Another Reason Oil Prices Are Falling?

Last August, economist Robert McCullough examined the volatility in the crude oil market surrounding the price spike on July 3, 2008 and the subsequent fall in energy prices.  In his final report McCullough examined the many events and announcements that had the potential to impact oil prices over this period.  He found that fundamental factors of supply and demand were not statistically significant, but found (on page 13 of the pdf):

The proxy for the short-lived Commodity Markets Transparency and Accountability Act of 2008 was highly significant. Interestingly, this was the only variable that would have affected excess speculation as opposed to supply and demand fundamentals…. One conclusion to be drawn from these statistics is that the news stories cited by pundits to explain the dramatic spike in oil prices have little or no explanatory power.

In other words, the prospect of regulation of the futures markets had a statistically significant impact on prices.   Let’s fast forward to the steep drop in crude this month.  While there’s certainly been negative news on the economy, we had some negative news at various points while oil doubled from February.  It is at least worth noting that the recent drop in oil coincided with a period in which Washington is seriously considering constraints on excess speculation in the energy markets. 

To the degree that excess speculation is a factor in artificially inflating oil prices, it needs a constant inflow of new money to sustain those prices, just like a Ponzi scheme needs new funds to keep the game going.  It’s hard to imagine money managers continuing to commit capital to commodities at the risk that they might be forced to liquidate if position limits are imposed.

Wal-Mart, Healthcare and Large Cap Outperformance

Wal-Mart made headlines last week by endorsing proposals in Washington that mandate employer-provided health insurance.  Fox New’s Elizabeth MacDonald does a good job analyzing the retail giant’s motives in her blog post and identifies competitive advantages that Wal-Mart would enjoy if this coverage were legally required.  In essence, because Wal-Mart already covers many employees and has the pricing power of an enormous company, new universal mandates are more crippling to its competitors.  MacDonald also argues that, by stepping forward now, Wal-Mart ensures a seat at the political table in shaping the legislation, ensuring that the law will be relatively beneficial to the company.

Wal-Mart’s action are a good example of the way that large companies, with their deep pockets and legions of lobbyists, can influence new regulations and legislation to their advantage at the expense of smaller competitors.  The more regulation created, the more the potential for this type of mischief.  This is not to pass judgment on the merits of the issue, but only to observe how large corporations can influence legislation in their favor better than smaller companies, and the more regulation, the greater the potential advantage.

It follows that a period of rising regulation can also be a period of relative advantage for large companies.  I’ve written before that investors should expect large cap outperformanceover the next few years.  The regulatory advantage is no doubt only a secondary or tertiary factor; I’ve tried to test relative large cap performance versus rising regulatory burdens (using proxies like the growth in pages of the Federal Register) and get inconclusive results as there are more important factors.  Nonetheless, logic and anecdotal support this view, and the Wal-Mart/healthcare episode is but one more example.

Certainly, large caps are putting in an unusually strong relative performance for this point in the investment cycle.  Below is the chart, illustrating the long term trends — a rising line in the upper panel indicates large cap outperformance.  Clearly the pronounced trend of  small-cap outperformance since the end of the technology bubble broke in 2006.  Since that time, there has been no pronounced broad capitalization advantage. 

Large vs Small: August 87 through June 09

It is interesting to note that small caps typically have strong outperformance as cash is being put back into the market after a downturn.  Cash flooding the market simply moves the price of smaller, less liquid companies more than that of larger ones.  This year, the historical pattern has not held true.  Reuters reported recently that cash levels are back to levels not seen since 2007 , and yet small caps performed essentially in line with large caps.  This suggests that there is underlying relative weakness in the small cap segment.  Although low interest rates may continue to drive cash levels lower, investors seeking yield are going to be biased towards bonds anyway.  Clearly the good news for small cap in terms of investment cash flows into equities is now largely in the past.   Superior liquidity, lower perceived risk, higher dividend yields, better ability to exploit emerging market demand, more access to credit, and yes, greater influence in shaping regulation, all point to the possibility of a long-term trend favoring large-cap stocks.

Disclosure: neither the author nor his clients have direct ownership of Wal-Mart stock.  Clients of the author’s firm may own Wal-Mart through discretionary accounts managed by third-parties.

More on the Wheat/Crude Oil Connection

Apparently the Senate report of excessive speculation in the wheat market has moved (discussed in this post last week).   All 247 pages of it can now be found here.

Going through the report, one of the footnotes briefly references an op-ed of mine that appeared in the Boston Globe last August and can be found here.

