Get Ready for Rising Commodity Prices

Driven by hot money seeking a low-risk haven
Tuesday, July 16, 2013, 8:27 PM

On the Nature of Conspiracies

The human mind seeks a narrative explanation of events, a story that makes sense of the swirl of life’s interactions.

The simpler the story, the easier it is to understand. Thus the simple stories are the most attractive to us.

This is one reason behind the explanatory appeal of conspiracies: 'Event X' occurred because a secret group planned and executed it.

Power groups may indeed have both the motivation and means to influence or control events. Certainly many price-fixing cases that go to trial uncover just such shadowy groups and conspiracies.

Even the Executive branch of government is, in essence, a series of private meetings in which policy makers craft plans to influence or control a series of events. And so we find the Internet a-buzz these days with rumors of grand designs of Orwellian-style populace control.

But conspiracies and power groups do not always provide comprehensive explanations for what we observe.

Multifactorial Causation

Life is messy, and situations with many participants and interactions – for example, markets – tend to be driven by amorphous forces, such as the herd instinct; and emotions, such as the infamous 'fear and greed'.

We have to question the ability of power groups to influence trends shaped by millions of participants and transactions.

For example, if we believe that the stock market is controlled by a power Elite, then we have to accept that this group engineers crashes and recessions along with Bull markets. Various explanations have been offered on how the Elite gains from crashes and crises (for example, Naomi Klein’s Shock Doctrine), but accounts from insiders suggest the 2008 financial crisis was not planned by the conventional power Elites. Rather, it left them scrambling to keep the system from melting down.

In other words, relying entirely on the machinations of power groups to explain a complex non-linear system veers into oversimplification. This leads to implausible claims such as “the Vietnam War was engineered by banks to profit from rising Federal deficits.”  There is exhaustive documentation of the many factors at work in the Vietnam War, and domestic banks’ profiteering from rising Federal deficits simply doesn’t make the cut as a dominant force.

The "Big Idea" Fallacy

Another category of simple, powerful narratives is “the big idea.” These include inflation, deflation, the conflict between labor and capital, and various aspects of systems analysis, for example, feedback loops.

But when simple stories and concepts fail to accurately account for events and fail to project reasonably accurate predictions, then we need to seek more nuanced and complex causal narratives.

Let’s take oil as an example. The global market appears to have ample supply, yet the price of oil keeps drifting higher.

The big idea that many believe drives the price of commodities such as oil is inflation/deflation: In inflationary eras, the expansion of money supply drives commodities higher as prices rise from increased demand and monetary inflation. In deflationary eras, slackening demand and contraction of credit/money supply causes commodities to decline.

The other primary narrative is supply and demand: Commodities rise when demand exceeds supply, and prices decline when supply exceeds demand.

Since the global economy is visibly slowing, demand for many commodities is declining. Though central banks are adding to money supply, this money is not flowing into the real economy, as credit and money velocity are stagnant.

These two factors are deflationary, and so the conventional expectation is for commodities like oil to decline. Oil’s price rise runs counter to both of these narratives.

Is there a conspiracy/power group engineering oil’s rise?

Various power groups – for example, the OPEC oil-producing cartel – clearly have both motivation and influence on the supply side of the equation, and government policy makers have strong incentives to control or influence both supply and demand.

Conspiracy narratives tend to overlook the conflicting incentives and agendas of competing Elites. Some power groups may benefit from rising oil prices, for instance, while others use their influence to lower oil prices. Competing Elites muddy the explanatory power of conspiracies.

Why is oil rising?  The conventional narratives fail to account for this trend. They also lack predictive value, as repeated calls for oil to reverse have been mooted by oil’s uptrend. For reasons I will explain in the next section, it is entirely plausible that oil could continue to rise, despite slackening end-user demand and deflationary stagnation in the global economy.

Such a continued rise in the price of oil would eventually push all commodities higher, even in the face of slackening demand, as producers would have to pass higher production/transport costs on to end buyers. This is why spikes in oil prices correlate to recession. As costs rise while wages remain stagnant, households and enterprises have less discretionary income to spend and invest.

With producer prices up 2.5% over the past year, the trend of higher oil costs leading to higher production costs already seems evident.

Since the conventional narratives fail to account for oil’s price advance, we must seek a new narrative.

Oil: The Super-Commodity

Oil is the Super-Commodity because it underpins the entire industrial economy. Coal and natural gas are used to generate electricity, but transport and the petrochemical industry are still largely fueled by oil.

