On Friday, all eyes were on Federal Reserve Bank chairman Ben Bernanke at the
annual conference of US Federal Reserve Banks in Jackson Hole.
As an expert on the Great Depression of the 1930s, Bernanke knows that a
further round of quantitative easing (QE3) will lead to negative interest rates
in the US, and the danger of debt deflation. He also implied, in his oracular
way, that the only solution to current problems lies in fiscal action through
taxation or spending, which is not within his power.
In other words, the Fed steering wheel has come off in his hands, so forward
progress will be difficult. But if he were to look in the rear view mirror, he
would see that the recent completion of the
QE2 round of US$1.6 trillion of Fed purchases of US Treasuries might now be
having unforeseen consequences.
The concept of "hedging inflation" was originated in the mid-1990s by the
"smartest kids on the block", Goldman Sachs, as a marketing narrative for their
Goldman Sachs Commodity Index (GSCI) fund. This innovative fund was invested in
a portfolio of commodities - of which oil had the greatest share - through
buying and "rolling over" futures contracts from month to month.
This concept gradually gained traction among investors over the years, and by
2005 other market participants were cottoning on to the potential. Oil
producers wishing to lay off or hedge the risk that oil would lose value
relative to the dollar found that these risk averse 'inflation hedgers' aimed
to do precisely the opposite by hedging the risk that the dollar would lose
value relative to oil.
Investment banks and traders, for their part, found that there are huge
advantages in bringing these two opposing but complementary constituencies
together. Based upon their superior market knowledge, massive profits may be
made, at little risk and use of capital, by providing financial services to
these funds, such as brokerage and liquidity provision/market -making.
These financial investments in the oil market were accommodated by oil
producers such as BP - which has had a long association with Goldman Sachs, for
12 years of which they had the same chairman - and from 2005 by Shell's
transparent relationship with a provider of Exchange Traded Funds, ETF
Through opaque sale and repurchase transactions in off-exchange Brent/BFOE
(Brent, Forties, Oseberg, Ekofisk) crude oil contracts, oil producers were
essentially able to lend oil to the funds and in return to borrow dollars
interest-free from the funds.
Accompanied by a drumbeat of hype in respect of oil market supply and demand,
the price was inexorably ramped up, until in early 2008 there was a "spike" in
price to $147/barrel; US gasoline prices reached painful levels, and demand
At this point, not only did speculators/manipulators (according to who you
believe) liquidate their positions, but speculators actually reversed their
position to go "short" of oil. The oil price fell rapidly, and in late 2008
many of the "inflation hedgers" - who are the complete opposite of speculators
and had by now taken a beating - also pulled out, and the oil price fell as low
as $30/barrel, which was an extremely painful level for oil producers that had
so recently been laughing all the way to the bank.
In October 2008, the collapse of Lehman Brothers led to extraordinary measures
by the Fed to keep the sinking dollar-based global financial system afloat.
Firstly, the zero interest rate policy (ZIRP), and secondly, QE1 - massive
injections of freshly manufactured dollars by the Fed as emergency liquidity -
which was analogous to a massive transfusion into an accident victim.
But while this patient's visible wounds were stitched up by capital injections
to banks, internal bleeding from the colossal overhang of unsustainable
property loans has continued, and this led to the need for $1.6 trillion of
what became known as QE2.
Now, these new Fed dollars had to go somewhere, and with dollar interest rates
at zero, investors wanted anything but dollars, whether potentially
income-bearing (equity), or not (commodities); and whether useful (oil; base
metals; agricultural commodities) or not (gold). A tidal wave of dollars flowed
into the markets, and in the oil market the sheer scale of these financial
purchases could be accommodated only by two producers: either Saudi Arabia - a
long-standing US partner - or Russia, a long standing rival.
From early 2009, for well over a year, there was clearly an accommodation
between the Saudis and the United States whereby the Saudis leased oil -
through sale and repurchase agreements - to financial intermediaries, who in
turn either leased it to the flood of new inflation hedging funds, or sold
complex - and remunerative - structured products instead.
Through this market manipulation on a cosmic scale, the global oil price was
kept pegged between an upper level, which would not endanger US presidential
prospects of re-election, and a lower level, which would provide sufficient
funding to meet the needs of an increasingly restless young Saudi population.
To all intents and purposes the Saudis have - through the good offices of the
best financial brains money can rent - been printing oil, which as Bernanke has
jokingly said, even the biggest central bank in the world cannot do.
For over a year, this strategy went swimmingly and the secretary-general of the
Organization of the Petroleum Exporting Countries routinely said at completely
boring OPEC meetings how comfortable his membership was with the oil price,
albeit ignoring half-hearted complaints by price hawks like Iran.
Unfortunately, this strategy was fundamentally unstable, like a car ferry with
its bow doors open and with water swilling around on the car deck.
Water on the car deck
In March 2011 the oil market vessel was hit almost simultaneously by two waves.
Firstly, and literally a wave, the Fukushima tsunami shut down a large part of
Japan's energy supply and created an energy demand shock; while in Libya a
supply shock took over a million barrels of high quality oil out of the market.
Genuinely speculative investors poured in, and the oil price spiked to over
$120/barrel - a distinctly "uncomfortable" level for the Saudis, since it led
to US gasoline prices rising to politically dangerous levels. The US and Saudis
discussed an oil swap of US reserves against Saudi production, but apparently
could not agree on price, and in the end the International Energy Agency (IEA),
led by the US, released strategic reserves on the oil market, to little
But all is not as it seems. The US and their financial agents must keep up
their side of the grand Saudi bargain by putting a financial floor under the
oil price at just the point that the QE2 tap has been turned off. So fresh
"inflation hedging" investment is now desperately sought, enticed by forecasts
of increasing energy demand in countries which themselves rely as a market for
their production on Western economies that are increasingly illiquid,
insolvent, or both.
In the opinion of this observer, peddlers of inflation hedging are both wasting
their time and opening themselves up to regulatory retribution for mis-selling,
since investors will have little idea of the true risks to which their
investment has been exposed.
The writing on the wall
The future market price of commodities may have one of two states: it is either
in contango, when future prices are higher than today's price, or in
backwardation, when the future price is below today's price.
Typically, markets are only ever in backwardation when current demand is high.
But at the moment. market commentators are at a loss as to why it is that an
over-supplied market can be in such a massive backwardation. There is in fact
so much oil available that the Saudis - no doubt cheered on by the US - are
making predatory offers to buyers of Iranian crude oil aimed specifically at
undercutting Iran and thereby applying further financial pressure.
In my analysis, what we are seeing is what happens when the virtual oil claims
printed by the Saudis and their collaborators are being liquidated. The
resulting financial sales of oil depress the forward market price in a mirror
image of the way that financial purchases inflated the forward price when funds
were flowing into the oil market.
In other words, I suspect that the switching off of the QE2 dollar pump might
be leading to the deflation of an oil market bubble. I hope I'm wrong, because
while high oil prices may be bad for economic growth, they are good for the
planet ... a statement which itself speaks volumes about the dysfunctional
nature of a global financial system now once again at crisis point.
Chris Cook is a former director of the International Petroleum Exchange.
He is now a strategic market consultant, entrepreneur and commentator.
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