It’s interesting to see the Senate report touch upon the crude oil/wheat connection — the authors are absolutely right to see linkage.  That connection is the fact that we are treating contract markets (whether exchange trades futures or OTC swaps) as if they were capital markets.  These markets were designed with different ends in mind (contract markets are designed for risk transference, while capital markets are designed for investment), and require different rules of governance.  

Whenever I write about the need for regulatory reform in these markets, I get some responses accusing me of everything from gross ignorance of the commodity markets to Marxism.  The need for reform is consistent with broad free-market beliefs, but recognizes that those markets need governance (not necessarily governmental) to protect their integrity.  In the capital markets, everyone accepts the need for prohibitions against front-running customer orders or trading on inside information.  Contract markets need rules, too, (e.g., speculative position limits) and while these rules differ from those that govern investment markets, we should accept that they are no less critical.

The Greening of Corporate America

We’ve all seen the new image ads of various corporations claiming to be leading the charge in making the world a better place.  We create better regulation and market governance if we remind ourselves that public corporations are inherently amoral (but not immoral) entities. Their mission is to make profits for their shareholders, not clean up the earth; any social or environmental benefits are either part of a profit-seeking strategy or ancillary benefits.  The folks at “The Onion” lampoon the many coporations that proclaim, “we’re all environmentalists now.”

Guest Post: Insight into the Baltic Dry Freight Index

I’ve written before about the Baltic Dry Freight Index as a leading indicator of commodity prices.  I’ve updated the chart of the BDI (dashed line) versus the CRB Commodity Index (solid bars) for the last six months:

Baltic Dry Freight Index (BDI) versus CRB Commodity Index

The BDI has become the “darling” of many market forecasters.  However, it is one thing to argue the narrow case of a  relationship between the index and commodity prices (which are increasingly determined by Chinese activity), and quite another to conclude, as many forecasters do, that the BDI is a good early indicator of broad economic acitivity. 

One of the problems with all that chatter about the BDI is that most of the commentators are financial markets professionals who can run a regression.  In other words, people like me.  That is, people who know very little about actual shipping.   Fortunately, I have a friend, Jim Grubbs, who knows a lot about shipping, and kindly agreed to let me share his thoughts as a guest post.  Jim Grubbs is President of JLG Associates, a firm providing strategic consulting services to shipowners and shipping financiers.  He was formerly a Managing Director and Head of Corporate Finance for Citigroup’s Global Shipping Division.  In total he has 35 years of experience in the shipping industry.  His comments and response to my questions:

 I know a fair amount about the supply side of the BDI – the fleet of dry bulk ships.  I know much less about the demand side.  My impression is that there probably is a fair case to be made for corrolation between global GDP and the BDI in the long run, but that market dislocations can screw up this relationship for discrete periods of time, and I believe we are in one of those periods now.  For instance, at present there is an over-supply of dry bulk ships brought about by the excesses of the past several years.  (Think floating real estate).  There is also a large orderbook, most of which will be delivered over the next two years.  Thus I think it is fair to say that the supply side sucks.

Notwithstanding, the BDI has more than doubled in the past few months from a very low level.  In my view, the three main reasons are China, China and China.  The Chinese are locked into a negotiating war on iron ore pricing from their two major suppliers – Brazil and Australia.  Because of this, they have been playing one off against the other and are also ordering from non-traditional suppliers, causing a shift in trading patterns that results in a temporarily greater tonne-mile demand for ships.  In addition, they appear to be buying physical commodities as a hedge against the dollar, again creating short term demand for ships.  The combination of these two factors has overtaxed China’s port capacity, resulting in long periods of demurrage with ships anchoring offshore for days or weeks until there is a berth where they can unload.

If you believe, as I do, that a) the Chinese will eventually hammer the Brazilians into a price they can live with and will resume their normal purchasing patterns; b) there is a finite amount of storage capacity in Chinese ports for iron ore and other commodities and, in any case, there are better ways to hedge against the dollar; and c) once these two things sort themselves out the port congestion will clear up, then you might expect the BDI to head south rather dramatically over the next 6 months or so.

I would like to think that the recent  rise in commodity prices concurrent with the rise in the BDI is a sign of green shoots in emerging nations that might lead to a global recovery, but I can’t wrap my mind around the developing world (with the exception of China) having enough domestic demand to make this happen.  If they can’t export their finished goods, I don’t know that they can sustain their demand for commodities and keep the prices up.  At this point, there are few signs that export recovery is underway – as evidenced by the fact that container shipments to the OECD continue to plummet.  Sorry to be gloomy, but I think we have still not turned the corner economically, although things seem to be getting worse at a slower pace. — Jim Grubbs

Many thanks to Jim for lending his expertise and experience to this blog! — Jeff K.