As the cost of oil rises, the cost of producing and transporting goods also rises across the entire commodity spectrum. Higher oil costs make it more expensive to grow, harvest, and transport agricultural commodities and mine, refine, and transport metals.

This is the basic reason why recessions follow spikes in oil prices. When oil costs rise, costs increase throughout the economy without offering any additional value for the higher prices. Higher oil costs act as a tax that transfers wealth from consumers to oil producers. Since consumers pay more for goods and services, they have less disposable income to spend and invest. This contraction triggers recession.

One key feature of technical analysis is that it is detached from explanatory narratives. The technical analyst doesn’t really care if the rise in price is caused by a cartel, inflation, expanding demand, or geopolitical tensions; he just sees a trend or a reversal of trend.

You have probably seen multiple versions of this chart of oil (WTIC); everyone sees the same wedge and the same technical breakout to the upside.

Every analyst also sees the rising MACD (moving average convergence/divergence) and RSI (relative strength) indicators that confirm the breakout.

This rise in the price of oil in U.S. dollars has flummoxed everyone who expected oil to decline as global demand weakened. Rising prices don’t align with stories of a world awash in oil; clearly, the conventional supply-demand narrative isn’t capturing the key dynamics.

You have probably read the same explanations I have for higher oil prices. These include:

  • Inflationary monetary policies will push prices of something higher, and that something is oil.
  • Shale oil is costly to extract and the wells deplete rapidly.
  • Oil supply is actually tighter than is generally realized.
  • Geopolitical tensions are a factor, specifically the coup in Egypt.
  • Stronger U.S. growth will drive increased demand.
  • Oil-producing nations need oil above $100/barrel to fund their domestic welfare programs.
  • Oil-producing nations’ own domestic consumption is rising rapidly, leaving less oil to export.

There is nothing new here to speak of; it has long been recognized that the energy required to extract increasingly marginal sources of oil (i.e., EROEI, energy returned on energy invested) is rising, and this naturally drives the end-cost higher. It has also long been recognized that oil exports are vulnerable to political turmoil and conflict, as oil (like all commodities) is sensitive to small increases in demand or contractions in supply.

A more intriguing dynamic has been presented by Financial Times reporter Izabella Kaminska (The Fed, QE and Commodities) over the past year: Financiers are buying oil as collateral for various speculations. Kaminska sees this financial hoarding of oil (i.e., reduction of supply) as inducing “scarcity amidst plenty.”  Simply put, financial demand is equivalent to end-user demand.

In broad terms, I would characterize this as one aspect of the financialization of commodities.

Again in broad terms, the financialization of commodities is driven by several macro factors:

  1. The scarcity of non-phantom, easily tradable collateral in a financial system that is increasingly dependent on phantom collateral.
  2. A scarcity of sound investment opportunities.

What is phantom collateral?  I will offer two of many possible examples.

A sovereign bond issued by an essentially insolvent government that is propped up by the intervention of a central bank (for example, the European Central Bank (ECB) buying Spanish bonds). The bond is presented as solid collateral, but the collateral is entirely phantom. Should policy change and the ECB stop buying the bonds or even sell them, the true market value of the bond would quickly be discovered. Much of the bond’s supposed value as collateral would immediately vanish.

Consider a mortgage-backed security (MBS) held on a bank’s balance sheet at full value. Now consider what a marked-to-market valuation of the underlying mortgages would discover: Much of the value of the MBS would be revealed as phantom.


That real estate, stocks, and bonds are in varying stages of bubble-type tops is generally accepted as obvious, at least when the microphone is turned off. “Chasing yield” at the top of asset bubbles is a very risky game. Thus “smart money” seeks lower risk opportunities, either the classic “buy low, sell high” variety or low-risk carry-type trades. 

The total financial wealth sloshing around the world is approximately $160 trillion. If some relatively modest percentage of this money enters the commodity sector (and more specifically, oil) as a low-risk opportunity, this flow would drive the price of oil higher on its own, regardless of end-user demand and deflationary forces.

If we grasp that financial demand is equivalent to end-user demand, we understand why oil could climb to $125/barrel or even higher despite a physical surplus.

In Part II: Understanding the Secular Shift of Capital into Commodities, we examine the impact of this financialization of oil on other commodities. With oil's recent breakout, the prices of many essential commodities (e.g., natural gas, wheat, copper, coffee) are bottoming or already entering new uptrends.

