THE FUNDAMENTALS OF OIL SHOCKS / SEEKING ALPHA ( RECOMMENDED READING )

The Fundamentals of Oil Shocks

by: Hard Assets Investor

November 27, 2009

Speculators take most of the heat for the recent oil spike, but were they really to blame for last year's high prices? Probably not, says Dr. James Hamilton, who argues that supply and demand, not speculators, were behind oil's 2008 rise.

A professor of economics at the University of California, San Diego, Dr. Hamilton co-authors the popular blog, Econbrowser, where he analyzes current economic policy decisions and conditions. He has written dozens of scholarly papers on commodities, as well as testified before a congressional committee on the effects of the 2008 oil shock on the current recession. Before he joined the UCSD economics department, he was a professor at the University of Virginia.

Recently, HAI Associate Editor Lara Crigger sat down with Dr. Hamilton to discuss his thoughts on the current state of affairs in commodities, including how index funds impact the way commodities move together, what really drove the 2008 spike in oil prices and why higher oil prices could hold back the recovery.

Lara Crigger, associate editor, HardAssetsInvestor.com (Crigger): For a long time, commodities generally moved independently of each another. But in the past decade or so, many have started moving up and down in unison, including those you wouldn't expect, like cotton and oil. What's behind this increased intercorrelation between commodities?

James Hamilton, economics professor, UCSD (Hamilton): A number of factors may have contributed. One important factor is the growing importance of the newly industrialized economies, with China being at the top of the list. China's grown so quickly to become such an important factor in the world market for these commodities, from food items to metals to oil. So fluctuations in the Chinese economy, that's one single factor contributing to all these prices.

Beyond that, there might also be some financial reasons that commodities are moving more together today. I think that a number of investors around the world think of commodities as a financial asset to a greater degree than we did 10 years ago. That's another factor, in that fluctuations in demand coming from that source would also be common to a broad range of different kinds of commodities.

Crigger: How have the commodities index funds, like those based on GSCI, affected this correlation between commodities?

Hamilton: Ascribing causation is, of course, a tricky thing. But we can say that in terms of the correlations, those commodities that were included in those popular commodity indexes seemed to have increased their co-movements with each other, relative to those that were excluded. To some, that suggests there maybe is a role of these indexes in producing this increased co-movement across different commodity classes.

Crigger: Since commodities are priced in U.S. dollars, how much does the currently very weak dollar have to do with it?

Hamilton: Well, that's also a contributing factor, but it's not as big as many people assume. For example, so far this year, the dollar has depreciated about 12 percent against the euro. That's a pretty big depreciation. But if all that were going on with commodities prices was that, then we'd expect to see something like a 12 percent increase in the dollar price of these various commodities. But the price of a typical commodity has gone up much more than that; it's gone up closer to 40 percent, and well beyond that for many of the particular highfliers.

So depreciation of the dollar, yes, that's a factor, but I think that people will make a mistake if they think of that as the most important reason that commodity prices are going up at the moment.

Crigger: You've written quite a bit about oil shocks, particularly the one in 2008. How did the 2008 oil price spike drive us toward the current recession?

Hamilton: According to the National Bureau of Economic Research, the recession actually started back in December 2007, even though the really dramatic financial developments—like the failure of Lehman—came in September of 2008. So we were in a recession for three-quarters of a year before the really serious financial problems ever started. And if you look just at GDP growth, U.S. GDP was actually growing in real terms over those first three quarters. That's unusual, to look at a period where GDP was growing and call it a recession. If we hadn't had the severe downturn in the fourth quarter of '08, the NBER might never have said we were in a recession at all.

So given all that, the question becomes: What were the sectors that really were in trouble? One of the very important ones was the U.S. automobile sector, which was subtracting about 0.5 percent GDP growth at an annual rate for those first nine months. There's no question that, for that sector at least, what was going on with oil prices was very important. Sales of U.S.-manufactured SUVs plunged at the same time that sales of imported, more fuel efficient cars were going up. That combination was unquestionably influenced to a great degree by what was happening in oil prices, and U.S. manufacturers were hit particularly hard.

Also, it was really starting to pinch consumers' incomes and their spending power as we got into '08, which was one factor causing a slowdown in consumption spending. In my opinion, these developments were really what tipped the scale. And if you say the recession started in December '07, I think it's hard to conclude that what happened to oil prices was irrelevant in making that judgment.

Crigger: What drove that price spike in oil in 2008? Was it supply and demand fundamentals, or was it speculative investing, as so many people have argued?

Hamilton: I think they both made a contribution, but I think supply and demand were very important. Basically, between 2005 and the first part of 2008, global production of crude oil was practically stagnant. We essentially had no increase in total oil produced worldwide over that period. At the same time, world GDP was growing very strongly, particularly from places like China. So there was a big increase in the demand for oil, and no more oil being produced, and that put a lot of upward pressure on prices.

Now, as that increase in oil prices gained momentum, I think there might well have been some speculative component on top of that. Maybe that sent it up over the top in the summer of '08. Certainly in retrospect, the price went up more than it should have, if you'd known what was about to come.

But while I think there is a pretty clear role these financial movements have had in the current price of oil, I think it's a mistake to think of them as the whole story in '08. I think a bigger factor is the stagnation of global production and the strong growth in global GDP since 2003.

Crigger: So then is the current recovery in oil prices being driven more by speculators than by fundamentals?

Hamilton: We do see indications that inventories of oil are higher than normal for this time of year. That means that the current situation can't be maintained forever: Either the price has to come down or demand has to come up to justify the current price of oil. Now I guess there's a lot of conviction that the demand is increasing, at least outside the U.S. But I still see the U.S. economy as very weak and vulnerable. So I don't see a strong rebound in demand coming from the U.S.; I think our consumption may very well continue to go down.

So I am more open to the suggestion that speculation is a factor in the oil price right now than I am to the suggestion that that was the key thing going on in February of 2008.

Crigger: Oil has traded in a range for a couple weeks now, but should it start to move significantly upward again, would that threaten what economic recovery we've seen so far?

Hamilton: Well, it's still well below the levels that helped trigger the recession in '08. I think as long as the retail price of gasoline in the U.S. stays below $3/gallon, we're not back in that territory. On top of that, the auto sector already has been clobbered. We're on the floor now. So what happened in '08, we got knocked down, but that means that I don't see an oil shock as having the same capacity to knock out autos like it had in '08.

But eventually there would be a tipping point. If the price continues to go up, that would be back into a situation where that's putting a real burden on consumers' budgets, and I think that would definitely be a factor holding back the recovery. But my current assessment is that oil at $80/barrel is not really the most important factor for the U.S. economy at the moment.