stock markets are declining and credit risks are rising.

Source: International Energy Agency

The above story should have the same effect on oil. The US consumption of oil is about one fourth of the global total and three times of China’s. If the US economy goes into recession, global oil demand is likely to decline, even as China and India continue to grow robustly. However, oil price rose as the subprime crisis intensified.  Declining dollar is cited as the most important reason. But, declining dollar reflects rising US recession risk, and a US recession should bring down oil price. Also, oil has risen so much more than the decline of dollar. The dollar story cannot explain the oil surge.

When dollar depreciates, precious metals tend to appreciate in value. The rationale is that weak currency would lead to inflation and precious metals should maintain real value during inflation. Hence, demand for precious metals rise in anticipation of inflation. The higher prices reflect future inflation. Other fixed assets, from commodities to property, all have inflation hedging potential. However, other than precious metals, all other fixed assets are imperfect inflation-hedging instruments. High inflation often means bad economy that decreases demand for property and industrial commodities. Hence, their prices still need to reflect demand-supply balance.

For example, industrial metals may perform well despite a looming US recession, because China and India do account for the majority of net demand increase and their economies would probably boom in 2008. Oil, on the other hand, depends on the US demand and should be more sensitive to a US recession. A US recession could drive capital into China and India, which may support their property market despite very high prices. On the other hand, the subprime crisis has decreased financing for property purchase in the US, which means declining price. In summary, the prices of fixed assets may have different trends despite a common theme like inflation.

My analysis above suggests that commodities will trend different in 2008. Those that depend heavily on US consumption like oil shouldn’t do well. Those that primarily depend on China’s demand should do ok. The precious metals that are good inflation hedges should do well.  Every commodity rose when the boom began in 2002. The fortunes will be different in 2008. All the commodities will fall when the dollar recovers significantly. For that to happen, the US must pull out of Iraq and the property price must bottom. The US bleeds over half a billion dollars per day due to the war. The bleeding must stop for the dollar to stabilize. Before the US property price bottoms, foreign creditors won’t have the courage to lend to the US like before, which means a weak dollar. The dollar will probably bottom in late 2008 or even in 2009. Strong recovery of the dollar, however, depends on structural reforms that improve the US’s competitiveness. Healthcare is the most important one. When the dollar becomes strong, a broad based decline of commodities and emerging market assets in general would follow. That may be a 2010 story.

What explains surging oil price, as I have always believed, is speculation. The volume of oil futures trading at NYMEX has surged about 30 times since 2003. The total trading volume in the futures market for oil is about twenty times the present global demand of 86 million barrels per day. Historically, oil futures market is where suppliers and users hedge against future price volatility. Hence, futures price is the balance between revealed demand and supply in the future. The price is a meaningful signal for future market condition. The current market is like twenty people making a living guessing what one person may do. The price reflects the opinions of those who are guessing rather than that of the real users and suppliers of oil. 

I argued two years ago that oil price was proportional to the number of oil traders on Wall Street. I remain convinced of this. The most important reason that oil surged after the subprime crisis was re-channeling of trading liquidity at financial institutions. Funds or divisions within investment banks that trade subprime products often trade oil too. Unless profits could be obtained from other sources to offset the losses from the subprime debacle, the mangers of these business units would not have bonuses and may lose their jobs. Hence, throwing everything into oil would be logical from their perspective. If the bet failed, they wouldn’t earn bonuses or lose their jobs, just like not making the bet. If it worked, they could regain their glory again. As there were so many thinking the same way, the crowd effect made oil price go up. It again shows that, when professionals have an opportunity to gamble with other people’s money (‘OPM’), strange market phenomena happen.

The oil bubble is supported by unusually low supply response to high price. Over 80% of oil production is with government-owned enterprises. The main export countries, mainly in the Gulf, are flooded with excess cash. Africa, Latin America, Middle East, and the form Soviet Union countries export net about 40 mn barrels/day. The average oil price in 2007 is likely to be four times that in the 1990s. These countries earn nearly ＄900 billion extra per year due to the price appreciation. We assume that private businesses want to earn more and more money regardless how rich they become. For governments, this may not be true. They cannot spend the money they have now and have low incentives to earn more. The higher the price rises, the less incentives they have to produce more.  This perverse relationship has supported financial speculators; they don’t have to fear supply increase.

