As reported in the cover story this week, Barron's outlines the argument that we may be seeing a near-term top in the crude oil markets, and in fact, this may be a sign of a bursting bubble. To setup the argument, Barron's discusses the impact of supply and demand, along with the effects of institutional investments in commodity-linked indexes. For a quick overview, Barron's provides a nice one page overview of oil supply and demand, along with a chart showing the linkage of the price of crude oil as compared to the rise of the Nasdaq Composite in the late 1990s. While Barron's does present the various points for crude oil prices increasing and decreasing (discussed more below), it refers in both the article and video linked below to the "eerily similar" linkage between crude oil prices and the Nasdaq Composite, and how this implies a correction is possible. While a correction is possible, and may be setting-up as we speak, I am not sure it will be happening simply because the price pattern looks like a previous non-commodity bubble, technical analysis notwithstanding. Even Barron's straddles the fence somewhat by stating that prices could increase to $200 a barrel in the next decade, but could fall to $100 a barrel by year end - not exactly your typical deflating bubble, but more like a short-term pull back or correction.

So what exactly are the pro and con arguments regarding the bubble bursting? As to demand, it is mentioned how while the U.S. per-capita oil consumption is 25 barrels annually, both China and India are small in comparison, with China consuming only two barrels per person per year, with India consuming less than one barrel per person per year. Given that China and India have 1.3 and 1.1 billion citizens, respectively, there is an expectation that oil demand will increase in each of these countries as more of their citizens look to enjoy the fruits of the world, such as air conditioning, automobiles, refrigeration, and computers.

It is further speculated that China has been hoarding diesel fuel ahead of the Olympics in order to produce electricity without coal generation - which has been polluting the country, in particular Beijing where the Olympics are being held. China will likely go back to the cheaper coal once the games are over, thereby reducing diesel demand. China has also recently raised prices on gasoline by 18% (see previous post), a move that is expected to place further pressure on demand, although as described in the post, some feel this may just allow pent-up demand to be satisfied as profitability will return for refiners who have been hurt by higher crude oil costs, but have not been able to pass prices on to customers. This has essentially reduced the gasoline supply in China as refiners shut down or scale back operations. Better margins will now increase supply for consumers demanding gasoline, even at higher prices.

It is also mentioned in the article how Saudi Arabia has pledged to boost production by 200,000 barrels a day, from 9.5 million barrels a day to 9.7 million barrels a day, in order to take pressure off prices (see previous post). The potential for supply-oriented news out of this weekend's summit for oil producers and consumers may also generate additional production increase promises. Unfortunately, much of this oil is sour, and not the light sweet crude currently demanded by the markets, and also subsequently responsible for driving up prices. Whether the Saudi's even have the ability to increase production in their aging fields is also a concern regarding any promised production increases.

As for global oil consumption, it is down in total for the OECD nations (which account for more than half of all global oil demand). Demand itself is currently running about 86 million barrels a day and is expected to be relatively flat as nations cut back on consumption, in particular, automobile miles traveled. Yet, oil demand continues to grow in the developing world, and it will be difficult for even developed countries to reverse their trends quickly. As stated by Byron Wien, the chief investment strategist at Pequot Capital Management, "The world isn't finding oil fast enough to replace the 3% to 4% that gets pumped every year." With oil being controlled by governments that have an interest in maximizing revenues, it is unlikely they will have any near-term interest in boosting current production until the signs of demand destruction become more evident. With supply projections even less, at around 85 million barrels a day, with excess demand currently being made up from inventories, lower demand may result in break-even levels at best.

Some analysts are also speculating (hoping) that the U.S. Federal Reserve will begin raising interest rates later this year, which while helping to fight inflation in general, would also help boost the dollar, thereby reducing the cost of dollar dominated crude oil. Given the upcoming presidential election, and the history/attempts of the Fed to stay neutral during the second half of election years, it is unlikely they will do anything until the elections are over in November. The same could also be said for opening up the Strategic Petroleum Reserve. It is unlikely that the president will begin flooding the market this year in an attempt to increase supply and lower prices, although the government recently did stop purchasing oil for the reserve. If the president would begin selling, it would no doubt appear political, even if welcomed. Ironically, opening up the SPR might end up being a good trade if the country was able to sell oil at current prices when it was bought on average at much cheaper prices. Of course, what prices would be paid in the future to replace the oil is unknown. In addition to the SPR, the lifting of off-shore and protected land oil drilling bans could also have some impact. While it is often argued that the impact would be longer-term, as much as 10 years out, lifting of the bans would certainly send a signal that the U.S. is finally getting serious about the problem and is willing to consider all alternatives, not to mention putting political partisanship behind it. Of course, I would not hold my breath on that one, but if prices continue to rise, expect to see pubic support for lifting the bans begin to shift as the U.S. approaches the next election.

