OPEC - Why it no longer calls the shots

"Are you nuts?" might be the first response of anyone who sees the title. Afterall everyone knows that the single factor which definitely affects the spot price of an Oil barrel on the floor of the NYMEX, the most, is an OPEC meeting. So let me elaborate. OPEC is powerful, but not as much as it once used to be. If anyone remembers the 1973 Oil shock - which brought America and most of the world to its knees in a decade long bout of stagflation, you will now know how much less power it wields today.

So what can be the reasons for such a powerful body's influence to wane? To understand the reasons, you need to understand the composition of OPEC. OPEC stands for Organization of Petroleum Exporting Countries. It is a cartel of 12 countries, the main member being Saudi Arabia accounting for over 25% of world reserves. Other countries like Venezuela have much smaller reserves. So now lets take a look at some of the reasons for the waning of its effects.

Production: Although OPEC used to control a lot of Petroleum production, New reserves discovered in the Gulf of Mexico, and Russia opening up its vast Oil reserves have reduced OPEC's global output to under 40%.

Price Issues: OPEC members have divided interests over Oil prices. While the naive reader might think that a higher price is in the best interests of all suppliers, things are more complicated. Saudi Arabia has much more Oil in the ground compared to other members of OPEC. So while a higher price helps in the short term, it will also accelerate development of alternative technologies, which will eventually reduce the world dependence on Oil. So OPEC members with less Oil in the ground, could not care less about the future, and want to make more money with less oil, and hence want higher prices. Saudi Arabia, on the other hand, wants the world to continue its addiction with oil, and hence would not want to invariably prop up alternative fuel technologies. This attitude is summed up by a quote by a Saudi Oil Minister as "The stone age didn't end because we ran out of stones". Even towards the end of 2008, Saudi broke ranks, and declared it will pump over its OPEC imposed production quota, to reduce the Oil prices which were in the stratosphere.

Infighting: Also after a great show of unity in the 1970s, the major OPEC nations turned against one another. Firstly the 8 year Iran-Iraq war distanced the Shia Iran from the rest. Later, Iraq which was trying to service its war debts more easily by rising Oil prices was rebuffed by Saudi and Kuwait which pumped out more Oil and depressed global Oil prices, finally provoking Iraq to invade Kuwait and eventually Saudi, if it were not for America's intervention.

The Iraq Factor: Although Iraq is a member of OPEC, it is not taking part in production quotas since 1998. And with the highly increased American influence, it is much more likely to do US's bidding at least in the near future, which most probably will not coincide with the official OPEC stand. Also after a long time, Iraq is comparatively stabler and will start pumping more and more Oil, increasing supply and indirectly reducing OPEC's influence.

America: And finally lets not forget US's Gunboat diplomacy by having a couple of warships and aircraft carriers patrolling the Gulf. Although Saudi is an ally, the war ships let it know its position, and the emergence of a Shia Iran, right next to its borders as well as a discontented population, rising Islamic terrorism against the ruling sheiks would make Saudi more reluctant to anger it ally America. And America is much more interested in the Gulf after the 1973 Oil Shocks.

These are some of the reasons why OPEC is less powerful, but lets not get carried away, It is still the single most powerful factor in determining global Oil prices. So let us hope that the dependence on Oil will decrease soon enough.

Oil prices scrapping the bottom - Lost Lessons

Now-a-days, Oil price is the last thing on people's mind, with an Election just over in the US, the economy in the dump, and theories about a very prolonged recession - which has even been compared to the Great Depression of the 1930s. Sure enough, it seems like almost no one remembers that oil prices were topping $147 just a few months ago... The commodity bubble has burst at last, and has dragged the price of Oil back into $50 range now.

So what now? Will the prices continue at $50? Obviously not. Once the downturn is over, the OPEC countries will actively seek their pound of flesh. So here is a golden chance for Obama to right many wrongs that were done earlier. Instead of seeking short term quick fixes for bumping up Oil production by offshore drilling or invading other countries, a comprehensive plan to rid America of its Oil addiction needs to be worked on.

