Black Gold was already transformed to Black Swan, Mr. President

The Transformation of Black Gold to Black Swan[2]

The author of the USA bestseller “The Black Swan: The Impact of the Highly Improbable”, Nassim Nicholas Taleb argues that none of the models that are used in international economy functions today. Once no colour but white came to mind in association with the “Swan”; however, as the “black swans” came into day light with the discovery of Australian Continent, people’s assumptions turned upside down. N. Taleb emphasises in his book that “unpredictable developments shape the markets.” Taleb, who was in Turkey as a guest of a bank in June, calls events that cause great impact, that are impossible to predict and that are out of normal expectations as “Black Swans.”  In the last 10 years, the world experienced various extremities in almost all sectors and economies. Oil prices are at the top of these extremities. While price of oil was 9.81 USD/barrel in February 1999, oil prices pushed 140 USD level in May 2008. It finally passed 142 USD in 27 June 2008.

The world is in “The Age of Turbulence”, as Greenspan named his book. Wild capitalism started showing its real face limitlessly and more fiercely than ever, as globalism replaced balances of the world and glocalism. The famous 80% – 20% Pareto Principle (A 20% section gets the 80% of the income.) is becoming 95% – 5%. Following globalisation of the world, the comprehension of risk is also changing and investors with high risk taking and absorption capabilities can invest anywhere in the world with no restrictions. Especially as a result of globalism, the power of laissez-faire capitalism is preferred as the aim of welfare state by all world economies, even by communist countries like China. Finance has become a lot more complicated, as risk absorption variety increased and diversified, communication and internet changed the face of the world, and new markets emerged.

Everyone including the president of OPEC pointed the increased demand as the cause of rising oil prices until now. The economists belonging to classical economy approach chose to assess the rising oil prices within the framework of supply demand balance. Even International Energy Agency exposed the growing demand in China and India as the main reason behind the increase in oil prices.

The investment bank Morgan Stanley predicted in a report published on 6 June 2008 that oil prices will continue to increase and exceed 150 dollars per barrel on 4 July 2008. Ole Slorer, the Morgan Stanley Analyst who prepared the report, emphasised that increase in demand in Asia and a boost in demand due to the Fourth of July Holiday when millions of Americans will be on road, will lead the oil prices to exceed 150 dollars.

All the same, CIBC World Market head strategist Jeff Rubin declared the imbalance between supply and demand as the main cause of the increase in oil prices.

Meanwhile, in parallel to the Morgan Stanley report, oil prices went up 10.26 dollars with a 8% increase in one day on 6 June 2008, to reach a record high increase in a day and a price of 138.05 $/barrel.

Another investment bank Goldman Sachs stated in the last weeks of May that oil prices will exceed 200 dollars.

However, there is no development according to the supply demand balance that will explain the 8% increase in one day. The oil prices was 9.81 $/barrel in February 1999 and on 6 June 1999, increased by more than 10 dollars in just one day. According to the average global oil consumption and production figures covering 2001 to 2007, average demand increased by 10.26% while supply increased by 8.9% from 2001 to 2007.

Source: Energy Information Agency / Figure 1

There is certainly a small difference between supply and demand. One of the factors behind the increase in oil prices is the growing demand. Nevertheless, it is absolutely not the sole factor. Despite the growing demand, oil supply also increases, due to the fact that not only OPEC quotes were raised, but also other oil producing countries outside OPEC, especially Russia, increased oil production and new wells became operative as new oil production plants were completed. The main cause behind the increase of the prices as much as 1350 % of the prices nine years ago cannot absolutely be explained with demand. The declining interest rates in the USA, the improvement of competitiveness against the declining dollar in China and India whose currency are indexed to dollar and a period without inflation because of their production have all accelerated the increase in the prices of not only oil but of all commodities. High commodity prices fuelled the transaction volume in futures exchange in parallel to this and the size reached by Institutional and State Pension Funds, Sovereign Health Funds, Hedge Funds, University Endowments and other institutional funds which operate in these markets, blew the futures exchange. Since these funds have high risk appetite capabilities against increased commodity prices, they can increase their income by entering more open positions using profits which can be called “easy come easy go money”, and making more speculative transactions.

The reason behind the volatility of oil prices is the futures, which are completely synthetic transactions. Funds with high risk appetites take positions in these markets and release such information. Some experts call this kind of investors as Index Speculators. This is due to the fact that the investment strategies of these investors are to invest in the Standard & Poor, Goldman Sachs Commodity Index and Dow Jones – AIG Commodity Index, each of which is a combination of the popular indexes of 25 main commodities (Table 1). In fact, speculation in exchange markets is not a new thing. It is there for ages. Edwin Lefevre, in his book Reminiscences of a Stock Operator, which covers the memories of the stock speculator Jesse Livermore who is known as Wall Street’s Gambler Boy, tells how Livermore made 100 million dollars by short-selling one day before the 1929 crisis.  Lefevre tells the Wall Street’s view on capitalism in that era through the words of Livermore who became rich and bankrupt three times and eventually committed suicide in 1940: “Bulls and bears make money, pigs get slaughtered.” What is new and lately developed is “Index Speculation.”