Of course, no article on crude oil prices is worth it salt without discussing speculation and investment. While speculation is not discussed in great detail in the article, the increase in commodity index investing is. Investments by endowments, pension funds, and institutional investors has totaled $260 billion as of March, up from just $13 billion in 2003, with $55 billion flowing into commodity investments in Q1 of this year. Calpers alone is listed as increasing its commodity exposure from $500 million to $7 billion. Yet, isn't this to be expected? Good managers should be expected to deploy capital to the areas they feel will see that greatest potential. While the risk are present, fund managers are under increasing pressure to generate abnormal returns. Right now, commodities and energy plays represent some of the best opportunities, but the party may be coming to an end as Congress and regulators are considering limiting fund investment in commodities, along with placing larger margin requirements on speculators. Yet to be seen is whether the higher margin cost, or increase cost of carry will force index funds and speculators to open up stored reserves - speculated in some cases to be in cargo ships off the coasts of various countries. Nonetheless, it will change the dynamic. Whether it changes to price trend is yet to be determined.

Like Barron's, a short-term correction would not surprise me. Nor would a retest to the $100-110 range. Breaking $100 would probably signal or long-term correction, and a possible bursting of the bubble, but even Barron's is not projecting the prices to fall this low. In fact, it has actually done a pretty good job of outlining both the bull and bear arguments, while also tempering how much it expects the prices to fall even if the correction it is predicting is severe enough to be bubble bursting. In the end, Barron's itself may have placed the best crude oil hedge yet.

As reported at Reuters, hedge funds have been raising capital and are looking for ways to deploy it in the current market. Possible outlets include distressed debt and higher quality mortgage debt. Funds also hope to take advantage of lower stock prices as forced selling of equities is expected to intensify as the summer progresses. Famed hedge fund manager John Paulson, who made a correct (and profitable) bet on sub-prime last year, predicts more gains from distressed debt as he expects to see an additional $10 trillion opportunity develop over the next 6-24 months.

Changes in focus are already showing benefits. The Credit Suisse / Tremont index rose 2% in May, as long/short equity, event-driven, and emerging market funds outperformed. High volatility and widening credit spreads are also creating opportunities for convertible arbitrage funds. Of interest is that quants funds are also optimistic, with the optimism not necessarily due to the current market opportunities, but due more to less competition from other quant funds. Last year forced credit selling created unpredictable moves (both directional and magnitude) that ended up shaking out a number of less-capitalized funds that were unable to adapt quickly enough to changing market conditions. Whether the rest of 2008 is any more predictable is yet to be seen.

A number of hedge funds are hiring talent from Wall Street as investment banks cut back on salaries and bonuses. As reported at Bloomberg, many traders, bankers, and analysts are giving up the once preferred bonuses and prestige of investment banks for the potential to cash in with hedge funds as the security once offered by investment banks decreases. As investment banks perform less underwriting and reduce leverage by selling assets, less money is being generated by Wall Street, translating to less bonuses come year end. Pay packages are expected to fall by 20% or more this year alone. Private equity is also benefiting from the dissatisfaction as they too are scooping up investment banking talent. Given the recent closures of small hedge funds, which in many cases are either shutting down entirely or simply being absorbed into larger funds, it looks as though the deck chairs of Wall Street will continue to shift over the summer as the market looks to right itself after the recent credit problems and current commodity and inflation issues.

There has been increased talk recently about the relationships between energy prices and demand levels for crude oil, natural gas, electricity, diesel, and gasoline. Even as prices have hit record levels, global demand has not fallen as sharply, or in some cases, even at all, putting into question the traditional relationship between the levels of price and demand. As it turns out, many countries are subsidizing the energy demands of their citizens, causing many users of energy to not directly feel the effects of higher energy prices, and therefore have no reason to curb their energy usage.