Why Crude Oil Traders Should Care About Wheat

Last week the Senate released a report that concluded that non-commercial participants, particularly index speculators have been disrupting the wheat futures market (for those not inclined to read the 247-page report, there’s a good summary in this BusinessWeek article).   The term, “index speculators,” refers to that new breed of market participant that treats commdodities as buy-and-hold investments rather than as short-term trading vehicles.   Index speculators are often people and institutions one would not associate with speculation — endowments and pensions, for example.  They generally have bought into the notion that a basket of commodities (or commodity futures) is a legitimate investment asset class; this is a view I dispute – I know of no other “investments” where the inherent value can only be realized in the consumption and destruction of the asset.

The wheat report highlights one of the dangers of “overspeculated” futures markets, a condition where non-commercial interests so outnumber commercial participants that the relationship between cash and futures prices (the “basis”) breaks down.  An erratic basis in a commodity futures contract is more than a mere curiosity: it can mean that the futures markets no longer offer reliable risk mangement tools for producers and users.  It’s worth remembering that these markets were never intended to serve investors, but were chartered from the begining to serve the commercial commodity industry.   Dramatic shifts in the basis can also cause severe financial problems for commercial hedgers who must meet margin calls. 

A spike in the cotton basis in March of last year was devastating for that industry.  I’ve often thought that the cotton problem was the “canary in the coal mine,” warning us of dangers ahead.  Wheat going down the same path is troubling indeed.  From the standpoint of greatest economic risk, one must wonder whether crude oil is also heading in this direction.  If crude oil is “overspeculated,” there’s a particular vulnerability given the geopolitical risks that can crop up with oil.  My sense is that much of the oil in storage is part of a cash/futures arbitrage play which means, as I believe happened with cotton, a sudden influx of futures buying would have no natural constraints, sending futures prices soaring.  With the central role energy prices play in the economy and the heavy participation in the crude oil markets by our wounded financial companies, a price disruption of this nature could have far reaching consequences.

Last year there was a great debate about the role of index and other speculators in disrupting commodity prices.  Unfortunately, too much of this debate centered on the oil industry, not only one of the deepest markets, but also one of the most opaque.   It’s simply hard to get the data needed to see the risks in crude.  Looking at smaller markets like cotton, it is easier to grasp that treating commodity futures as investment assets can cause grave problems.  Although the debate is still tainted by politics, it’s good to see that these dangers are getting the recognition they deserve.

Industrial Policy at Calpers?

The current edition of “Barrons” carried an interview with Joe Dear, the head of Calpers (California Public Employees’ Retirement System), the largest public pension in the United States.   Calpers behavior is often an important bellweather, as both the size and activist bent of the fund has made it an industry leader.   I may be making too much of this, but if I were a participant in the plan, I’d certainly want clarification of this comment from Dear:

Whether venture capital really helps in a portfolio of our size is an open question. The one mitigating factor is, because the California pension fund is in the home of the high-technology industry, you want to be making moves that, after we consider the investment return, also help the state with respect to the growth of the economy here.

Does Dear believe it is the pension fund’s responsibility to subsidize the venture capital industry even if not fully justified on the investment merits?  Does he believe that Calpers has a special responsibility to support California businesses?

 It’s a curious comment, and perhaps one made without much thought.  However, it makes one wonder whether an element of politics has entered the investment management of the fund.  Our financial crisis has taught us that the ethic of fiduciary responsibility has eroded in many areas — let’s hope not in the pension arena.

Zombie Nation

In a post a little over a month ago, “Watch the Zombie Bank Lifeline,” I suggested that market observers needed to keep an eye on the expiration date of the transaction account guarantee program within the FDIC’s Temporary Liquidity Guarantee Program.   The transaction account guarantee program offers unlimited protection to certain low interest bank accounts — this prevented a mass exodus of bank deposits during the height of the financial crisis.  But this guarantee also represents a crutch by which deposits remain in institutions which may be too financially compromised to grow their loan portfolios — in other words, deposits in these institutions have a velocity of zero.  The program is supposed to be temporary and is due to expire on December 31, 2009. 

