I am taking a few days off. Rachel Ziemba and Christian Menegatti — my former colleagues at RGE — will be guest blogging here. I should be back on Labor Day.

Dubai is rather frothy. Landon Thomas of the New York Times reports that rents are up 40%. New supply has to be coming onto the market, but I guess it has yet to catch up with demand. And it isn’t hard to see why. Oil is — thankfully — off its recent highs. But at close to $130 a barrel, it is still well above its average 2007 price of around $70 a barrel.

The rise in prices between 2008 and 2007 has, obviously, come a lot faster than the rise in prices from say 2003 to 2007. The following chart* shows the estimated export revenue of the world’s major oil exporting economies as a share of world GDP if oil averages $120 a barrel this year. An average price of $120 a barrel requires $130 oil for the remainder of the year.

I also plotted the y/y increase in oil export revenues — both in billions of dollars and as a percent of world GDP. If oil averages $120, the 08 rise in oil export revenues would be comparable in size — relative to world GDP — to the rise in 74 and 79. An average oil price of $120 a barrel would increase the export revenue of the oil exporters by about $900 billion.

This calculation assumes that the oil exporters will export about 45 million barrels a day of oil.
Each $5 increase in the average price of oil increases the oil exporters’ revenues by about $80 billion, so if oil ends up averaging $125 a barrel this year rather than $120 a barrel, the increase in the oil exporters revenues would be close to a trillion dollars.

I consequently was a bit slow putting this post up. If I had put it up a few days ago, I could have talked about the “Trillion dollar oil shock.” I learned the value of a catchy headline last week.

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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.

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This post is by Rachel Ziemba of RGE Monitor, filling in for Brad Setser.

Norges Bank Investment Management, which manages Norway’s $380 billion Government Pension Fund-Global announced Q1 returns last Friday (A more detailed profile from which this piece draws heavily is available at RGE Monitor). Norway’s results tend to be watched quite closely as it is the most transparent sovereign fund, it thus provides a benchmark for measuring other funds. Furthermore, it gives some indication of how funds might have fared in the tumultuous last few quarters – allowing us to start testing how far these funds are stabilizing investors. Stabilizing they might be, but the evidence suggests that many of these funds have sustained significant losses in recent months, highlighting the importance of selecting managers.

In Q1, the GPF-G reported its worst ever quarter, with the fund posting a negative return of 5.6% on its portfolio as calculated in a basket of currencies in which the fund holds assets. Its equity portfolio reported a -12% return (again in international currency). More interestingly and concerningly perhaps, the results show that Norway’s internal managers performed even worse than its benchmark portfolio. As in Q4, excess return from the portfolio managed in house underperformed the benchmark portfolio – this time by about 1%.

Similarly, the investment portfolio of Norwegian reserves reported negative returns in Q1 and underperformed the benchmark portfolio. Despite transfers of almost $18 billion (88b NOK) from oil revenues, the fund was worth less (in a basket of currencies and in Norwegian Krone) in March 2008 than in December 2007. Dollar weakness boosted the value of its large euro and pound holdings (about 60% of the portfolio) meaning that the fund did gain somewhat in dollar terms (though not if one strips out transfers)

Now, given some of the losses sustained in Q1 by a broad range of investors, such results are perhaps not surprising. In fact, any fund that held the equity index would have reported losses. A good thing they have long investment horizons.

Should funds like ADIA and KIA have primarily tracked the index, they too would have reported losses. We imagine that they didn’t though. The results do highlight the importance of picking managers well. Something to think about now that many commentators are suggesting that sovereign funds pick professional managers. But one or two quarters does not a track record make or break (given the long-term nature).

There are a few reasons not to extrapolate too far from Norway’s results. 1) Norway’s asset allocation is different from an ‘average’ sovereign wealth fund portfolio, being more exposed to fixed income than most funds and with no exposure to alternative assets. It also has less exposure to emerging markets and invests only in a narrower group of EMs. 2) Norway tends to take small stakes, with the average stake size less than 1% of the equity in question. Its different management style means it might be less exposed to individual stocks. 3) Finally, Norway has an official policy of rebalancing its portfolio, that is new inflows will be targeted towards the weakest sectors and regions. This policy had the net result of directing most of Norway’s inflows to fixed income during the equity boom and likely means most of the $18 billion in Q1 transfers accrued to the equity allocation. It also means that transfers from oil revenues not capital gains accounted for much of the Norwegian funds growth in 2005-7.

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This post is by Rachel Ziemba, filling in for Brad Setser. I want to thank Brad for giving me the chance to guest blog again.

With oil futures staying above $130 a barrel – the links between dollar and oil are under the microscope. Overall, some recent evidence seems to indicate that despite protests to the contrary, oil exporters are still buying dollar assets and that dollar weakness may have delayed ongoing diversification away from the dollar. But a number of oil exporters including QIA and ADIA might have a dollar share of less than 40%. All of which makes some speculation about Libya’s dollar assets rather interesting. Libya alone is a relatively small oil producer – it is among a group of countries producing between 1.5-2 million barrels of oil a day but its investment decisions are indicative of broader trends.

