–“So much depends upon a red wheel barrow, glazed with rain water, beside the white chickens,” wrote the American poet William Carlos Williams. That’s the way he wrote it. But this is how he meant it to appear:
So much depends
a red wheel
glazed with rain
beside the white
–How to explain the fall in oil prices? Yesterday we mentioned that corrections in bull markets are a normal fact of life. An oil price of around $45 indicates a 40% correction in the price of oil from its $78 high in 2006. Is that a reason to panic?
–Until you see oil trading at $30 again, and for more than a few hours, we aren’t convinced that this is anything more than a correction. But there is a little more to the story, and it has to do with the two types of demand currently driving world asset prices: real demand, and investment demand.
—Real demand is simple enough to understand. How much oil does the world actually need on any given day? Doing the maths here at the Old Hat Factory, we reckon the world sucks down about 82 million barrels of black gold per day.
–On the other hand, it produces about 84 million barrels per day. According to the math we learned in school, that leaves about 2 million barrels of production above daily demand. Where does that oil go?
–Not being an expert in global petroleum flows, we’ll speculate anyway: it gets stored in strategic reserves, or on ships, or in stock piles at refineries. It’s these growing stockpiles and the reduction in the claims on them, that have driven traders and investors away from oil, causing it to trade at 18-month lows.
–We pause to ask a simple question: Does the world need less oil today than it did yesterday? Not that we can see. Is the world producing more oil today than it did yesterday? Again, we don’t see it. So what’s changed?
–If real demand is about the same, and stockpiles are only slightly larger (stockpiles being highly volatile to begin with, while the source of demand is NOT volatile), we need another explanation. Seek, and ye shall find.
—The investment demand for oil is what has changed. There, that was simple.
–Hedge funds and traders who were long the commodity in the futures markets have decided its time to exit. In this respect, investment capital is a bully, pushing its away around asset markets with little regard to the feelings of the assets in abandons, or the ones it favours at the moment. Money is amoral. It wants yield, not love.
–The falling oil price, then, reflects falling investment demand. But we also learn that changes in the composition of key commodity indices have reduced investment demand for specific commodity contracts like natural gas and zinc. Funds that track the indices alter their buying accordingly. Real demand hasn’t shifted. But changes in asset allocation affect investment demand, which are passed through on the prices of the actual stuff.
–An asset manager can change his mind for any old reason. It doesn’t have to be a good one, rational, or ultimately, even right. In a market dominated by capital flows, the effect is immediate. The result of changes in the indices and the shifting preferences of money shufflers are wild swings in commodity prices that have little or nothing to do with the underlying demand of the resource in question.
–For example, we read in today’s Australian Financial Review that the zinc price is falling. “Selling was prompted by the rise of inventories on the London Metals Exchange, the most in four months, and gained momentum after the Dow Jones began adjusting the weightings of the 19 futures in the Dow Jones AIG Commodities Index this week. The weighting of zinc will be reduced to 2.8 from 4.9 per cent.”
–It’s all very well for Dow Jones to change the weighting of zinc in its index for some particular reason. But why would it do so? Is zinc forty-two percent less important to the commodity market today than it was yesterday? Is it forty-two percent less effective in galvanizing steel? If so, someone had better tell the steel makers!
–We queried the Dow Jones website for an answer and found this quotation, “A commodity index should fairly represent the importance of a diversified group of commodities to the world economy.” Fair enough. But why the change in zinc?
–We learn that the decision to rebalance the AIG Index weightings was made in July of last year by an oversight committee. Without much more to go on that than, we can only conclude that zinc has been treated ‘unfairly’ by the committee and deserves, at the least, an apology, and ideally, a 40% restoration in importance and respect.
–We jest. But it’s a serious point, so we’ll belabour it: commodity price volatility is driven more by changes in investment demand than it is in real demand. This says more about the bizarre state of the world’s financial economy than it does about underlying trends in the world’s real economy. But what, exactly, does it say? Find out here.