Paul Brodsky

Brace Yourself

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The bad news for investors pursuing positive real returns is obvious: the first half of 2011 was painful. The good news is that a set of conditions now exist that we think sets the stage for meaningful structural change… and it may occur soon.

After three years of Western governmental economic heavy-handedness in the markets, the global commercial marketplace seems to be asserting its priorities. While politicians and policy makers retain mandated authority to intervene into public markets, it seems obvious that they are quickly losing their power to incentivize private wealth and capital. This is a stark change from the recent conventional perception of free markets leavened only occasionally with necessary policy stimulus.

Very recent events show clearly that Western bureaucrats are panicking, struggling to regain control over the global marketplace. They are fighting small battles and losing the war. Sovereignty is shifting from governments to commercial and individual incentives, from managed financial markets back to the marketplace. Three events in June made this clear: 1) the IEA’s surprise release of 60 million barrels of crude oil, 2) US congressional deliberations to change how the CPI is calculated in an attempt to reduce government spending, and 3) the EU/Greece situation. (We discuss these events in more detail below.)

There is a palpable loss of overall confidence and in institutions implicitly set up to provide economic and social confidence to the masses. According to a recent CBS/NY Times poll, nearly 40% of Americans think the US economy will not recover in their lifetimes to prosperity level of a few years ago. Banks have started foreclosure proceedings on 15% of all US mortgages but cannot actually foreclose due to sloppy paperwork, robo-signing, legal challenges, etc. Volume across stock, bond and derivative markets is way down and Wall Street has begun significant lay-offs. Congress remains at loggerheads over raising the debt ceiling. President Obama is powerless to improve the situation and admitted so on TV.

Wealth and capital holders around the world have increasing incentive to “get real”. The widespread conversion away from fiat-sponsored debt-money and the levered financial assets denominated in them into scarcer supplies of precious metals and natural resources with inelastic demand qualities is upon us. We think global wealth holders will soon crowd into relatively small precious metal and consumable commodity markets as they recognize the limited economic power of sovereign nations and international policy bodies to provide lasting economic solutions or even temporary cushions.

Cynical Gimmicks

Last month’s announcement by the International Energy Agency that it would release 60 million barrels of oil at a time when there was no public outcry for it was a watershed event in our view. Not only did this action imply that $100pb – $130pb is base equilibrium pricing, rather than “speculator-driven bubble” pricing (more on this in a moment); it also displayed publicly that “global economic managers” are willing to use preemptive intervention to control pricing. This is a big deal.

Official justifications behind the surprise intervention were multiple, including a way to make up for Libya’s lost oil production (whatever happened to “days, not months” in Libya anyway?), and that a declining oil price would pressure Iran to negotiate with Saudi Arabia so OPEC could reach an equilibrium range acceptable to the West. Whispered justifications included the politics of keeping gasoline prices down in the US as the driving season commenced. Whatever the reason, last month it became overt state policy across all domains to maneuver the price of global energy. Desperate times call for desperate measures.

This preemptive action was very different from foreign exchange intervention commonly executed by one or two central banks when the markets steer FX currency values away from best interests of implied trade policies. The IEA’s intervention was coordinated among State and Energy Ministries in the US, Europe and Asia (including China). The reason for the intervention seems to have been overtly political and geopolitical, and occurred when energy prices were already well-below their highs.

The day before the IEA’s announcement, researchers at Strategic Energy Research and Capital produced the following insight:

“According to the IEA STEO release on Absolute OECD Storage, comparative inventory, as we calculate, is already in deficit at -19 million barrels. If we are to believe the IEA, for the balance of 2011… comparative inventory (of Brent to WTI) will decline further to a deficit of -85 million barrels, with the largest net decline occurring next month. As we can see, in U.S. Dollars, this should increase the price of Brent relative to WTI, and it has. The interesting aspect of the OECD trend in comparison to the U.S. is that the markets are both responding to respective available supply as reflected in Absolute Inventories calculated into Comparative Inventory (i.e., the market is rational, at least to us). The OECD is net short, that is a fact, and that includes the U.S. barrels, while the U.S. separately is still in surplus. So we are not surprised to see the Brent-WTI spread widen, as so many are fixated on lately. From our seat, the regional market gears are working smoothly. The globe is still short to the tune of 1.0-1.5 million barrels per day and no new meaningful supply will be added before 2015, as we forecast it.”1

Although WTI crude is stored at Cushing and used as the basis for futures trading in the US, making it the benchmark oil price for most financial asset investors, the price of Brent crude greatly influences gasoline prices across the world (including the US due to refining channels). So then an imminent price spike of Brent in particular and global crude in general seems to have been temporarily averted by the IEA intervention, which served to frighten weak hands out of the market.

The perception among some financial asset commentators that recent oil prices contained a significant speculative premium seems a bit off the mark. Unlike past bubble pricing in financial assets, crude oil futures potentially have an element of reality to them because arbitrage opportunities exist between notional and delivery pricing when spreads get too wide. Within this context, consider the long term trend. WTI futures reached a peak of $145/barrel in 2008 before plunging to $45/barrel, traded mostly above $80/barrel since June 2009, above $90/barrel since December 2010, and above $100/barrel from February through mid-June of this year. Crude oil is in the midst of a multi-year bull market based on fundamentals. It should not be surprising that it took only two weeks for WTI and Brent crude futures to rise back to the levels at which they were trading before the IEA’s intervention.