Recently, some of these countries are being singled out in the ever growing and popular game of assigning blame for higher energy prices. Just ask SUV drivers, President Bush, the Saudi King, congress, the Iraq war, speculators, supply-demand relationships, environmentalists, emerging markets, Mother Nature, and even alternative fuels, such as ethanol. Each has had its turn as the energy boogie man. As a sign of increasing pressure, the Wall Street Journal is reporting that China is now lifting energy prices for domestic consumers, raising prices for gasoline (by 17%), diesel (by 18%), and electricity (by 4.7%). As a comparison, this will raise gasoline prices in China to the U.S. equivalent of just over $3 a gallon. China has also stated that some of the gains in global energy prices that are realized will be passed on to consumers.

Ironically, the raising of prices may actually increase demand, and subsequent prices, as profits return for Chinese refiners. Refiners are currently buying crude oil on the open market at recent high prices, yet are limited as to how high they can price their refined products. As prices rise to meet and exceed their raw material costs, refiners will begin making more gasoline, resulting in more crude oil being purchased. Price controls have created fuel shortages in some parts of China since last year, and the level of pent-up demand is strong. The United States ran into similar problems in the 1970s as shortages developed and volatility increased when price controls were implemented.

Yet, the question still remains - will this have any impact on the global price of energy? Probably little, unless more countries follow suit. China currently consumes about 10% of all global oil. Significant, but small changes in China may have less of a global impact than hoped. Furthermore, the economies of China and other emerging countries continue to grow at high single and double digit rates. Small changes are therefore unlikely to slow growth enough to reduce demand, and as seen with the refiners, could have the opposite effect.

As the U.S. presidential election approaches, and an new president is elected, expect to begin hearing more about cap-and-trade for reducing carbon emissions. Both presidential candidates support some form of cap-and-trade, and the Congress at this point seems inclined to proceed. Fortunately for the U.S., Europe implemented cap-and-trade for carbon in 2005, and their experiment offers a number of lessons that hopefully U.S. lawmakers and regulators will learn from.

As reported in an International Herald Tribune article, emissions from factories and plants that trade pollution permits actually rose 0.4% between 2005 and 2006, and 0.7% between 2006 and 2007. It appears that the initial problem developed when the market was created, as some EU governments allocated too many trading permits to polluters. The flood of permits caused their value to be cut in half, and raised questions about the validity of the permit market. The overall allocation not only allowed polluters to keep polluting, but also allowed companies to sell excess permits into the market, profiting from their sale while reducing their value along the way. Prices have since rose after reforms were put in place.

Another problem with the system is the catch-22 of not enough, yet too much government intervention. Without government intervention it is unlikely that industry would impose such a system on themselves, yet with too much intervention, the market is not allowed to operate as it probably should. Of course, government intervention also gives lawmakers opportunities to do one of the things they do best - look out for businesses and industries within their own states and districts. Not that this is inherently a bad thing, but in this case it does not facilitate the problem at hand - reducing carbon emissions.

Careful consideration also needs to be made as to the type of system put in place. While the cap-and-trade systems created in the 1970s and modified in the 1990s to reduce acid rain did have some success, and is now being seen as a framework to build on for carbon trading, the environment at the time - pardon the pun - was different. The acid rain problem was somewhat localized, at least the part we were interested in. Carbon emissions are more of a global problem, and being consider as such. While a cap-and-trade system could possibly help to reduce U.S. emissions if successfully implemented, a U.S. system may do little to curb overall global emission levels, even with the large levels of emissions generated by the U.S. If developing and fast growing countries are not on-board or forced to participate in a similar market system, especially larger countries such as India and China, then the global benefits will be small. Furthermore, making business operations more expensive for small companies and developing countries makes it more likely that companies will either go out of business, pass costs on to consumers, relocate, or look for ways around the regulations. Developing countries will find it more difficult to lift their citizens out of poverty. If not probably designed, and we simply dive in for the sake of political expediency, then the only thing regulators and lawmakers will have achieved is to reduce U.S. competitiveness, and make it more difficult for countries to increase the quality of life and standard of living of its citizens - the very thing such regulation is trying to achieve. If done right, there is potential, but various outcomes must be considered first.

