8/12/15: Commodities Rot Runs Ahead

Commodities rot continues unabated, as Bloomberg Commodities Index fell to its lowest reading since June 1999:

Source: @Schuldensuehner

Which, of course prompted another repricing of the commodities-linked currencies:

 Source: @Schuldensuehner

As I noted few days ago (post here) for the Russian Ruble, there is some room to the downside from here on.

Here is an interesting discussion of the historical trend/cycles in commodities busts via Carmen Reinhart: https://www.project-syndicate.org/commentary/commodity-price-decline-will-continue-by-carmen-reinhart-2015-11. And long-view chart of same:

Trend-wise, that is 160 years of deflation...

5/10/2012: Did Economic Fundamentals trump QE

Two effects of QEs and LTROs - the drivers of temporary inflation - were to boost returns on commodities and reallocate funds into Emerging Markets early on, followed by the fundamentals taking over once again, bidding down commodities and re-diverting EM inflows to developed markets...

Put differently, you can't fight fundamentals with money when the real transmission mechanism is broken. So far, we had this theme powerfully reverting returns back to the 2010 norm. It remains to be seen if the recent firming up of the US growth is going to be sustained.

3/2/2012: Big Bad Speculators & Little Red Riding Hoods

That "Gotcha..." moment, you know... speaking last night at a round table discussion on the future of Europe, I was confronted with a question from the audience and a fellow panelist remarks in the same vein that, roughly speaking, attributed the entire current crisis in Europe to the derivatives markets and speculative investment. More than that, the same were blamed for everything from the environmental disasters to increases in commodity prices. Some parts of the Left just love the idea of finding a "capitalist" (even arch-capitalist - aka speculative) root to every problem - the "Gotcha..." thingy of pseudo intellectualist disdain for facts as much as for 'speculators' and 'markets'.

This of course does not mean that financial instrumentation, speculation or other forces of the financial markets did not contribute to the crisis, but it is a distinct claim from the one made by those proposing that they caused the crisis single-handedly.

By sheer accident, looking through some old research papers, I came across this study from the ECB: Lombardi, Marco J. and Van Robays, Ine, Do Financial Investors Destabilize the Oil Price? (May 20, 2011). ECB Working Paper No. 1346. Available at SSRN: http://ssrn.com/abstract=1847503

The study looks into the large oil price fluctuations that were observed in the recent years. In particular, the study considers the role of financial activities in the determination of oil prices.

Per study (emphasis is mine):

"The oil futures market has indeed become increasingly liquid, and the activity of agents that do not deal with physical oil, the so-called non-commercials, has greatly increased. This led some to hypothesize that inflows of financial investors in the futures market may have pushed oil prices above the level warranted by fundamental forces of supply and demand, whereas others argue that the impact of financial activity on the oil spot market is negligible or non-existent beyond the very short term."

The paper studies "the importance of financial activity in determining the spot price of oil relative to the role of oil market fundamentals", using a sign-restricted structural VAR model. The model allows the study authors to separate financial activities into two types: stabilizing and destabilizing. This is achieved by postulating a model that links "the oil spot market to the futures market through a no-arbitrage condition", so that:

• Destabilizing financial shock is identified as one that creates "a deviation from the no-arbitrage condition, thereby ...driving oil futures prices away from the levels justified by oil market fundamentals. 
• Stabilizing financial activity is defined as "driven by changes in oil supply and demand-side fundamentals". 

In addition, the econometric framework adopted in the study allows to identify four different types of oil shocks:

• an oil supply shock
• an oil demand shock driven by economic activity 
• an oil-specific demand shock which captures changes in oil demand other than those caused by economic activity, and 
• a destabilizing financial shock (such as a spike in speculative activity).

The results suggest that 

• Financial activity in the futures market can significantly affect oil prices in the spot market, although only in the short run. 
• The destabilizing financial shock (speculation) only explains about 10 percent of the total variability in oil prices.
• Shocks to fundamentals "are clearly more important over our sample. Indeed, looking at specific points in time, the gradual run-up in oil prices between 2002 and the summer of 2008 was mainly driven by a series of stronger-than-expected oil demand shocks on the back of booming economic activity, in combination with an increasingly tight oil supply from mid 2004 on. Strong demand-side growth together with stagnating supply were also the main driving factors behind the surge in oil prices in 2007-mid 2008, and the drop in oil prices in the second half of 2008 can be mainly explained by a substantial fallback in economic activity following the financial crisis and the associated decline in global oil demand. Since the beginning of 2009, rising oil demand on the back of a recovering global economy also drove most of the recovery in oil prices."