Table 1: S&P GSCI components and dollar weights

At the beginning of the 2000’s and especially in 2000-2002, some institutional investors viewed futures markets as a new investment vehicle. There has ever been speculation in commodity markets; however, commodity markets have been very unfamiliar for portfolio managers. In recent years, there have been considerable a price increase for not only oil and oil products, but also for all commodities which cannot be explained by classical economy principles (Table 2).

Table 2 - The Increase of Commodity Forward Prices Between March 2003-March 2008

The profiles of actors and investors involved in open transactions in American commodity futures markets are listed in Table 3 below. As seen in the table, only an average of 33% of the investors trades commodities for physical hedger. The rate of index speculators is high for oil products. The most important reason for why fund managers prefer commodity markets is that they follow buy-and-hold investment approach rather than buy-and-sell approach like other fixed-income and security investments.

Table 3 - Investor Portfolios for Open Position Transactions in Commodity Futures Markets

Index investment amount for 25 commodities, which was 13 Billion dollars in 2003, raised 183% by March 2008 to reach 260 billion dollars (Figure 2). The US Commodity Futures Trading Commission and spot market participants comment that physical commodity prices are directly influenced by the raise in futures prices initiated by index speculators and there is a direct relation between the two.

Figure 2 - Commodity Index Investment Size

The increase in China’s oil demand is a common belief behind the increase in oil prices. However, this is absolutely not the cause of increase in oil prices especially for the last year. According to the USA Department of Energy’s figures, the annual oil consumption of China has risen from 1.88 billion barrels to 2.8 billion barrels (Table 4). Hence, there was an increase of 920 million barrels. In the same period, the increase in sum of Index Speculators’ oil futures transactions was 848 million barrels. So, the transactions of Index Speculators were almost as much as China’s demand.

Source: Energy Information Association US Department of Energy The figures in this table are calculated via co-basing China’s crude oil and product consumptions / Table 4 - Increase in China's Oil Demand (Last 5 Years)

Today, the positions equivalent to 1.1 billion barrels of oil occupied by the USA Index Spectators in futures exchange have reached a level of 8 times more than the figures of the Strategic Oil Stocks of the USA. The position size of the index speculators for corn (2 billion bushel for the last 5 years) is sufficient for annual ethanol production at full capacity in the USA. This means approximately 23.85 billion litres of ethanol (The USA is the largest methanol producer.) The position size of the index speculators for wheat is equivalent to the USA consumption for two years.

Source: US Commodity Futures Trading Commission / Table 5 - Index Speculator demand for oil (last 5 years)

Demands come to futures exchange from two different groups. First group is the physical consumers, who are in the chain of commodity trade and consumption; while the second group is speculators. Traditional speculators have been around from the day that commodity markets were established. However, the index speculators have reached an incredible size today, while they used to make transactions on smaller scales only five years ago. This is the issue overlooked by the classical economists. The size reached today is actually a virtual one. The ones who know the mechanics of these markets also know that only a little portion of the transactions being made does turn up to be real trade, and the larger part is virtually end with a position closing before due date.

The difference of index speculators from traditional speculators is that they make decisions according to portfolio allocation. In other words, index speculator is not interested in the unit price of commodity, but just looks at the rates in the portfolio.  He decides his positions, purchase and sale not depending on number of units, but the size of the funds allocated. Besides, the size of commodity markets is very small compared to the size of financial markets. Hence, a fund allocation of a few billion dollars causes a movement of a great scale in commodity markets and prices. While the total value of a futures contract including 25 indexes was 180 billion dollars in 2004, the size of the securities exchanges in the world was 44 trillion dollars in the same period. So it was approximately 240 times bigger. The extra amount that the index speculators invested in commodity futures exchange in 2004 was 25 billion dollars. This number corresponds to the 14% of the total size, which is 180 billion dollars. An extra 14% can easily cause a rapid rise in a market without resource depth.

Figure 3: Commodity Futures Market Size

The sizes of commodity futures markets are shown in Figure 3. The structures of these markets expand and prices increase with the funds increasing with a snowball effect. Index speculators do have an only goal. The prices shall increase, so that their funds get bigger. While traditional speculators earn money from the arbitrage between the increase and decline of price and take different positions, index speculators move in one direction. Growing markets, increasing funds maintain that more funds are attracted to these markets.

Consequently, unless the regulations and controls are efficiently practiced on funds with high risk appetite by regulatory institutions especially in developed countries and countries adjust their tax legislations to obtain more efficient taxation of the incomes gained in these markets, then the domino effect will continue with more profit, more risk appetite, more fund size, higher price like a spiral… The raise in commodity prices renders poor societies poorer and ignites both the conflicts in the world and the conservatism to prevent this. The swan has been wallowed in oil and become the black swan. Now, classical economists should examine the effects of synthetic market products on real markets and think as creatively as finance engineers. Social Engineers should design better models while considering the impact of commodity price increase to societies.

Ali Arif Aktürk, Energy Expert, Former Head of Natural Gas Department, BOTAŞ and Managing Director, NATURGAZ, Member of the Board İZMİRGAZ and ESGAZ

Please cite this article as follows:

Aktürk, Ali Arif (May, 2012), “Black Gold was already transformed to Black Swan, Mr. President”, Vol. I, Issue 3,  pp.14-22,  Centre for Policy Analysis and Research on Turkey (ResearchTurkey), London: ResearchTurkey (http://researchturkey.org/p= 833)

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