Although the end of the cold war made the world a much safer place, it inevitably resulted in America losing its focus on Science & Technology. Ofcourse the top technology companies are still US-based ones, but they are private. And private companies tend to be short sighted for obvious reasons. And real technologies take time to mature and generate profits. It is the federal govt's responsibility to fund such long-term technologies, which will help tap into renewable resources.

The recession is showing at least some signs of waning, so once again a message from the Oil crisis is being lost. Renewable sources are the way to go, and still more research and funding into better batteries, solar power, etc is needed. Lets hope Obama does not lose sight of the future while trying to save the present.

Financial Weapons of Mass Destruction - Credit Default Swaps

While Bush was busy searching for weapons of mass destruction in Iraq, he neglected to bother about the ones that were being "stockpiled" in his own country. No we are not talking about warheads, but Credit Default Swaps - or "Financial Weapons of Mass Destruction" as Warren Buffet, the most successful investor in the world, likes to call them. Now that they blew up in America's face, leaving the country in recession, and spreading the fallout across the world, we will try to see what these things were about.

So what exactly are these credit default swaps? Lets say Bank X loans a large sum to a lets say Tom for mortgage. There is a chance that Tom might not be able to repay his mortgage. In that case, the bank stands to lose the money loaned - which is a major risk for it. So to offset the risk the bank enters into a Credit Default Swap contract with a counter party. Bank X then starts paying fixed payments to the counterparty. In turn, the counterparty assumes all risk of the person defaulting on the loan itself. Although this looks like a typical exchange, the rotten part of it is simply that - the seller of the contract does not need to have any real assets to make the contract.. and can technically go bankrupt.

So a credit default swap makes everyone happy - as long as Tom is making his payments. For Bank X, it kept a huge amount of default risk off its books, and for the counterparty, it is pure money for nothing. But once Tom does not pay his mortgage payment, as it happened, then the system begins to unravel... Bank X demands money from the counterparty, who might go bankrupt since he does not have enough assets to make good his promise. The counterparty is also unable to raise the cash, as the house value would have fallen in the market. So it declares bankruptcy. Immediately, the huge losses starts to appear on the books of Bank X... which takes everyone by surprise, since it was not "expected".

The market for Credit Default Swaps is Over-The-Counter, and not regulated well. In some instances big firms used to buy CDS contracts from little known players, who declared bankruptcy once the defaults started piling up, forcing many big firms to become insolvent. The notional value of the CDS market grew from a couple of hundred billion dollars at the end of 2000 into more than $40 trillion by 2005.

This is one of the reasons for the US Govt trying to bailout firms. Since if they have lots of CDS contracts, then shutting them down would force some other company to take huge debts onto its books immediately, and itself become insolvent, starting a chain reaction. The govt hopes that this will in the meantime allow the values of the assets to grow slowly, and reduce the impact on the firms.

Dollar in the dump

The massive bailout of the financial sector, valued at nearly $1 trillion, is causing a record deficit, which is sinking the dollar. Already investors have started moving away from dollar into commodities. Commodities across the board like Gold, Oil, Copper etc are seeing a massive rally. (Oil price increased by almost $35 to $130, and is expected to go up.) The details of the bailout have also not emerged completely, leading to volatility, which is only expected to get worse.

Dollar's position as a reserve currency will be challenged if the slide continues. China has billions of US dollars in reserves, so if it sees that the dollar value is dropping, it may start dumping its dollar assets in favor of other more resilient assets. Other countries also have substantial dollar reserves. This would release a lot of dollars into the global markets putting much more downward pressure on the dollar. The only reason against that happening now, is that the Euro, the nearest alternative, is also in a pretty bad shape.

To control the drop in dollar, the government has to reduce the deficit. One way is to reduce expenditure, which appears to be nearly impossible due to the bailout plans of Paulson. The other alternative is to increase taxes, which is equally unlikely. A weak dollar will cause much harm to the economy and raise inflation, leading to a very damaging recession.

