Investors blast BofE on gilts sale

Angry investors blasted the Bank of England on Thursday when it sparked a sell-off in the gilts market after one of the biggest government bond offerings of the year. In an interview published 20 minutes after the £5bn bond deal was finalised, Andrew Sentance, an external member of the Bank's monetary policy committee,...

Sinochem approaches Nufarm

Nufarm, Australia’s biggest supplier of farm chemicals, confirmed a takeover approach from China’s Sinochem, sending the shares to a more than seven-month high and valuing the company at A$2.4bn ($2bn), reports Bloomberg. Buying Nufarm would expand Sinochem’s share of the market for herbicides and pesticides,...

RBS and Lloyds bow to Brussels

Royal Bank of Scotland and Lloyds Banking Group have submitted to the European Commission restructuring proposals that may see the banks forced to sell off branches and other assets in order to qualify for state aid. Lloyds could be forced to sell its Halifax or Bank of Scotland branch network to comply with European antitrust rules and RBS is understood to have considered selling branches if the Commission were to demand significant divestments.

Liberty investors set to agree Pearl deal

Pearl Group, the UK life assurer owned by financial enterpreneur Hugh Osmond, is expected to get the go-ahead for its capital restructuring on Friday from shareholders in Liberty Acquisition, the vehicle that will inject about €600m (£519m) into the company. Amsterdam-listed Liberty will count up votes on the deal to acquire a 60% stake in Pearl at an extraordinary meeting on Friday following three weeks of investor meetings.

Amex, Capital One, see earnings plunge

American Express, the credit card issuer, reported an annual 84% drop in Q2 earnings per share on Thursday but expressed increased optimism for the rest of the year based on improved trends by delinquent credit card and loan holders. Amex posted Q2 earnings of $337m, compared with $653m a year ago. Capital One,...

SWFs tipped for greater financing role

Sovereign wealth funds and multinationals from the developing world will in future take the place of western banks in financing and paying for major construction projects, according to consultant Turner & Townsend. Vince Clancy, chief executive, cited clients Bharti Airtel, the Indian mobile operator,...

Oil price: where next?

A reduction in global oil production capacity will mean that higher future oil price will be attained at a lower level of demand than in 2008. Is another oil price spike on the way?

One thing that was anticipated in the run up to peak oil was that the oil price would become volatile. Volatility leads to uncertainty creating difficulties for national governments, economic planning agencies and oil companies to plan ahead. One consequence of this has been the postponement of many large new oil field developments creating concern that future supplies may be insufficient to meet demand leading to a new oil price crunch in the years ahead.

So what is the right price for oil? To what extent can market mechanisms be relied upon to strike the right price? Is it possible to make sense of the volatile price signal shown in Figure 1?

Figure 1 Global total liquids from the IEA, data compilation kindly provided by Rembrandt Koppelaar. Oil price data from Economagic. All data are month averages.

Last year Phil Hart provided us with a model to explain the relationship between oil supply, demand and price (Figure 2). Put simply, demand is inelastic in that it does not vary much owing to price variations alone - we still drive our cars even though it gets more expensive to do so. Supply used to be elastic (the flat part of the supply curve), higher prices easily translating to higher supply. In the real world this meant OPEC opening the taps on spare capacity. But then in 2004 the supply rules changed. OPEC spare capacity effectively fell to zero (Figure 1) and new supply became inelastic (steep part of the curve), i.e. higher prices did not lead to a ready flow of new oil since new capacity had to be built, at great expense, using expensive energy. The result was escalating prices and the spike of 2008.

Figure 2 Phil Hart's oil price, supply, demand model.

Somewhat surprisingly (for me at least) cross plotting the data from Figure 1, provides a picture that is still consistent with Phil's simple model (Figure 3). To understand Figure 3, the blue line is a time line, charting the evolution of supply / demand and price since January 2002 through to June 2009. Once production hit 84 mmbpd (million barrels per day) the plateau was effectively reached and expanding capacity in the face of 4.5% annual decline became an arduous task. Prices rose to keep supply and demand in balance until the peak in July 2008 when the economic crisis took hold leading to a collapse in demand.

