LONDON (Reuters) – Over the next few days, once they recover from shock, analysts and investors will try to seize control of the market and fashion a new narrative for commodity prices in the wake of Thursday’s brutal selloff.

At banks and hedge funds around the world, the telephones will be working hard as traders, sales staff and portfolio managers make contact with clients and one another and try to work out where commodity prices go from here (and to ask for more margin in the nicest possible terms).

Two big narratives will be battling it out.

In the bullish camp, this is no more than a temporary setback. Markets had become overheated — moving too far too soon. But the fundamental forces driving prices upward over the last six months, and indeed over the last six years, have not changed. Prices are likely to resume their climb once the current wave of panic-driven liquidation has been completed.

For the bears, the events of the last 24 hours signal the top of the market. Investors had become caught up in a speculative mania. Like other manias, this started with some fundamental justification, but price increases far outstripped the level that could be sustained. Markets carried on rising on a cycle of self-validating buying. But like all bubbles this one burst when the prospect of further gains no longer outweighed the growing risk of a setback.

As usual the truth lies somewhere between these extremes.

STRATEGY AND OPPORTUNISM

LONDON (Reuters) – The brutal sell off that swept through the oil markets Thursday should finally dispel some myths about how commodity prices are set and behave.

Front-month Brent crude futures sank almost $12 per barrel (well over 9 percent) in a series of vertiginous declines that took the market down from over $120 at the start of the day to under $110.

The price change was more than 4 standard deviations — which is something that should be seen on average only once in every 63 years — if the market was well-behaved and changes followed a normal or Gaussian distribution.

At times the move has approached 5 standard deviations — which should only occur once every 7,000 years.

In fact, spot Brent prices have moved by 9.5 percent or more no fewer than 33 times since January 1990. The most recent was the 9.7 percent rise on March 17, 2009, which marked the end of a series of no fewer than 11 massive moves in the autumn 2008 and spring 2009.

Before that we have to go back to the aftermath of the terrorist attacks on the World Trade Center and Defense Department in 2001 (2 moves), 2000 (2 moves), 1998 (1 move), 1996 (2 moves) and the first Gulf War in 1990-91 (16 moves) for similar or larger movements.

The first myth that should be demolished is the idea that commodity price movements follow even an approximately normal distribution. Large price movements occur too frequently for the normal distribution to be a useful proxy.

LONDON (Reuters) – The brutal sell off that swept through the oil markets Thursday should finally dispel some myths about how commodity prices are set and behave.

Front-month Brent crude futures sank almost $12 per barrel (well over 9 percent) in a series of vertiginous declines that took the market down from over $120 at the start of the day to under $110.

The price change was more than 4 standard deviations — which is something that should be seen on average only once in every 63 years — if the market was well-behaved and changes followed a normal or Gaussian distribution.

At times the move has approached 5 standard deviations — which should only occur once every 7,000 years.

In fact, spot Brent prices have moved by 9.5 percent or more no fewer than 33 times since January 1990. The most recent was the 9.7 percent rise on March 17, 2009, which marked the end of a series of no fewer than 11 massive moves in the autumn 2008 and spring 2009.

Before that we have to go back to the aftermath of the terrorist attacks on the World Trade Center and Defense Department in 2001 (2 moves), 2000 (2 moves), 1998 (1 move), 1996 (2 moves) and the first Gulf War in 1990-91 (16 moves) for similar or larger movements.

The first myth that should be demolished is the idea that commodity price movements follow even an approximately normal distribution. Large price movements occur too frequently for the normal distribution to be a useful proxy.

LONDON (Reuters) – Genera Motors and other American car manufacturers reported strong vehicle sales last month led by sales of smaller and more fuel efficient cars and sport-utility vehicles.

While some of the increase may represent a rise in market share at the expense of Japanese automakers whose supply chains have been disrupted by the earthquake, the bulk of the quake effect was yet to feed through in April, and it probably signifies a shift in consumer preferences in response to escalating fuel costs.

“Consumers are continuing to rethink their vehicle choice,” according to GM sales head Don Johnson, in remarks referring to the impact of high gasoline prices reported in the Wall Street Journal. Speaking for an automaker, Johnson has no axe to grind in the debate among analysts about whether rising oil prices have begun to ration and destroy demand.

Johnson’s comments lend support to the view of analysts at Goldman Sachs, who wrote last month that they saw “nascent signs of oil demand destruction in the United States.”

It is a view that has been rejected by leading research teams at Barclays Capital (“it is far too premature to signal that the first signs of demand destruction are already noticeable”) and Morgan Stanley (we have “not seen any material evidence to convince us any (gasoline) demand destruction is taking place in the U.S.”).