A positive effect of a weak dollar is that it will increase exports, and make imports more costlier. But this is a long term effect, which wont necessarily kick in, in the short run.

The current bailout, as bad as it is, is the only way to offset much bigger crisis in the American economy. But the loss of confidence in the dollar will take a long time to recover.

Socialism for the Super Rich - Moral Hazards in US economy

The recent bailout of Freddie Mac, Fannie Mae and AIG, by the US Govt to protect the faith in US markets has created a moral hazard. A moral hazard indicates that while you take a risk, the profits from it go exclusively to you, but losses are distributed to parties which do not have anything to do with the deal. This creates a situation which rewards an overtly risky behavior.

The US taxpayers are paying for the mistakes of a few who tried to make a lot of money in the US real estate and mortgage businesses. The Fed by arranging the shotgun marriage of Bear Sterns to JP Morgan a couple of months ago, while assuring at least $30 billion against losses from Bear's trades, indirectly rewarded the overtly risky behavior, by letting the taxpayers buttress the downside of the risks. Freddie and Fannie losses could potentially run into hundreds of billions of dollars. The Fed tried to take a stand by not bailing out Lehman, but the odds were stacked against its favor as the AIG posed a huge counterparty risk to all the financial markets. In the end, the AIG bailout cost the taxpayers $85 billion.

This is not new for the Fed. It arranged the cleaner disposal of Long Term Capital Management (LTCM) Hedge fund after it blew up in 1998, since the fund with $10 billion in deposits and controlling over $1 trillion of the economy through leverage would have brought down the entire global economy.

Moral Hazards have always existed in the world of Hedge funds, where the fund managers gets to take home a large part of any profits he makes. Losses would typically result in him getting fired, but without any monetary damage. This caused the Hedge fund managers to take up increasingly risky trades. Mutual funds were somewhat safer due to strict regulation which limited the riskiness of trades they undertook.

In a free market enterprise the Fed has to let these institutions fail for their mistakes. But they would also cause global economic collapse and cause a lot of harm to the common man. So this is amounting to near blackmail by these firms (a more apt term would be brinkmanship).

Other than the explicit bailouts of Freddie, Bear, AIG etc, The Fed is also implicitly bailing out the other firms by keeping the interest rates extremely low, at a time when inflation is eating into the savings of the common folk.

So who is at fault? The fault is the lack of proper regulation and laws governing Investment banks and financial institutions in general. For example the repeal of the Glass-Steagall act is one such action, which increased the moral hazard since banks can also do investment actions and lose lots of money rendering them insolvent. This would cause the FDIC to dole out money to the depositors from tax payers if the banks fail. This is definitely not the best solution, but can be one solution which can be used to reduce this moral hazard, which if ignored further would result in increasingly worse depressions, as traders start taking increasingly risky trades.

Although it is against the spirit of free markets, the US Govt must be more proactive in analyzing the markets and bring in relevant laws and regulation, instead of waiting for the storm, to pass new laws.

The Bursting Oil Bubble - Aftermath

The Oil bubble has more or less burst for now as expected. with the price of crude down to nearly $94 from the peak of $147 in July. The main reason for the decline is that the US Dollar is once again stronger than earlier. Since Crude is priced in dollars, any fall in dollar value will increase the dollar price of crude and vice versa. Oil is one of the main commodities that is also used as hedge against the dollar, and now that the dollar is doing good, Oil is getting dumped in favor of US Treasuries and the like. The price of Oil is expected to drop further, since the Lehman bankruptcy will possibly unwind some Oil trades.

The global economic downturn is also playing its part, by reducing the demand for Oil. The last time the world economy was down after the 1997 East Asian crisis etc, Oil fell to under $10 a barrel. The cracks in the OPEC are once again out in the open, with Saudi Arabia not wanting to reduce its production. Politically also, the fall in Oil price is significant with the tide turning away from the Oil producers - especially the politically active ones like Russia.

The presumed demand from rising economies like India and China causing a global upward price spiral proved to be unfounded at least in the short run. And it also showed that however inelastic the price demand curve of oil is, there is still a curve there which causes unrealistic prices to throttle demand. Airlines can once again breathe easily.