Such a financially driven rise in oil could spark a self-reinforcing feedback as others note the rise and jump into the trade. If trillions of dollars in hot money exit bonds, stocks, and overheated real-estate markets, a small percentage of that money chasing oil and other commodities would have an outsized impact on prices, which are always set on the margins.

This is how oil and other commodities could continue climbing in price even as the global physical demand slumps and more economies slip into recession as oil costs rise.

Click here to read Part II of this report (free executive summary; enrollment required for full access).

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sand_puppy's picture
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CHS, clarification request

Thank you CHS, I always enjoy reading your thoughts.  I don't have a background in finance and would appreciate a bit more explanation of a couple of basic points.

When your refer to the "financialization of oil," I understand you to mean that big investors (whose money might currently be tied up in stocks, bonds and real estate) sell these assests and purchase oil.  This oil can then be used as high quality collateral to get ever bigger loans.  

1.  Is the money being used to purchase the oil created by the recently expanded money supply?  Is it being created by direct Fed "money printing" and excessive loans encouraged by the very low interest rates?  Is this surplus "hot" money a direct result of recent Fed policy?

2.  So what physically happens to that oil?  Do they rent huge storage tanks, fill them and then just hold the oil off the market in storage?  There has to be a limit to available storage capacity.

3.  Or are they buying contracts to purchase oil, not yet extracted, at sometime in the future?  And again, will it be stored or kept off the market?  What happens when the storage facilities are full?  Won't it need to enter the market at that point?


yogiismyhero's picture
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Sandpuppy, great questions.

I too look forward too Charles response to these. I would add that when I break this down to the simplest form it seems to me to be a high risk strategy because if market fundamentals do in fact matter then buying oil at these lofty prices and any contraction in the oil market would cause a huge hit on the purchases of oil at these prices. It costs a great deal to pay storage fees. For instance: It made sense to load up on oil in oil tankers, have them float off shore until the market reversed when oil was below $40 bucks but doing this now would be a horrible strategy unless you figured oil was going to take a moon shot into an already well supplied oil market. The OPEC countries MO has been to just break the quota rules and just release more oil thus effecting supply to the upside to make their budgetary commitments. Bottom line, and until I see something different I am betting that oil will revert to the fundamentals.

Any contraction here and if we get the hit Chris is talking about then we will have excess supply and is why the longer this goes on is why I think oil will go lower than many contemplate. I too am no expert but my focus is oil and we'll see. Of course so many above ground issues could effect the cost of oil so must be monitored.

Lastly sandpuppy, I like most everything you write. I visualize you as a complete gentlemen and frankly I like you very much. I wish you the best. I have always wanted to say this to you and now I have. All the best.

charleshughsmith's picture
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stretching my own understanding here

Hi Sand_Puppy and Yogiismyhero:

Thank you for the kind words. I strive to engage forums where informed views can be discussed civilly without emotional nets tangling the propellers, so to speak.  I could be dead-wrong here about oil, and my basic context is this: oil is breaking out technically, and so the question is why? All the usual explanations make no sense, so there must be other dynamics in play that we're not recognizing.

A few years ago I read a piece in The Economist or BusinessWeek (can't recall which) that reported the financial markets for oil were undersized relative to the physical market. In other words, the financial industry saw an opportunity to financialize the energy market just as it did to housing and other markets.

Though I am not an expert in the financial side of energy markets, this makes absolute sense to me, i.e. an unexploited market that can be leveraged with finance, and a close reading of Izabella's columns suggests there are carry-trade type opportunities in oil markets that do not require ever taking delivery of physical oil.

Some finance-savvy people who claim to know the oil market reject this idea--they say financial demand is *not* equivalent to physical demand and the cost to store oil negates any trading profits.  I am not so sure; consider this story which noted that inventory of oil fell by 20M barrels in a week, something that has never happened in 30 years.

Hmm. Isn't this reduction rather odd? What's actually going on here? I see the fingerprints of financialization in this sort of data.

We can boil this down to a question: if financial demand isn't pushing oil higher, then what is? I have yet to find any other plausible explanation. The conventional view is to short oil because it "should be $70/barrel" due to full storage tanks. Since the market is not doing what it should, something else is at work.

As for the source of the speculative capital--it seems self-evident to me that it is the direct result of Fed and central bank credit creation, and the ability of financiers and trading desks to borrow money in size at near-zero interest rates. If we use the Yen carry trade as an example, it seems several hundred billion dollars moved out of that trade once it was no longer profitable.  That is simply one hint of the size of the pool of "hot money" seeking a large market where it can move in and out without distrupting the market.

