As I start this posting the WTI NYMEX Oil Price has just gone through $49 per barrel on a general trend upwards. This is an increase from a bottom of $26 and change in February. This upward trend is concurrent with increasing strength of the dollar which supposedly causes decreasing oil prices. This upward trend is also contrary to general predictions on Wall Street (e.g.: Goldman Sachs) that oil prices will drop to around $20 (some are predicting $10) but it is also in compliance with many other predictions that an increase back to more than $100 can be expected by the end of the year.
Daily headlines regarding the oil supply – demand balance and the effects on oil price also are conflicting. We can read on a single day that “Oil price is down due to a stronger dollar”, “Oil price is up due to significant lost barrels”, “Oil price is down due to a storage build” (of 1.3 million barrels), “Oil price is up due to strong demand from India”, “Oil price down due to return of Canadian oil sand production”, and “Oil price down as Fed signals interest rate increase in June”. Other influences are that Iran, Alberta, and Iraq are increasing production while Nigeria and Venezuela are decreasing production and Libya is predicted to decrease and increase depending on whose prediction you read.
All these conflicting influences and predictions indicate an oil market and pricing environment which is not well understood, buffeted by a myriad of influences, and very sensitive to all of them. This confusion is the result of a oil price downturn like none of its predecessors, subject to forces and influences not present in previous downturns and therefore responding to those forces and influences in unanticipated ways.
This downturn is taking place in an international financing, banking, economic, and geopolitical environment which, despite wishful thinking and pronouncements from the Obama administration, has never recovered from the 2008-9 financial crisis. At this time, we have a fragile banking system with low reserves in a chaotic and unstable high-risk environment. Europe has never recovered and has compounded its problems with immigration crises, uneconomical energy decisions, and increasing pension and union labor burdens. Investors are pulling out of European markets.
In the US, we have a Federal Reserve Chairman who, within 30 minutes testified to Congress that she was very surprised by changes in the oil price (which she had a large influence on) and was taken off-guard by the drop in the value of the dollar (management of the value of the dollar is a responsibility of the Fed). High officials in the IRS admit to corrupt and unlawful practices but the Treasury and Justice Departments take no action. Such public admissions of incompetence and corruption do not instill confidence in investors with respect to our banking, finance, and legal systems.
At the same time, the head of the IMF, Christine LaGarde, is advocating that banks in the major economic countries alleviate government debt problems by confiscating 10% of the deposits in their banks. Of course, she does not call it confiscation; for the funds confiscated she proposes awarding shares in the same bank that has been so mismanaged it must confiscate depositors’ funds. In addition, she advocates negative interest rates, which is an incremental form of deposit confiscation already in practice in some European countries and Japan. Negative interest rates were also mentioned as a possible policy by our own Federal Reserve Chairman in a speech in which she also suggested the Fed would be increasing interest rates at some time in 2016.
What the Fed Chairman does not seem to realize is that in response to the vote to approve Quantitative Easing 2 (QE2) in late 2010 the oil price increased and in response to the end of Quantitative Easing in August 2014 the oil price started a long slow decrease.
Many commentators blame the oil price decrease on storage increases and refer to the increased production capacity and storage as a “glut” but storage increases did not start until early 2015 and the surplus production capacity is variously estimated as between 1.3 and 1.8 million bbls/day – in a 95 million bbls/day market – or about 1.5%. This is certainly the smallest glut to ever cause an oil price crash and industry downturn.
In August 1971 President Nixon cancelled the convertibility of the United States dollar to gold; the dollar started a long decline in value and has lost approximately 95% of its value from then until now. In October 1973, the United States supported and supplied Israel in a war with Egypt and Syria. In retaliation, Saudi Arabia declared an embargo of oil shipments to the United States (and Holland, and later South Africa). US Government agencies and the American public presumed this action reduced oil available to the US (it did not) and everybody tried to fill their car gas tanks at once causing gas lines and a panic about fuel shortages.
Secretary of State Henry Kissinger, about the only functioning part of the United States Government who was not caught up in the Watergate scandal, flew to Saudi Arabia and met with the Saudi King. He renewed the US guarantee of Saudi security (first provided by Franklin Roosevelt during WWII) on the condition that the Saudis would sell their oil only for US dollars. The Saudis agreed but, because the US dollar had been de-linked to gold, they would increase the price of the oil from about $2.50 per barrel to $15. In addition, two years later they nationalized the US companies out of Aramco and renamed it Saudi Aramco. Thus, the Petrodollar was born. Nixon resigned. A decade followed of Arab domination and turmoil in the oil markets. Other Arab countries followed suit and eventually the US dollar was used for all international oil trading and the US dollar is the world’s reserve currency to this day – but it is under attack and may not be for long..
