Monday, May 26, 2008

Oil Price "Head Fake"?

Late post today as I've just returned from vacation--I try to get new posts out early Monday mornings, but at least it's still Monday...

Oil prices have certainly been in the news lately, and I've written here and elsewhere that the concept of Peak Oil has "tipped" in the mainstream media and in the markets. Many people still think that oil prices are just a bubble. Others think that the recent run-up in oil prices are just due to the declining dollar (apparently they haven't viewed a chart of oil price superimposed over the Dollar:Euro price chart lately, as that clearly can't explain the last few weeks' dramatic run-up). Others think it's all evil speculators--I won't repeat what I've said before about why that opinion does little but demonstrate a fundamental misunderstanding of the oil markets. But increasingly people are waking up to the reality that this is simply an issue of geologically and geopolitically constrained supply and rising demand. Over the long-run, we'll either develop a new substitute for oil and/or we'll reduce our demand for oil. Unless some new miracle technology (or miracle cohesive political will) moves us consciously away from oil, or unless the global economy collapses for reasons other than energy, then over the long-run these substitutes or this demand reduction will be a result of prices rising to significantly higher than they are now. The questions, to me, is whether this price rise will be relatively smooth or whether it will come in waves with serious retracements.

In other words, will oil prices make a "head fake," and decline significantly for a few years as current high prices cause a global recession, only to prevent us from mitigating the near-term onset of production declines causing truly dramatic price increases 5-10 years down the road? Charles Hugh Smith seems to think so.

Here's Smith's graphic depicting a potential "head fake" in oil prices.

Let's consider the potential for such a "head fake" more closely:

Taken in isolation, I don't see how increased oil prices cause destruction in demand sufficient to cause prices to decline, but rather only enough to prevent or slow additional price increases. The exception to this is the time-delay inherent in demand destruction. If oil prices now make everyone choose a more fuel-efficient car when they buy their next car, then current prices will cause a reduction in demand that continues over several years as we roll-over our auto fleet. Similarly, it may take oil prices staying at current levels before people are adequately convinced that they'll remain high, and therefore incorporate these prices into their decision making. That's a reasonable enough argument, but absent this time delay, I don't see how oil prices alone can cause a massive collapse in demand that isn't already present at current price levels. I do see how we could reach a wall where it would be difficult for prices to rise further because any increase is met immediately with a demand response, but that doesn't seem like a possible cause for a significant price decline--a "head fake." Why would $5 gas suddenly cause people to radically cut consumption any more than $4 gas did? I think there's a generalized perception that at some point there will be a demand response to high prices, but I think the common fallacy is assuming that this response will be digital, that at some magic number everyone will sit up and take action. Rather, demand response to high prices is extremely graduated, with a little bit happening at every rise in demand. Sure, some psychological barriers (e.g. $5 gas) may have a bit of an extra kick, but in general price increases won't cause a decrease in demand sufficient to significantly lower price. It just isn't logical--why would $4 gas cause prices to drop to $3, when people were apparently willing to consume enough gas at $3.50/gallon to sustain that price level? It's difficult to account for the time-lag issue, but I don't think that there's such a large time-lag waiting to unfold to actually decrease prices significantly.

The "head fake" scenario proposed by Smith IS, however, possible if increased oil prices merely act as a catalyst to set off a larger economic chain reaction that, in turn, destroys far more demand than the catalyst alone can account for. This is similar to what happened with the recent credit crunch--mispricing of risk in one area cause an entire risk-pricing industry to suddenly clam up, over-correct, and over-price risk for a brief period. This same thing could happen if gas prices caused a general recession that led to people postponing capital investments and other economic activity until the recession had ended--a sort of chicken and egg problem. While I do think that gas prices alone can cause economic hardship, any recession caused by high gasoline prices seems to be only a problem of the global economy evolving to a new reality, not to an inability to maintain current levels of economic growth. If $500 Billion a year is going to the Middle East, and they are in turn spending it on luxury products, then the global economy must re-tool and re-orient to produce luxury goods for Middle Eastern sheiks rather than Fords for Ohio factory workers. That might be a painful transition, but it doesn't necessarily reflect either a decrease in economic activity OR a decrease in energy consumption, just a shift in where and how it takes place. It is important to differentiate a recession caused by the market's inability to quickly re-tool for a new economic environment due to high oil prices and the very different even of a recession due to an actual decrease in economic production due to a decline in oil production (and, possibly, also total energy available to the economy). This latter event--something that I think is still a few years away--could cause a very serious recession. The former--just high prices due to tight supply/demand issues--should only cause a re-focusing, which might be painful for some, and painful in general in the short-run, but may actually be beneficial in the long-run because it could allocate energy to higher value-added tasks than in the present. I'm not sure that the more minor recession caused by mere high oil prices would be enough to cause a "head fake" in prices, but I think it is a distinct possibility due to issues of market psychology.

