John DizardTue Apr 18, 6:10 PM ET
Iran's government is becoming isolated in the diplomatic world and is losing access to international banks but it still has a few allies who share a fanatic, faith-based approach to this world's problems: oil speculators.
That includes both the "sophisticated" large holders of long futures contracts and the retail "investors" in oil exchange-traded funds. They are making the same bet and using the same instruments - the ETFs and the large speculators both rely on futures markets instruments. There is some difference, in that the large speculators are aware that they lose money every time they have to roll their front month position into the next month, given that the oil markets are in "contango" - the technical term for when distant delivery prices for futures exceed the current spot prices.
The ETF holders have confusing monthly statements to lessen the immediate pain of having the storage and financing costs stripped from their assets.
Looking back say four years ago, before the tripling of assets under management by commodities hedge funds, many of these markets were in "backwardation". That is to say, the price of oil, for example, in future months was lower than it was in the active, nearer month. And why not? After all, if the same oil could just as easily be left in a free storage facility called "the ground" rather than being pumped up and piped into a metal tank for which the owner would pay interest and storage fees, would this not put a lid on the amount of capital someone would want to commit to buying crude oil?
The only use I have ever seen for unrefined crude oil was in an installation art piece in a New York gallery. A Russian artist had put Urals and Basra crude oil in transparent plastic containers to make an incoherent point about how important oil is. There was apparently a market for this work.
Other than that, crude oil has to be refined into products to be valuable. This would seem an obvious point but like a lot of other obvious points, such as the inadvisability of land wars in Asia, it gets ignored. That is why there is almost no storage space left for crude oil. Anywhere.
Long-term commodities people have noticed this. "In the old days, there was a roll yield you could exploit," says one, nostalgically. That means that when the oil market was in backwardation (future prices lower than spot prices) and you were long in the futures, you could roll the position forward into the following month at a lower price and make a small profit.
The opposite is happening now. In the disclosure documents that the ETF investors do not read, they could find out that a dollar a month per share, or, annually, about one-fifth of their money, would go to pay the contango. So to break even they need a continued speculative frenzy. That should create a real opportunity for crude oil professionals to build storage tanks, fill them up, and sell the stuff to the public, but they don't seem to think the opportunity will last long enough to finish building the tanks and take the money. So they're not doing it. That keeps the contango steeper than it should be - in other words, delivery prices stay too far in excess of the current spot price.
So, instead, the professionals are coming up with "innovative" investments - which in this context means making an unattractive investment look plausible to the public. It's not unlike that Russian artist's work.
There is a shortage of refined product, because that takes big, complicated plants that take a long time to build and are difficult to operate. That's too much like work for people in the developed world. So the developed world (and its speculators) is effectively long crude and short refined product.
There will continue to be a shortage of refined product, in part due to price controls on product in fast-growing parts of the world. One of those places is Iran, which heavily subsidises refined products, which it has to import. According to Iran's numbers, they use 50 per cent more petrol per capita than Americans.
So Iran is long crude and short refined product. Just like the speculators, it needs a high and rising oil price. Without $70+ oil, Iran would face fiscal disaster. In the Iranian fiscal year just ended, government expenditure rose by 25 per cent, or27 per cent above what was budgeted. Only high oil receipts kept government finances from collapsing. Most of the increased spending went to operating expenses such as salaries and price subsidies, rather than capital expenditure. That will be hard to cut. The report of an IMF mission to Iran from last December said a "fiscal adjustment", or government spending cut, of 3 per cent of gross domestic product would be needed, along with tightened monetary policy.
To avoid that, Mahmoud Ahmadinejad, Iran's president, needs crude oil prices to keep rising. I don't know why people think he's insane. Creating a panic over the prospects for oil supply is his only way out. If Gulf crude oil were to decline to $40 a barrel, the long-term upward price trend would remain in place, expensive substitute supplies such as the Canadian tar sands would still be economic, and the rest of the Middle East would still prosper, though at a less frenzied pace.
But those who bought the ETFs and the "sophisticated" investors who bought into crude-long hedge funds would lose a lot of money. When they started liquidating their futures positions and selling ETF shares, the product behind those holdings would also be sold, eventually, to refineries, which would accelerate the price decline. And the Ahmadinejad administration would be finished.
This won't take that long. Energy prices are cyclical. The underlying physical and economic laws haven't been repealed. We are talking about a year or two until this happens, based on past experience.
Nationalist frenzies in commodity exporting countries collapse with the decline of commodities prices. It always happens. This time will be no different. The professional commodities players will go back to making nickels and dimes off rolling their contracts into a backwardated market. The war freaks will slink back to their think-tanks.
Copyright © 2006 The Financial Times Limited.
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