The demand destruction is the only thing that speculators fear. It didn’t happen until now.  The IEA has cut its demand forecast for 2007 four times to 85.7 mb/day. Latest, it cut 4Q07 forecast by 0.5 mn bbl/day. It is still sticking with 2.3% growth forecast for 2008. I suspect that the demand may not grow at all in 2008. The US accounts for one fourth of global consumption. Its recession would bring down demand significantly. American households have not responded to high price in consumption pattern, because they could always borrow more to support their lifestyle. As money dries up, they have to adjust their lifestyle. For example, most American households have a SUV and a car. The easiest choice for saving money is to drive cars rather than SUVs. That will cut the US’s oil demand significantly.

The downward revisions in oil demand have not shaken the confidence of speculators because they must win money somewhere and they can count on optimistic forecast for future demand to prop up their psychology. Remember that lack of refining capacity supported the bull case for quite a while, which is like justifying rising steel price on less property developments. As I wrote then, it was laughable. Now everyone agrees. But, they have other excuses to prop up oil price.

The bulls have been arguing that the world is running out of oil, which would support higher prices regardless of current supply-demand balance. Indeed, between 2001-2006, the proven reserves rose by 5.6% vs. consumption by 9%.  The trends would support ‘running out of oil’ argument. But, the fast demand growth has been due to a very strong upturn in the global economy. As the US economy goes into a recession, the demand may even drop in 2008. Also, the proven reserves can still support consumption at the current level for 45 years. Why is the worry of ‘running out of oil’ quintupling the price now?

It doesn’t matter if ‘running out of oil’ is true or even relevant.  As long as enough speculators believe it, it pushes up oil price. When there is enough money, all sorts of predictions can be self-fulfilling.

The positive aspects of the current oil shock are technological and demand responses. Nuclear power, for example, is being revived. Nuclear power promises unlimited supply of power without causing global warming. The safety problems and the difficulties in storing waste made the technology unpopular. Nothing changes popular opinions like oil price quintupling. Unfortunately, nuclear power has a long gestation period. The response now will significantly affect supply in twenty years.

The change in driving behavior also promises to decrease oil consumption for years to come. In the past two decades, automobile engine has increased fuel efficiency by 30%. However, the average weight of automobiles, due to the rising popularity of SUV’s, has also increased by 30%. As 50% of oil demand is from automobile driving, just going back to the average weight two decades ago could decrease oil consumption by 15%. Consumer response to rising oil price was initially to wait it out. The response has become much stronger in the past year. Fuel efficient cars have been increasing sales, and the sales of SUV’s have declined.

The technological and demand responses are quite sticky, as they require fixed investments. Hence, even when oil price comes down, the oil demand may not rise. This would lay the foundation for a total collapse of oil price.  After the oil shock in 1970s, oil price collapsed in the 1980s mainly due to similar market responses. The recovery took twenty years. OPEC may be making the same mistake again, earning a lot today but very little in future.

The bubble bursts when it runs out of money or some factor blocks its circulation. In the case of subprime, mortgage borrowers refused to continue serving their debts and turned to bankruptcy to walk away from negative equity. The bubble couldn’t continue with bankruptcies flying all over the place. It is possible that the oil bubble bursts as some financial schemes are exposed. At ＄100/bbl and market turnover of twenty times real demand, ＄170 billion goes through oil market everyday. As futures market requires a small fraction of notional value as collateral, the real money is probably one fifth of the notional amount or less. It is still a small market compared to stock market (＄1 trillion turnover per day) and currency market (over ＄2 trillion turnover everyday).  We don’t know how much of the turnover is new money and how much churning. I suspect that most of the turnover comes from existing money rolling over positions. It is shocking to learn that maybe ＄50 bn speculative capital is determining the price of oil- a commodity that consumers pay over ＄2 trillion per year at current price. If western governments want low oil price, all they need to do is to throw their oil traders into jail.

