Oil prices – what supply shock?

If prices go up, demand should go down, right? This is not the case for many countries where the governments subsidize energy. Demand has moved with overall economic growth and been insensitive to the world price of crude. The combination of lower prices not attached to market movements and strong growth has caused higher demand for gasoline. The world is not facing a supply shortage but a demand shock. The current supply cannot keep up world demand. Of course, part of this problem is always supply. Capacity utilization for OPEC oil is down from its high, but if the cartel is wrong about their demand estimates, that is, there is a demand shock, there will be a spike in prices. It takes some time to increase production.

Governments are trying to put market forces back in place by raising the price of gasoline. China announced a price increase of 10% on gasoline because they are in the extreme position of seeing shortages. These shortages are not from the high price but from cut in refining. The refiners take it on the chin when crude prices rise. They buy on the open market and then have to sell at the subsidized price without being compensated by the government for the difference. You cannot make it up with volume, so you might as well cut refining production.

Most of the BRIC’s have subsidized oil prices. Nevertheless, India is also thinking of raising prices. Gasoline is subsidized in OPEC countries which have also seen significant growth. Prices of gasoline in Iraq and Iran are less than 50 cents a gallon. These drivers have not felt the pain of higher prices. (It was reported that Hummer sales in Venezuela were strong because of cheap gas prices.) McKinsey has actually concluded that if subsidies were eliminated in many developed countries the savings would be approximately 3 million barrels a day.

Market forces will allow for demand to decline and force prices down. Any changes in pricing in developed countries will cool the oil market. Look for any news of changing government policies as means of reducing the demand shock.

New commodity weights for GSCI

The new weights for the GSCI have been announced for 2008. There were few surprises accept for the large change in unleaded gas which increased 330% over last year. This will bring sizable amount of open interest to the contract as well as more trading volume especially during roll periods. Grains showed increase percentages across the board except for Kansas City wheat. Softs and live stock markets remained the same. The energy complex overall remained close to last year except for the relative change with gasoline. Gold showed a slight decrease in the metals sector.

While not the same as the issues with additions and deletions of the S&P 500, there will be an effect from changing weights. There should be upward pressure on those commodities that have weight increases and downward pressure on those with declining weights. The impact will be greatest during roll periods.

Index volume has continued to explode with strong interest across all of the major markets

Following is a table showing the commodities weighting in

percent of the total GSCI index for 2007 and 2008.

                                                                PCT        PCT

COMMODITY                                       2007       2008

Wheat ( Chicago )                                                 3.14       3.40

KBT Wheat ( Kansas )                                           1.12       0.79

CBT Corn                                                              3.27       3.30

CBT Soybeans                                                      1.79       1.84

ICE US3 Coffee "C"                                                0.70       0.69

ICE US Sugar #11                                                 1.22       1.23

ICE - US Cocoa                                                     0.21       0.22

ICE - US Cotton #2                                                0.87       0.90

CME Lean Hogs                                                   1.54       1.53

CME Cattle (Live)                                                  2.72       2.74

CME Cattle (Feeder)                                             0.62       0.54

NYM/ICE Oil (WTI Crude)                                     35.12      35.32

NYM Oil (#2 Heating)                                           5.76       4.68

NYM Oil (RBOB)                                                 1.37       4.55

ICE - UK4 Oil (Brent Crude)                                14.62      13.04

ICE - UK Oil (Gasoil)                                          5.01       4.55

NYM/ICE Natural Gas                                       7.71       7.48

LME Aluminum (High Gd. Prim.)                       3.41       3.49

LME Copper (Grade A)                                    4.05       4.01

LME Standard Lead                                        0.52       0.52

LME Primary Nickel                                       1.62       1.64

LME Zinc (Spl. High Grade)                            1.28       1.29

CMX Gold                                                      2.04       1.95

CMX Silver                                                     0.29       0.29

Source: Standard & Poor's.

Can we learn to love a bubble?

David Goss, the author of a witty short book called Pop! Why Bubbles are great for the Economy provides an alternative to all of the negative comments on bubbles. Unfortunately, there is no good way to spin the bad news from a bubble. He argues that there has been a significant amount of good which has resulted from bubbles. The capital invested has not been completely wasted but has provided powerful long-lasting effects. An interesting argument, but there is no documentation of the huge toll associated with the wild swings in asset prices and the bust when the markets fall.

He reviews the following bubbles and always found a silver-lining:

The telegraph – the country got wired (19^th century version).

The railroads – the country got connected.

The financial services – the country got regulated.

The internet – the country got wired (2oth century version).

Real estate – the country got housed.

Alternative energy – the country will get fueled.

In all of these cases, the capital stock did not go away, but this growth could have been more efficient. Is there good that could come from the housing crisis? Building will not be destroyed but households have been. If the capital was placed in other areas, the pay-off would have been stronger. The down-side price of the combined housing and credit bubbles has still not been determined. We do know that it has started to help clean house of executives not minding their risks. So something may be positive from all of this.

Financial statecraft and the declining dollar

The Treasury Department and presidential candidates have ignored the broader policy ramifications of a declining dollar. While the declining dollar seems to be having a positive impact on manufacturing exports, the financial capital flow issues are more important. The financial power of capital flows is more important than trade because it is so much bigger.

The importance of a stable dollar goes beyond the cost of financing our debt. The power of the United States around the world will decline with the dollar. A lower dollar reduces the ability of the United States to use its financial influence or policies to affect world affairs – the use of dollar financial hegemony. Another way of putting this dollar influence is as a form of financial statecraft.

Foreign governments have less demand for dollars which are declining in value, so the financial clout of the United States is reduced. The dollar decline has strained relations for all those countries which have tied their currencies to the dollar. This is having significant implications in the Middle East, where the declining dollar has caused more internal inflation and financial stress. Oil is sold in dollars but imports are often in euros. The creditability of the United States in a financial crisis will also be hurt. It is hard to have other countries accept American advice if its high current account deficits are forcing the dollar lower. Regional and bilateral solutions will be more likely where the US does not play any role in negotiations.

What is financial statecraft? A good description can be found in the recent book by Benn Steil and Robert E Litan of the Brookings Institute, Financial Statecraft: The Role of Financial Markets in American Foreign Policy. Financial statecraft is the application and extension of economic policy through capital markets. Steil and Litan provide a nice table contrasting economic and financial statecraft.

Economic statecraft	Financial statecraft
Trade privileges, tariffs and quotas	Capital flow guarantees and restrictions
Trade sanctions	Financial sanctions
Foreign Aid	Underwriting foreign debt in a crisis
Regional trade agreements	Currency Unions; dollarization

Financial statecraft for the United States is important at this time because its ability to influence the rest of the world through diplomatic or military means has diminished since the Iraq War. Arab countries have been hurt internally by the declining dollar. Discussions between Asian countries have increased the likelihood of regional solutions without the United States. Latin American countries have a greater desire to take advantage of stronger growth without interference by the IMF or the United States. America's ability to use the dollar as a source of aid is hampered by its lower value in the world market. Higher growth around the rest of the world reduces the ability of the US to use the dollar to influence economic policies.

There is not much investors can do about implementing financial statecraft, but being aware of the greater ramifications beyond changes in price will provide a better picture of what could happen in financial markets. Generally, the dollar's role will be diminished, and the rationale for holding dollar assets will also decline. Portfolio adjustment will cause further dollar deterioration.