Lehman Brothers: Nuclear power?

Bloomberg broke the story this week that Lehman Brothers Holdings Inc. is sitting on a nuclear bomb's worth of yellowcake uranium. Apparently, the bank physically acquired the uranium after a futures contract matured. It now sits in a secure storage facility in Canada. Which begs the question:

How the hell did Lehman allow this to happen?

Actively traded futures contracts are typically closed out before the contract expires. This absolves the trader/firm from having to take physical delivery of the underlying commodity. It is remarkable that Lehman failed to close such a massive contract. DealBook wonders if the contract simply slipped through the cracks amidst all the chaos of the Lehman bankruptcy.

However it happened, the bankrupt bank is reportedly sitting on the uranium until prices rise; uranium has fallen for five straight months as traders expect delays to nuclear power projects in China and India, and under the expectation that Lehman could dump its stock on the market. Essentially, by holding tight Lehman depresses the very market it needs to recover.

I highlight this story because it underlines just how disastrous, and far-reaching, the Lehman bankruptcy has been. Lehman was an active commodities trader in the broker-dealer and exchange markets, and it got caught on the wrong side of a massive trade that continues to depress an illiquid market. The ripple effects of Lehman's failure haunt us in the most improbable of areas.

(photo source)

Say uncle: So much for that commodities rally

In my last post, "The inflation hedge of choice", I highlighted the recent run-up in commodity prices, buffeted by OPEC production cuts and speculative capital seeking a hedge against the Fed's big inflationary adventure. While I expressed deep scepticism over the sustainability of such a rally, I did anticipate a speculative run up in prices over the near-term. Perhaps I should have broadened my outlook.

A trip over to Bloomberg.com made me say uncle. Headline: Commodities Head for Worst Slump Since 2001 as Demand Shrinks. D'oh! The Reuters/Jefferies CRB index fell 5.8% in the first quarter, on top of a 50% decline in the second half of 2008. Afshin Nabavi, senior vice president at MKS Finance SA, shot down the idea that speculative capital would contribute to a commodities rally, “For commodities, the main mover is demand and supply and if demand is down, then the price comes down, no matter how many speculators are in the market.”

True, in a perfect market. But speculative capital often drives prices beyond levels justified by supply and demand fundamentals. No one still believes that $150 oil was driven solely on the strength of Chinese demand. Right? Mike Wittner, head of oil-market research at Societe General SA, makes the point that, while we have seen speculative inflows driving certain commodities higher (oil, for instance), the focus will quickly shift away from long-term inflation and back towards "the global recession, weak demand, and still-high stocks." Copper, which I cited as one of the highest-performing commodities, is still expected to decline by over 9% in 2009, in spite of the 30% run-up thus far. This would mean another price collapse is right around the corner.

I draw two important points from these experts. One, this commodities rally is likely to be shortlived. Two, it is misleading, financially speaking, to speak of "commodities" as one monolithic asset-class. As the article notes, while copper and gasoline have experienced a significant recovery this year, it was more than overwhelmed by further declines in natural gas, wheat and nickel. That is the mistake I made in my last post: I took a particular segment of market as indicative of a broader trend.

So beware of false rallies, bet on gold instead and don't take investment advice from me. Or this guy.

(photo from the following photo stream)

The copper campaign

Building on Rory's discussion of China's investment in Rio Tinto, it's worth noting that China's most recent move to develop a stake in the international copper market goes back to early 2006, when demand for copper in China far exceeded growth in the industry. By March of that year, investments in copper smelting and the production of copper-based value added products like wires and cables seemed like a safe bet. According to some estimates, demand for copper grew by nearly 87 percent between 2001 and 2006.

If you were reading government publications, you might have thought otherwise. Just months before, in late 2005, five government ministries came together to publish "Proposals on Curbing Blind Investment in the Copper Smelting Industry," citing worries about the stability of copper prices, international copper supply, the environment, and the financial risks linked to loans for new smelting facilities. But news of these worries did not seem to hit mainstream media until August 2006, nearly a year later.