Lately, various countries have started trading oil in other currencies, notably China and Russia. Iran is also trying to trade oil in Euros. With a sustained attack on the Petrodollar and a weak US Administration, the dollar may lose its status as the world’s reserve currency in which case, with high US Government debt and a weak bank system, it can be expected to lose value precipitously.
With a weakened and vulnerable banking system which may be used by governments to confiscate deposits to pay down government debt and attacks on the dollar the question arises as to what one should do to protect wealth. Where can you park your money? Many suggestions are offered for investor consideration: Farmland, gold, silver, pallets of AK-47 and AR-15 ammunition, diamonds, art, and others. These all may be of interest for individual investors up to a certain value but for storage of wealth in the range of several billions of dollars some of these are not practical. What possibilities are available for fund managers moving out of equity and bond markets looking for places to put wealth where it can be maintained and have a reasonable return?
An interesting study by Ramon Marimon, Ellen McGrattan, and Thomas Sargent (Journal of Economic Dynamics and Control 14 (1990) 329-373) found that in a market actively trading many goods and commodities the medium of exchange will become the commodity with the lowest storage value. For centuries that medium has been metals, usually in the form of small metal discs. But when one considers the preservation of value of billions of dollars the transport and storage of metal discs (or bars) becomes awkward and impractical and the storage cost may not be so small. In addition, low storage cost may be necessary but it is not sufficient.
A medium of exchange must also:
- Be of a recognized and certified character and quality. This was achieved with small metal discs by stamping images of kings or emperors on one side and a coat of arms or religious symbol on the other. The US tends to put an image of Miss Liberty on one side and an eagle on the other.
- The medium must be available in sufficient quantity to provide liquidity in the markets where it becomes the medium of exchange. This rules out such things as the Swiss Franc for the international markets.
- The medium must have widespread acceptability and be politically neutral. The dollar’s status as the world’s reserve currency is still justified and supported by its status as the Petrodollar but this status is under attack from external parties (China, Russia, and Iran) and is in doubt because the Obama administration has scuttled the US-Saudi relationship.
In addition, widespread acceptability and political neutrality of the dollar has been systematically undermined by domestic policies for several years. Quantitative Easing, Dodd-Frank, IRS and DOJ corruption, banking system instability, imposition of US politics on foreigners, and FATCA have undermined the value, stability, neutrality and desirability of the dollar and banking relationships of foreigners with the US. Many foreign individuals, banks, companies, and other organizations now avoid business with the US unless they need dollars to trade in oil. Because of this, if the status of the Petrodollar erodes, dollar value in international transactions will collapse.
Because of the current weakness, instability, and low returns in the traditional bond and equity markets and the banking system, oil has several advantages for storing and investing wealth:
- It is one of the largest and most fungible commodities in international trade. Its trade is large enough to provide liquidity in the international trading system.
- Because an adequate oil supply is necessary to maintain any modern economy, oil has a liquid market and will for decades to come.
- Oil is fungible in the currency markets; it can be traded directly or exchanged into any other currency – now or after any major upheavals in the international monetary system and re-alignment of the world’s currency markets after either dollar or Euro collapse.
- Oil is traded on open markets and public exchanges with open pricing, and
- The quality and quantity of oil trades are certifiable in a widely recognized and accepted format by international agencies, shipping companies, terminal operators, transport operators. and other third parties.
- The oil markets are closely interrelated with the financial markets.
Storage of a barrel of oil generally costs between $0.25/bbl/mo and $0.50/bbl/mo or, at today’s oil price, between 5% and 10% per year. Thus, buying oil and storing it makes sense as an investment if one believes the return is higher and safer than can be obtained by keeping money in a bank or investing it in a bond market. With a production overcapacity of about 1.5 million bbls/day in a 95-million-barrel-per-day market, overcapacity is only about 1.5% – pretty thin, so once that disappears, a rapid increase in oil price can be expected. Volatility is a hallmark of marginal prices determined by open bidding in public markets so a rapid increase of oil price can be expected for a small variation of the demand/supply balance.
The question then becomes: Where else could you invest funds and get a better return in the next three years than in buying oil and storing it? As an investor or as a refiner.
The oil downturn and drop in oil prices since August 2014 is commonly attributed to surplus production capacity compared to demand and large increases of stored oil in various parts of the world – commonly described as a “glut”. As noted above, however, oil prices started downward in August, 2014 with the end of Quantitative Easing by the Federal Reserve. Increases of storage above normal levels did not occur until several months later in early 2015. Reports of tankers full of oil standing in various ports of the world and above-normal storage of oil in various land terminals and storage sites have persisted ever since. Additional storage facilities have been built. Crude oil storage in the US is above normal by about 40%. The downturn in prices did not result in widespread production shut-in, however. Somebody is taking advantage of low prices and buying the surplus oil and storing it. That buying is putting upward pressure on prices.
As I post this, the WTI NYMEX oil price is still above $49/bbl.