Now-a-days, none of the bad news is really affecting the crude price slide very much. News such as Hurricane Ike likely to impede Oil production in the Gulf of Mexico, increased terrorist activity in Nigeria or likewise, which would have caused massive rallies earlier, are causing no more than a whimper, and the price slide stops temporarily before resuming its journey down to a more realistic value.

On the negative side, the push for alternatives to oil is once again reducing, indicating the short sighted nature of the public. Also the reduction of premium on Oil, removes the financial incentive for private investors to pursue alternative renewable fuels. Oil has also stopped being a major campaign issue. This is high time the coming Govt in Washington takes a stand and pumps money into the research for alternative fuels, instead of bailing out companies like the Detroit Big Three to prop up the economy in the short run.

The dent made by the spike of oil prices, made the American consumer more aware of the risks of owning a gas guzzler. It will be a while before this harsh lesson is forgot, which is good news.

The American consumers at the Pump still see Oil at more than $4 since Hurricane Ike destroyed the refining capacity on the east coast, resulting in serious Oil shortages. But this is a temporary phenomenon which should pass in a week or so.

I really applaud the Indian govt's decision to NOT reduce the price of Oil at the pump, even though it is the election year. This goes a long way in reducing the oil subsidy to more manageable levels, and will leave the image of India as a good investment destination intact.

Nightmare on Wall St - Failures of Lehman, Merryl, AIG, WaMu....

In The Simpsons Movie, when Bart Simpson, utterly embarrassed by a situation, moans - "This is the worst day of my life!", his father replies - "This is the worst day of your life, SO FAR". The same could be said about the happenings in the last week of the US Financial sector.

What a week it was. just when you were thinking that the worst was over, the financial sector keeps hitting new lows. Couple of months back Bear Sterns was taken over by JP Morgan in a Shotgun wedding arranged by The Fed. Markets were a bit stable, and now it spread like wildfire in the last week. These are a couple of things which went bad in the financial sector in the last week.

- Freddie Mac & Fannic Mae were nationalized
- Lehman Brothers stock in free fall resulting in its declaring Chapter 11 bankruptcy
- Merryl Lynch bought over by Bank of America, after a free fall in its stock
- AIG group stock going down, resulting in its "restructuring"
- Washington Mutual (WaMu) Bank's stock tumbling
- Wachovia Bank's stock nose diving

So now out of the big Five wall street investment firms, only two - Goldman Sachs & JP Morgan were left standing. This extreme uncertainty in the financial sector trashed the DowJones, making it face the worst percentage fall in 6 years.

The ticking timebomb here is that the investment firms make a lot of trades with one another. Since there are a very few big firms taking up both sides of most of the trades, the trades suffer from counterparty risk. i.e. if you make a trade which realized a profit on the books, but the counterparty to the trade cannot pay up since it went bankrupt, then you lose too since you wont be seeing any real money from them. Now that Lehman has gone down, all the trades done with it need to be unwound, or a loss taken. When these losses start appearing on the books of other investment firms, they too will start taking a hit.

Lehman's is the biggest bankruptcy filing ever with $639 billion in assets. So there are bound to be repercussions everywhere in the financial sector. UK regulators have already asked firms to declare their exposure to Lehman. Citi group looks like it has a serious exposure to Lehman, which if it did, would seriously undermine its current precarious position.

Already there is a talk of a further rate cut by the Fed, which, at current inflation levels, can only be bad.

So is the rock bottom hit? is this the worst? I cant help thinking of the answer given to Bart Simpson...

End of Credit Crisis in Sight - Freddie Mac & Fannie Mae nationalized

The Credit crisis which has roiled the markets for over 2 years is now hopefully nearing an End with the near-nationalization of the US Secondary Mortgage Market Majors - Freddie Mac and Fannie Mae, yesterday. This action has fed a lot more confidence into the credit markets reeling from the subprime crisis.