Note: The latter part of this post was truncated – it has now been replaced.

Collectively four African countries (Algeria, Libya, Nigeria and Angola) produce under 8 million barrels a day of oil – somewhat less than Russia or a bit more than that produced by GCC countries aside from Saudi Arabia.

So far African oil exporters have had amongst the most conservative asset allocations. For the most part this was of necessity, Nigeria and Algeria had a lot of debt to pay off. And sanctioned Libya kept most of its wealth in very short-term bank deposits though it had some equity stakes, mostly in Europe. So far only Libya has made the move to higher yielding assets, creating the Libya’s Investment Authority (profile here), grouping together six pre-existing funds. The legacy funds had assets totaling around $16 billion including the Libyan Africa fund, Although its asset allocation was never disclosed, it likely takes equity stakes and otherwise invests in higher yielding assets than the deposits that dominate the holdings of the Central Bank.

About a week ago, an article by Jay Solomon in the Wall Street Journal suggested that Libya was cutting trade in US dollars, preferring the Euro or yen. If that’s the case, this would make it the second country after Iran to ask its trading partners to reduce dollar use in oil transactions (for now at least Libya’s non-hydrocarbon exports are pretty minimal). But its the currency where oil wealth is saved that is more significant that what currency is used for invoicing. Solomon also suggested that Libya’s investment fund (AUM ~ $50 billion) was halting investments in the U.S.

But its not clear that Libya ever really started investing in the U.S. (it did have some indirect stakes even in 2000/01 and a lot of its bank deposits may be in dollars). Like many sovereign funds, Libya’s investment plans have been relatively opaque. While initial statements suggested Libya might choose its foreign investments with an eye to Libyan economic development – that is, investing in companies (especially U.S. ones) that might invest in Libya, there haven’t been any noticeable stakes – to my knowledge.

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Rachel Ziemba

Note: This post is by Rachel Ziemba, filling in for Brad Setser

Despite the fact that the price of oil and in fact almost all commodities has slid in recent days, they are up substantially in recent months. This year so far the price of oil has averaged over $95 a barrel and over $93 in the last six months – a tremendous jump up from the 2007 average of $71.5 (all figures a simple average of WTI, Brent and Dubai Fateh, as used by the IMF).

Source: EIA, federal reserve, my calculations.

Such levels may not continue, particularly in light of US economic weakness. Oil demand is falling in the OECD. Much depends on the value of the US dollar and how long financial investors are long commodities.  But some factors do point to sustained high oil prices, despite a US economic slowdown. After all much of the demand growth for energy comes not from the US but from emerging markets, and they may find it more difficult to lower demand. Furthermore as I discus below, oil exporters have become more accustomed to higher oil prices and might find it harder to rein in their spending should oil prices drop. 

So where has the oil windfall gone? Oil exporters have been spending a significant share of new oil revenues – as much as 2/3 of incremental revenues, meaning that they are starting to erode the imbalances – despite their large headline current account surpluses.  How might those patterns change over the next five years. How oil exporters, especially in the emerging world spend the windfall at home and abroad has major implications for global and local economies and the cost of assets. And also on the price of oil,  because most are choosing not to invest much in an energy sector with rising costs – Saudi Arabia is reportedlly spending more to achieve the same output as some of its fields are depleted. This post draws upon an updates a few previous  works,

The central banks of emerging economy oil exporters added over $400 billion in foreign exchange reserves last year. Their oil funds likely added at least another $100 billion. This is of course about what China added in reserves over the course of the year.

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Rachel Ziemba

This post is by Rachel Ziemba filling in for Brad Setser.

The move towards a voluntary code of conduct for sovereign wealth funds took on new momentum today (see the previous developments). The Treasury Department just released policy principles for sovereign wealth funds agreed to in a meeting with representatives of the governments of Abu Dhabi and Singapore and the leaders of their sovereign wealth funds.

On all sides this seems like an attempt to show that they are serious about what is at stake. The treasury likely wants to avoid protectionist responses from Congress but still attract investment when it is needed. For Abu Dhabi and Singapore, they want to show themselves as responsible actors and play some role in setting those rules. It may a fire under the IMF discussions about good practices for sovereign investment. Recent discussions in the US and EU were clearly intended to make sure that some usable outcome came out of the IMF discussions.

There’s not much too contentious in here – funds should make explicit their non-political motivations, more disclosure is good and can reduce uncertainty as is risk management. and funds should abide by the regulations where they invest.

But even these funds have made no promises about disclosure. They only agree that disclosure may build trust and aid in assessment of systemic risks. This won’t go far enough for some. 

In return, recipient countries should avoid protectionism, have proportionate responses to any national security concerns and strive to build as predictable an investment regime as possible. Furthermore, similar institutions should be treated similarly.

But it may not really change much. yet. The bigger issue is in whether sovereign funds will continue to (return to) investing or whether they might sit on the sidelines with cash for the duration.

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Rachel Ziemba

Note: This post is from Rachel Ziemba, not Brad Setser.

“Like private firms, pension funds, and other institutional investors, Abu Dhabi’s investment organizations have always sought solely to maximize risk-adjusted returns. …The Abu Dhabi Government has never and will never use its investments as a foreign policy tool.”

