LONDON (Reuters) – At the start of the year, soaring oil prices sparked a spirited debate among analysts about the level of prices that would start to choke off demand growth.

Like most oil-market debates, discussion was heated, with analysts fiercely divided about whether any reduction in demand growth should be characterized as “rationing” and “restraint” (both of which sound more short-term and reversible) or “destruction” (with its connotations of long-term irreversible loss).

Forecasters were just as divided about whether the price threshold at which meaningful amounts of demand would be lost was at $100 per barrel, $120, or even higher.

International Energy Agency (IEA) Chief Economist Fatih Birol warned the market was entering the “danger zone” when prices crested over $90 and then soared over $100. At the other end of the spectrum analysts at Barclays Capital concluded in April that it was “far too premature to signal that the first signs of demand destruction are already noticeable” even though Brent prices were then over $120.

I discussed the various views at length in an earlier column “Oil market hunts for signs of demand destruction” so won’t repeat the arguments here, except to note demand destruction is always more obvious in retrospect, and absence of clear contemporaneous evidence should not fool anyone into thinking it is not happening.

Events in the last few months have provided a partial answer to the debate, but the most important aspect remains unsettled.

OECD THRESHOLD AT $100

LONDON, Sept 1 (Reuters) – At the start of the year, soaring oil prices sparked a spirited debate among analysts about the level of prices that would start to choke off demand growth.

Like most oil-market debates, discussion was heated, with analysts fiercely divided about whether any reduction in demand growth should be characterised as “rationing” and “restraint” (both of which sound more short-term and reversible) or “destruction” (with its connotations of long-term irreversible loss).

Forecasters were just as divided about whether the price threshold at which meaningful amounts of demand would be lost was at $100 per barrel, $120, or even higher.

International Energy Agency (IEA) Chief Economist Fatih Birol warned the market was entering the “danger zone” when prices crested over $90 and then soared over $100. At the other end of the spectrum analysts at Barclays Capital concluded in April that it was “far too premature to signal that the first signs of demand destruction are already noticeable” even though Brent prices were then over $120.

I discussed the various views at length in an earlier column “Oil market hunts for signs of demand destruction” so won’t repeat the arguments here, except to note demand destruction is always more obvious in retrospect, and absence of clear contemporaneous evidence should not fool anyone into thinking it is not happening .

Events in the last few months have provided a partial answer to the debate, but the most important aspect remains unsettled.

OECD THRESHOLD AT $100

LONDON, Aug 19 (Reuters) – Uncertainty about the future is normal, but how households, businesses and policymakers deal with it determines whether the economy grows or stagnates.

Reactions to uncertainty determine whether the economy booms as in the 1920s or the 1990s or stalls as in the 1930s or the advanced economies after 2007.

Earlier generations of economists and investors understood the central role played by uncertainty in asset prices and growth.

Economist Frank Knight devoted an entire book to explaining the role of entrepreneurs organising production and guaranteeing payment to suppliers, workers and lenders in order to meet the highly uncertain future demand for products, interposing their own credit in the process (“Risk, Uncertainty and Profit”, 1921).

John Maynard Keynes focused on the “animal spirits” governing investment behaviour and gave a whole chapter of his most famous work to the impact of uncertainty on decision-making (“General Theory of Employment, Interest and Money”, Chapter 12, 1936).

The Great Depression taught policymakers the fundamental role of uncertainty and expectations in determining whether the economy would remain paralysed in a slough of despond or could recreate the dynamism of the previous decade.

Not for nothing did President Franklin Roosevelt begin his 1933 inaugural address with the warning but also rallying cry that “the only thing we have to fear is fear itself — nameless, unreasoning, unjustified terror which paralyses needed efforts to convert retreat into advance”.

LONDON, Aug 15 (Reuters) – Residual strength in nearby Brent futures reflects lack of liquidity in the benchmark grades rather than the global supply-demand balance.

As global growth slows, the distribution of price risks and investors’ positions appears more balanced than at any time since last autumn, shortly after the Federal Reserve prepared to launch its second round of large-scale asset purchases (LSAP2).