The US mortgage market is structured in such a way that, you have the primary lenders (banks like Wells Fargo etc) who make loans to individuals for the purpose of housing. However, these mortgages run into hundreds of thousands of dollars. So a normal lender can only give so many mortgages, before his cash flow is completely stuck in these extremely long-term (upto 30 year long) loans. So to add more liquidity to such a market, the US Govt established the Freddie Mac in c1970, which would buy the loans (at its discretion) from these primary lenders. Having got back their initial capital, the primary lenders can provide other people loans. Freddie Mac in turn pooled and securitized (oversimplification:bundled) these loans and sold the resulting securities to investors in various organizations. Freddie Mac, guaranteed the rate of interest on these securities and hence assumed the credit risk, for which it charged a fee. Essentially, this means that any non-payment of mortgage by a person, will be made good by Freddie Mac. Fannie Mae is also essentially similar, except for its beginnings. Between themselves, these organizations own over 50% of all home loans in the US.

Technically these organizations were supposed to be Government Sponsored Enterprises, but essentially private corporations owned by stock holders, without any Govt insurance for their loans. However, due to their size and presumed US Govt backing, they had acquired the tag of "Too big to fail", as in, if they fail, they would drag down the economy with them. This caused them to take up riskier mortgages from the primary lenders. At last count, Both Freddie and Fannie had over $12 Trillion exposure to the mortgage market.

Now that the Subprime crisis has precipitated a downturn in the US housing market, this downturn has resulted in a lot of mortgage defaults (although Freddie Mac does not buy subprime loans), which caused Freddie & Fannie to declare losses of nearly $15 billion last year. This has led to their credit rating dropping to Junk status, forcing the premium on loans to them (bonds) going over 2.5%, making it very difficult for them to raise much needed new capital.

To alleviate the crisis, the US Congress in July passed a law, with bi-partisan support, allowing the US Govt to step in and bail out these corporations if required. This was supposed to give confidence to potential lenders that their loans to Freddie would not go bad (thereby reducing the risk and hence premiums on the bonds). But this action backfired badly, since people know that any such nationalization would wipe out Freddie's stock value. This caused its share price to plummet to less than $5. This precipitated a crisis, forcing the Govt to act immediately and nationalize them both. As expected, Freddie Mac shares dropped to less than 25 cents.

So now the US taxpayers are "bailing" out these corporations. The impact of the bailout is not completely known, and is supposed to be in tens of billions of dollars, if not hundreds of billions. This will also cause tighter regulation in the housing markets, with people having even prime credit ratings facing difficulty to make a mortgage. The US treasury bills have also dropped.

On the brighter side, however, markets are very optimistic over the measure since the credit markets will now be more liquid, stock of various banks which gave loans to Freddie (like Citi Group) have gone up a lot, the premiums have also dropped on mortgages. The last one will once again hopefully rejuvenate the housing sector, which makes up over 25% of the US economy. So overall the housing sector can recover from the glut of unsold inventory, and once again start growing. These will also help to reduce the effects of the current recession the US economy is undergoing.

The new bubble - Oil

Most people here in India, do not know whats going on with Oil Prices. All they know is that their Petrol costs 10% more. And they are pissed off. Driving 20 miles daily on my Bike, I am too. But the distubing part is that - the Indian govt flush with the recent huge tax revenue increases and under the influence of the coming national elections in 2009, has blatantly increased the Oil Subsidy - causing huge long term problems for the Indian economy, and will result in downgrading of its Investment grade rating.

Anyway, this article tries to focus on the reason why Oil prices are increasing on a global scale. What most people do not get is simply this - If the oil demand and supply have not changed, then the simple law of demand and supply should dictate at most a marginal increase in prices to account for inflation maybe. But why are we seeing a 350% increase in under 4 years? Its not like the demand jumped suddenly, or the supply got throttled. (For all those who believe that emerging economies are contributing to the demand increase, note that both china and India consume only a fraction of the world's Oil supply. In fact, in face of the rise in prices, demand has come down multiple percentage points.)