The most recent decline in commodity prices has kept these same copper smelting facilities and copper dependent industries on edge - over the course of 2008, growth in the industry dropped to less than 3 %. In December, Mineweb offered some interesting observations that bode poorly for copper's future. For one, they agreed with many economists that growth in China will no longer be in the double digit percentage range. And while "infrastructure counts for some 40% of copper consumption with the bulk being for power cables," the demand for copper is likely to fall proportionately with growth in the economy. Looking closer, "factory closures, leading to workers seeking new jobs, fits labor intensive infrastructure projects like roads, railways, bridges etc. rather than unwanted electricity generating and distribution capacity." On top of this, many power supply companies canceled orders for copper cables and some provinces have even begun using aluminum for cheaper medium voltage cables.

As the force of the economic crisis become a reality, China stepped forward to make a significant effort that may save the chunk of its economy leveraged by the copper industry. This effort began in January 2009 when China released a stimulus package aimed at infrastructure projects that will inevitably require copper wire and cable. Just a few weeks after this, they bought a huge stake of copper options with the hope of maintaining a supply of cheap unrefined copper. This has become a high profile campaign, but the stakes of unemployment and economic collapse in China is a high profile game that government cannot afford to lose.

(Photo from planewalker001's photostream)

Poland solves economic crisis by going back in time

Poland deserves some recognition: they brought us Lech Kaczyński (left) and Jarosław Kaczyński (right). In 2006, Lech, the president of Poland, appointed his twin brother Jaroslaw as Prime Minister. While dutifully manging the fragile coalition government and promoting a conservative Christian agenda, the duo became overnight YouTube sensations (as well as the butt end of a new wave of politically charged one-liners). In 2007, the Law and Justice party that was co-founded by the twins lost its majority in Parliament and Jaroslaw, became leader of the opposition. Lech will continue to serve his five-year term as President until 2010.

On February 10th, Poland set another precedent (unless you consider Medvedev Putin's twin) by announcing a solution to the country's currency problems. The economics minister, Waldemar Pawlak, announced that the Polish government will pass a law allowing companies to renegotiate currency option contracts established last year. Back then economists believed Poland's currency, the zloty, would continue to strengthen into 2009 and threaten Poland's export industry. These companies had the option of purchasing currency in advance at prices below the predicted value. Had the currency continued to appreciate, these companies would have been able to continue to sell products overseas at more competitive prices than the predicted exchange rate would allow. This was before the economic downturn. Now these companies are holding currency options priced well above the going rate. According to the Economist, the zloty has lost nearly 37% of it's value against the Euro since 2008 and led to cumulative losses estimated at $5 billion. Many of these companies face bankruptcy and or failure.

To solve this crisis, the Polish government is going to allow businesses to retroactively renegotiate or simply back out of their currency options. In this scenario, the burden of the currency decline will weigh more heavily upon banks and save many companies from catastrophe. Aside from the legal mess that this will create, the move is flat out sketchy business; not unlike appointing your own brother to a top political office. Laugh all you want, but these backwater politics just may stave off the collapse of the country's export industry.

Lech Kaczyński Photo via the President of the Republic of Poland
Jaroslaw Kaczyński Photo via the Chancellory of the Prime Minister

Why you should never forecast prices

We live in strange, rapidly changing times. Just trying to keep up with the latest news on the financial crisis is practically a full time job. Last week? Might as well be talking about last year. 3 months ago? It’s like the swinging 60s are back again!

In this spirit, I want to publicly admit that I was wrong. I’ve spent a lot of time writing about oil prices on this blog, and it’s plain to see that the prediction I made about a $100 price floor for oil was... quite misguided. I still think I have the supply and demand fundamentals right, but I realize now how remarkably little I understand about pricing in oil markets. A $100 floor, which seemed reasonable in July, now looks rather absurd.