Chart 1 shows realised prompt prices for the ICE Brent contract since 2000 as well as the closing forward curve on three selected dates: 1 July 2008 (near the peak of the last price spike), 31 December 2010 and 12 August 2011.

Prompt Brent prices have climbed almost $17 per barrel (18 percent) between December 2010 and August 2011.

But most of the strength is concentrated nearby. Forward prices have risen much less. Futures for Dec 2012 delivery are up just $10.65 (11 percent). Futures for Dec 2013 are up $8.25 (8.7 percent).

About half the rise in Brent prices has come from a rise in long-term price expectations. The rest has come from a shift from a flat forward structure to a pronounced backwardation.

Forward Brent prices are far below the levels traded at the height of the price spike in 2008. Dec 2012 Brent futures are trading at only $105, roughly 25 percent lower than the $138 per barrel at which it was marked on July 1, 2008. Prices for Dec 2013 and Dec 2014 futures look even weaker compared with July 2008.

LONDON, Aug 12 (Reuters) – The Bank of England could usefully borrow the concept of a “reset”, popular in international relations, to restore credibility to its inflation forecasts and bridge differences among members of the rate-setting Monetary Policy Committee.

The current global slowdown provides a unique opportunity for a fresh start.

Under a reset, Chief Economist Spencer Dale and external member Martin Weale would acknowledge a growing recession risk has undercut the need for an interest rate rise to tackle inflation and drop their votes in favour of an immediate increase.

In return, Governor Mervyn King would reconfirm his commitment to actually meeting the inflation target within a reasonable and plausible timeframe, and promise to support rate rises if the threat of recession lifts and inflation fails to show sufficient convergence with the target in H1 2012.

External Member Adam Posen would agree to drop his dogged insistence on more money creation if inflation fails to converge sufficiently in H1.

Resetting would provide an elegant way to break the year-long stalemate that has paralysed decision-making and led to the Bank’s increasingly error-prone inflation forecasts being derided by investors.

CONVICTIONS TRUMP EVIDENCE

LONDON, July 27 (Reuters) – Markets remain transfixed by the prospect of the U.S. government defaulting and the restructuring of Greek debt, but investors should be more worried about signs of severe overheating in emerging markets, which presents a much larger threat to the global economy over the next year.

There is an air of theatricality about negotiations on the U.S. debt ceiling and the Greek restructuring since the underlying fundamentals in both cases are not in doubt.

When those crises are resolved, or the markets lose interest, the problem of overheating in emerging markets will present a much more serious and intractable challenge, with the potential to severely destabilise the global economy.

BRAZIL

Writing in the Financial Times newspaper Wednesday, Samantha Pearson explains how Brazil’s equity market is shaping up to be one of the worst performers of the year despite a booming economy. Soaring inflation and the attempt to control it by boosting interest rates and rationing credit are all symptomatic of an economy seriously overheating (“Inflation fears take their toll in Brazil”).

“Structural problems in the economy have also hit certain sectors. The credit squeeze has driven down construction stocks, but the industry is also suffering from the country’s record-low unemployment, which has led to a shortage of manual labour and driven up costs,” Pearson writes.

“Similarly, steel producers such as Gerdau and Usiminas are down 36 and 40 percent respectively this year, partly because of the sharp appreciation of the Brazilian real, which has made the companies’ exports less competitive.”

LONDON, July 26 (Reuters) – Led by University of California Professor James Hamilton and Fed Chairman Ben Bernanke, economists have sought to quantify the impact of oil shocks on economic performance.

The conventional approach treats oil prices as a (partly exogenous) input into forecasts of growth. The causality runs essentially in one direction from oil prices to economic growth.

But it is worth reversing the analysis and examining growth as an input into the formation of oil prices — in particular the role of periodic recessions ensuring there is a sufficient buffer of spare capacity in the oil market to absorb supply and demand shocks and stabilise prices.

Recessions leave a legacy of spare capacity that mutes upward pressure on prices, at least until the next expansion has matured and resource tensions re-emerge. They play a crucial role in helping balance the market.

THE CAPACITY MYTH

Lack of spare capacity is usually identified as a risk factor in oil forecasts. But few analysts and forecasters have asked where spare capacity comes from and what governs its availability.

