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Although I’m loathe to admit it, I spent several years in the professional financial markets earlier in my life, but contain myself from commenting on the various financial shenanigans going on in the world (with some exceptions). However, the reason rise in commodity prices and the attendant finger pointing and “solutions” has driven me to at least make a couple of points, because the level of disinformation out there is getting a bit alarming. I spent my time in the equity markets, so I’m by no means a commodities expert. However, it seems to me that there are some fairly straightforward reasons as to why we’re seeing what we’re seeing.

This rise is oil prices is not a permanent problem. It is a speculative bubble. Oil is something that we have lot of historical data on, and it always regresses to the mean, despite one “crisis” after another. There’s also plenty of it, despite what people say otherwise.

There are a number of reasons why oil is going through the roof. Some people are convinced that drilling offshore or in Alaska will solve the immediate problem (it won’t), and some people want the government to “do something about it”, by nationalizing oil, or giving oil tax holidays, or other silliness. These ideas, often spoken with great vituperative zeal, are not the solution to the immediate problem. Both the right and the left are bellowing about various solutions which fit their own agendas, but we need to get past this — food needs to get on the table and we need cheap gas again, before we lose more truckers and airlines.

Putting aside the fact that it’s disappointing from a technological standpoint for a 21st century society to still rely on burning some type of fuel for power, the main reasons why oil has shot through the roof are largely ignored because they are a bit too complex to make into a campaign slogan, or for a radio show host to ignite the fire of his listeners. Start talking about derivates and yield curves to most people, and they start getting sleepy. Start blaming the problem on the other political party or belief, and they brighten up.

The driving forces behind the increase in prices are primarily related to financial reasons, not necessarily supply or demand. Yes, China is competing for our oil, Iraq and Nigeria aren’t producing, yada yada, but that’s not the primary problem. So here goes:

– The decline of the dollar: This is a factor in the current problem: Oil is priced in dollars, and the dollar has declined precipitously. A major aspect of the price increase is the fact that the dollar is crap these days (due to a spiraling budget deficit, the Fed selling lots of dollars at firesale prices, inflation in Europe, etc.). But that’s not going last forever. Also, the dollar has not dropped 80% in the last year to mirror the increase in oil prices. So it is only part of the problem.

Massive inflow of investment. It’s pretty much a first principle that any major influx of capital into a market creates an attendant rise in prices. In the commodities markets, we’ve seen an inflow of dollars by professional funds that is staggering. In the past five years, investment by commodity index funds has gone up almost 20x. The result is obvious: think of tulips, the dot com bubble or the recent real estate bubble. Hence, we have another asset bubble, which we keep getting because of monetary policy — whether it’s the dot com boom, the real estate bubble or the current oil bubble.

It should be noted that it should be of some concern to have commodity markets be anything more than a mechanism to buy and sell tangible and necessary goods. You turn them into investment vehicles, and you’re going to have problems.

– Speculators. Speculation is a healthy dynamic in any market, but unchecked, it creates disaster (think of what happened in 1929). It’s been allowed to go too far, in part because the rules on how much speculators can borrow are too lax. In the stock market, post-depression rules only allow investors to get a loan (margin) on 50% of what they own. The commodities markets are different — you can leverage your money up to 20 times. This was fine in the old days, when places like the Merc was actually there to give Kelloggs or General Foods a place to buy corn or wheat. But now commodities buyers have to complete with day traders and hedge funds.

Fundamentally, you have a problem where commodities markets have turned into major financial investment vehicles, with the not-surprising outcome of inflationary pressure and volatility. Going to Saudi Arabia and begging for more oil does nothing. Oil company executives issuing stern pronouncements that they need to be able to drill in ANWAR is similarly ridiculous. “Huge problems with supply”, “too much demand” and “peak oil” is nonsense: there’s plenty of the stuff out there. Oil prices are on a parabolic bubble-like curve, but actual supply and demand is not parabolic. There is a miss-match in price vs. the actual situation.

These markets are, in principle, simple things, a place where producers and buyers buy and sell commodities. These markets have existed since the dawn of humanity, and the derivatives (futures and options) are simply more sophisticated methods of providing risk management. However, if you throw gunpowder (lots of speculation and lots of extra liquidity) onto a gently burning fire, you’re going to start getting some sparks. It’s not a question of whether or not the markets need to be regulated, but whether or not they are managed. This may require regulation, but it also could be fixed by the various oversight organizations.

As far as the reasons why food is going through the roof, the above explains part of the problem, but it is exacerbated by other problems, and I’ll let someone else jump on that subject.

I believe, like Soros and others, that we’re dealing with a speculative bubble, and that we’ll see oil prices reach some degree of sanity again in the not too distant future — which would free up quite a bit of capital again for economies to start kicking again. It’s also going to seriously burn some investors, but I suspect that there won’t be much sympathy going around when it happens.

Alex Eckelberry