Brad Setser

Brad Setser: Follow the Money

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$140 oil

by Brad Setser
June 6, 2008

Call me surprised.

If you had asked me two years ago if oil could come close to $140 amid a US slowdown in the absence of a major interruption in supply, I would have hedged a bit, but ultimately said no.

I understand the logic that argues that weak US data implies low US interest rates — and low US interest rates, in various ways, push up the price of oil.

But weak US data also implies a weak US economy, and the US remains the world’s largest consumer of oil.

Some players in the market also seem to have been caught by surprise. Short-covering seems to have contributed to today’s large move. The FT’s Michael Mackenzie, James Politi and Chris Flood report:

Traders who had bet on falling oil prices through short sales – in which they selll the commodity in hopes of buying it back later at a lower level – were forced to cover their positions, sending oil prices skyrocketing.

Wall Street banks contributed to the rally as they bought crude oil futures to cover their obligations under agreements that compensate investors and companies such as airlines if crude rises above $140 a barrel.

Jim Hamilton is right: this looks like a major oil shock. At $140, oil would be twice its average level in 2006.

$140 oil for the rest of the year implies an average oil price for 2008 of around $120 (maybe a bit higher)

Concretely, a rough calculation would suggest that this implies that the US will spend about $250 billion more on oil imports this year than last year. I don’t quite see how the US trade deficit can improve in the face of that kind of shock.

It implies a comparable increase in the oil import bills for Europe (which imports a bit less than the US) and the major oil importing economies of Asia (which together now import a bit more than the US) — and a roughly $750 billion increase in the revenues of the major oil exporting economies.

Some will be spent – or used to finance domestic investment. But a lot will be saved.

I had estimated that if oil averaged $115 for the year, the Gulf would add roughly $400 billion to the coffers of its sovereign funds and central banks. Just to be clear, this is money that is invested abroad; the various domestic investments of the big Gulf countries aren’t counted — even if they are done by a sovereign fund or a subsidiary of a sovereign fund. Overall official assets of the oil exporting economies might increase by something like $800 billion.

That would be roughly twice my estimate for the increase in their assets — excluding capital gains — in 2007. And $400 for the Gulf and $800 for all the oil exporters now looks like an underestimate. $450b and $900b look more likely now …

Don’t be fooled by the fall off in big, visible headline grabbing investments by sovereign funds. The oil exporters are sitting on a lot of cash. The amount of interest in how institutions like ADIA allocate their portfolios is only going to grow.

17 Comments

  • Posted by Howard Richman

    Brad,

    I’m enjoying how wrong the Wall Street Journal was just two days ago. On June 5, in their editorial that you discussed they heralded the Fed’s supposedly wise strong-dollar stance and claimed, “As the dollar has strengthened in welcome response, the price of gold and oil has fallen in each of the last two days.”

    Howard

  • Posted by Howard Richman

    It’s even better than I said! That editorial was yesterday!

  • Posted by FG

    Is China accumulating “oil reserves”, kind of like the US strategic reserves?

  • Posted by Peconomist

    Some reports have attributed the sharp rise today to ECB comments. . .I would tend to agree that this was the reason for the start of the rise. IF, ECB does raise interest rates, the spread between U.S. and Eurozone rates are going to start to put everyone in a difficult position. The U.S. would almost be obligated to raise rates regardless of domestic economic considerations to begin to preserve the integrity of the dollar. Traders seem to think Asia will keep demand high regardless of what happens to U.S. demand. However, this is short sighted, the U.S. remains, for now, the single largest market in the world, Asia is premised on high value added export led growth. To ask the rhetorical question: Can Africa buy enough Chinese/Korean made Dishwashers and Dryers?

  • Posted by Peconomist

    One other point, the whole LIBOR business now becomes even more important. Increased inflation will force increased interest rates, however, because the true cost of funds, as expressed by LIBOR, is in doubt, financial institutions are going to have a difficult time determining just what the impacts are going to be, making them even less inclined to lend money. Cost of borrowing will increase, as short term low interest debt must be swapped out for longer term MUCH higher interest debt.

  • Posted by Charles

    FG, China is accumulating prudent stocks, but is far short of what would be called a strategic reserve. Last I heard, they had ten day’s supply.

  • Posted by Richard Blair

    Does anyone find it remotely interesting that the big runup yesterday was due to a Morgan Stanley analyst’s prediction that oil would be $150 in a month? Can you say “market manipulation”? I knew you could.

    The other day, S&P downgraded Morgan Stanley because of their exposure in mortgage backed securities. From a market manipulation standpoint, could Morgan Stanley have issued their “prediction” in order to drive up the value of their holdings in the petroleum commodity market, as a way to offset the downgrade due to their exposure in mortgage backed securities? Hmm? Just askin’.

    This certainly smells like market manipulation to a novice such as myself, but then, I’m not a securities lawyer. However, it might be prudent for the SEC and Department of Justice to look into it.

  • Posted by Twofish

    Blair: From a market manipulation standpoint, could Morgan Stanley have issued their “prediction” in order to drive up the value of their holdings in the petroleum commodity market, as a way to offset the downgrade due to their exposure in mortgage backed securities?

    This may be hard for people not working in the industry to believe, but people on Wall Street take legal and compliance issues very seriously, and there are people that you are not allowed to talk to without having an lawyer present, and people take these rules very, very seriously. Analysts are not supposed to talk to traders, and e-mail is monitored for this sort of thing. Also there are also marked off restricted areas on the trading floor which certain people are not supposed to go.

    One reason why people take this seriously is that if you break the rules then the SEC will come and shut you down. The other problem is that if your competitors believe that you are trying to move the market, they won’t trade with you, and they’ll get on the phone with the SEC to try to sink you. One thing that keeps people very honest is the knowledge that if you do anything dishonest then you will become “expendable” and the company will get rid of you to save their own skins.

