Tuesday, November 26, 2013

Oil Market Goings-on During the 2008 Price Spike

I can't recall a situation in commodities that led to more polarization between market participants and the academics we depend on ex post facto to tell us what happened.

I'd get in arguments that something very strange was going on in the complex and the economists would get vitriolic in their insistence that prices were simply being driven by classic supply and demand and anyway where were the storage builds and I'd posit in situ storage and the econ guys would laugh and when it was over I'd show them a chart of the action:
Ten Year Oil Chart
And I'd laugh and point out that this sure looked like a bubble and that guys smarter than I, Wilbur Ross, George Soros and Paul Tudor Jones for example, had thought it was a bubble and bet accordingly and....good grief, who has time for all the jaw, jaw, jaw to swipe Churchill's locution and speaking of journalists one of the few who got that '08 was an anomaly was Izabella Kaminska and here she is again with  a sweet find of a paper.

From FT Alphaville:
The role of dark inventory in the commodities bull run of 2008
We’ve argued before that the 2005-2007 commodity bull-run could have been the product of an unwitting self-manufactured squeeze, as the industry rushed to monetise as much inventory as possible to benefit from higher than usual interest rates and as inventory levels dropped. (All pretty much unwittingly, of course.)
As prices increased, the economy choked.
But here’s an interesting addition to that view by way of Ing-Haw Cheng and Wei Xiong in a paper on the financialization of commodity markets. As the researchers note it’s entirely conceivable that as the economy began to choke from 2007 onwards (and in some cases even earlier), what appeared to the world to be tight inventory levels justifying higher prices, were in fact sufficient stores given the demands of the system at the time.
The final price hike therefore may have had little to do with insufficient supply, and more to do with the speculative inflows from other classes seeking diversification and principal protection in the wake of the housing asset collapse.
From the authors:
While no one doubts the importance of the theory of storage, the dramatic increase in oil prices during the first half of 2008 presents a challenge for studies which attribute it to a rise in fundamental demand. Although strong oil demand from emerging markets such as China drove prices to high levels before 2008, oil prices further increased by 40% in the first half of 2008 before peaking at $147 per barrel in July 2008. During this period, oil inventory did not spike, leading many to conclude that the price increase during this period was driven by strengthening demand as it was before 2008.

However, major world economies such as the U.S. were falling into recession in late 2007, with the U.S. beginning its recession in December 2007 (as marked by the NBER). The S&P 500, FTSE 100, DAX, and Nikkei equity indices had peaked by October 2007; with the collapse of Bear Stearns in March 2008, the world financial system was facing imminent trouble. Growth in China was also slowing: year-on-year growth in China’s GDP peaked in mid-2007, and the Shanghai CSI 300, MSCI China, and broader MSCI Emerging Markets equity indices peaked in October 2007.

With the benefit of hindsight, it is difficult to argue that the growth of the emerging economies, themselves slowing, was strong enough to more than offset the weakness in the developed economies to push up oil prices by over 40% in half a year. The puzzle is then how perceptions of demand could have strengthened in early 2008. Explicitly accounting for the informational role of commodity prices helps solve this puzzle....MUCH MORE
I think the authors and Izzy are being too kind to the oil traders but we'll leave it for now.