Market solutions may in fact be the answer to reducing carbon emissions, but increased regulation and government interaction often make it less likely that markets can operate efficiently. Ironically, high crude oil and gasoline prices, a result of market forces already in place (be it supply-and-demand and/or speculation driven), may do more than even cap-and-trade could for reducing carbon emissions. As carbon-based energy sources continue to rise in price, the marketplace will look for cheaper, and often cleaner, alternatives. We are already seeing this with the increased interest and investment in solar and wind energy (and even the government mandated ethanol - which has its own carbon footprint). While each does have various forms of government incentives for investment, the market is still being allowed for the most part to operate as its should. Maybe in the end we don't need another market to solve our problem. Maybe what is needed is a little patience, a little incentive, a little trust in the markets, a little faith in American business and ingenuity, and a lot of political courage.

A recent Financial Times article discusses timetables for U.S. businesses to manage the move from domestic accounting rules to the International Financial Reporting Standards (IFRS). Five years is being discussed as a good time frame in that it is short enough to get people interested now, but long enough to give them time to successfully implement the standards. The SEC is still considering proposals and time frames. Foreign companies are already allowed to file international financial reporting standards without converting them to GAAP (generally accepted accounting principles). IFRS is already being used by over 100 countries, including China and India, and members of the European Union. U.S. acceptance would essentially make it the chosen standard for other countries still on the fence.

Given the increased level of globalization, and the increased interest in international investment, the move to a global standard would on the surface make it easier for investors to analyze international companies. Yet there are issues to be resolved and worked out, such as inventory issues, dealing with extraordinary items, depreciation of existing assets, lease issues, derivatives, and numerous tax issues, among others. Details of the differences can be found in a report from Price Waterhouse Coopers. In another report, described in an article from Accountancy Age last August, an analysis by Citigroup found 426 reconciliation differences. The biggest areas of difference included the general areas of tax, pensions, goodwill and intangible assets, and financial instruments. Of additional interest is that moving to IFRS would allow some U.S. companies to boost some of their numbers. The Citigroup study found that 82% had higher net income under IFRS, while book value was lower for 70% of the sample. Overall returns on equity were also higher under IFRS. Nonetheless, it is felt that over time these differences would be worked out.

One potential drawback of moving to an international standard is that it could make it more difficult for the U.S. to maintain flexibility without additional regulation when dealing with reporting issues that present themselves unexpectedly. Nonetheless, the positives and environment currently seem to outweigh the negatives, even with the initial inconsistencies, so it is likely that such a move will be made. While it is hopeful that investors and companies will benefit in the long-term, there is no doubt that consultants and accountants will see some short-term benefit as well, at least in terms of increased business. As transitions are never as smooth as originally planned, investors and traders relying on fundamentals can only hope that the makers of headache medicine and antacids also do not see an increase in business as they wade through the new standards.

Companies are expected to shift investment over the next five years from the U.S. to BRIC countries according to KPMG International, as reported at Financial News Online. As a result of the shift in investment, by the year 2014 China is expected to be the leading recipient of corporate investment worldwide, rising to 24%, while the U.S. falls to 23%. Of the BRIC countries, India is expected to have the largest shift in corporate investment during the next five years, going from 8% to 18% of worldwide corporate investment. Part of the shift is explained not only by the emergence and growth of the BRIC economies, but also by a desire for corporations (and investors in corporations) to diversify and take on greater international exposure.

There is an interesting article at the Financial Times Online about how Deloitte & Touche is helping Goldman Sachs restructure their SIVs without direct help from the US Treasury supported SuperSIV scheme for purchasing SIV assets. The proposed restructuring is too involved to detail here (see the article), but the advantage to Goldman and others is that it would allow these firms to keep the assets long enough to hopefully avoid fire sales prices. The Deloitte/Goldman model is expected to be rolled out for orphaned SIVs within Goldman (those in receivership that were unable to be restructured quick enough), and could be used as a model for other companies.