Goldman’s thesis got some further support last week when the U.S. Energy Information Administration reported domestic gasoline consumption was running at a rate of just 8.648 million barrels per day in February, unchanged from last year and down more than 2 percent compared with 2009 and 2008.

It was a big downward adjustment from the average 8.9 million barrels per day the agency reported at the time in its weekly consumption estimates.

LONDON (Reuters) – Market participants are probably over-estimating the level of prices needed to achieve demand destruction and restore oil market equilibrium because their judgement is over-influenced by recent high prices and fails to give sufficient weight to a longer price history.

Psychologists and behavioural economists have long known that humans assign too much weight to recent events at the expense of a longer perspective. One result is the phenomenon known as anchoring — in which estimates of value or forecasts for the future cluster around current levels or recently mentioned numbers, even fairly arbitrary ones.

In “Priceless: The Hidden Psychology of Value”, William Poundstone reviews the numerous experiments showing how estimates and predictions are influenced by recently mentioned numbers — even when the subjects knew those numbers were entirely irrelevant. Estimates and predictions could be influenced even by random numbers generated by the spin of a roulette wheel.

Anchoring has been observed for inconsequential, low value decisions where individuals have an obvious incentive to take mental short cuts rather than waste time and effort computing estimates and forecasts from scratch. But it has also been shown to affect serious decisions involving high-value items, even for goods and assets with a market-determined value, such as real estate.

OIL MARKET ANCHORS?

The question is whether recent price rises and the whole period of high oil prices since 2006 have imparted an upward bias to estimates of the level at which demand destruction sets in, which is sustainable in the long-term, or even “fair” for producers and consumers.

There are good reasons to believe anchoring is indeed at work in the oil market. Top-producer Saudi Arabia certainly thinks so.

LONDON (Reuters) – U.S. politicians tend to focus on the bilateral trade deficit to accuse China of maintaining an undervalued exchange rate and press Beijing to permit a substantial appreciation.

Some economists and lawmakers have called for the yuan to be revalued as much as 25-40 percent to close the trade gap.

But bilateral deficits are not a good way to measure under or over-valuation. A closer examination of the structure of China’s trade with all its major trading partners suggests the degree of undervaluation is much smaller. The large U.S.-China deficit reflects the structure of their economies as much if not more than currency misalignment.

TRADING PARTNERS

China ran an overall trade surplus with the rest of the world of around of $200 billion in 2009, the last year for which complete data are available, according to the International Monetary Fund’s “Direction of Trade Statistics” (DOTS). The overall surplus represents a modest share of GDP and is not large in the context of the world’s second-largest economy. (here)

In most cases bilateral flows are close to balance. The exceptions are large surpluses with the United States ($144 billion) and United Kingdom ($23 billion). These are partly offset by big deficits with Korea ($49 billion), Japan ($33 billion) and commodity producers such as Australia ($19 billion), Saudi Arabia ($14 billion), Brazil ($14 billion), Malaysia ($13 billion) and Angola ($12 billion).

China is often characterised as a giant processing economy, importing raw materials and exporting relatively low value-added manufactured products. The truth is more complicated. Big deficits with commodity exporting countries highlight China’s dependence on imported raw materials especially iron ore, copper and crude oil.

LONDON (Reuters) – Standard and Poor’s decision to put U.S. government debt on negative watch says nothing new about the condition of the U.S. budget and as a result has been met with an indifferent shrug by investors.

The agency affirmed its AAA rating for U.S. government obligations for the time being, but cut its outlook from stable to negative. According to the agency, a negative outlook means “there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years”.

Despite the country’s exceptional strengths, stemming from flexible markets and its role as issuer of the world’s main reserve currency, S&P fears gridlock between the president and Congress could prevent budget deficits being dealt with in a timely manner.

Predictably, the announcement sent a jolt through global markets — but more of a tremor than an earthquake. Yields on U.S. bonds barely moved. U.S. equity markets and commodity prices fell but declines were modest and largely continued a small sell-off that began last week.

It was not so much a reversal of the risk-on/risk-off trade as an excuse to close out positions in a broad range of risk assets many observers had concluded recently were over-extended. The announcement contained nothing that was not already very well known and fully priced in.

STEIN’S LAW

Investors have long known the U.S. fiscal trajectory is unsustainable. Hardly any private investors have bought U.S. government debt recently, which remains overpriced and provides inadequate compensation for risks of inflation and devaluation. Issuance is being soaked up by the Federal Reserve’s quantitative easing programme and foreign central banks. None of these institutions is investing on a normal commercial basis.