I still intend to theorize on the fundamentals and whether they will shift prices, but I'm going to shy away from price predictions.

On Mandelson, money, and oil

I apologize for the light blogging as of late. I’m starting a new job next week and moving very soon thereafter, so I’m trying to get about a million things done before then.

Three thoughts. First, you’ve no doubt seen that Gordon Brown, in an attempt to shore up his eroding political position, has asked Peter Mandelson (his once arch-enemy) to join his cabinet. Mr. Mandelson was formerly the EU Commissioner for Trade (rough equivalent to the United States Trade Representative.) His departure is a serious blow to multilateral trade negotiations, and it makes it that much less likely that we’ll see a Doha deal in 2009. In my opinion, he understood how far he could successfully push the EU position to the inch, and he had no problems standing up to some of the more recalcitrant members. His departure also seriously diminishes the institutional memory of the major negotiators, which means quite a bit in trade talks.

Second, after tonight’s debate, we can probably start talking about the McCain campaign in the past tense. He looked worse than usual tonight: old, irritated and tired. Mr. Obama didn’t have a great night either, but you don’t need to shake things up when you’re in a commanding lead. Tonight was one of Mr. McCain’s last chances to do something, anything, to reverse that. Aside from proposing that the Treasury buy everyone’s mortgage (I’m pretty sure that was new) and simultaneously proposing a government-wide spending freeze, he didn’t do much. I think he’s toast, and I will argue, as I have done repeatedly in the past, that contracts for Mr. Obama winning the presidency are still undervalued on Intrade. Fivethirtyeight’s electoral projections give Mr. Obama a nearly 90% chance of victory, which strikes me as closer to the reality. His Intrade contract is trading for $7.20ish. Do the math. If you buy right now, and he wins on Nov 4th, you’re making a 39% return in less than a month. Did I mention that Intrade trades contracts worth Real Money?!? Now who said there weren’t good investment opportunities in today’s markets? It just depends on which markets you look in.

Finally, great post by my illustrious coauthor yesterday about the “black lining” (catchy!) of the current economic turmoil: oil prices closed below $90/barrel, although I think they went back above that mark today. Either way, they’re down nearly $60/barrel since July. The point is, commodities correlate well with economic growth: you need more oil, copper, and aluminum to make stuff when the economy is good and demand for ‘stuff’ is strong, so the prices of inputs (commodities) rise as well. Problem is, now that everyone thinks the economy is going to hell in a handbasket, commodities prices are tanking. Great if you want to buy into the market, not so great if you like strong economic growth. So while Nick is right that less oil revenue frustrates the plans of nasty petro-crats, I’d qualify this slightly by saying oil prices are low for the wrong reasons. We want prices to be low because a diversified energy portfolio means we’re demanding less oil, not because we simply can’t afford it. The foreign policy implications may actually be more, not less, dire than we imagined.

Lower oil prices make me nervous

I try to avoid making hard predictions on this blog, but regular readers know that I’ve recently made two high profile picks. I’ve argued more than once that political-economic fundamentals suggest that Barack Obama will win the Presidential Election in November handily. Admittedly, that’s looking a bit dicey at the moment, but I’ll still be astonished if Mr. Obama somehow manages to snatch defeat from the jaws of victory in the most favorable electoral climate in almost three decades. I will also petition that the Democratic Party disband and its leaders seek gainful employment in a completely different line of work. Further, I’ve argued that the new baseline for oil prices will be $100/barrel. In recent days, however, oil has crossed the Rubicon and is currently trading around $96. Does that mean I’m wrong?

It’s too early to say definitively, though I don’t think so. But there’s a larger problem: it could very well be a bad thing if oil prices continue to slip.

