Post Edited (Forum Admin) : 5/29/2008 12:32:14 AM GMT

Dear Friend,

Yes the world today is different and it isn’t. The Asian Tiger, The Chinese Dragon awakening all occurred in the years immediately following the collapse in oil demand, the whole region became a new entrant. Their GDP boom didn’t stop the OECD from severely curtailing demand for petroleum and go on a massive infrastructure investment in alternative energy. We are saying the same is very likely to happen today. After all the Asia Pacific region is more mature and itself could do with alternatives.

Dear Jan - Isn't adaptation what human beings are best at, for better or for worst? Like you I remain optimistic that satisfactory solutions will be found.

Today “commercials” hold 827 million barrels of length (for sure almost the same in short positions but that’s not the point). In the early part of this decade they held between 300 and 400 million barrels only. World consumption hasn’t grown by 100% and “true” commercials that are classified as natural hedgers by the CFTC only hedge part of their production, never 100%, unless they are very small marginal producers whose finances are tied to hedging 100% of production (even that must have change in today’s environment). In fact big oil never hedges production at all. They only lock-in physical commitments with spreads which is their bread and butter since the time optionality associated with delivery has never been priced-in and is theirs for the taking.

So where are all these new 400 million barrels of “commercial” activity coming from? Well when an Investment bank option trader takes an order from one of its client like a “hedge fund”: “Buy me 40 million barrels Dec-09 OTM calls, will pay no more than 5%” the bank’s trader will make him a market (over time etc.) but then the bank’s delta hedging is now classified as a natural hedger and the option’s delta goes into the “commercial” classification. Now how do you disentangle between a physical hedging and a speculative hedging? The fact is that the bank’s hedging activity from its customer flow is not purely related to physical hedging. If it was then the open interest for commercials wouldn’t have changed so much.

Does that affect the price?

That’s an even more contentious issue. I am of the opinion that we’ve recently witnessed three types of hoarding of commodities:

1. Price hoarding from commodity index speculation. (Type 1)
2. Physical hoarding from some ETF contractual obligations. (Type 2)
3. Commodity exposure hoarding for lowering a portfolio’s correlation. (Type 3)

The first point above, Type 1, constantly adds volume on the buy side which forces higher price level regardless of the fundamentals of the underlying market. Yes for every buyer there is a seller but then why does price change? It changes because of tiny liquidity gaps where no seller can be found or not much volume is to be found on the sell side, forcing buyers to chase volume at higher price. Speculation is a natural phenomenon associated with open markets and it serves a valuable purpose. Today, however, the decision to enter the long side is mainly based on price momentum which feeds upon itself. That can and will disappear, however.

The second point, Type 2 is worrying because if you hoard physical commodities purely to satisfy contractual demand based on price then that commodity will not reach the markets in times of penury. After all there’s nothing like penury to send price higher so hoarding becomes even more attractive.

I'll explain the third point, Type 3. In 2006 I attended several workshops on ETFs. It became clear that portfolio managers only interest was on diversification through low to negative correlation. Price had no meaning. If a manager bought oil at $200 and its price fell to $100 the manager would keep on buying as long as it served its beta purpose.

Now if enough players enter a market to hoard for any of the three reasons above then we reach a stage where price gains momentum and sustains it purely on that buying decision. If we look at the price of oil, historically a price trend never lasted for more than 3 months. Now we've been in an uptrend for over 18 months and that trend keeps on accelerating. So hoarding type 2 and 3 kill the purpose of price acting as a signal. The only signal we get today is that price is getting higher which in turns motivate price hoarding (type 1).

The purpose of government inventories is to store in years of plenty and release stocks in meager years. A practice that dates back since Joseph interpreted the dream of the seven fat cows followed by seven lean ones.

In my view none of the points above achieve a smoothing out of commodity supplies and certainly not type 2 or 3. In that case price signal has ceased to exist (we don't rely on dream signals anymore). It is just incidental that today's oil markets could do with a price spike to shake-out consumption behaviour (some readers will beg to differ, I know).

While I do not doubt that demand behaviour is changing we are in no ways assured that a serious slowing in demand will in any way affect the price uptrend. So far it hasn't for oil.

That's why I believe that Michael Masters' analysis and recommendations are extremely relevant. What I think is being missed in reading his analysis is precisely that current hoarding will never achieve a smoothing out of supply. That is the point that was very clearly understood in the early years of 20th century America by market regulators. And to ensure that price will keep on acting as a signal to stabilize supply/demand balances, regulators then had to seriously limit non-commercial position size. That has completely disappeared today.

I’m not too sure that qualifies for a 101 in oil futures and would be happy to clarify further.

Actually holders of futures contracts can always go for EFP (exchange for physical) which would move them onto the spot market. The rules are that 3 days prior to expiry you cannot hold any large quantity of futures contracts. This is to avoid having anyone cornering the market at expiry. So any player, whether long or short, will have to roll his position to the second nearby or exit some time before expiry.

Whatever they do will not involve anyone on the spot market which is a very different market, although it prices off as a differential to the prompt futures.

Dear Greg,

as a quick answer since we will publish soon about these questions.

1. I think Peak Demand has become mainstream now and that should accelerate as price subsidies keep on being removed or lowered. If energy prices keep on falling the incentive to remove them altogether will become greater. Then will see what is the true demand from EM. Afterall current demand keeps on getting weaker, future demand is seen even lower than at present and world growth is seen as slowing. Meanwhile imports are slowing, refinery runs are slowing, stocks are building and pure refining companies are seeing distrastrous falls in their YoY profits. Supply demand balances are improving as a result and should get much more comfortable next year.

2. I believe that oil prices have stayed high to very high long enough to radically change not just consumer behaviour (the prime example being the collapse of light trucks purchase in the US) but also at governmental level. Again the US is the most vociferous example or most visible one. Besides drilling for new oil there is ample talks and action taking place on the renewable space, especially for the production of electricity from wind and solar to displace natgas away into a transportation fuel.

The French President has even proposed that the North African desert should be used to build solar power plants and its output sent to Europe. Theoritically it is feasible.

Many proposals won't see the light of day but what matters is that they are openly aired at the highest level. So we are exactly where we were after the first oil shocks with a search for alternatives which means getting more power and less driving.

I believe the change will be permanent and also that countries like China have every incentive to move away from oil towards alternative solutions on a large scale and pull a similar type of policy (and growth) as Japan did in the 80s.

Dear Rob,

You are making quite a few hypotheses on agriculture.

In a recent paper: Comparative Advantages: Oil vs. Land (http://gavekal.com/redirectdoc.cfm?r=1&id=3933&rn={ts%20'2008-08-08%2019:18:31'}&CFID=368689&CFTOKEN=40290937) we talked about how Africa's farming is likely to become much more efficient thanks to large FDI from land poor but cash rich countries such as the UEA.

Will the same happen across Asia? We do not have any particular view that this will happen, although if it did then in theory this would increase efficiency.

so working with a theoritical yes we'd now have a new labour force entering cities. By and large cities are more energy efficient per capita than the country side so there is no clear evidence that that new labout force would add to energy demand. the net effect from more efficient farming methods and new city dwellers could be a net saving on energy.

on that note it is interesting to find that the latest "Energy Use Per Unit of GDP" figures out of China are showing a 2.88% fall year to date,  thus as very large numbers enter the cities.

But regardless i think hard to draw hard conclusion on the hypothetical questions you've raised other than China's precedent shows efficiencies.