However, the study did find that financial investors "did cause oil prices to significantly diverge from the level justified by oil supply and demand at specific points in time. In general, inefficient financial activity in the futures market pushed oil prices about 15 percent above the level justified by (current and expected) oil fundamentals over the period 2000-mid 2008, when the volume of crude oil derivatives traded on NYMEX quintupled. Particularly in 2007-2008, destabilizing financial shocks aggravated the volatility present in the oil market and caused oil prices to respectively over- and undershoot their fundamental values by significant amounts, although oil fundamentals clearly remain more important."

So some speculation is harmful to fundamentals-determined pricing, although the study does not consider the potential benefits from speculation-induced greater liquidity in the markets (which was not the core objective of the study to begin with), but largely, 5-fold increase in speculative activity accounts for just 10 percent of prices variability. 

18/06/2011: Two papers - Commodities Speculation and Flat Taxes

Some interesting studies worth reading released in recent weeks.

First: Lombardi, Marco J. and Van Robays, Ine, paper "Do Financial Investors Destabilize the Oil Price?" (May 20, 2011). ECB Working Paper No. 1346. Available at SSRN: http://ssrn.com/abstract=1847503

The study results "suggest that …financial activity in the futures market can signi…ficantly affect oil prices in the spot market, although only in the short run. The destabilizing …financial shock only explains about 10 percent of the total variability in oil prices, and shocks to fundamentals are clearly more important over our sample.

Indeed, looking at speci…fic in the second half of 2008 can be mainly explained by a substantial fallback in economic points in time, the gradual run-up in oil prices between 2002 and the summer of 2008 was mainly driven by a series of stronger-than-expected oil demand shocks on the back of booming economic activity, in combination with an increasingly tight oil supply from mid 2004 on. Strong demand-side growth together with stagnating supply were also the main driving factors behind the surge in oil prices in 2007-mid 2008, and the drop in oil prices activity following the …nancial crisis and the associated decline in global oil demand. Since the beginning of 2009, rising oil demand on the back of a recovering global economy also drove most of the recovery in oil prices.

However, we …find that …financial investors did cause oil prices to signifi…cantly diverge from the level justi…ed by oil supply and demand at speci…c points in time. In general, inefficient …financial activity in the futures market pushed oil prices about 15 percent above the level justi…fied by (current and expected) oil fundamentals over the period 2000-mid 2008, when the volume of crude oil derivatives traded on NYMEX quintupled. Particularly in 2007-2008, destabilizing fi…nancial shocks aggravated the volatility present in the oil market and caused oil prices to respectively over- and undershoot their fundamental values by signi…ficant amounts, although oil fundamentals clearly remain more important."

Note - emphasis above and below is my own.


Another interesting study I came across is the Blumkin, Tomer, Sadka, Efraim and Shem-Tov, Yotam, paper "Labor Migration and the Case for Flat Tax" (May 31, 2011). CESifo Working Paper Series No. 3471. Available at SSRN: http://ssrn.com/abstract=1855947

The study examines the case for a flat tax in the presence of migration threats - in other words, in the case of open labour markets. The study considers a tax competition game between two identical countries populated with individuals with two skill-levels.

"We compare between a non-linear tax regime and a flat tax system and demonstrate that in the backdrop of a high-skill migration threat (due to a reduction of the migration costs faced by high-skill individuals), the re-distributive advantage of a non-linear system over a linear (flat) one is significantly mitigated." In other words, when high skills workers are mobile across borders (as in the case of advanced economies, and especially small open economies like Ireland), progressive taxation's main benefit over flat taxes (its actual redistributive 'progressivity') is reduced significantly.

"In the presence of migration, and in sharp contrast to the autarky case, a coordinated shift to a flat system (with its entailed administrative advantages), still allowing for fiscal competition between countries (by maintaining the countries' sovereignty over the welfare state generosity), is not too welfare-reducing; and when administrative costs are taken into account, such a shift may prove to be mutually beneficial for both countries."

"... taking into account the administrative gains associated with a flat system (relative to a non-linear tax regime), even when both countries may choose a general non-linear tax regime, an equilibrium where both do set a flat system in place is likely to form." So for two systems starting from a non-flat progressive taxes base, open labour policies will lead to a flattening of the tax systems.