The energy market is large enough to appeal to hot money. Few markets are large enough and liquid enough to enable massive speculative capital flows.

As to what happens to the oil, clearly it remains in the physical distribution system. The question then becomes, is the world really awash with oil or is supply tighter than generally assumed? That is a question that's beyond my pay grade to answer in an informed way, but I tend to think supply only looks ample because we're looking at the margins.  A billion barrels of stored oil sounds like a lot, but that's only 11 days supply at roughly 90M barrels/day global consumption.

Here's the question I think about: if speculators are buying oil futures contracts (or derivatives based on futures) and then rolling them over *and adding more with every rollover*, then wouldn't that sustained futures buying push the price of the underlying commodity higher? It seems to with other commodities, so why not with oil? To say that financial demand is not equivalent to physical demand is to say that futures contracts have no effect on commodity prices, which is clearly incorrect.

The cause of oil's breakout is an open question, andmy answer is tentative and open to revision or correction as data dictates. If oil does drop to $70/barrel, then conventional supply-demand metrics willbe proven correct. But if oil keeps rising as the global economy slows, then some other dynamic is in play.

Thank you for the questions.

sand_puppy's picture
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Thanks again CHS

And, on a personal note, I especially appreciate your book "Resistance, Revolution, Liberation: A Model for Positive Change" as it provided me with a much needed way of framing a personal response to the increased centralization of social control, a process that is profoundly distressing to me.  

RoseHip's picture
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Commodity prices during a forth turning

Could we not view commodity pricing and financial market behavior thru the lense from the lessons of the forth turning, and it's ability to predict future outcomes? Would entering into crisis mode thru generational motivations be enough of a push to lower the influences of supply and demand and replace them with the driving indicators CHS is seeing? I would think if oil is the supper commodity, this is the first place we should expect odd behavior to begin. And the greater the perceived crisis the greater the influence this will have on investing and commodity prices. Just a thought don't know if there is any validity to...


yogiismyhero's picture
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Charles, what is special with your responses are that... make us think along with you. Charles, I see and the explanation could fit what is happening. I just don't know how long a strategy like this would work. I will go and re-read the article you left for us to maybe pick up on the nuances of the essay more clearly. I will say though that with the commodities and assuming gold is that too they have all been trending their fundamentals in spite of all the thin air cash. relatively speaking. My gut feeling, we got a strong leg down to come, and I will stand pat on this feeling. I just heard an explanation today from Erik Townsend over at Financial Sense that is intriguing too. Thank you again Charles.

gillbilly's picture
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Financializaton of oil

Charles, thank you for the article. I would guess you're correct. The big players have financialized almost every other market. Won't this financialization only cause larger volatility since it's also tied into the real economy supply and demand, which can be fickle. Once the leverage gets to the tipping point, won't those playing this game try to correct any mis-financialization causing faster and larger swings? It's evident from 2008 that algorithms and stochastics only go so far in predicting what is outside an acceptable level of risk. If this is what you say it is, it seems the downturn could in fact be fast and deep, since most of this pricing is not based in reality. What's your opinion?


Calm47's picture
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The world is changing, and

The world is changing, and changing much. The world started to transition to the new system of production. Such a shift is changing our view of the world changes the meaning of the concepts of power and strength. Introduces a new scale in geopolitics ( ). When the mechanisms of these changes are not known, when you do not understand the processes, are often looking for simple explanations, such as conspiracies.

yogiismyhero's picture
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Charles, it appears you are spot on with your...

...observations about this essay of yours. For me, I see it, all of it and still cannot believe what I am seeing. I understand all the hot money but perhaps I give too much credit to those who should know how toasty this market is and yet still play the long end.

Adam just penned a brief but concise essay on why the markets are acting in just the opposites of anything that makes any logical sense. i went short oil not long ago, and still have no fear for what drove me to my decision. I do not like my percentage loss at all but I made my bet on the fundamentals and will just let this run. Anyways, great call here and of course I wish I had waited but I really don't have issues with "Risks" and will let this take its course. My greatest fear really is not being in this market on the short side when the HFT go all stupid and sells. Crazy what is happening now are my thoughts, and not so crazy to you and is why you make the big bucks.

