Thursday, November 13, 2014

Connections: Understanding Oil and Finance

This is what I think of as the ecological view of commodities.

Not ecological in the touchy-feely Earth Day connotation but rather in the hard science denotation: Everything is connected.

And if you can figure out the connections you have a fighting chance at global macro.

From FT Alphaville:
Dollar reserves as goodwill oil-product claims
A while back we proposed that oil prices are more interest-rate sensitive than most people appreciate.
The logic goes as follows.

When interest rates are low it makes more sense for producers and commodity owners to hold their wealth in commodity-form rather than in money-form — especially if speculators are prepared (via the forward curve) to compensate them for the cost of storing these commodities in terminals, tanks or even in the ground.

Low interest rates thus support commodity prices because they encourage commodity owners to sell only what they need for financial liquidity purposes and little more, a fact which naturally keeps the market tight.
The more generous speculators get, however — by means of the contango payments they offer to commodity producers or holders — the greater the incentive to dig up commodities for store-of-value purposes rather than consumption purposes, and to withhold that supply from the market.

The inverse is true if interest rates are on the rise. During such periods it makes much more sense for commodity producers and owners to transform as much commodity stock into monetary claims and park it in the bank. But this is also the case whenever speculators decide to stop compensating the industry for holding commodities in physical form, and the costs of storage become too great.

And, what factor is likely to woo speculator money away from forward commodity claims and back over to claims over real economy product? Well, we’d propose, the compensatory rate they are likely to receive from the real economy for deferring consumption until tomorrow — also known as the interest rate.
After all, if you’re not redeeming your claims today, you’re in the business of preserving the relative value of your claims tomorrow. And claims over commodities ain’t really half as useful as claims over the stuff that commodities can create or provide to society.

Point being, when interest rates are on the rise, there’s a good chance you’ll be better compensated by allocating current claims to those who can make use of available commodities, than those who have an interest in withholding them from the public.

Take note of the coincidental flow factors that support the story via this chart from Simon Derrick at BNY Mellon...MUCH MORE
I suppose you could also consider it a "Burkean" framework (James not Edmund).
However, see also "Resolved: This House Believes You Can Take The "Connections" Crap Too Far"