It is a fact that the global economy runs on oil. It is also true that right now there exists no substitute that could completely replace oil. Therefore, if the global economy continues to grow, which most people agree is a good thing, it also means that oil consumption will continue to grow, which most people agree is a bad thing. But without a substitute, the world will need more oil. 37.5 million extra barrels a day, to be exact, according to the International Energy Agency. That’s on top of about 85 million barrels consumed each day currently.

Without a substitute or sustained economic recession, that oil needs to come from somewhere. The problem, as I’ve mentioned, is that most of the ‘easy’ oil is already being pumped. In a fascinating article today, RI notes that most of the oil majors are pricing new investment projects at a cost of about $70/barrel, which they would like to sell at market for $100/barrel. Simply put, if the price of oil continues to fall, it is likely that they will delay these new investment projects, which could lead to a major supply gap in the future. Rather than a gradual rise in oil prices, we might see a disruptive spike.

Conversely, it is clear that in the face of accelerating climate change and higher energy prices, the world needs to develop renewable energy sources. Say what you will about Tom Friedman, he’s an ideas man and his new book looks like it highlights what will be one of the major political economy challenges of the coming era (n.b. I haven’t yet read it). However, as I’ve also mentioned, declining oil prices likely reduce the impetus for investment in alternative energies.

Understandably, oil companies want to keep selling oil for as long as possible. It’s what they know, it’s what they’re good at, and it’s extremely profitable. In Congressional testimony last week, the President of M.I.T. noted that oil companies invest less than 0.25% of their revenue in R&D, compared with 18% for pharmaceutical companies and 16% for semiconductor firms.

But this is ultimately unsustainable. Anyone interested in developing an energy substitute in a timely fashion must first acknowledge that the era of cheap oil is over. In my opinion, any prolonged forays below $100/barrel are just delaying the inevitable hangover, and very likely making it worse.

(Incredible picture by nzdave)

Slumping oil

It looks like Hurricane Gustav wasn’t the “storm of the century” (I think that one’s pretty much locked up), nor has it caused “rain of biblical proportions”. This is not to downplay the storm’s impact: it has done some significant damage, but relative to what was expected, I am relieved for the residents of the Gulf Region. From a commodities perspective, the hurricane has come and gone without doing much damage to Gulf energy production infrastructure. The result? Oil prices have tumbled about $10.

Last month, I wrote about why I thought oil prices would stay above $100 from here on out. However, some of what I’ve read in the past couple days suggests that Gustav could be a turning point for oil markets. Now that the largest natural disaster threat to prices has passed without causing much damage, the thinking goes, the price will continue to fall. I’ll note two things: the long term supply/demand fundamentals I talked about last month have not suddenly changed, and they still suggest a bullish price outlook on oil. Second, if oil continues to fall at this point, it suggests to me that the market thinks it’s still overpriced. I’m not sure that’s the case.

At this point, I stand by my assertion last month that absent a major change in supply/demand fundamentals, oil at less than $100/barrel is unlikely for any extended period of time. You’ll recall that I also wrote about the volatility of modern oil markets: perhaps we’ll see a dip, followed by the price rising back up.

Let’s all keep watching: like most everybody, I’m an oil consumer and not a producer or trader, so I’d be quite happy if my predictions prove to be wrong.

Lower oil prices ain't gonna happen... and that's not all bad

The price of oil soared this spring and earlier this summer. Remember that? Investors, journalists, and politicians were all sounding the doomsday whistle, and not a day went by without hearing some previous unthinkable news: Goldman Sachs says $200 oil is possible. For the first time ever, investors bet that oil would reach $300 by December. On July 11th, the price reached the dizzying heights of $147.25 per barrel. Then it suddenly lost steam and began to fall faster than it had risen. The price has settled for the time being in the $110-$120 range.

People who tend to believe that the spike in oil prices was the fault of speculative traders could be forgiven for thinking that the markets will continue to correct themselves and that prices will settle at even lower equilibrium, perhaps under $100. Unfortunately for consumers, this just isn't going to happen. You've heard it before, but it's true: the era of cheap oil is over. Markets, and especially long-term market pricing, are driven by supply/demand fundamentals, which don't look good for oil (unless you happen to work for Exxon, and if so can you please get me a job???) Supply capacity is strained, and demand is surging thanks to economic development in the non-Western world. We all know this part of the story.

