In an interview with The Daily Telegraph , George Soros said that although a weak U.S. dollar, depleting supplies from aging oil fields, government fuel subsidies, and record Chinese and Indian demand could explain the parabolic surge in energy prices, the crude oil market is also significantly inflated by speculation. “Speculation is increasingly affecting the price, which has a parabolic shape, which is characteristic of bubbles,” he said.
However, Soros warned that the oil bubble wouldn’t burst until both the United States and British economies slipped into recession, after which, oil prices could fall dramatically. “You can also anticipate that the bubble will eventually correct, but that is unlikely to happen before the recession actually reduces the demand. The rise in the price of oil and food is going to weigh and aggravate the recession.”
It’s dangerous to pick a top in a raging bull market, since bubbles can inflate more than anybody could have imagined. On May 20th, T-Boone Pickens told CNBC he expected crude oil prices to keeping going up. “I think we’ll get to $150 this year,” he reckoned. The next day, soon to be deposed Israeli PM Ehud Olmert called for a U.S. naval blockade of Iran, and if that happens, crude oil could hit $200/barrel.
Who is inflating the bubble in the global oil market? The Federal Reserve is the chief culprit, by slashing the fed funds rate 325-basis points to a negative -2%, after adjusting for inflation, and expanding the US-M3 money supply by 16.5% from a year ago, in a desperate effort to stop the slide in the sinking US banking sector. By slashing interest rates deep into negative territory, the Fed encourages speculation in commodities by pushing down the dollar, which in turn, is pushing up the price of dollar-denominated commodities, such as crude oil and gold.
So far, the Fed’s aggressive rate cuts haven’t found any meaningful traction in the S&P Banking Index, which is still languishing at the March lows, and -40% lower from a year ago, with banks posting hundreds of billions in losses from toxic sub-prime mortgage debt. The Fed’s single focus on rescuing the banking sector, with no regard for the inflationary consequences of its actions, has led to the emergence of the “crude oil vigilantes” who punish central bankers with sharply higher oil prices, whenever they become too abusive with the money supply.
In the past, a sharp slowdown in the U.S. economy, the world’s biggest oil guzzler, usually pushed the price of crude oil and other commodities lower. But the Fed was caught by complete surprise, after crude oil prices doubled, even as America’s economy slipped into a recession in the first quarter. “The current oil price has no relation to market fundamentals,” explained Saudi oil chief Ali al-Naimi on March 5th. “It is linked to tremendous speculation in crude oil futures. There are even those who buy futures and speculate that oil prices will reach $200 in 2013,” he said.
On April 28th, OPEC chief Chakib Khelil observed that crude oil prices were climbing, “even though supply is adequate, because the market is driven by the dollar’s slide. Each time the dollar falls 1%, the price of the barrel rises by $4, and of course vice versa. If for instance, the US dollar would strengthen by 10%, it is probable that oil prices will fall by 40%,” he figured.
But such simple logic has its limitations. China, India, Russia and the Middle East combined, are now consuming more crude oil than the US, burning 20.7 million barrels a day, up 4% from a year ago, according to the IEA. The emerging economies are picking-up the slack in the oil market, more than offsetting a -1.3% contraction in U.S. oil demand to 20.3 million barrels this year. Thus, a mild recession in the Western economies and Japan might not weaken global demand for oil.
Economies of big oil-exporters in Russia, Mexico, and OPEC itself are growing so fast that their need for energy within their own borders will limit how much they can sell abroad. Internal oil demand in Saudi Arabia, Russia, Norway, Iran and the United Arab Emirates, grew 6% last year, and their exports declined 3 percent. Mexico’s oil output fell -9% in the first four months of 2008, from the same period a year earlier. If these trends continue, global crude exports could fall by 2.5 million barrels a day by the end of 2010, adding new strains to the global oil market.
If crude oil speculators on the Nymex were buying “black gold” as a hedge against the U.S. dollar’s slide against the euro, the #2 reserve currency, then perhaps, traders in London were buying North Sea Brent as a hedge against the British pound’s devaluation against the Euro. The Bank of England engineered the British pound’s sharp devaluation against the Euro, by joining the Fed’s rate cutting spree last November, with three quarter-point rate cuts to 5 percent.
The euro soared 17% to 80-pence, while at the same time, North Sea Brent crude oil prices doubled to $130 /barrel. Flipped the other way round, the British pound buys around €1.25, down from €1.50 last summer, making European imports considerably more expensive. For Ivory-Tower economists, the euro’s ascent against the British pound and U.S. dollar, which closely tracked North Sea Brent was just a statistical coincidence. But for crude oil speculators, the sharp devaluations of the pound and U.S. dollar translated into enormous windfall profits in their brokerage accounts.
When riding the waves of a bubble, it’s always good to have the basic fundamentals are your side. Oil production is shrinking in 54 of the world’s top-60 oil producing nations, including Britain’s North Sea, where output peaked in 1999, and has already plunged by half. The United Kingdom began importing liquid gas, for the first time in history in July 2005, and its North Sea oil reserve is dwindling at an -8.5% annual rate. The curtain might fall on North Sea Brent by 2012, if enough isn’t done to maintain development and exploration, according to the U.K. Offshore Oil Industry.
But political pressure on the BoE for more rate cuts could intensify, after British home prices dropped for the eighth straight month in May, down -2% from a year ago. The average selling time for U.K. homes has climbed to 9.8-weeks, compared to 5.8-weeks in May 2007. A further slide in home prices could topple the U.K.’s asset based economy into recession, and deepen losses for British banks. Another round of BoE rate cuts could renew selling pressure on sterling and buoy oil prices.
Currency devaluations do not fully account for crude oil’s dramatic rise to as $135 /barrel last week. “Peak Oil” theorists have a better explanation, and Saudi Arabia’s threat to ramp-up oil production by 2012 is sounding hollow. However, currency swings do magnify the volatility and price trends in the crude oil market, the same way the “yen carry” trade magnifies swings in the global stock markets.
No market travels in a straight line forever, and shakeouts in the crude oil market are designed to wipe-off the speculative froth. However, a British and U.S. economic recession would not necessarily burst the oil bubble, if the net result is another sharp devaluation of the British pound and U.S. dollar in the foreign exchange market, which would support high oil prices.
for Markets and Money