One think does seem certain--if we accept the assumption that oil prices will rise over the long-term, then a steady rate of increase with minimal volatility will best facilitate adaptation to a lower-energy, costlier-energy world. The "head fake" that Smith writes about is potentially very dangerous because it could cast new doubts over the very notion of Peak Oil at exactly the time when the world must address the problem with great urgency. A "head fake" would breathe new life into the abiotic oil crowd, the "markets will always provide" crowd, the Super-Hummer crowd, etc. Because I think that there is a significant possibility of a "head fake" due to market psychology (or, possibly, due to a short-term increase in supplies if the megaproject and geopolitics stars all align over the next 24 months or so), I think that our outlook and investing in the energy sector needs to incorporate a fairly long-term time horizon. I don't think that $200 oil is a sure thing this year or next (though I think it's a strong possibility). But oil under $200/barrel in 2016 seems highly, highly unlikely absent a general economic collapse (and, in that even, we have equally big problems to deal with).

Hat tip to FutureJacked.

Monday, May 19, 2008

Peak Oil Tips (Out of Backwardation)?

Has Peak Oil, as a meme, "tipped"?

One indicator of a "tipping point" for acceptance of Peak Oil may be the state of backwardation in oil futures. I first raised this idea over 2 years ago, but recent market movements, coinciding with attention in the press, may be validating it: when the markets accept Peak Oil, we will see the end of backwardation in crude oil markets, and possibly even Contango. Here's what has happened over the past 6 weeks:

UPDATE: Chart updated with 10:00 AM EST, May 19th data to reflect move into contango.

A few quick definitions: Backwardation is when prices in the future are lower than in the present. Contago is the reverse, where future prices are higher than in the present.

Normally, oil markets are in backwardation. It is conventional wisdom that oil markets will always return to backwardation for several reasons:

- The Hotelling Rule, e.g. the expectation that improved technology will lead to ever lower extraction costs (which, of course, Peak Oil theory rejects, and in fact argues for the opposite)
- The vicious cycle theory: when backwardation reaches zero, there is no incentive to hold inventory of oil, which then causes inventory to decrease, which then causes spot prices to rise, resulting in increased backwardation
- There is no incentive to fix current prices at today's price, because the time-value-of-money would actually result in you paying more than today's price for oil (which only makes sense if you accept that Peak Oil will likely lead to dramatically higher prices in the future)
- Arbitrage (discussed below)

Is contango even possible in oil markets? The conventional wisdom is no, at least not over a sustained period of time. The theory behind this is that if oil is selling for more two years in the future than it is today, then producers will use arbitrage. They'll buy a front-month oil future, sell a distant-month oil future, pocket the difference, take delivery of the front month oil and store it for delivery at the later date. This prevents oil in the future for selling for any more than the cost of storage of oil until that date, and when time-value-of-money is accounted for, that usually requires that future oil sell for less than spot oil.

Contango could exist if a few circumstances were met: present rate of oil production would need to be effectively fixed, there would need to be a consensus that future rate of production will be lower and that demand will remain highly inelastic, and there must be some impediment to storing today's oil to sell in the future. If all three of these came to pass, then the oil markets could be in significant contango and arbitrage would not be able to remedy the situation. Of course, it seems unlikely that these things (specifically the inability to store oil) will come to pass unless through some kind of political or regulatory move, but it is possible.

Because backwardation is the norm, and contango seems unlikely, I think it is highly significant that oil has gone from very large backwardation to nearly zero backwardation over just the last 6 weeks. It seems consistent to me with an emergence of Peak Oil awareness in the markets that led the market to the rejection of every reason for "normal backwardation" listed above except arbitrage (which can only maintain backwardation equal to the difference between storage cost and time-value-of-money).

It's easy to explain away the spot price of oil in isolation without resorting to some form of Peak Oil theory. It is much more difficult to explain away the dramatic decrease in backwardation.

