Monday, June 30, 2008
Friday, June 27, 2008
Wednesday, June 25, 2008
Tuesday, June 24, 2008
Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price. And that’s true no matter how many Joe Shmoes there are, that is, no matter how big the positions are.His charts are clear and I do agree with them, BUT they ignore one key component that his readers keep posting to his site. Since he may not be reading his readers comments, I'd like to summarize them by attempting to answer his parting question:
Maybe I’m misinterpreting what the advocates of a speculative story are thinking. But in that case, what are they thinking? I’m curious.
Paul likes basic examples, so here we go with a little story about Country A....
- Country A owns one oil well.
- This oil well contains 1000 barrels of oil.
- They planned to sell 100 barrels of oil this year (1/10th of their total inventory) at a forecast of $70 / barrel.
- They can pump out more oil, but they are worried about their future when they run out (currently projected at 10 years)
- They do however, need at least $7000 / year to manage their country
So what happens when speculation drives up the futures price to $140 / barrel? Country A is faced with two options (keeping it simple):
- Option 1: increase production and lock in this profit
- Option 2: meet the current budget by selling half of the amount planned (50 barrels); sell a portion of the remaining inventory in the futures market
- Pro: can lock in this high profit and get cash to meet future budget needs
- Con: what do they do with this money (in reality they may already have too much cash to put to use)? The best investment opportunity for global investors these days is where else? Energy companies and commodities! Why take the best investment option for many and swap it for U.S. dollar based Treasuries which barely have a positive real yield?!?!?!
- Pro: along with the possibility of even higher prices in the future (global demand, geopolitics, peak oil), Country A can maintain its relevancy as an oil producer in world politics for more than the previously thought 10 years.
- Con: uncertainty of the future price of oil, but Country A can sell to Joe Shmoe, who is now an investor in the futures market or more simply, just keep it in the ground!
So what is happening to the world supply of oil? Production by the Organisation of the Petroleum Exporting Countries fell by 350,000 barrels of oil a day last year, coinciding with a decline in net imports of crude into the U.S.
In summary, oil producers have a significant value in keeping oil in the ground. In fact, I believe the important question to ask is whether this value is causing the price of oil to spike OR whether speculation in oil (i.e. massive amounts of new commodity investments) is in fact creating much of the value in keeping it in the ground?
With the market now firmly believing a pause is in order, lets quickly recap how credit markets (specifically the yield curve) reacted over the past month to Mr. Bernanke's "strong dollar" statement.
June 2nd "Strong Dollar":
The challenges that our economy has faced over the past year or so have generated some downward pressures on the foreign exchange value of the dollar, which have contributed to the unwelcome rise in import prices and consumer price inflation. We are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations and will continue to formulate policy to guard against risks to both parts of our dual mandate, including the risk of an erosion in longer-term inflation expectations.
June 13th Peak / June 16th: Fed "speaks" to Sudeep Reddy?
I previously detailed that CPI may overstate inflation for an individual who:
- does not own a home
- would like to own a home
- will likely soon buy a home
As can be seen below, the Case-Shiller Price Index flipped negative year over year for the first time in April as today's Case-Shiller release shows further deterioration, with the Composite 10 dropping over 16% year over year.
In looking at the Composite 10's five year rolling returns (annualized), even after the huge downturn in prices, returns over the most recent five year period are still positive at ~5% / year. A 5% return over this period is still pretty significant considering current housing fundamentals and tells me there is still room for further deterioration.
Thursday, June 19, 2008
While I completely buy into the whole China / emerging markets story for a portion of the higher prices we've seen in oil, it is amazing to me how many people question whether new investors / speculators "inspectors" have made an impact. 'If it were "inspectors" where is the build up in inventory?' they asked. I believe much of this was was correctly explained by Paul's own readers. With the emergence of this little tidbit, which supports the hypothesis that not all information regarding the questionable (lack of) inventory build up is available, lets put that to rest until we get some better data points.
