Buttonwood on Oil

This Buttonwood column($) from the current issue of The Economist is about as mainstream as you can get when it comes to oil prices. Like most others in the financial world, this anonymous economist sees the commodity price action of the last few years as an aberration - much ado about nothing.

WHAT a difference a year makes. When Russia cut off gas supplies to Ukraine in January 2006, crude prices jumped 19% within a few weeks. This year, a similar halt to supplies, because of an oil dispute with Belarus, was a one-hour wonder in the market. The crude price slipped close to an 18-month low on January 9th.

Oil has not been rescued by planned production cuts by the Organisation of the Petroleum Exporting Countries nor by speculation about an American or Israeli attack on Iran, both stories that would normally add several dollars to a barrel.

Some attribute oil's fall to the mild winter in the northern hemisphere, which saw New Yorkers sunbathe in early January. But copper has also been plunging in price, which cannot be blamed on the weather. Other metals have been dragged down in copper's wake. The Economist All-items commodities index, which excludes oil, fell 10.2% in the week to January 9th (see chart).

It is possible that falling commodity prices are signalling a rough patch ahead for the world economy. Perhaps they are catching up with the mood in the bond markets, where the inverted yield curve (in which short rates are higher than long rates) has, many believe, for months been pointing to a slowdown.

But the gloom thesis is not really borne out by recent economic data, which have shown, for example, strong American employment gains and buoyant German manufacturing. Nor are there other signs that investors are becoming depressed about the outlook for global growth. The Baltic freight index, a measure of trade flows, has more than doubled within the past year (also see chart).

It seems more likely that commodity prices are being driven down by two other factors. The first is supply, as higher prices have steadily led to increased production. Dresdner Kleinwort, a German bank, reckons that 2007 could be the first year in the current “super-cycle” in which the supply problems in a range of metals will start to subside. Meanwhile, users of oil have piled up inventories (although the most recent data showed a dip), leaving them less vulnerable to supply disruptions.

Commodity markets are now turning into something like that game "Whack-a-Mole" - oil goes down then corn and wheat go up, copper goes down then nickel goes up. The production and consumption figures seem to change so quickly it's hard to make sense of any of it, but ever-optimistic economists are sure that an ever-increasing supply will tamp down prices - that's the way it's always worked.

And investors who have shunned paper assets in favor of hard assets have made the problem much worse - why can't everyone be happy with paper assets?

The second force is the flow of investment. It is surely no coincidence that the two commodities to suffer most in the recent sell-off are oil, the most-traded commodity, and copper, where speculative excess seemed greatest.

The enthusiasm for commodities in recent years has been part of a general move into “alternative assets”, a term that covers everything apart from shares, bonds and cash. The idea was to find assets that were uncorrelated with traditional holdings, a move that should improve the risk-reward trade-off of portfolios.

When such a fashion takes hold, it can rapidly gain momentum. This is because alternative-asset classes are often small and new investment flows drive prices up very quickly. To those participating in the trend, that confirms the wisdom of their original decision and encourages others to jump aboard.

With commodities, institutional investors often bought index portfolios, which meant putting money into raw materials, regardless of the fundamentals of each market. (One problem for copper is that its index weighting, along with that of other base metals, is being reduced.)

Oil is the biggest single component in most commodity indices. Citigroup estimates that, from 2003 onwards, financial flows had pushed up the price of oil by some $35 per barrel.

Well, that's the kind of number you like to see next to the word "oil".

Eventually Steve Forbes will be right - he's been wrong for two years now, but eventually the price of oil will go to $35. None of us may be alive, but eventually he'll be right.

No mention of gold in this report. The metal has been hanging around over the $600 mark for what must be an uncomfortably long time - for an economist.