Monday, May 12, 2008

Center for a New American Security: More Palliatives from Policy Wonks

A friend at the Pentagon recently sent me a copy of this article from Jim Thomas of the Center for a New American Security entitled "Sustainable Security: Developing a Security Strategy for the Long Haul." CNAS seems to be something of a democratic alternative to PNAC (Project for the New American Century--the incubator for "NeoCon" thinkers in the Bush administration). Its approach, while somewhat different from PNAC (well, radically different if you only consider the highly constrained spectrum of "conventional" options), is equally, disappointingly misguided. Thomas's policy proposals in "Sustainable Security" are particularly misguided. He essentially suggests that we pour more concrete on the Maginot line, and his "solutions" are equally "sustainable." Saddly, CNAS is likely to play a role in any upcoming democratic administration similar to that of PNAC from 2000-2008 (here's Hillary Clinton speaking along these same lines while giving a keynote address at a PNAS event).

First, Thomas fails completely to understand the constitutional basis of our Nation-State system, and why it is breaking down: increasing discontinuity between a State and its constituent Nation, and the simultaneously increasing failure of the Nation to justify the Nation-State order by actually ensuring the ongoing welfare of its component Nation. The Author clearly hasn't read (or absorbed) Phillip Bobbitt, who's "Shield of Achilles" is the seminal work in this area. Then, the author proposes to solve a problem the genesis of which he fails to comprehend. That's a tall order...

2. After assuming that A) the viability of the Nation-State system is a prerequisite to our security, and B) we can prevent its decline without addressing the increasing discontinuity between State and Nation (both inaccurate assumptions, in my opinion), the author proceeds to offer a number of palliatives about how we can shore up that system and create effective partners for cooperative action through simple (to articulate, not necessarily to implement) policy means. And they'll greet us with flowers on the streets of Baghdad--this has failure written all over it.

The mess in Iraq is a classic example of how the post-Colonial Nation-State fiction rests on a fundamentally rocky (and worsening) foundation (there, when the French and British draw nice lines in the sand pursuant to the Sykes-Picot accord and then assume that this haphazard jumble of disparate national groups can form the "Nation" to underly a "Nation-State"). One maxim: a suggested solution that clearly demonstrates a lack of comprehension of the cause of the problem is highly unlikely to be successful.

Of course, it wouldn't do for me to simply critique another's solution without offering one of my own. Here's a link to my paper, "The New Map: Terrorism and the Decline of the Nation-State in a Post-Cartesian World" (also now available in German). I presented it at the 2006 Yale Journal of International Law symposium, and developed it further with feedback from Ved Nanda (of the Nanda Center for International Law). It discusses the genesis of the declining Nation-State system, the forces that are currently exacerbating that trend, how the Nation-State system is not our end goal per se but rather an outdated means to achieve our end goals, and how, in light of the inevitability of its decline, our policy position should be to support the development of an alternative paradigm to the Nation-State system (among the many alternatives currently in competition) the supports our end goals. Specifically, develop networked nodes of localized self-reliance. Radical solution, I know, but interestingly another theorist out of USAFA, John Robb, has recently shifted to saying much of these same things in his new "resilient community" set of briefs and is grabbing the ear of many Pentagon insiders. I think that the institutional inertia is, frankly, too great to adapt such a radical (but I think fundamentally necessary) change, and that current leadership would rather take the safe route of pedaling just another set of palliatives as if it were substantive policy change, but maybe I'm wrong...

...either way, you heard it here first: Judging by the buzz inside the Pentagon and the list of email addresses that are enthusiastically forwarding this article to friends (note: my source was not among the enthusiasts), CNAS is an acronym that we will hear much more of, especially when it is time to for the party out of power to start apportioning blame for our next round of failed energy/security policy.

Sunday, May 04, 2008

CDSs vs. CDOs: Why the party isn't over quite yet

The Economist has an interesting article on the Credit Default Swap marketplace ("Swap Shop"). I've written about this market before, but it is one that is even more important today than it was just a 18 months ago. Credit Default Swaps are essentially bets that anyone (well, any financial institution) can place on another credit instrument (e.g. a corporate bond). You can buy or issue a CDS without being a party to the underlying credit instrument, though often the participants in the CDS market use these vehicles to hedge their risks as parties to credit issuance. CDSs are different from the current black sheep of the finance family, the Collateralized Debt Obligation (CDOs: basically a pool of mortgages or other debt that is bundled, chopped up ("securitized"), and then re-sold). While the current "Credit Crunch" is largely a result of a meltdown in the CDO market due to mispricing of risk and other negligent/reckless lending practices in home loans, the CDS market is prospering. It grew from $34.4 Trillion in 2006 to $62.2 Trillion in 2007 and continues to grow rapidly (yes, you read those numbers correctly--the CDS market is many times larger than the entire US economy, even if most people have never heard of it). Here's the rub: this vibrant CDS marketplace will actually rescue us from the "Credit Crunch," unless of course it manages to cause the entire global economy to implode in the meantime. Fortunately, that unless isn't very likely. Yet. The CDS marketplace is like a safety net. As it grows more dense, more complex, more perfectly optimized as a risk-management tool, it also becomes more rigid--losing the very flexibility that it needs to perform its function. Currently, firms use the CDS marketplace as a network of insurance policies. When something goes wrong, as long as those firms that are obligated to pay under the CDS system have the spare change to do so, the safety net functions admirably. Of course, as a largely unregulated world shrouded in the fog of murky and non-transparent accounting practices (or worse, overly rigid ones like the new Basel-II standards), it isn't really possible to tell when a firm has over-committed themselves in this CDS shadow-world. Because CDS providers make money by issuing these swaps, and because at the right price there is a virtually unlimited market to purchase said swaps, the ratio of committed reserves to actual reserves of the financial industry in aggregate is rapidly accelerating. This makes the CDS marketplace increasingly "rigid"--where rather than absorb a shock, it spreads through the network without dissipating.