Now comes word from Reuters that regulators are considering extending the program for another six months.   While a worthy temporary measure, such support of unworthy institutions could lead to the creation of Zombie Banks, the living dead of the financial world, competing on equal footing for deposits with healthy firms, but unable to lend the money back into the economy.   The decision on extension will be worth watching — the longer this program is extended, the greater the risk of this becoming the new status quo; the real dangers is that yesterday’s temporary program becomes today’s extended program becomes tomorrow’s permanent program.  A permanent guarantee program, while not on the table now, would almost certainly doom us to stunted economic growth as it sustains otherwise unsustainable banks.  Stay tuned…

 

A Terrible Idea Whose Time Has Come

If we’re going to trade crude oil like a currency, we should regulate it like a currency, too.

I hold an apparently quaint and obsolete belief: “Not everything that can be traded should be traded. ”  Specifically, there’s great danger in using long-term, long-only commodity futures positions as an investment asset class.  The same is true of the derivative baskets of commodities that replicate such futures position.  Please note that I’m not talking about futures funds (which trade both sides of the market and are generally in positions only for the short term), but rather the way that commodities are increasingly being used by pensions, endowments and hedge funds as investments rather than short term speculations; this has sometimes been called “index speculation,” to distinguish it from the traditional variety.

Investment flows into the futures market can distort the pricing that should instead be determined by producers and users of commodities.    Price distortions of this type cause enormous economic inefficiencies, are deeply injurious to the world’s poorest, and create significant structural risk in the markets.  The chart below is a good illustration of just how “financialized” energy prices have become, charting the trade-weight U.S. Dollar index (the dashed line) versus the DJ-UBSCI Energy Spot index (the solid line) since the beginning of the year:

Dollar vs Energy Prices

As emphasized by the arbitrarily drawn horizontal line, these plots are virtually mirror images of each other (running a regression results in a correlation of -0.88).   This corresponds to the type of linked price action we saw during the buildup to the commodity frenzy last year.  It’s interesting to note that commodities like gold show nowhere near the correlation (-0.177) with the dollar over this same period.  Clearly, the pricing of crude oil and energy products have become dominated by financial, not commercial interests.  Specifically, oil is being treated as a currency and not as a commodity.  This is a terrible idea, but apparently a terrible idea whose time has come.

While using crude oil as a currency/asset class is a bad idea, there are some good (or at least interesting) ideas on how to address the associated risks.  I have been a fan of applying speculative position limits to energy contracts, importantly including the OTC swaps market.  This approach has some downsides: a) it may be ineffective since the problem is really that all the positions in aggregate are dangerously large, but perhaps not on the individual basis constrained by position limits, and 2) it may simply migrate investment interest away from futures and into hoarding physical oil.  In some ways this has already happened, as the speculative interest in crude oil (”virtual hoarding”) has created a cotango market that has resulted in a massive, arbitrage-induced inventory buildup (physical hoarding). 

Last July as crude was peaking, my friend, Tom Rooke, submitted an alternative idea to the House Committee on Agriculture, the Congressional committee which oversees the Commodity Futures Trading Commission.  With the bust in crude prices in the latter half of 2008, this whole issue was put on the back-burner.  With energy prices once again being pushed up by speculative forces, it’s worth reexamining Tom’s idea.  By way of credentials, Rooke has extensive experience in the world of commodities, having served as the head of UBS PaineWebber’s futures division for many years.  He is an expert in the term structure of futures contracts and in cash/futures arbitrage. 

Rooke’s proposal, in essence, regulates crude oil much like some of the ways that money supply is regulated.  In his creative structure, the U.S. would require that holders of crude be required to maintain a reserve requirement which would be controlled by a central governmental authority, much like the Federal Reserve can change reserve requirements for banks.  This would raise the costs of hoarding crude (probably not a bad thing), represent a second, private strategic petroleum reserve in event of national emergency (definitely a good thing), and provide a stabilizing buffer in crude oil pricing (much like what OPEC used to do when it had more market power).  In the proposal, the initial transition period and reserve buildup would be eased through using depository receipts issued by the Strategic Petroleum Reserve.  Tom’s submission can be read here: TWR Letter.  The specific proposal starts on page 10, although the earlier pages include a discussion of index speculation and the evidence that it was impacting crude oil prices.  It’s worth noting, that at the time the crude oil futures were in clear backwardation and the impact of speculation was more muted (Tom estimated 10% of price increases, I guessed around 20%); with the cotango markets we’ve seen more recently, speculation plays a more direct and potentially greater role.