One major energy hedge fund, Amaranth, went burst and its unwinding triggered significant market corrections. Its burst didn’t lead to unraveling of others. Next time may not be so lucky. The subprime crisis has impaired the capital base of most big financial institutions. They all have capital tied up in the oil market. If their capital base shrinks further, they may have to cut exposure in the oil market. You can bet that, if one does it, all the others will do the same. This is one scenario that would burst the bubble.

The oil bubble, like the subprime bubble, is a part of the global liquidity bubble. The later is due to the rise of financial capitalism. In a market economy as Adam Smith envisions, financial market follows the real economy and gives money to businesses that can make money and take money away from businesses that don’t make money. This dynamic leads to optimal allocation of capital, i.e., all investments, even though in different industries, earn about the same return. When there is too much liquidity or capital, the return drops like in a normal supply and demand situation. Financial capitalism refers to the scenario that excess capital supply doesn’t lead to declining return. Instead, those who control capital try to create monopolies or bubbles to rearrange income from consumers and workers to capital owners.

Excess capital is the anchor for financial capitalism. The rise of excess capital is due to rising productivity growth and rising income concentration. The former leads to an expanding cake. When technologies are progressing fast, fast economic growth rate follows. The later insures that the rising cake benefits a small minority. The rich can only spend so much. They save more than the poor. Hence, rising income concentration leads to rising savings, and rising savings lead rising capital supply. 

One century ago, the West entered financial capitalism. The emergence of several mutually reinforcing technologies (e.g., railroads, steamboats, electricity, and telegraph) increased growth potential. At the same time, the technologies cut the bargaining power for labor, as new technologies could substitute labor. That led to rising income concentration. The era of tycoons arrived with large-than-life personalities that controlled vast amounts of capital. The tycoons made big profits by creating monopolies, speculating in stock markets, or cornering commodities. Their successes led to even more capital for reinvestment. This dynamic caused the bubble to become bigger and bigger. It all burst in 1929.  Western governments introduced redistribution fiscal policy to narrow income gap and established anti-monopoly agencies, which laid the foundation for the middle class consumption-led growth in the west after the World War II.

Three factors led to financial capitalism today. First, the Reagan-Thatcher deregulation revolution twenty five years ago increased efficiency but also decreased the bargaining power for labor. Second, globalization decreased the bargaining power for labor further, especially in developed countries. Third, the IT revolution decreased the bargaining power of white-collar workers who live on processing information and are the majority of middle class in developed economies. Like one century ago, fast growth has coincided with rising income concentration. Governments around the world have failed to distribute the benefits from new technologies equitably. We are seeing financial capitalism again.

The twist in today’s financial capitalism is that the masters of the universe are fund managers and traders on Wall Street. The difference between them and the tycoons is that they speculate with other people’s money (‘OPM’). Hence, their risk appetite is much bigger. If the bet goes wrong, they at most lose their jobs. If the bet works, they may earn billions of dollars. This asymmetry between risk and reward is why financial markets have been so resilient.

The difference may imply very different ending to the current cycle.  One century ago, speculation was followed by deflation, as speculators fled markets out of fear and demand fell with declining asset markets. But, for speculators armed with OPM, fear doesn’t exist. When one bubble bursts, speculation shifts to another market and another bubble follows. In such a dynamic, asset prices keep rising until central banks take the money back.  That happens only when inflation gets out of hand, i.e., inflation will pop today’s bubble. Rising asset prices pump up demand one way or another, inflation eventually follows asset inflation.

The oil bubble may burst. But, it doesn’t necessarily mean the end of bubbles. When oil price comes down, it depresses inflation temporarily, which gives central banks another excuse to release more money. The rise in liquidity will lead to other bubbles and may even bring the oil bubble back.

We live under financial capitalism. Asset prices don’t have to make sense. It will all end when inflation spikes up everywhere.