Since the 1970s, most spare capacity has been concentrated in OPEC, especially swing-producer Saudi Arabia. That has given rise to the myth, fostered by Saudi officials, that the kingdom deliberately invests in spare capacity to calm price swings as part of a grand bargain with the United States (swapping spare capacity and price stabilisation for military and diplomatic protection).

LONDON, Jul 25 (Reuters) – Is there any rational basis for UK investors, businesses and households to expect inflation will average 2 percent over the next five years when it has averaged much more than that over the last five?

The Bank of England remains publicly committed to achieving its 2 percent inflation target in the medium term. But the commitment is increasingly threadbare and investors as well as wage and price-setters would be unwise to place much faith in it.

Officials have taken to stressing the flexibility built into the Bank’s mandate. Recent speeches have quoted the remit set by the government, which states “the actual inflation rate will on occasions depart from its target as a result of shocks and disturbances. Attempts to keep inflation at the inflation target in these circumstances may cause undesirable volatility.”

Armed with this flexibility, the Bank appears to be ignoring or suspending the 2 percent target to pursue other objectives – such as offsetting the fiscal squeeze, propping up house prices and other asset markets, and stimulating growth and employment.

These are all worthwhile aims. But they appear to have usurped inflation as the Bank’s primary concern. If this is true, rational households, businesses and investors need to update their own expectations about inflation and the Bank’s policy decisions to take account of changes in the way it interprets its mandate.

In the meantime, policymakers appear to be relying on households and firms not reacting to the pick-up in inflation (“sticky expectations”) to improve the trade-off between inflation, unemployment and growth, implementing a naïve version of the Philips curve most central banks abandoned in the 1980s and 1990s.

Rather than blame the Bank for failing to meet the target, investors, households and firms should anticipate a prolonged period of above-target inflation and incorporate it into their financial planning. Rising expectations will disturb policymakers at the Bank but are the only rational response to the persistent overshoot recorded in the last five years and expected to last at least two more.

LONDON (Reuters) – In their famous 2004 paper “Facts and Fantasies about Commodity Futures” Gary Gorton and Geert Rouwenhorst outlined the case for treating commodity futures as an asset class offering a similar risk premium to equities as well as diversification benefits and protection against inflation.

But is the indexing approach to investing in commodity futures still valid?

Substantial inflows of capital chasing roll returns in commodity markets have eroded the risk premium Gorton and Rouwenhorst found in the years before 2004. Rising investor participation has also tied returns more closely to those in other asset classes.

Index operators have responded by offering second and third-generation products that take a more dynamic or discretionary approach to index weightings and roll procedures in a bid to outrun the contango problem. But new products could soon become afflicted by the same crowded trade problem as their forebears.

In the end, investors may find themselves pushed towards a fully active approach via long-only discretionary funds or long/short hedge funds. There may not be any systematic risk premium to being long a basket of commodity futures, however weighted. It may be that any premiums are a return to investors’ and managers’ skill in understanding fundamentals and timing the market.

For a presentation on “Commodity index performance: the case for active management?” please click on the link here: here

LONDON, June 28 (Reuters) – There is no evidence anyone can successfully predict commodity prices. Most forecasts seem to be adaptive — reacting to past price changes — rather than forward-looking, and therefore miss turning points.

There is no evidence any forecasters consistently get it more right than wrong. Forecasts can never be more than a baseline for planning and investing surrounded by significant uncertainty.

Nonethless, preparing forecasts remains a useful exercise because it forces analysts to identify factors driving prices and how the balance might change in future. It is the process rather than the outcome that is valuable.

While equity investors have embraced this approach – valuing research for the supporting information and analysis of sensitivities as much as the price call — too much research in commodities still emphasises point forecasts . There is little consideration of the distribution of risks or of factors that might drive alternative outcomes.

Enormous resources are now being poured into commodity price forecasting but a thoughtful paper by the New York Fed casts doubt on whether it is likely to be successful.

The challenge is to transform the purpose and presentation of research. Rather than trying to help investors and hedgers predict the future (which is doomed to failure) research should help them accept and manage uncertainty in the most appropriate way .

FORECASTING FUTILITY