What are the fundamentals? When the US and Europe began printing base money in earnest three years ago, equilibrium pricing for crude oil has risen consistently. As we have argued, there is a direct correlation linking the process of base money growth to higher resource pricing because resource manufacturers demand equal relative value for their products and services (the nominal prices of their goods are determined in relation to the ongoing purchasing power of the currency they receive in exchange). The marketplace is implying that a price range of $95 to $130/barrel is where supply meets demand (WTI & Brent) at the current level of global base money. Unenlightened market speculators are anchored by past nominal pricing —pricing unadjusted for past currency debasement.

The fact remains that the magnitude of the IEA’s intervention was relatively trivial. Sixty million barrels amounts to only about 70% of daily production. While crude oil pricing is established by each marginal barrel over demand, the fact that it is to be released over time suggests there might be a million barrel daily surplus for a couple of months. All things equal, it would seem reasonable to expect a change in WTI pricing to, say, $105 – $115 (the middle of our assumed equilibrium range) as the IEA surplus runs off. (Of course, the IEA can always intervene again.)

It should be obvious to all that “speculation” does not drive prices higher in any meaningful way. For every buyer of crude futures there is a seller. If one wants to blame financial markets for higher gas prices at the pump then one should blame high levels of overall market sponsorship, which derives directly from high levels of investor leverage, which in turn is generated directly by banks through their lending and prime brokerage divisions, which ultimately derives from easy global monetary conditions. Blame the Fed and the BOE.

So we think that the global marketplace for crude oil is naturally biased to trend towards pricing that global policy makers find problematic (too high vis-à-vis wages), and that global policy makers are desperately applying short-term fixes. They will lose. The marketplace reigns supreme over time whether or not there is temporary froth in futures.

We think that the impact of discrete policy interference on market pricing is declining and increasingly short-lived because it pales next to the dominant (and necessary) policy of base money creation. The global financial markets weakened over the last two months as it became clear that the Fed was going to suspend direct quantitative easing. Crude oil prices did not “play ball” (weaken) because demand is inelastic and equilibrium pricing was fair. It took a cynical gimmick by policy makers to make a temporary impact. Confidence in the global public sector’s ability to manage near-term resource pricing is declining and perhaps that much closer to being ignored. Investors looking for freer markets can only migrate to one place —hard assets.

Investors in shares of energy companies, which are ultimately financial asset expressions of the true cost of energy in the global marketplace, are subject to the vagaries of changing sentiment of fickle and poorly-funded financial asset players without strategic conviction who are influenced by daily news flow. This beta risk is diminishing. The longer energy and other commodities show resilience, the more sponsorship resource shares will gain in the equity markets. True investors are biting the bullet, and more and more are not being shaken out of positions while fundamentals are on their side.

Infellation

Speaking of cynical gimmicks, Dow Jones reported last month that congressional aides for Democrats and Republicans were close to an agreement that would save up to $220 billion over the next decade by “changing how the Consumer Price Index is calculated”. (It is difficult to know where to begin with this one.)

First, if there was ever any question in serious economists’ or investors’ minds about whether the CPI is accurately calculated presently, then this news should completely dispel any doubt. It should be obvious to all that calculations ostensibly produced by the Bureau of Labor Statistics are corrupted by political maneuvering and budget negotiations and that its output is economically worthless. Looking forward, it is inconceivable that serious observers expect the CPI to be an honest and objective indicator of “inflation”.

The Bureau of Labor Statistics

(Inflation is kept in a secret compartment.)

Image of old desk

Fred Sheehan, offered the following: “I think Sir John Cowperthwaithe, Britain’s financial secretary to Hong Kong in the 1950s, was on to something. He did not allow his government to collect statistics for fear the statistics themselves would define policy. In the U.S., this is seen in our infatuation with “growth” no matter the human and material wreckage choking in the gutter, a sure sign of our government’s and of the economic establishment’s senility.”2 Fred’s comments were in response to the following note from a reader of his blog:

“In 1977 I accidentally ran into a high school friend of mine who had taken an advanced degree in mathematics and statistical analysis. He was working for Federal Reserve Chairman Arthur Burn’s Fed. He informed me that he was working on a new methodology of calculating the inflation rate. When I asked what it was based on he demurred saying it was “Classified Secret.” I was truly stunned. He did imply that, when done, the new methodology would greatly reduce the reported value. Sure enough, during the Volcker Fed, the new methodology was introduced and has been modified since then to greatly reduce the reported numbers. It made the Volcker effort at controlling inflation seem much more effective than it actually was.

However, if one takes 1965 as the starting year for the present acceleration of inflation it can be shown that, on average, the cost of living has gone up about 1400%. And, the total money supply has also grown —up to 2008— about the same. So, a person willing to do the research can always by-pass short-term obfuscation and see the truth through widely available published costs of living.” 3

We cannot confirm the veracity of the reader’s claims above. Regardless, since everyone agrees with Milton Friedman that “inflation is always and everywhere a monetary phenomenon”, the synchronicity of his numbers makes perfect sense.

Image of man looking at blank pictures

So Congress is determining the US “inflation rate”. Perhaps it feels that purchasing power loss is subject to interpretation and that Congress knows best how to calculate that? Or maybe the members of Congress collectively believe it is in the public’s best interest to be lied to and that the public is either too stupid to figure it out or too lazy to care? (They might be right.)

Whatever the case, we are glad we do not have jobs with salary increases tied to the CPI; glad we are not retired and collecting social security; and glad we are not relying on TIPs to protect us from “inflation”.

The next time someone of ostensibly good economic pedigree suggests that inflation is not a problem, cut him off and ask him he means CPI, and then ask him if he is talking about pre- or post-Kennedy, Clinton or Bush era CPI, and then pre- or post-2011 budget negotiation CPI. Then ask him how much he paid for his degree.

 

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