The authors "...also confirm the race-to the-bottom hypothesis that suggests that migration reduces the extent of redistribution." This point should be salient for Ireland. As we all know, Ireland is currently experiencing very substantial outflow of skills, especially at the higher (internationally marketable) segment of skills distribution. This means that this trend alone will tend to lead to a reduction in the redistributive effectiveness of the existent taxation system progressivity. Thus, there may be serious grounds to consider flatter (not more progressive) taxes as the means to actually mitigate the effects of lost progressivity. Some food for thought.

Economics 24/08/2009: Oil and Gold – an imperfect hedging tango

In the last bout (right before the collapse of the financial markets in Autumn 2008) much of the inflation was driven by the rapidly rising commodities prices. These prices were in turn linked to the price of oil. Thus, one can naturally think of oil as an inflation hedge. In contrast, the traditional inflation risk management instrument – gold – has hardly kept up with oil prices in the short run back in 2008. So there is a natural question that arises in this context – which is a better inflation hedge? Well, for each month in 2008, in year on year (yoy) changes, oil actually beat gold as a counter-inflationary asset. Only this year have gold and crude exchanged places. But this is optics.

First, both gold and oil prices show some serious medium range inter-annual volatility. This volatility is driven by speculative motives, but also by real demand for oil as a storable commodity that is an input into physical economy. So to abstract away from seasonality and active speculative trading, consider both commodities prices in terms of annual averages. Setting 1968 price index for gold and oil to be equal 100, and adjusting for inflation, chart below shows that both commodities are way off their historic highs and that even in 2008 the two commodities were nowhere near their long term maxima when it comes to a cumulative appreciation since 1968.

Pre 1970, average price of gold ranges around $38-39. It peaked in 1980 at $615 and then got stuck in the flat until 2007 when it breached the 1980s high in nominal terms. The average price of gold was $872 in 2008. Similarly, crude peaked at an average price of $91 a barrel last year. But despite nominal appreciation, oil is still way below its inflation-adjusted highs. Ditto for gold. To do this, gold needs to be at nearly $1,610 and oil at $98-100 per barrel. These are steep, but just how steep? Well, for oil this means roughly an 8% appreciation on 2008 annual average. But for gold this implies a whooping 84% appreciation on same benchmark.

Now, in annual terms, average annual inflation since 1968 was 3.6%. Median annual return to gold exceeded CPI by 1%, while oil did the same by 1.7%. So cumulative gain for oil in real terms since 1968 has been around 96.3%, and for gold it was almost a half of that, or 48.9%. Given that oil took a nose dive in 2009 while gold held its ground, long term comparisons suggest that

• Either oil is oversold today and thus has a mean-reverting potential of ca 45% on current prices to ca $105-110 barrel range (chart below shows WTI, $pb)

• Or gold had been under-bought in the historic past and thus has an oil-inflation trend-reverting potential of ca 50-75% on 2008 average annual price (chart below shows gold price in $ per oz, daily close)

I happen to think that both are likely, though in much more moderate terms, with oil heading for $85pb in 2010 and to $95pb over medium term (5 years), while gold heading for $1,050-1,100 range in 2010 and to $1,300 over the medium term. That would imply annualized gains in oil price of roughly 4.8% and in gold price of ca 6.5% before inflation. Thus, assuming a reasonably well-underpinned by the current money creation worldwide inflation averaging ca 3% pa, this would result in oil beating CPI by 1.8% annually, and gold doing the same by ca 3.5% pa. Why?

For two reasons:

1. Oil demand is going to be imperfectly matched to inflation hedging and short term volatility due to supply/demand for physical commodity will be weighing in oil as a hedge instrument in the current environment where investors are relatively jittery about the markets;
2. Gold simply has to catch up with oil over medium term.

One potential downside to this is continued orderly, but nonetheless pronounced disposal of gold holdings by the Central Banks of the more fiscally strained countries and the IMF. Although China and possibly India are likely to start picking up some of the rising supply through ‘private’ or invisible sales from one CB to another, this unwinding of gold reserves will weigh on the markets.

Per short term oil price volatility a recent example is in order. About two weeks ago, the US crude reserves have been reported to have fallen some 8.4mln barrels, prompting a serious spike in oil to $72.5pb. At the same time, gasoline supplies fell by 2.1 million barrels, distillate stocks declined by 700,000 barrels and refinery utilization reached 84% above analysts’ expectations of ca 83% - in a sign of tighter supply.

In medium term (3-5 years horizon) – watch US Oil Fund (USO) for oil.

On gold side, watch the correlation in gold and stocks, with gold tending to max just ahead of stocks lows (note July/August 2008, October 2008, March 2009 and so on in chart above). In my view, we are set for another local maxima to be tested by gold in months before the end of October 2009.