The American peso
The American peso. Since oil prices are up 66% this year (as of Nov. 20th), it’s fitting that I should begin and end the year discussing them. Things haven’t changed much fundamentally: supply is still more than adequate and demand is crummy. So, it’s definitely not fundamentals. There are five reasons for high prices, in no particular order:
1. Changes in US law. The Commodities Futures Modernization Act of 2000 enabled large oil and gas traders to trade US energy commodities on unregulated, Over-The-Counter (OTC) electronic markets without any record or oversight, as was previously the case. NYMEX has complained that “instant” arbitrage across these markets is morphing in unpredictable ways, especially, between NYMEX and the Intercontinental Exchange (ICE), the latter of which is neither self-regulating nor externally overseen. This creates opportunities for manipulation. A market that exists purely to set prices for paper barrels, and does so in the dark, is nothing more than gambling. Traders in the new “black hole” created by the OTC-ICE should go to Las Vegas. But they won’t-because Las Vegas is regulated!
2. Increased volume. The oil-trading volume is up at least 300% over the last five years. It is increasing because of changes in US law, and the way banks and brokers have become one, and because of new products and derivatives making it easier for more people to “play” the futures markets.
3.Media hype and The Matt-T. Boone Pickens factor. This one really irks me, not so much the part about peaking world production-that’s been a perennial prediction for decades-but rather, the way the media helps it become a self-fulfilling prophecy. We all know how writers often come up with lame excuses as to why the stock market moved up or down. But with oil, they are being more creative, and are either distorting the facts or failing to check out facts that someone else was quoting. For example:
“Oil prices went up today because inventory levels fell.” While this was true, what they failed to mention is that they fell from above five-year norms, all the way down to the top of the five-year norms. In other words, they fell from very high inventory levels to high inventory levels-hardly a reason for already high prices to go even higher.
Context matters, but is rarely given accurately. For example, “Oil consumption shot up the third month of this quarter-the steepest increase in 20 years. If it continues at this pace, it will end the year with a 1.4% annual increase!”
What they should have said was, “Oil consumption improved over last year, but was still below average. If this pace continues, it will finish the year with a 1.4% annual increase-12% below its 20-year average of 1.6% per year growth.” One good thing: The media is finally starting to consistently (and correctly) blame...
4. The weak dollar. Some folks want to say that the connection between the fall of the dollar and high oil prices is weak or that it’s complicated. I think that the connection is strong, but it is indeed complicated, except for the simple part.
Oil and other commodity prices took off at the same time that the dollar began to fall against most other currencies. Coincidence? And now, even the media is noticing that as the dollar falls, oil rises, something that was previously only rarely mentioned in mainstream media. Let’s look at the simple case.
The US is the world’s largest consumer and importer of oil, with Canada its largest supplier. The Canadian dollar, the “loonie,” had been trading at US$0.60-0.70 for several years prior to 2003. Now, it costs more than $1 to buy a loonie. The 57% increase in the loonie’s value implies that $30 oil (2003) must sell for $51. The correlation with oil prices is obvious. Interestingly, since natural gas prices are not internationally set, it also helps explain why Canadian gas drilling is falling off: After currency conversion, Canada gets increasingly less for the gas it sells to the US.
Now for the complicated part. The value of the dollar is not based on precious metals or other real goods. To a large extent, it is based on faith. Perception matters. The nuts-and-bolts part of it is simply US fiscal policy. Too many dollars are being exported. Trade imbalances with oil exporting countries, massive foreign borrowing and the exporting of dollars by US citizens and corporations investing in a global economy, all add up to far too many dollars overseas. After 9/11, the US had the goodwill of virtually every nation on earth. That has been squandered, even reversed. With no end in sight to the massive borrowing and trade imbalances, governments and individuals are shedding dollars. Again, perception matters.
Foolishly, China (with $1.4 trillion), Iran, Venezuela, and others have publicly stated that they want to divest away from the dollar. Hugo Chavez, even more stupidly, called the dollar “worthless paper” at the recent OPEC Summit, thereby costing his country millions. A smarter man would have kept secret the fact that he wanted to dump dollars on an open market, so as not to drive down its value even more than selling would.
But not all currencies have lost the same value relative to the dollar. For instance, the Persian Gulf (GCC) countries, have all pegged their currencies to the dollar. So, when the dollar falls, their currencies are unaffected…sort of. As in the US, a weak dollar makes dollar-dominated exports cheaper. So, the GCC find that Europeans have not had nearly the same oil price shock as Americans. Even more complicated is the fact that the GCC countries import more from Europe than from the US, which makes things more expensive when the dollar falls. Last May, Kuwait surprised the GCC, when it dropped its peg to the dollar. The Nov. 20th Dubai Ports’ IPO raised $5 billion-nearly 20X oversubscribed, and is a harbinger of Dubai’s ambition to become a world-class financial trading center. Both of these actions threaten the hegemony of dollar-dominated oil trading. The euro is looking very good. I’ll make the unheard of prediction that the dollar will reach 2-to-1 parity with the euro.
5. Fear has always been an integral part of commodities markets. Since the Iraq war, geopolitical fear has been exaggerated, certainly in the press. But, I think a new kind of fear is now operating: fear of capitulation of the dollar in currency markets. With so much flight from the dollar, and so little confidence in our world leaders, the dollar could become the Mexican peso of the 1970s and ’80s; will we call it the American peso?
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