So writes Yousef Al Otaiba, the Director of International Affairs of the Abu Dhabi Government in a letter to Treasury Secretary Paulson, other G7 finance ministries and international institutions. The letter which expresses Abu Dhabi’s investment guidelines is unprecedented as a public response from sovereign funds, the government investment funds of many countries that have been under the spotlight. These funds are large – Brad Setser and I have estimated they manage $2 trillion – and growing – they could add $500 billion this year. In 2000, they managed around $500 billion. The availability of funds (including leverage) has helped them make higher profile purchases in search of higher returns. After all, sovereign funds respond to a desire to diversify assets and make higher returns than those possible with holdings of US and other government bonds. They are increasingly a go-to capital source. Just today, Dealogic suggested that they accounted for $48.5 billion in cross border M&A in 2007 and about $24 billion so far this year. In 2006, it was $19 billion. Their investments in fixed income, smaller equity stakes and alternatives are even larger.

The following graph – which adds the Russian oil stabilization fund and Saudi Arabia’s non-reserve foreign assets to that of dedicated investment funds of Asia, the Gulf and Norway- gives a sense of how quickly these funds have grown. Oil’s surge has fed the growth of sovereign funds 3/4 of the assets managed by sovereign funds are oil funds. About half of the almost 20 funds that we routinely track were created after the year 2000. Sovereign wealth really is a new superpower.

As estimates of SWF assets proliferated, so have concerns from policymakers (summary here) questioning how the prominence of state-directed investors will affect the financial system. Sovereign wealth funds now seem to be responding to concerns. The head of Singapore’s GIC suggested in December that it might increase disclosure. Other funds already disclose more about their holdings, management and investment decisions – Norway, Temasek, the funds of Alberta and Alaska. Even China has been a little more publicly conciliatory to the process. But most are likely wary of having the rules dictated to them. This is the time to play a part in fashioning the rules both at the IMF and in the public domain. Sovereign wealth funds will likely be a big topic at the IMF/WB spring meetings – though systemic risk and a deteriorating global outlook will loom large.

Abu Dhabi’s investment strategies.

- To operate for the public good, generating long-term, attractive returns for the prosperity of the people of Abu Dhabi.

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Jeffrey Frankel

Note: this post is from Jeffrey Frankel filling in for Brad Setser

If strong economic growth is not the explanation for the large increases since 2001 in prices of virtually all mineral and agricultural commodities, then what is? One wouldn’t want to try to reduce commodity markets to a single factor, nor to claim proof of any theory by a single data point. Nevertheless, the developments of the last six months provided added support for a theory I have long favored: real interest rates are an important determinant of real commodity prices.

High interest rates reduce the demand for storable commodities, or increase the supply, through a variety of channels:
- by increasing the incentive for extraction today rather than tomorrow (think of the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled)
- by decreasing firms’ desire to carry inventories (think of oil inventories held in tanks)
- by encouraging speculators to shift out of spot commodity contracts, and into treasury bills.

All three mechanisms work to reduce the market price of commodities, as happened when real interest rates where high in the early 1980s. A decrease in real interest rates has the opposite effect, lowering the cost of carrying inventories, and raising commodity prices, as happened in the 1970s, and again during 2001-2004. It’s the original “carry trade.”

The theoretical model can be summarized as follows. A monetary expansion temporarily lowers the real interest rate (whether via a fall in the nominal interest rate, a rise in expected inflation, or both – as now). Real commodity prices rise. How far? Until commodities are widely considered “overvalued” — so overvalued that there is an expectation of future depreciation (together with the other costs of carrying inventories: storage costs plus any risk premium) that is sufficient to offset the lower interest rate (and other advantages of holding inventories, namely the “convenience yield”). Only then do firms feel they have high enough inventories despite the low carrying cost. In the long run, the general price level adjusts to the change in the money supply. As a result, the real money supply, real interest rate, and real commodity price eventually return to where they were. The theory is the same as Rudiger Dornbusch‘s famous theory of exchange rate overshooting, with the price of commodities substituted for the price of foreign exchange.

There was already some empirical evidence to support the theory: Monetary policy news and real interest rates, along with other factors, do appear to be significant determinants of real commodity prices historically (see graph below).

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Jeffrey Frankel

Note: This post is from Jeffrey Frankel not Brad Setser.

It is hard to remember now, but mineral and agricultural commodities were considered passé less than ten years ago. Anyone who talked about sectors where the product was as clunky and mundane as copper, corn, and crude petroleum, was considered behind the times.In Alan Greenspan’s phrase, GDP had gotten “lighter.”Agriculture and mining no longer constituted a large share of the New Economy, and did not matter much in an age dominated by ethereal digital communication, evanescent dotcoms, and externally outsourced services.The Economist magazine in a 1999 cover story forecast that oil might be headed for $5-a-barrel oil.

Since then, of course, we have seen tremendous increases in the prices of most mineral and agricultural commodities, many of them hitting records in nominal and even real terms. Oil is now well above $100 a barrel, and gold has just crossed the $1000 an ounce line.

The question is why.

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