Figure 3 Monthly oil production data (from the IEA provided by Rembrandt Koppelaar) and monthly average oil price data from economagic fit Phil Hart's simple model. The return path since July 2008 is shown in light blue. Marks at one month intervals.

Following the time line down from the July 2008 peak, the oil price overshot its mark by about $40, but since then it seems to have been correcting back towards the trend set during the ascent. First, the price stabalised at $40, tracking left as demand continued to fall. And then demand stabalised at about 84 mmbpd and the price rose from 40 to over $70 per barrel. The June 2009 position is within the trend set during the price ascent of 2006 and 2007, and on this basis I'd conclude that we have seen a correction back towards market equilibrium rather than a "dead cat bounce" in oil price.

The integrity of this trend from January 2002 to June 2009 is surprising since there have been large movements in OPEC spare capacity, which is adjusted to maintain supply in balance with demand. I suspect the fundamental reason to explain this is that global production capacity has remained fairly constant throughout this period. If there was to be a dramatic increase or decrease in productive capacity then this trend would break down

So that leaves the $60,000 question. Where next for the oil price? I believe that plateau supply of 84 to 88 mmbpd are secure for a couple of years as this summary of mega-projects compiled by Tony suggests (Figure 4). Therefore, the near term price will be controlled by demand. If the trend of Figure 3 holds good, then we could expect prices to rise towards $80 / bbl if demand rises by 2 mmbpd (likely spiking higher than that) or conversely falling to below $40 / bbl if demand drops a further 2 mmbpd, which is the scenario considered by Rune last month.

Figure 4 TOD megaprojects production capacity forecast compiled by Tony Erikson.

Longer term, productive capacity will begin to play a role and one can envisage how a fall in capacity of around 1 mmbpd may shift the supply demand relationship to the left. Combined with marginal growth in demand will result in a new price spike as shown in Figure 5. It is impossible to be precise on timing, but my best guess would be 2012±2 years, subject to the global banking system surviving the current crisis and the global economy resuming growth in 2010.

Figure 5 Scenario showing how a drop in productive capacity of around 1 mmbpd may move the supply curve to the left, combined with an increase in demand from 84 to 86.5 mmbpd, may result in a new oil price spike in excess of that seen in July 2008. Squiggly line is real data from Figure 3.

In a recent post I argued that there was a limit to the oil price that the global economy can bear. Any new price spike, as the name suggests, will be short lived as high price will kill demand and we will likely see a repeat performance of the 2008 crisis. At some point global leaders need to awaken to the prospect of that supply curve marching to the left, always.




Finbar Taggit is living in a wooden lodge somewhere near the Canadian border. He is cold and damp and smells of fish. His thoughts are no longer connected with his sharpe ratio but more his sharp rated gun skills that have allowed him to kill fish and crows.

The Canadians nearby seem very friendly and jovial. Their country is doing just fine and I haven’t experienced those John Steinbeck life sapping gregarious Yanks for a week now. My weak sterling, on the other hand, is keeping me awake at night but my premier BUPA health care cover is protecting me from the horrors of having to attend an insurance lovin’ hospital wanting to be paid to fix my half bitten leg thanks to the bears that roam freely in this part of the world.

Yesterday I had breakfast with a 3 year Iraq military man who was a democrat. I pointed out Obama was full of hot air and a wind bag of Neil Kinnock like proportions. He then showed me how to strangle a man with a flick of his elbow.

Business will be resumed in August.

