Oil gets much stronger as investors fear inflation

Oil prices averaged $94 a barrel in 2008. So far this year, they’ve averaged less than $50.

Cheaper crude has delivered the world’s oil-importers - not least the major Western economies - an annualised windfall saving of $1,600bn (£1,000bn). That’s more than all the heralded fiscal stimulus packages announced by the US, UK and Eurozone for both this year and next.

The current situation is bad, but how bad would it be if Western firms and consumers faced rocketing energy prices? By provoking inflation, high oil would also threaten our ultra-low interest rate policy - seen by many as a prerequisite of Western recovery.

Back in December, oil was below $40 – down 72pc from its mid-summer high. This column warned the credit crunch meant many oil projects would be scrapped, creating the conditions for a “bounce” in prices.

The suggestion was made that the “comfort” provided by the then widely-held view that crude would drop below $30 gave such arguments “more credence than the fundamentals suggest”.

Since then, oil has indeed spiked. Earlier this week, crude traded at $62 a barrel - 85pc up on three months ago. No credible analyst foresees $30 oil anytime soon. In fact, global commodity markets strongly assume oil will keep going up.

In mid-March, crude for immediate delivery traded at $45 a barrel, while the futures market priced oil for delivery in 2012 at $63. Since then, the entire futures curve has shunted upwards. The oil market isn’t only in “contango” – that is, future prices are above those today. The contango now exists across a range of prices which have all surged some 50pc in eight weeks.

That’s happened even though growth assumptions have been down-graded. Since mid-March, the IMF has lowered its growth forecasts for the US, UK, the Eurozone - in fact, for the entire global economy. That should mean lower oil prices, but crude has still gone up.

Oil traders are now realising “demand destruction” arguments have been over done. Across the big emerging markets, now accounting for around half of the world’s total oil use, consumption is still rising fast, despite the credit crunch.

The global population continues to escalate – and in the most populous countries per capita oil use is growing faster still. Even in the Western world, the fall in demand has now bottomed out and oil use is growing once more.

But the real cause for concern is the supply side. Amidst a lack of finance, large crude exporters such as Saudi Arabia, UAE and Russia have indeed put major drilling projects “under review”.

The number of oil and natural gas rigs operating around the world dropped 11pc in April alone. Having fallen for seven months in a row, this “rig count” is now down 42pc since September as energy companies’ credit lines have been cut.

The International Energy Agency, the Western oil watchdog, has just acknowledged that spending on oil exploration and future production will drop 20pc this year, double its earlier decline forecast. On top of that, global oil markets are growing ever more concerned at mounting evidence the world’s largest fields are now seriously depleting.

These developments are setting up a “vertical supply curve” – where, as the global economy recovers, just a small demand increase could cause a shocking price jump.

The “demand and supply” fundamentals, then, point to firmer oil prices going forward. There will be lurches - there are in any market - but in my view the trend is up.

Having said all that, even these fundamentals have been out-gunned in recent weeks by more important trends. On Friday, the dollar index – which compares the greenback to a basket of the world’s major currencies – hit a new 2009 low. The index is now down more than 5pc this month, one of its steepest falls in 25 years.

As the US currency drops, oil prices rise – not least because crude is priced in dollars. At the same time, the weakness of America’s economy means the dollar’s “safe haven” status is being questioned. Again, long-term doubts about the dollar tend to drive crude prices up.

But something else is happening too. In recent months, the Western world has broken a series of policy taboos, printing money like crazy and issuing mountains of government debt.

All this is spooking sophisticated global investors. They worry about future inflation and the debasing of the world’s major currencies. That’s why they’re buying oil and other commodities – as a new safe haven and an anti-inflation hedge. It’s no coincidence the decisive shift in the oil futures curve has coincided with the onset of “quantitative easing”.

This column has often argued the West’s policy response to sub-prime would make a bad situation much worse. I fear global oil markets could soon be saying the same thing.

CLINTON ADMITS HE SHOULD HAVE LISTENED TO BROOKSLEY BORN

Last weekend, I repeated my long-standing view that US President Bill Clinton made a grave error by repealing Glass-Steagall in the late 1990s.

Since then, I’ve heard from the former President himself, at a conference in Switzerland. So did Clinton regret removing the firewall between prudent commercial banks and riskier investment banks? Didn’t this act encourage excessive risk-taking with state-backed deposits, landing taxpayers with an almighty “bail-out” bill?

“I’m not convinced we made a mistake in allowing commercial banks to get involved in investment banking,” said Clinton. “But I accept the legislation facilitated more bank mergers and banks got too big, too fast, to be properly managed”.

After that semi-concession, Clinton back-tracked. “The bill [repealing Glass-Steagall] was passed on the basis someone would be minding the store - that the regulators would do their job,” he said. That lays the blame squarely on the US Securities and Exchange Commission.

But then, unprompted, the former President added: “I regret that I didn’t regulate derivatives … I should have taken advice”.

This is a telling reference to an episode involving Brooksley Born, a distinguished financial lawyer, appointed by Clinton in 1996 to run America’s Commodity Futures Trading Commission.

Admirably independent, Born issued warnings within government about the systemic dangers posed by America’s vast and entirely unregulated “over-the-counter” derivatives market.

Worth some $600,000bn (£375,000bn) today – having grown 20-fold since Born first raised the alarm - there is now near-universal agreement this massive expansion, and the counter-party risks involved, did a lot to cause the current crisis.

When she issued her warnings, though, Born was treated disgracefully. As a first step, she asked financial institutions for data about OTC derivate trading. But Clinton’s Treasury and Alan Greenspan’s Federal Reserve issued a joint statement expressing “grave concern about this action and its possible consequences”.

Larry Summers, then Deputy Treasury Secretary, said Born’s request “cast the shadow of regulatory uncertainty over an otherwise thriving market, raising risks for the stability and competitiveness of American derivative trading”.

As Born recently observed: “Recognizing the dangers wasn’t rocket science … but it was contrary to the conventional wisdom and the economic interests of Wall Street”.

The US government is now finally trying to “crack-down” on OTC derivative trading. Yet Summers is the pivotal figure in Obama’s economic team. Officials should heed Clinton’s belated advice, admit they were wrong and listen to Brooksley Born.

 

Liam Halligan is Chief Economist at Prosperity Capital Management