Charles, I have everything from 2008 and this so reminds me of the run up to $147 (?) a barrel and my thoughts are that every dollar rise is just killing this economy further. I expect a mess and I just have to participate in this come hell or high water. Nice call Charles.

crysangle's picture
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Hello Charles . 

Your overview covers  oil market reality well . I have a slightly different view that might help gain perception . I am not an investor, but the price of oil has followed my estimates . Firstly consider oil as a currency , roughly similar to what some may wish gold to be , except that apart from having a relatively fixed static amount available over time , or tradable at any one point in time , it also has a continuous demand , a  main part of which is by pure human necessity . In other words one society may reduce its oil use a certain amount , but there are many other takers elsewhere - you would know the proportions of advanced economy usage vs. developing markets etc. So we might make no mistake there is no shortage of demand . The next question is how production is distributed globally - at what price , or conversely what price is any currency worth in oil . The dollar has a large pegged following which is part of what might be called a club , but the dollar is losing value vs. oil - have you not considered that oil is a superior currency ? A more necessary unit ? In other words the rising price of oil is little more than the falling value of the dollar . We might add to this the financial adventure of price discovery . I don't think that storage or purposefully reducing production has a great effect on prices , they moderate prices somewhat , they form a public sentiment , they may even be used to make small profits , but in the greater scheme they are minimal . So the finacialization of oil is in essence the targeting of the highest price - when sentiment finds an investment that gains traction , that might be made to gain traction , it finds a reality of its own . This is manifest in a simple example,  before true scarcity of supply or demand is reached :

Consider demand exists and has ten cash to spend . Demand needs oil . Oil was being sold previously by the middle men (finance) at one cash , demand paid one cash . Finance decided to raise the price to two cash , demand paid .... and so on . 

So simple price discovery will shake out the true value of oil in dollar terms - it does not have to restrain supply , all that needs to happen is that the offer side of the market , as a whole , presents a higher price of purchase , and demand has to be able and willing to pay that price . When it comes to a modern necessity like oil , the only question is how demand reacts . No matter the price paid , if it is above production cost at least, the greater flow of cash to the producer of oil will find its way back into the economy , and in doing so will be spent eventually where there is greatest demand (oil)  . So the concern is not what price level any given economy might stand before demand implodes , unexpectedly to a degree from the overall cost increases due to higher energy prices that only incorporate themselves with some delay , but from the perspective of a supplier of this currency (oil) how , in the greater picture , might he benefit the most from who he supplies his necessary currency to . In other words the world economy will have to adapt itself , in one way or another , to the availability of energy , and fiat , by comparison , is very  cheap in exchange . Obviously there are wider geopolitical agreements at stake also , but the elite forces compete within roughly the same parameters or objectives and though in outright displayed disagreement nevertheless tend to be tacit enough to understand the rules and to quietly concede where there is no loss to themselves, or at the least to minimize loss - not to give the whole game away by direct open confrontation . So no great conspiracy , it is simply in every oil producers and traders immediate  interest to set the price as high as possible , and it is in every consumers interest  to be able to pay that price . 

agitating prop's picture
agitating prop
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Great article, Mr.CHS

....I just finished having a conversation with a fellow I met on a peak oil forum, about 8 years ago, on this very subject. When oil prices began to really spike up, I realized that oil's price was only tangentially related to scarce geological supply--at that time-- and had more to do with a weak dollar and financialization of oil supply.  I was nearly booed off the forum!

  Further to financialization of oil, the process can be applied to other necessary commodities, like wheat,  corn, potash, phosphorous.  When the effects of climate change and genuine scarcity are figured in, there could be explosive price moves upward.

There is a role for govts to play here. The Arab Spring was about Arab hunger. It can happen anywhere when large pools of money, engage in piracy of the basic necessities of life.

The best way for governments to curtail this kind of activity is to make gold bullion a tier one asset. Should central banks do this, much of this money sloshing around, doing real harm, would park in gold and let oil and agriculture rise or fall in a sane way that reflects real supply and demand. If a gold bubble is blown skyward, it's not going to hurt anybody, won't provoke revolutions. 

The argument that paper-bugs use to defend their position that--gold is a worthless relic, not good for anything, is precisely why it makes it the perfect vehicle for a bubble and a safe haven in uncertain times. We don't need it to fill our vehicles or our stomachs. Ultimately, for the reasons you have stated so well in your article, Mr. Smith, I think govts are going to be forced to change the status of gold.

Didn't mean to turn this into a gold rant...forgive me!smiley


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