Crude markets are being bullied by black swans

March 18, 2011

By Christopher Swann
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Heads are spinning on oil trading desks. Markets are now weighing two competing tail risks — sliding demand from an injured Japan versus no-fly zones in Libya and Saudi troops in Bahrain. But in the absence of black swans, the relatively abundant flows of oil should eventually drive Brent below $100.

Uncertainty over developments in Japan complicates the oil price calculation. As the world’s third largest importer of oil — just over 4 million barrels a day — Japan is big enough to move the needle on world crude. Initially the nation’s appetite will climb as it switches on back up oil-fired electric generators to compensate for nuclear outages — as happened after the 1995 Kobe quake. If this is followed by a modest slowdown in growth, as many economists expect, there could then be a fairly trivial reduction in oil consumption. Yet if Japan’s nuclear emergency worsens, and the economy freezes, the nation’s thirst for oil could dry up fast.

At the same time it is rational for traders to brace for the worst in the Middle East. The intervention of oil kingpin Saudi Arabia in Bahrain raises the risk of supply disruptions that would send the oil price rising fast. The situation in Libya is more complicated. Oil supplies have already largely been disrupted. If UN intervention brings a quick end to the Gaddafi regime, oil prices could even fall. But there’s also a risk that Gaddafi’s forces could sabotage oil market infrastructure taking capacity out of the market for the long term.

Still, extreme outcomes remain unlikely. It is also worth recalling that nuclear and oil supply different types of energy: electricity and transportation fuel are not simple substitutes. And for those without a crystal ball, a reminder of the present oil supply and demand outlook is reassuring. For a start, energetic pumping by Saudi Arabia has more than filled the gap left by Libya. Indeed, the global surplus is running at 900,000 barrels a day, against a shortfall of 1.6 million at the start of 2008, according to data from Oil Market Intelligence. Ample global inventories and plentiful OPEC spare capacity should also help sooth rattled nerves.

Traders would be foolhardy to ignore mounting tail risks. But unless these black swans show up, the comfortable balance of supply and demand should bring prices back to more sober levels.

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It’s all about the psychology of the herd, the herd being retirement funds, hedge funds, “investors” who will not ever produce or use the commodity in the amounts they are buying. The real decision for the commodity fund manager is, “what will spook the herd next, and which way will they go?” In 2008 all it took was for some “expert” at Goldman Sachs or Morgan Stanley to say “with the situation in Nigeria, with the possibility of an Israeli attack prompting Iran to close the Straits of Hormuz, we believe oil will hit $200/bbl later this year.” The herd spooked and oil went to $140. Never mind that there never was an actual shortage of oil, the herd’s perception that there might be a shortage some time in the future caused them to spook. In 2008-2009, when the herd saw that the Israelis were not going to fly, and that a weakening economy would reduce demand, they spooked the other direction, liquidating their long positions as fast as they could, driving the price down to $35.

In 2011, corn and soybeans follow the price of oil up, on the bet that higher oil prices mean higher biofuel prices. Corn and soybeans are the feedstock for biofuels, and they are also feedgrains for livestock. Volatility in the feedgrains market keeps ranchers from expanding the stock cow herd. Fewer stock cows means a smaller beef supply down the road, and voila’ hamburger is at $3.50 per pound.

So the real information people need is this: What are the possibilities that action X can cause the herd to stampede? Las Vegas quotes odds on a given team winning the super bowl, with all kinds of side bets. Las Vegas needs to start betting on which way commodities prices will go. Vegas oddsmakers do their homework, and can be relied on a lot more than pundits. When you are trying to figure out who will win an approaching election, ignore the polls, and check the odds in Vegas. All the evidence shows they are far better at indicating who will win.

And if Vegas will start doing that, all those fund managers can just do their betting in Vegas (we should actually call them bettors now). The herd betting we have now creates volatility in commodities markets, volatility that does real damage to commodity producers and consumers, and in the end, the retail consumer. Make no mistake about it, real families suffer when gas is at $3.75, hamburger is at $3.50, and a box of corn flakes is twice what it should be.

Oil prices going up

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