I thought I'd move on to discuss another reason listed as to why "inspectors" do not have an impact, which is because they:
"Invest in futures, rather than in physical supplies of oil. So every month, they must trade contracts that are about to fall due for ones that will not mature for several months. That makes them big sellers of oil for prompt delivery."This is flat out flawed. In a nutshell, participants (buyers and sellers) of futures which CAN be delivered, can buy / sell the spot / future (or a mix of the two) because they are THE SAME THING, just with a different delivery dates. Think of a spot sale as a future at Time = 0. With more buyers emerging to invest / speculate, demand has increased which equals higher prices.
Let me provide a very basic example. For simplicity assume no financing or storage costs associated with the futures, thus the futures prices should always be equal to the spot (or else there is an arbitrage opportunity) and that only two dates of which the futures are available; 1 and 2 years out...
1) With no speculators; spot price = futures price at Time 1 and 2
2) Speculators (or index investors) new to the market buy at Time 2, driving up prices
3) The difference between 1 and 2 year prices are arb'd out by futures participants (ignoring cash market for now)
4/5) The spot market converges as those who typically buy in the futures market have an incentive to buy in the spot (i.e. producers or even hedge funds), while sellers who typically sell in the spot market, have an incentive to sell in the futures market and keep storing the underlying (either in inventories or in the ground).
Click picture for larger size
Thus, the actual position where futures players "invest" (Time 1 or Time 2) does not matter. What matters is the "net exposure" of their investments. Thus, rolling the position (the trading of contracts quoted above) which consists of a buy and a sell order to keep the investment in the futures market, has little or no impact on the spot price, as the "net exposure" does not change!
It is only at initiation of the new position that the demand for the underlying commodity has increased. As each day passes, more and more "investors" globally are adding commodities to their portfolios (because commodities are exploding) which increases the "net exposure", the net demand, and the price even more! Sound similar?
Wednesday, June 18, 2008
Sunday, June 15, 2008
Paul Krugman points out in a recent post that free trade does not necessarily mean lower prices. He directs us to a Dani Rodrik post from 2007 which makes the case that:
When a country opens up to trade (or liberalizes its trade), it is the relative price of imports that comes down; by necessity, the relative prices of its exports must go up! Consumers are better off to the extent that their consumption basket is weighted towards importables, but we cannot always rely on this to be the case.Dani later theorized that:
when the U.S. gets better market access abroad for its agricultural exports (a key demand under the Doha round), you can be sure that this will raise domestic prices for these goods, not lower them. The reason why this is the case can be seen in the following basic "all else equal" example related to Meat X (my personal favorite)...
- Americans consume a lot of Meat X.
- Free trade now allows U.S. farmers to export Meat X to Europe
- The U.S. supply of Meat X decreases
- The price level of meat X in the U.S. increases (if you don't know why, please go here)
So what happened to the price level? When looking at data since 1999 and comparing the speed of this increase (in this case by calculating the change in the year over year increase) to the YoY change in the U.S. Food and Beverage Consumer Price Level, when net exports increased, the food and beverage price level did in fact follow.
Expect to see a lot more on this in the coming months as the election nears...
Friday, June 13, 2008
- I am an individual
- I am self-serving
- I do not own a home
- I have wanted / would like to own a home
- I will likely soon buy a home
How you may ask did I create this index? I took reported YoY CPI and backed out the YoY change in U.S. Housing CPI at the 23.942% weighting. I then took this result and added the YoY change in the Case-Shiller Home Price Index at that same weight.
The result? While it ignores things like the increased financing costs associated with a home purchase, the CSPI shows inflation is not as bad for an "average person" looking to purchase a home. It will be interesting to see how this reacts when home prices finally hit a floor. Stay tuned...
Thursday, June 12, 2008
There were a lot of posts regarding the latest retail sales figures and how well the stimulus plan is / isn't working, so I thought I'd take a stab at it. There was applause, doubt, and Calculated Risk showed that even though things seemed rosy month to month in nominal terms, sales remained negative in real terms. This got me wondering how well "real" sales really were broken up by category.