    Securities rules are rather interesting. For example, if you are a broker and you get inside information, then you violate inside information laws if you trade on that information. The interesting thing is that if you *don’t* trade on that information and your client loses money, then you are violating your fiduciary duty to your client and can be sued. So it is in said brokers interest not to know inside information since once you know something, you are damned whatever you do.

    Blair: I’m not a securities lawyer. However, it might be prudent for the SEC and Department of Justice to look into it.

    Don’t worry. They are. I doubt they’ll find anything, but I’m sure that they are looking into it.

  • Posted by Ralph

    FG,

    I suspect there is accumulation going on, but not necessarily in large quantities by any one or more major players.

    Rather I think invisible accumulation may be occurring as many entities, large and small, add to their inventories, or at least avoid allowing their inventories to fall. This would be something like “topping off” the gas tank because of nervousness about possible long lines or shortages at the pump.

    Widely distributed, such hoarding — even if taking place at relatively modest levels in many nations, municipalities, large companies — might have a huge impact on prices.

    Personally, if I were running a petroleum-dependent organization right now, I would definitely be trying to lay in some stocks, if only by keeping my existing storage facilities full. And I would be seriously considering building new storage.

    Wouldn’t you?

  • Posted by black swan

    It was interesting to see the way oil prices spiked following Congressman Bart Stupak’s conspiracy announcement.

  • Posted by Dave Chiang

    Does Federal Reserve Socialism for Wall Street bankers really help the American middle class? Should Americans trust unelected officials like Bernanke and Paulson that pander exclusively to the narrow economic interests of Wall Street investment banks for a “cheap money” monetary policy? Do Wall Street bankers deserve a federal taxpayer bailout for financial loss? The results of the misguided US monetary policy are in:

    Oil went from $30 to $140
    Gold went from $280 to $1000+
    The US Dollar Index fell from 110 to 73

    If this all seems counterproductive to you, it’s because it is.

  • Posted by aim

    Dave C,
    It seems to me that currency manipulation and price supports in Asia are the root cause for general inflation and the run up in oil. They have been causing the Fed’s easy money policies.

  • Posted by Twofish

    DC: Does Federal Reserve Socialism for Wall Street bankers really help the American middle class?

    Ummm…. Yes….

    DC: Should Americans trust unelected officials like Bernanke and Paulson that pander exclusively to the narrow economic interests of Wall Street investment banks for a “cheap money” monetary policy?

    Trust no one, including the people that tell you to trust no one. :-) :-) People have to look at all sides of an issue, and hear from multiple perspectives before making up their own minds. Part of the reason I blog as much as I do is that I’m the closest thing that most people are likely to get to hearing the point of view of someone associated with “Wall Street banking interests.”

    Expensive oil and inflation are a direct result of Bernanke’s decisions, but had Bernanke made different decisions, the results I think would be far worse. If you have tight money then you end up increasing unemployment and triggering a cascade of bank failures. Most people in the US have relatively few liquid assets outside their house, and depend on employment for economic survival. This biases things toward loose money.

    DC: Do Wall Street bankers deserve a federal taxpayer bailout for financial loss?

    Well they aren’t going to get one. During the events of mid-March, a lot of the discussion was on how best to punish Bear-Stearns, which is why the initial stock price got set at $2/share. Lots of people at Bear got their retirement savings wiped out and there are layoffs happening all over the place. So it’s not as if Wall Street bankers are all making money off of this. They aren’t.

  • Posted by gillies

    so.on.we.go

    sorry.my.space.bar.is.broken.

    north.korea.counterfeits.dollars.,

    they.say.,by.printing.

    but.bernanke.debases.the.dollar.by.fiat.,

    electronically.

    the.trouble.really.starts.when.the.dealers.value.the.korean.issue.more.highly.than.the.u.s.electronic.dollar.knowing.that.the.koreans.cannot.print.as.fast.as.bernanke.can.wave.his.wand.

    then.the.counterfeits.become.a.harder.currency.than.the.feds.own.electronic.entries.

    and.north.korean.greenbacks.become.a.sort.of.swiss.franc.of.the.far.east.

    if.this.sounds.like.madness.,madness.is.where.we.are.at.

    of.course.the.north.korean.policies.are.illegal..(for.more.of.this.see.recent.fed.policies.)
    .

  • Posted by Movie Guy

    Brad,

    One of the more important issues is how the governments of the world will deal with the speculation on crude oil futures.

    This matter deserves considerable attention. While few may support government intervention in principle, rest assured that collapsing economies or portions thereof will not be tolerated.

  • Posted by artichoke

    Twofish:

    Please describe how it helps the American middle class when they are forced to bail out creditors of Bear Stearns. Be specific, because I am quite sophisticated financially but it’s not clear to me.

    Those members of the middle class should have some say in the matter. Why not hold a referendum, rather than have the Fed decide what’s best for us? Presumptively, those creditors’ losses should be their losses not ours.

  • Posted by Pallj

    Predicting oil will hit 150 $/brl next month cannot be construed as sinister, or an attempt to manipulate the market. It is much too easy to logically conclude this will indeed be the price of oil in the near future. It looks too much like a certainty, for it to be called a prediction, even.

    The only assumption you need to make is that the ongoing trend will continue. How steep the curve is depends upon if you are looking at the 12 month trend or the 24 month trend. We’ll see 200 $/brl by Xmas on the 12 month average increase, and around the middle of next year at the 24 month speed.

    It requires a great deal more of insight to figure out what would be:
    • a significant enough decrease in demand for oil to halt the present trend, or
    • by how much production would need to be increased before a balance is reached, and price of oil would stop rising.

    Are there any good arguments out there that this balance has now been reached?

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