LONDON (Reuters) – Goldman Sachs analysts’ decision to withdraw their recommended long position in crude and some other commodities last week, triggering a sharp sell-off, has drawn a firestorm of criticism.

The world’s most powerful commodity trading bank sees continued upside for oil and many other commodity prices over a 12-month horizon. But near-term risks are more symmetric, and the risk-reward ratio is no longer appealing.

Goldman analysts fear oil prices have pushed ahead of fundamentals, citing record speculative positions and early signs of demand destruction. The bank makes no formal trading recommendations in energy and base metals but suggests investors adopt an underweight allocation to commodities on a three-to-six-month horizon, while expressing confidence the long-term bull trend remains intact.

Only a few weeks ago, the bank insisted the balance of risks in oil was tilted towards the upside. Its abrupt turnaround drew fierce condemnation from an unusually wide range of traders, commentators and analysts – some clearly wrong-footed by the subsequent price drop.

In a thinly veiled response, researchers at Barclays Capital, the oil market’s other leading research team, restated their view the “market is currently massively out of equilibrium” and “the highs for oil prices this year are not yet in”.

“On top of that the underlying political and economic uncertainties are so great that were we to call for a top to prices at this point, it would probably appear more than simplistic. Indeed, it might even look opportunistic as it would perhaps guarantee a few short-term headlines and some more headlines later when that view was reversed,” Barclays wrote in a note Friday.

They went on to argue, “If analysis were to be judged solely in terms of the weight of headlines generated and their impact on the petroleum paparazzi, then following a route of frequent turns in a basic view might well be the best way to proceed.” (here).

LONDON (Reuters) – Demand destruction has taken over from geopolitical risk as the number one concern in the oil market — as participants assess whether prices have risen enough or must go further to cut demand in line with diminished expectations about supply and spare capacity.

Preliminary data for early 2011 already show signs of slowing oil demand, according to the latest monthly “Oil Market Report” published by the International Energy Agency. Goldman Sachs analysts claimed to see “nascent signs of oil demand destruction in the United States” in their much-cited update advising clients to close recommended long positions in crude.

Reuters reports Saudi Arabia has cut its oil production back to pre-crisis levels, citing poor demand, and lacklustre interest in the new special blend of crude offered to replace Libya’s light sweet oil. Many in the industry have interpreted this as a sign high prices have started to dent consumption.

But in a note to clients Barclays Capital analysts warn “it is far too premature to signal that the first signs of demand destruction are already noticeable”. They question whether Riyadh has really cut output in response to a fall in demand and conclude “price levels at which global oil demand is choked off have not been truly tested yet”.

LAGGING, NOISY INDICATOR

Barclays analysts are correct to note the absence of clear signs of demand destruction, though perhaps not for the reasons the authors cite the report.

Consumption data provide a notoriously backward-looking and noisy picture of the market. Most of the information is subject to a lag of at least two months — in some cases much more. Weekly numbers published by the Energy Information Administration (EIA) are an exception. But even they are subject to reporting and estimating errors as well as some confusion between exports and domestic consumption.

LONDON (Reuters) – Behavioural approaches to asset pricing, which stress the role of subjective sentiment as well as objective fundamentals, have been gaining ground steadily in financial markets over the past three decades.

Once a rather marginal inter-disciplinary approach, wedged uncomfortably between psychology and mainstream economics and criticised for being a set of intellectual curiosities with no general application, behavioural economics has gained respectability and adherents.

It received the ultimate imprimatur when Daniel Kahneman — co-pioneer of the discipline — was awarded the Nobel Memorial Prize in Economics in 2002.

Prominent economic thinkers and investors ranging from Robert Shiller (author of “Irrational Exuberance”) to George Soros (“The Alchemy of Finance”) and Didier Sornette (“Why Stock Markets Crash”) have all used behavioural approaches to develop compelling theories of how asset prices move, including how bubbles form and implode.

To answer criticism that behavioural approaches are interesting but not useful in understanding real prices in real markets, Professor Hersh Shefrin has developed an impressive synthesis combining rigorous pricing models from traditional economics and finance with more realistic assumptions about decision-making taken from behavioural approaches (“A Behavioural Approach to Asset Pricing”).

But this revolution in economic thinking has almost completely bypassed commodities. While Shefrin shows how movements in asset prices can be decomposed into fundamental and sentiment components, commodity economists and practitioners remain stuck in a bitter and inconclusive debate about whether prices are driven by fundamentals or speculation.

It is as if commodity markets had decided to stick with Newton while the rest of the financial world embraced Einstein’s theory of relativity — or worse stuck with the Ptolemaic model of the solar system while everyone else discovered Copernicus.