Oil and Food Inflation. We know who has the silver paintbrush for this cloud

At no point in the past has there been greater confusion about the future than today. I will attempt to explain why we are in such a state of flux by explaining the real culprit behind rising food and fuel. Stay with me on this one.

The ‘bong’ news headlines brimmed with despair last week with reports about the price of oil. The world is doomed it would appear, or is it?

On one side we have driving inflation caused by issues we cannot control (food and energy), and on the other side we have a plummeting economy with house prices taking a bashing, and the Times reporting that house completions dropped to a 30 year low.

The news now reports that interest rates will have to rise to curb inflation! Are you really suggesting that I will eat less or drive less because you take money out of my pocket through interest rate rises?

Whilst dealing with any matter I have always believed that if something does not make sense, it is either wrong or I am stupid. I always investigate both options.

The real villain is purported to be two issues, namely the ‘credit crunch’ and food/energy costs driven up by excessive demand.

Nothing could be further from the truth, and it is very concerning why nothing is being done about it.

For years we are being told that the soaring price of oil relates to fighting in Iraq (caused by who), attacks on oil facilities in Nigeria, labour issues in Norway and Asian demand (China appears to be taking most of the flack here). More scaremongering appeared last week with the concerns of the tanker driver strikes driving prices up.

Goldman Sachs predicted $200 per barrel of oil which has caused immense concern as various journalists actually believed it and printed it. ⁽¹⁾ Whilst it could easily become a self fulfilling prophecy, it was interesting to note that Goldman Sachs has a neutral weighting on some of its oil holdings like Exxon Mobile, which doesn’t follow that they believe oil will go to $200. Why miss out on that gain? Something is not making sense.

The cost of an asset is driven by supply and demand. If supply is flat, demand must be increasing for the price to go up. If supply is interrupted and demand stays the same or goes up, the price goes up, and of course there is the counter argument to all of this.

So let’s look closer at supply and demand to see if this accounts for the price rises.

According to CNN, brimming oil tankers sit off the coast of Iran and Louisiana. The strategic petroleum reserve has been filled, demand is flat and the U.S. has cut back dramatically on energy consumption. The Department of Transportation shows figures in March have the steepest decline in driving miles ever recorded in history. Americans drove 4.3% less miles than the year before (11 billion miles, or a very long way whatever way you look at it)^(3). Construction across the western world is reducing. Gasoline demand in the UK fell a massive 7% in April against last year^.(2)

So we know that supply is fine (in fact we have an abundance), and demand is falling!

What can possibly be driving oil upwards? A falling dollar, buying on margin and also speculation are the key drivers.

Either of these three could be crippling the world and in turn could starve the poorest countries to death. Let’s investigate:

There is no doubt the dollar has taken a bashing with no real blame being taken by Mr Bush and his mates. Bush took over a national debt of $5.8 trillion which is now over $9 trillion –great work^.(4) This will continue putting pressure on the dollar. Comments from Bush one week of ‘the economy is in good shape’ followed the following week by Bernanke stating that the economy will get worse before it gets better, will do little to make the dollar attractive.

Oil (denominated in Dollars) is another alternative to the dollar as an investment and whilst the dollar is weak, oil will remain attractive, forcing the price upwards. Ok so that’s a reason for upward price but not the dramatic rise we have seen.

There are two key issues that are driving the price upward and they are buying on margin and also index speculators.

The average world price of oil since 1869 has been $21.66. The average since 1970 has been $32.23. ⁽⁵⁾ On few occasions since this period has the price risen above the average, in fact it’s only the late 70’s that is notable with the remainder of time being flat. The 70’s can easily be put down to the Arab oil embargo, the Iranian revolution along with the Iran/Iraq war and US price controls kicking in.

The graph, as I said, is virtually flat. That is of course until we get to 2003 when it rockets from $30 to the high we saw last week of $139.