Evening Briefing for July 23rd

* MARKET THEMES FROM THURSDAY - Upside breakout lifts stocks to bull market highs. Those highs were well confirmed by such indicators as advance-decline and new highs/lows, with over 3000 new 20-day highs. Bullish themes dominated across asset classes with oil strong and weak 10-year Treasury prices (rising yields), but strengthening in the U.S. dollar and weakening of gold in the afternoon led a late stock market retreat from the day's highs. Given the strong upside momentum and the tendency of momentum peaks to lead ultimate price highs, it would not be surprising for pullbacks to be limited on the way to new bull highs.

* OVERSEAS/OVERNIGHT NUMBERS: 11:30 PM CT - Japan, Industry activity index; 1:45 AM CT - France, consumer confidence; 2:00 AM CT - France, PMI; 2:30 PM CT - Germany, PMI; 3:00 AM CT - EU, PMI; 3:30 AM CT - UK, GDP.



-- Longest winning streak in Asia since 2004;

-- Interesting look at the bond/stock relationship;

-- Continued problems at regional banks;

-- Overview of Fed policy and where it might be headed;

-- Recap of the strong market day;

-- High frequency trading getting more scrutiny.

Not necessarily always stabilizing …

One common argument — at least prior to the crisis — was that sovereign investors, because of their long-term focus, were generally a stabilizing presence in the market. Sovereign wealth funds in particular. And presumably central bank reserve managers as well. After all, in many cases, the line between a sovereign wealth fund and an aggressively managed central bank reserve portfolio is rather thin.*

These arguments were always a bit hard to assess. There isn’t enough data on the actual actions of sovereign funds to evaluate their true impact on the market. Did sovereign funds step up their purchases of equities when the markets went down? Or were they sellers then?

The available data does suggest that reserve managers have generally acted to stabilize the currency market. Central bank demand for dollars tends to rise when the dollar is going down. But the available evidence also suggests that reserve managers added to the instability in the credit markets during the recent crisis.

Central banks rather suddenly stopped buying Agency bonds, pushing Agency spreads up — at least until the Fed stepped in.

And, as the latest BIS bank data makes clear, they also withdrew large sums from the international banking system. The following chart comes table 5c in the BIS locational banking data; it shows the annual change in the deposits that the world’s reserve managers hold in the banking system.**


To be sure, central bank reserve managers weren’t the only ones pulling money out of big international banks. Money market funds were too. But the loss of $400 billion in deposits — $220 billion in q4, another $170 billion in q1 — from the world’s reserve managers added to the pressure a lot of banks faced. Including, I would guess, some European banks with large dollar balance sheets; that is one reason why there was “extraordinarily high demand for dollars from foreign financial institutions” during the crisis.

A central bank that is intervening to support its currency during a crisis will, of course, need to run down its foreign assets. Some of the fall in central banks’ deposits in the international banking system during the past crisis consequently is just a reflection of the fall in reserves.

But some of it also reflects a flight to safety. Remember the surge in central bank purchases of short-term T-bills during the crisis?


Central banks were, in aggregate, big buyers of Treasuries during the crisis even as their total assets fell. In fact, central bank demand for Treasuries was — for a while — going up even as the world’s dollar were were, best I can tell, going down.


The Fed — helped by the US Treasury, which sold a lot of T-bills during the crisis and put the funds on deposit at the Fed so the Fed could act as dollar lender of last resort to the global banking system — was able to offset these shifts. The US government in effect lent dollars to the banks that were losing dollar deposits as the world’s reserve managers shifted into Treasury bills. It all sort of worked.

The crisis was contained.

The flight to safety on the part of the world’s reserve managers during the crisis was understandable — and individually rational. No reserve manager wanted to have funds (uninsured funds) in a bank that failed. But it also wasn’t stabilizing.

My conclusion: reserve managers need to be cautious as they seek yield in good times, as they are fundamentally loss-adverse. That aversion to losses can, in some circumstances, prove to be a destabilizing force in the market. And, of course, the regulators of the major international banks also need to do a better job …

* Some reserve managers took more market risk than some sovereign wealth funds.
** The BIS data is adjusted for valuation effects