Perhaps less obvious, bringing significant new amounts of oil to market is challenging. You can't think of oil reserves as an absolute number: you have to consider which sources of oil are 'economically recoverable'. This basically means whether or not the profit you make selling the oil is higher than your operating costs of pumping it. The really easy sources of oil to pump (say, the desert sands of Saudi Arabia) are going at near full capacity. The moderately-difficult sources of oil to get are also mostly tapped, and you increasingly have a scenario where you're looking at pumping oil in very inhosipitable places. Think oil sands in Alberta and deep offshore drilling. This kind of production ain't cheap, and the higher costs are built into the price consumers pay. According to CNN (although I can't independently verify this), the head of exploration for Conoco Phillips says that they need a long-term base price of about $100/barrel to make future investments profitable. Because of these higher production costs and the supply/demand fundamentals, I'm quite skeptical that we'll ever see oil again at less than $100/barrel for any extended period of time.

It's also important to remember that oil markets are probably more volatile than they've ever been, so large price swings in a very wide band are likely to be the norm. And for what it's worth, a number of analysts I trust think oil prices are currently sitting near the low end of that band. Don't be surprised if the markets resemble a roller coaster for the foreseeable future.

But there is an upside to high oil prices. It is the only way that large industrialized countries will ever seriously invest in alternative fuel technologies and actually sustain that investment. Necessity in the mother of all invention. Plus, oil prices closely track expectations about the economy: the main reason they collapsed in the last month was that markets perceived that the prices would be too high for struggling economies such as the US to afford. If prices continue to retreat right now, a large reason for that is weakened demand, which suggest the economy is struggling even more. At best, lower oil prices would be bittersweet.

Economics and cable news just don't mix

I've been watching more cable news than is probably healthy since I moved back to the US. What can I say: every day is a new struggle to put off writing my dissertation. Anyways, one thing that I've noticed in particular is that the cable news format is atrocious for discussing economic news. As is such, I feel compelled to comment on two issues that I saw today:

1. The price of oil: CNN's economic "experts' have been cheering as the price of oil continues to tumble. Light Sweet Crude for September delivery is trading around $124.70 on the NYMEX. Today, they even had a poll asking whether viewers would go back to their old driving habits now that the price of gas is falling again. Easy there, CNN: oil's price fundamentals are still pointing up and any reversals may well be temporary. These days, there is high volatility within oil markets and price swings within wide margins are likely to become the norm. Oil prices may be down temporarily, but there is no evidence at this point that they'll stay down. Don't buy that new Hummer just yet.

2. The budget deficit: All the major cable networks are giving a lot of play to the new US deficit figures, the largest ever at $482 billion. Democrats are screaming bloody murder at GWB. Republicans are blaming Democrats. I don't like to take sides on things like this, but this is an election year and the Dems are really overreacting. Don't get me wrong: deficits do matter, in the sense that they signify that the government is spending more money than it is taking in. But the size of the deficit as a percentage of GDP is more important than the overall figure. Right now, the deficit is at 3.3% of GDP, compared with highs of 6% in the early 1980s. By comparison, I borrowed roughly 100% of my "personal GDP" last year to finance graduate school. Granted, this was an investment in future earnings, but many people wouldn't bat an eye at credit card bills that were higher than 3% of their yearly salary.

However, the government's budget deficit in any given year is far less important than the overall national debt, which is the total amount that the government owes from all of the times it has borrowed money to finance expenses. Again, it's important to consider this figure in relation to the GDP and GDP growth. This metric suggests that the debt isn't historically bad or unsustainable at its current level (see graph above. Source: Wikipedia.)

Enjoy cable news, but please enjoy responsibly.