If I look at one other chart the graph is alarming. That chart is the problem – the purchasing of commodities. The purchase of commodities (of which oil is one) has been greater in the last five years than the rest of history. Wait for this. In 2003 the amount allocated in total to index trading strategies (buying commodities) was $13 billion. This is the highest it has been. Since then the total amount grew by $247 billion. Read that again.⁽⁶⁾

The graph is a straight line upward which is almost identical to the price of oil. Interestingly the amount of WTI crude oil futures rose 439% over the last 5.25 years and the price of oil rose by 363%..⁽⁶⁾ It’s easy to see the comparison.

The biggest concern however is the type of index trader. The normal every day trader buys and sells shares and commodities and creates liquidity so that is normal market conditions. The institutional investor above is dangerous in that they buy and hold. They are effectively hoarding these assets and starving the world, driving the cost of living through the roof. The culprits are US corporate and government pension funds, sovereign wealth funds, university endowment funds and other institutional investors.⁽⁶⁾

Could it be that the latter are banks?

China has had the blame for demand increases. Really? According to the DOE the annual demand for petroleum has increased by 1.88 million barrels to 2.8 million. This is a total increase of 920 million. Index speculators demand has been broadly equal at 848 million. Their demand is almost equal to the entire demand of China, but they are hoarding it.⁽⁶⁾

Food is the same, with index speculators having effectively stockpiled enough wheat to supply every American with bread, pasta and baked goods for two years and enough corn for one. The numbers do not make economical sense. Once again, I am either stupid or it is wrong.

Michael Masters delivered a written testimony before the Committee on Homeland Security and Governmental Affairs, US Senate on the 20th May 2008.

In it, he damned the situation, and explained we were heading for disasters in terms of starvation and food riots. He explained that the purchase of commodities should be heavily regulated. He highlighted that the problem had been created by the commodity futures trading commission (CFTC) loophole.

In 1936 when Congress passed the commodity exchange act they did so with the understanding that the market could not be dominated by speculators. Unfortunately they have since slipped up. They granted Wall Street banks an exemption from speculative position limits (basically no restriction on what bets they make). This loophole has created others so if hedge funds for example want to take a position beyond their limits in oil/wheat etc they can enter a swap with a Wall Street bank who will do it.

The CFTC classifies futures contracts purchased through the Swaps loophole as ‘commercial’ rather than non commercial, thereby distorting the data and opening the door for unlimited speculator activity. The results are all there to see. Failing economies are sat between struggling house prices, poor spending on the high street, record debt and the threat of higher interest rates because of inflation driven by the outside forces above.

Masters goes on to outline the steps needed to be taken to put an end to this before its too late: Prohibit the commodity index replication strategies within pensions; Close the Swaps loophole to force everyone to have clear position limits they can take; The CFTC should be compelled to reclassify all the positions in their commercial category, thereby providing transparency to see who is actually trading.

If they don’t, the average investor will be carried along by it all, will assist with the momentum by purchasing more, and in turn drive the market up. I suspect it will be just in time for another twaddle excuse to be used to plummet the price shortly after the larger investment institutions have put on their designer parachutes and bailed out.

As a consequence oil and the food costs will plummet and normality will resume. George Soros, the billionaire financier has already condemned the institutional investors following a ‘craze’.

In the last few days talk of higher inflation in the US has been met with the view that interest rates will need to rise thereby strengthening the dollar and weakening oil.

Notwithstanding that there is no ethical or moral reason why strong steps should not be taken to regulate the above arrangements immediately so how long will it take congress to carry it out. How long indeed.

If you have a query on investments call Peter on 0800 0112825 or e-mail info@wwfp.net.

Sources

⁽¹⁾ Market watch
⁽²⁾ Yahoo news
⁽³⁾ CNN
⁽⁴⁾ Washington post
⁽⁵⁾ WTRG
⁽⁶⁾ Michael masters

The value of shares and investments can go down as well as up

Tags: commodities, food prices, fuel prices, house prices, inflation, interest rates, oil prices

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