In short, the principle used to restructure the SIVs is similar to those used to restructure debt-laden companies. First, the claims of the junior creditors are wiped-out allowing the senior creditors to control the assets. The assets are then reorganized into a new framework, which may involve additional restructuring and recapitalization. The main difference lies in the valuing of the assets, which is more difficult given that it is hard to get creditors to agree on valuations. While not transferable to all companies, if successful the structure could help to reduce the burden on the government and taxpayers, while also allowing firms to eventually sell assets for more reasonable prices.

An article in The Bond Buyer discusses how investment and commercial banks that originate municipal bonds are having a difficult time determining how to put their risk capital to work. Many are pricing securities to sell, thereby keeping less inventory and less securities on their books. Firms in general are reluctant to put capital at risk, and therefore are beginning to leave the municipal origination business. With approximately half of all muni bonds on a typical balance sheet insured by the bond insurers (who have their own problems), companies are feeling the effects of the on-going credit issues as many of these bonds have fallen 30% or more. Given the desire to unload positions, electronic trading platforms that sell munis are playing a larger role, with electronic trading up 40% over the last year.

Less origination by the large firms is also having an effect on trading operations. Traditionally, new underwritten securities give traders something to sell, while also providing products to clients serviced by the wealth management groups. UBS, which recently exited the origination business, is transferring some of its municipal securities unit back to the wealth management business, effectively shifting this business to a new profit center. By using an electronic platform for trading, UBS feels it will still give clients "... access to a broad supply of both new issues and secondary securities." For UBS and others, it is unclear who will be providing the new securities. Once possible source are regional firms that are already looking to fill the void generated by larger firms exiting the origination business. The shift back to regionals is already taking place as displaced brokers from the larger firms are already making the move.

Regionals do have the advantage of understanding the local environment better, be it economic, legal, regulatory, or political issues. Whether the shift from more to less capitalized firms is good for the credit markets is yet to be seen. There is no guarantee that smaller firms will also not get into trouble in the future by putting too much capital at risk. Many regionals would not be classified as "too big to fail," and will therefore be more difficult to justify bailing out unless a larger scale "saving-and-loan type" of contagion presents itself. The ramifications of this would certainly be further reaching and worse overall than bailing out another Bear Stearns.

As reported in a recent WSJ article, small hedge funds (those with less than $1 billion in assets under management) are struggling to not only beat the market, but also stay in existence. The impact is seen below in a chart from the WSJ article, by way of Hedge Fund Research, Inc.

Source: Hedge Fund Research, Inc., Wall Street Journal
At the end of 2007, 87% of all hedge fund money was in funds with $1 billion or more assets under management, and 60% was in funds with at least $5 billion in assets. Furthermore, while the number of hedge funds has grown to over 8,000 from only a few hundred just 10 years ago, only 1,152 new funds were launched in 2007. While 1,152 is still a large number, this figure is down 50% from the 2005 peak. When you also consider all the funds that were either merged or went out of business, the net number of new funds was even lower at 589.

The shift towards larger funds appears to be occurring for a number of reasons. For one, smaller firms are having difficulty borrowing funds, making strategies that utilize leverage much more difficult to employ. Some lower cost mutual funds are also beginning to act like hedge funds using various replication strategies, thereby giving investors other options. Institutions and pension funds, which are increasingly looking for alternative investment opportunities, are also choosing to allocate capital to larger hedge funds, which many believe are safer, given their larger capitalization and risk management (i.e., hedging) practices. The more flexible smaller funds have at times generated higher returns, but given the current market environment, larger funds with better risk management have made up for their lack of flexibility. Given that some smaller funds can spend up to $1 million or more a month for staff salaries and expenses, along with the reality that it may be a while before some hit their high water marks and can begin capturing 20% or more of profits, it is becoming more difficult for these funds to contend with current cash burn rates. As a result, don't be surprised if more smaller funds either change strategies, close down, or merge with the larger funds as the credit problems continue to unwind, and new capital continues to get allocated to hot markets, such as commodities and energy.

Recently there was an interesting article at Spiegel Online regarding the faces of commodity speculation, as told by a farmer, baker, banker, and hedge fund manager. The use of the futures market by both the farmer and baker (hedging against falling and rising prices, respectively) are well known, as is the interest by both investment bankers and hedge funds, but the perspectives offered by the participants are interesting nonetheless.