At any given point--such as now--it is much more likely that the system absorbs whatever shock it receives. But, as every moment passes, the CDS system becomes more optimized, and therefore less flexible and more brittle (there are historical precedents for this). Over time it will become increasingly likely that the any given shock shatters an increasing inflexible CDS system, but, in my opinion, we're not there yet. There is still lots of room for optimization in the system--for example, this CDS-style risk-management notion really hasn't spread to the retail level. When that happens--when I can buy a CDS on my neighbors mortgage to protect myself from the decline their bankruptcy and resultant foreclosure will cause in my home value, then I'll think we've crossed the Rubicon. Coincidentally, that's a really good business idea... (note: only partial sarcasm... I've long thought that there is a huge and untapped market for retail hedging of risk exposure far beyond life, car, and home insurance: why don't more individuals hedge exposure to volatile energy costs, food costs, housing values, job markets, etc.??)

So am I just saying that, most likely, we'll recover from our current economic mess? Not quite. What I am saying is that the current economic problems are caused by a very curable problem--poor credit practices. They are, admittedly, being exacerbated by the onset of the next source of economic problems, Peak Oil, but that is not yet the underlying cause of what's happening. I must admit, the media does seem fixated on telling us how there really is a depression, right now, in America--in my opinion because they have to talk about something, and because you don't get ratings for saying "nothing particularly striking to report today, Bob." Parts of the broader media complex--blogs and websites mainly--do nothing but cherrypick news that supports their view that we're one wake-up away from a "Mad Max" apocalyptic future. All this motivates me, at times, to defend my prediction that we aren't in a recession, and that we won't see a real recession this year at all. Of course, this conflicts starkly with my other prediction that we are currently experiencing a "slow crash." Am I schizophrenic? I don't think so (who does?)--rather, I suggest that these two views are compatible provided that the differing time periods are kept in mind.

I maintain my prediction that we won't enter a recession this year. Of course, I take that narrow-minded position that a recession should actually have to conform to the definition of recession before it counts--if people are allowed to go about willy-nilly and define what a recession is and then tell me that I'm wrong when I say the current data doesn't meet the definition, more power to them. Just for completeness, US Q1 2008 GDP growth = 0.6%, and a recession is officially defined as two consecutive quarters of zero or negative GDP growth. Contrast this with the incessant ranting of the media that "7 out of 10 Americans think we're already in recession" (and the unspoken data point: 9.9 out of 10 Americans can't actually define the threshold for recession, but the media still reports their opinion... kind of like "7 out of 10 Americans think the Surge in Iraq is working" while "9.9+ out of 10 Americans don't have the data to reach an informed opinion on the topic"), the current economic figures suggest that we are NOT in a recession.

So there's nothing but smooth sailing on the horizon and I'm transitioning my oil call options into suburban homebuilders? No. There are some grey swans that could create a true recession or depression: actual and sharp decline in oil production is one of them. I don't care how high oil prices go ($300/barrel, $500/barrel), as long as it's just a bidding war for plateauing, but not yet declining supplies, this won't cause a true recession in my opinion. Our very ability to bid prices to such heights will be reflective our our economic strength. But once actual energy supplies begin to decline substantially (say, 5% from peak), then this will cause economic damage.

Net oil exports are one key data point to watch--and they may already be showing substantial declines (in the 5% range). However, to the extent that oil exporting countries are increasing domestic demand by stepping up purchases of consumables and durables from the West, this may temporarily postpone the impact of net oil export declines. No telling, yet, whether net oil export declines or actual net production declines will be the first to start to impact the global economy, but I think we'll have time for one more bout of partying before either one puts the permanent kaybash on the festivities...