The main problem here is the rampart speculation in the Oil Futures market. Money from Institutional Investors (like Hedge funds) needs to be invested in areas which give good returns. Until the 2001 recession, it was the technology firms, which resulted in the the dotcom bubble and the subsequent slowdown. That money shifted to the next best thing - Real Estate. But when real estate did not give the required returns, the Sub Prime mortgage market with its high risk, high returns profile was tapped, eventually resulting in the Subprime Crisis, which has still not completely blow over. Now the money is looking for a new place to be invested - and Oil is the answer.

So when the amount of money put into the futures market increases 31 fold from $9 billion to $280 billion in 8 years, you know where the problem is coming from. Too much money, giving an illusion of demand.

So what happens next? My guess is as soon as the rate of returns starts to slow down (when the most basic law of economics catches up), money start flowing out to the next area which gets a high rate of return. This will result in a slump in the Oil prices, back to the $80 a barrel level. Unfortunately though, this market is slightly unlike others, in that Oil has a very inelastic demand curve. But with the current prices, the demand will go down, eventually leaving many casualties like the Oil suppliers. (The last time this happened after 1970s Oil crisis - the 8 year Iran-Iraq war broke out, followed by the 1991 Gulf war)

The only silver lining is that - hopefully this crisis will bring to the fore the alternative fuel technologies. But if the US Govt behaves in a shortsighted way, like it did after the 1970s oil crisis, then we set the stage open for another bubble in the future.

The End of Outsourcing?

Outsourcing has been a boon for many third world countries. It changed Wealth creation in many fundamental ways in China and India. Many detractors of outsourcing point out that US is losing jobs fast, and is piling on debt due to this globalization of manufacturing. However recent events show that these trends might soon be reversing.

Recent jumps in Crude Oil prices have been pretty disturbing. The $4 oil is cutting into consumer pockets and hence some analysts are predicting that this will push manufacturing of more and more goods to low cost manufacturing destinations like China. But there is something missing in this whole theory. The cost of outsourcing is not constant. Manufactured goods from China have to come to the US in shipping containers, the cost of which have proportionally increased due to the oil price increase. Given a weak dollar, China's rising costs and this added transportation cost - the outsourcing of some class of products might soon be coming to an end. Business week reports that this is already happening with products like batteries etc, which cost a lot to transport.

Coming to the Indian story of IT and IT enabled services outsourcing we are seeing the rapidly increasing wage bill of the Indian outsourcing firms which is cutting into their profits. This is affecting India's ability as the destination of choice for the IT related outsourcing areas.

Although this is a blow to Outsourcing, there is no denying that outsourcing is here to stay. But the outsourcing industry as we know it might soon be gone. The outsourcing bubble would have burst.

They Screw up, We pay?%&#*@

Imagine you have a friend who borrows money and invests it in a venture. If it pays up, he returns the money he owes you. If not he just reneges on the debt. This is a win-win deal for him and obviously a lose-lose deal for you - the sucker. This is EXACTLY what is happening with the Credit crisis in the US.

These companies repackaged extremely risky sub-mortgages and traded them like securities, without bothering about the inherent amount of risk that was being created. During the boom these companies made tons of money on these kind of deals. The corporate management took home huge bonus for their "achievements". Now that the boom is faltering, they are threatening to take down to US economy with them. Enter Fed. It reduces the interest rate by multiple percentage points. So how does this affect you? Simple. Reduce interest rate, and inflation goes over the roof... and what is inflation? - though few people realize it, its just fancy talk for saying - the dollar in your pocket is worth lesser than before.

If you were thinking - "Hmm.. Tough luck US residents, Thank god I am not in the US" - you are missing a very basic point about how the currency system works. Countries whose major trading partners include the US, generally have lots of dollar reserves - so that the balance of trade does not push up their currencies. China is one which has used this to the point of "abuse". India is not far behind. So when the dollar goes down, these countries with their *HUGE* reserves of the dollar find themselves poorer.

So now the world is the sucker. No wonder the saying goes - Life is not fair...