To do this I simply took year over year sales growth and subtracted out year over year CPI, again by category (basic, but I am a basic man). I was going to wait for new CPI data tomorrow, but was flat out too excited to see the results...
For a little background; inflation has been shown (previously here at EconomPic Data) to be especially high in:
- Fuels / Transportation
- Medical Care
- Home Furnishings
So where are the stimulus checks going? I would argue that the stimulus checks are going straight to the tank in nominal terms (i.e. important terms) and that new shiny Plasma in "real" terms (i.e. unimportant terms). While "real" sales at gas stations are down a massive 30%+ year over year, nominal sales are up 13.8% year to year after the unbelievable run up in prices. The only area in which we see an actual "real" increase is within Electronics. This is an area in which prices are being squeezed, so using a conservative CPI inflator (yes inflator) of -6.4% deflation, we get a 10.1% year to year increase by volume vs. 3.7% increase in nominal terms.
Are people using their stimulus checks for more Plasma TV's rather than more gallons of oil? YES!
Are people spending more money year over year on gas than electronics or anything else for that matter? YES!
Wednesday, June 11, 2008
Almost everywhere on the blogosphere and mainstream media, there are posts/articles detailing how inflation is running rampant and that recent Fed policy mistakes may push inflation to that of the 1970's. The more analysis I do, the more I think investors / economists are not fully grasping what a declining economy (with declining home values) can do to price levels. I think this has all the variables required to make a strong contrarian case.
CPI specifically has been a huge target (and justly so), but on a going forward basis, the US is an economy defined by falling home prices and the impact that has spread from these falling home prices.
But what makes up CPI? Lets take a look:
Shelter makes up more than 30% of CPI, with transportation, food, and medical running significantly behind at ~15%, ~12%, and ~5% respectively.
From 1997 - 2007, CPI significantly understated the impact of shelter for the 30%+ of Americans who don't live in a dwelling they own (almost 50% for those who, like me, live in New York). This understatement shifted dramatically last year after home prices dove off of a cliff. Now, with the homeownership rates likely to decrease dramatically over the next few years, the importance of ACTUAL home prices on inflation (not wealth) will play a larger role in pricing as homes become more affordable. Thus, it is my hypothesis that declining home prices will cause CPI to be OVERSTATED going forward.
Medical costs have trended surprisingly low in recent years (note: the three year rolling period likely understates the level, but YoY figures are VERY choppy). Will medical costs continue to rise from this level? While many are critical of an Obama Healthcare plan, with the assumption Obama wins, I view it likely that medical costs will stay inline or decline.
TRANSPORTATION / FOOD / COMMODITIES:
Transportation costs have also been surprisingly steady (not sure I buy into this completely). The big pain, especially in recent years has been rising fuel costs and commodities. Looking at the year over year change in gasoline price below, one can clearly see why this is in everyone's mind.
However, in my opinion we are now at an important fork in the road with oil prices. On the one hand, if the price of gasoline were to increase, it would have to be dramatic to cause further inflationary pressures. Until two months ago a level of $150 a barrel by next June was unthinkable, but with that $150 price the YoY increase would be only ~10% (significantly lower than recent memory). On the other hand, if prices were to decline to mid-2007 levels, YoY change would be in excess of 50% to the downside. With many analysts listing the long term price of oil at $85 (and Japanese officials listing a fundamentals based value of $60) is it possible our short term biases may be wrong in assuming $200 oil is just around the corner?
While high energy /commodity costs will push manufacturers to increase prices, it is my view that a slowing economy will prevent that from happening. I won't go into specific details as there have been plenty in recent weeks / months (i.e. here, here, and here...), but with prices already declining in non-necessities, the possibility of a decline in oil, and the definite decline in home prices (which again makes up 30%+ of CPI), I view it possible that CPI is already overstated. While I don't think there is a risk that the U.S. will match Japan's lost decade, I view deflation as a serious enough threat to secular growth that it should not be completely ignored.