It is critical that this issue be addressed.   Rooke’s proposal may not be the right way to go, but it deserves serious consideration.  On the third page of his letter, Rooke outlines just one type of structural risks we could face.  We’re flirting unnecessarily with danger.  What’s truly amazing is that without greater regulation of the commodity swap market, we won’t even know how close to the precipice we are or how far the fall might be.

A New Productivity Revolution

One of the brighter but surprising elements of the current recession has been the resiliency of overall business productivity.  The chart below illustrates the year-over-year change in U.S. productivity (output per person) since the 50s:

source: Bureau of Labor Statistics

Note the downturns in productivity during recessions (complete list here): 1953/54, 1957/58, 1960/61,  1969/70, 1973/75, 1980, 1981/82, 1990/91, 2001.  A decline in productivity is logical and to be expected in recessions.  Against all odds, the current cycle has not seen a similar productivity drop.  To be sure, manufacturing productivity is now distinctly negative, but the overall economy continues to see productivity gains.

 

The productivity gains are more than a mere curiosity.  Productivity is one of the great drivers of economic growth.  If there are fundamental factors supporting these gains, one could argue the case for a much more vigorous economic rebound than most forecasters (including me) expect.   The steady gains from the 1990s have largely been attributed to new information technology and a managerial culture that supports and incentivizes  its adoption.  (see, for example, this thoughtful piece by Martin Feldstein).  One would think that productivity gains from the adoption of information technology and incentive systems would have diminishing returns without significant new technological breakthroughs.  Haven’t we all adopted the interenet?  Or could there be a whole new productivity revolution?

 

The productivity statistics suggest that something significant is happening.  I believe there is the potential for a whole new round of efficiency gains to be won from creative new applications of internet and other existing communication technology.   There’s a case to be made that the applications of this technology have only been enhancements of existing business models (e.g, electronic bill-pay is not so different from writing out checks, online retailers are not so different than catalog stores, etc.), and do not reflect the opportunities available in creating whole new ways of structuring businesses.

 

We will only know years hence whether such a technological revolution is in the works.  However, I think a concrete example can illustrate this point.  Consider the publishing/book-selling industry.  Amazon.com, a truly impressive pioneer, and others have clearly added efficiencies to this business.  However, at the end of the day, Amazon is just an online store structured much like any real world store — better prices and inventory perhaps, but similar nonetheless.  Even the book recommendations and purchaser feedback is not all that dissimilar from bestseller lists and “staff picks” available at my local bookseller.  But there are other ways, as yet unexplored, of restructuring this industry using technological advances.

I recently saw some press about a new publishing venture in New York, OR Books, founded by industry veterans John Oakes and Colin Robinson.  John Oakes is a serial entrepeneur in that field and a longtime friend (see disclosures below).  The two editors are seeking to completely remake the industry (video here).  The industry, as presently contstructed, is fraught with inefficiencies:

• The biggest costs of book publishing revolve around the fact that publishers initially have no idea which books will sell.
• Publishers must go to the enormous expense of printing and distributing books.  If they don’t sell, the publshing firms are then forced by the bookstores to accept the returns.
• This system produces uncertain financials for publishers, constrains marketing budgets, wastes bookstore shelf space with unwanted books, and results in long delays in royalties for even successful authors.

OR Books is seeking to build an alternative structure for the industry, first launching new books as “e-books,” to test demand.  At least part of the savings from the forgone initial printing will be used for marketing and promotion.  Once demand for the e-book version establishes interest in the text, then and only then will OR Books do a tradition print and distribution run.  Not only should this eliminate print and distribution costs for unsaleable books, this also give OR Books better leverage in distribution terms with bookstores.  Bookstores benefit by stocking books for which there’s known demand.  Authors benefit from having more promotional dollars available to (electronically) launch their books.  It seems probable that readers should benefit too from the opportunity to hear more about new authors.  If successful, this could be not only a different, but a better way of publishing.

Although I wish them every success, I have absolutely no idea whether OR Books will succeed.   This venture, however, forces us to consider that the productivity gains from telecommunication technology may have a long way to go.  Certainly our unsinkable productivity numbers suggest something significant is going on in the economy.  Capitalism has been famously described as “creative destruction.”   The past 18 months have been focused only on the destruction element.  Perhaps there’s hope to be found in capitalism’s essential creativity.

Disclosures: I have no investment opinion of OR Books, no personal or client direct interest in that or any other company in publishing/bookselling, and lest there be any confusion generated by John Oakes’ comments, I generally disagree with John’s politics as well!