Oil, dollar traders feed each other crude lines

[mawilson 2,133]

Every generation has its own satirists with a unique finger on the pulse. For

the US, at present, the ruling comedians, appearing late every night on cable,

are Jon Stewart and Stephen Colbert.

Ruthless political satirists, they are also skilled market analysts. To understand

the psychology behind the global spike in oil prices, listen to their dialogue

from Monday last week.

Temperatures hit 96 degrees Fahrenheit in New York. “And it’s only early June,”

said Colbert. “Temperatures have nowhere to go but up. Forecasters say it could

be in the low hundreds by next week.”

When Stewart protested that the weather does not work that way, Colbert replied:

“I strongly doubt it. If the weather keeps going at this rate, by peak vacation

season we could be looking at upwards of 200 degrees. It’s a vicious cycle – more

people need to stay cool, less can drive, temperatures up for the rest of us.

Supply and demand.”

When Stewart protested that weather is not set by a market mechanism, Colbert

roared that it was.

Just such arguments, with just as much basis in fact, are being used about oil prices.

There is a debate to be had over the long-term causes of the oil spike. But there

is no valid explanation for the volatility of the last two weeks, except the flow of

human greed and fear.

Stephen Schork, an energy analyst, said last week: “If anyone tries to spin a

rational explanation as to what transpired last Thursday and Friday in the energy

complex, then just tune them out, or better yet, punch them in the nose.”

Oil would take its place with Dutch tulips, the South Sea bubble, or dotcom stocks,

he said.

Statistics bear him out. According to Bespoke Investment Group, crude oil’s

730 per cent rise from its bottom in 2001 now tops the 639 per cent rally in the

Nasdaq Composite over a similar period before the bursting of the internet bubble

in 2000.

It is important here to distinguish the short and long term. Demand from the

developing world has been increasing, which is a “good” reason for oil prices to

go up. But there was no fresh evidence for this in the last two weeks. Indeed,

with Brazil and China tightening monetary policy, cuts in oil subsidies, and bad

employment data in the US, the evidence if anything was of declining demand.

Similarly, many believe in the “peak oil” thesis – that oil production is entering a

period of decline. But no new evidence for it has arisen this month to justify the

rise in prices.

Some cited comments by a senior Israeli politician, who said there might be no

alternative to a strike against Iran.

But this year’s spike is far greater than the rise when Iraq invaded Kuwait in 1990.

Mere words could not have this effect.

The clearest explanatory factor has come from the correlation between the

weakening dollar and rising oil prices. As the chart shows, on an almost

minute-by-minute basis, oil rose when the dollar weakened, and fell if the dollar

rose.

In the long-term, there are reasons for this. Oil producers are paid in dollars and

then recycle them into other currencies. As oil is quoted in dollars, a weaker dollar

should lead to higher oil prices.

But these are not good reasons for such a tight correlation in the short term.

It looks instead as though traders in the two markets were mindlessly looking to

each other for cues. And the correlation came dramatically unstuck early this week,

as forex traders digested a series of speeches by US officials talking up the dollar.

Since then, as that confusion has subsided, the two have traded in line once more.

In any case, unrelated events can stay closely correlated. A classic false correlation,

from Roger Mortimore of the Mori polling organisation, shows that British elections

correlate with soccer. With only one exception since 1959, if the reigning FA Cup

holder wears the Labour colours of red and yellow, Labour has won. If they wear

the Conservative colours of blue and white, Labour loses. In 1974, when neither

won a majority, the Cup holders, Sunderland, wore red and white stripes.

This correlation is, of course, nonsense. But in the grip of market manias, investors

can latch on to factors which are just as absurd. Human psychology offers the

best explanation for what is going on.

When fear is elevated, correlations between asset classes increase. People also

look for “anchors” – the mere mention of a $200 oil target by a Goldman Sachs

analyst prompted investors to “anchor” around a new, higher level, and to keep

projecting prices higher.

Like the weather, high oil prices have a direct impact on people, and provoke fear.

In bubbles, markets become a game of second-guessing the fear and greed of

other participants.

Technical analysts would say that the volatility is a symptom of a bubble that is

about to burst. Something similar was seen at the end of the Nasdaq bubble.

But there is still reason for fear – one last ridiculous spike upwards is perfectly

possible.

So for the best guidance, turn to the late-night satirists.

The FT