While the article highlights only four individuals/institutions, and is somewhat anecdotal, it does offer a few observations. For instance, the following quote from the farmer is telling: "Farmers who don't have supply contracts at the moment are now calling the shots." This particular farmer, who had not yet signed a contract, is planning to sell only half of his crop to the cooperative at the end of July at the current price. He then plans to store another 50% until at least October in silos in the hope that prices will rise further. He admits that farming is becoming more speculative and that he is willing to take the risk. Quiet a turn of events and roles.

The baker on the other hand is worried about speculation and the associated risk, and is still worried that his raw material costs will be too high. As prices have increased, he is being forced to pass cost increases on to his customers, and is worried that the markets he must now operate in are too unpredictable. Since the EU has abolished intervention prices - which had helped to regulate the market he operates in, prices are now set at the CME, which he worries is being driven by speculators.

The investment banker is, not unexpectedly, trying to take advantage of the market by offering new products, such as certificates whose value rises or falls along with the price of food commodity contracts on the CME. Of interest from the investment banker is the quote of how they want to "provide each private investor with a toolkit he can use as if he were a hedge fund manager worth millions." This brings back memories of people quitting their day jobs in the late 1990s to trade stocks online at home, only to see the market correct violently. As has been pointed out by others numerous times before, when the average investor begins talking about securities and markets that he or she never talked about before (day trading tech stocks before, commodities and futures this time around), it is usually the sign that a top in the market is near.

Finally, a hedge fund manager was interviewed and pointed out that he no longer trades crude oil futures (ironically, since they are too speculative), but continues to watch them closely, since at the moment "... oil futures are the measuring stick for everything." Whether trading in oil futures or not, the fund manager needs to know how high crude oil might go given that its price has such a strong impact on the stocks he trades. Many other traders have also expressed how crude oil is affecting nearly every other asset, and how crude oil itself is becoming the new global currency. Right now that currency is in an uptrend, but volatile, and worrying market participants of a correction.

As reported at Arab News, and commented on at Bloomberg, United Nations Secretary General Ban Ki-moon is saying that Saudi Arabian King Abdullah "... acknowledged that the current oil prices are abnormally high due to speculative factors and he is willing to do what he can to control it.”

Video Source: Clip Syndicate Bloomberg
Saudi Arabia had previously offered to increase production in June by 300,000 barrels, and may now increase production by 500,000 barrels in July. Given that Saudi Arabia is one of the few countries that has idle capacity and can actually raise production, this could certainly help in the short-term.

Nonetheless, even with the news of increased production, crude oil prices were still up sharply this morning in futures trading. While the crude oil markets are volatile and seem to have a mind of their own, the current news may be a reflection of a few realities. First, there is only limited idle capacity that can be brought to market. If the world were to suffer another shock, given a political or weather-related oil field or pipeline shut-down, it may be difficult for the markets to make-up reduced capacity in short-order, quickly putting pressure on prices. Second, the increased crude oil that is being placed on the market is not the light sweet crude that is demanded and driving price.

Of course, prices may also be reacting to recent calls by analysts, CEOs, and speculators, such as the one made by the CEO of Gazprom (see Bloomberg article), forecasting $250 a barrel for crude oil in the "foreseeable future." The call is more of a worst case scenario, and certainly is not unbiased, but does reflect the current mood of the crude oil market. T. Boone Pickens recently called for crude oil to reach $150 a barrel over the summer (when it was around $120), only to see the price spike higher. Recent calls such as this bring back images of the dot.com bubble in the late 1990s. During this rush, all things technology and Internet-related were doubling on a regular basis, with many stocks reaching new analyst annual forecasts in a matter of weeks. A $100 stock that was forecast to reach $180 over the next year often found its market price close to the new $180 target in just a few trading days. While I am still a skeptic as to how much speculators and not supply and demand are driving the crude oil market, calls such as the one recently made by the Gazprom CEO are not helping to stabilize the market, and are certainly enticing some momentum traders to take positions and enter the market.

2nd Notice: Given that the weekend link summaries are a little dated, in the future I will just post the shorter summaries as I write them in an effort to make them a little more timely.