Former commodity mega-bulls Goldman Sachs are expecting markets to continue to pull back from current levels in the near term as “fundamentals are not yet stable enough to support higher prices”, according to their latest Commodity Watch.
In oil markets, the Goldman analysts argue, this is largely down to the substantial US total petroleum inventories that have been building up counter-seasonally in the last few weeks.
Accordingly, they say they’ve opened tactical shorts in both the oil and metal markets. Being ultimately bullish in mindset, however, they say it’s also a longer-term buying opportunity based on their view that deficit markets will return by the second half of 2009, generating “sustained commodity price and returns upside”.
We’re not so sure about this latter point. Judging by the chart below, US implied total oil demand stands to significantly depress commodity prices for quite some time. Furthermore, as Goldman themselves note, the collapse this spring has already surpassed autumn’s lows. What’s more, the plunge has been much more intensive in the US than in Japan (see exhibit 5).
As Goldman state (emphasis ours):
This deterioration provides evidence that current fundamentals are not yet stable enough to handle too much price appreciation, too soon. Thus, we believe that WTI prices need to pull back to the mid- $40/bbl range in the near term to shore up demand and bolster current fundamentals, setting the stage for a stronger recovery in 2H2009.
Nevertheless, Goldman maintain their $65 per barrel forecast for WTI year-end prices and a $70 per barrel target for the 12-month horizon. These forecasts are based on expectations economic growth – boosted by fiscal stimulus programmes – will help stabilise economies later this year, especially in the context of a worsening supply outlook. Essentially Goldman is pinning a lot of hope on the G20 measures and other fiscal stimuli working.
Merrill Lynch, meanwhile, has a slightly different view on the problem of capacity utilisation and the duration of oil price weakness that may come with it. As they state in a report on Monday (emphasis ours):
With the burst of the credit bubble, global economic activity has collapsed. As a result, capacity utilization has fallen across a broad range of industries. On our estimates, global capacity utilization rates have fallen to 92% for crude oil, 81% for refining, and 86% for liquid natural gas. Thus, we see little potential for energy price spikes in the next 12 months even if the global economy recovers.
Global capacity utilisation of 81 per cent in refining is certainly no small decline. We’d describe it as quite a staggering drop-off in fact (note the chart below).
What’s more, these decline rates should really be telling about prospects for the global economy. For us, they send a clear signal that idle capacity is ramping up around the world at a very quick speed, a factor that should not go unnoticed considering its role in turning the 1929 stock market crash into a Great Depression. As Merrill put it (emphasis ours):
The world now faces substantial spare productive capacity With the burst of the credit bubble, global economic activity collapsed. As a result, capacity utilization rates have fallen across a broad range of industries in the economy. At the peak of the last business cycle, most economic sectors saw capacity utilization rates above 80% (Chart 4). Now, utilization rates have collapsed for a broad range of industries such as motor vehicles, semiconductors or chemicals. As a result, spare productive capacity has increased well above and beyond previous business cycle downturns in a number of economic sectors in the United States (Chart 5), and also in other countries.
And here are the charts that accompany those sobering statistics (particularly sobering perhaps in light of the recent debate about possible green shoots):
Firstly, US sector utilisation rates at the peak of the last business cycle’s downturn:
And here are current US sector utilisation rates (note particularly the variation and degree to which specific industries have been affected above others):
Austrian School economist Josef Steindl was among the most prominent academics to tie growing spare capacity, unemployment and general economic deterioration together. He did so in specific reference to the Great Depression.
For those unfamiliar with his work here follows a neat summary of his theories by Michael A. Bernstein, a history and economics professor at the University of California. As Bernstein wrote in a 2001 paper, Steindl saw all three of these factors influencing each other in snow-ball type effect (our emphasis):
At the macroeconomic level the implications of inelastic profit margins are most profound. In these circumstances, price reductions do not compensate for declines in the rate of growth, and thus companies tend to reduce their rate of capacity utilization.
Reductions in capacity utilization imply not only declines in national income but also increases in unemployment. In the presence of underutilized capacity, firms will be increasingly disinclined to undertake any net investment. A cumulative process is thereby established wherein a decline in the rate of growth, by generating reductions in the rate of capacity utilization, will lead to a further decline in the rate of expansion as net investment is reduced.
Individual firms, by believing that decreases in their own investment will alleviate their own burden of excess capacity, merely intensify the problem economy-wide. The greater the proportion of the nation’s industry that is highly concentrated, the greater the tendency for a cyclical downturn to develop into a progressive (and seemingly endless) decline.
But if that seems familiar, there may be even greater synergies between what is happening now and what happened back then.
First, Bernstein goes on to argue that there is a slight flaw in Steindl’s observation that the tendency for a cyclical downturn to turn into a progressive decline increases as the proportion of the nation’s industry becomes more highly concentrated.
In contrast, Bernstein argues that the depth and persistence of the Great Depression cannot be explained by cyclical theories alone. Instead he says the Great Depression manifested itself exactly because a financial market crisis happened to coincide with a long-run transformation in the kinds of goods and services being required by firms and households. These two factors together, he says, turned what would have been a severe cyclical downturn into a Great Depression.
None of which bodes well for the current financial crisis, given it coincides directly with “the great renewable-energy shift” happening across the world. As Merrill Lynch observes:
In our view, a global misallocation of capital sits at the heart of the current economic crisis. As we first highlighted in our September 24 Global Energy Weekly (“Credit crunch & energy crunch: same market failure?”), capital markets failed in recent years and channelled too much money into real estate, too little into energy. If capital had been efficiently allocated to the most productive sectors in the global economy, high savings rates in emerging economies would have enabled a high investment rate in key sectors (Chart 2).
Furthermore, Merrill’s industry utilisation breakdown appears, at first glance, to further support the above notion given non-environmentally focused industries are indeed the ones piling up spare capacity most.
The key question now is — will our ‘green rebalancing’ intensify the recession into a full-on depression to the same degree? One thing is sure, industry is already being forced to stop, take stock and adapt.
Related links:
The crude inventory problem, pictorial edition – FT Alphaville
Crude inventories still a problem – FT Alphaville
Oil, the great inflation hedge - FT Alphaville
Forget Treasuries, is copper the future for China? – FT Alphaville