As the 2011 trading year truly kicks into gear, it is becoming clear that markets for all asset classes are being driven to various degrees by a range of macro forces.These include:
1. A gradual recovery from the GFC (genuine, mildly positive).
2. The various quantitative easing (QE) programs, which are the biggest global stimulus campaign in living memory (artificial stimulus and highly positive in terms of capital flows).
3. Incredibly volatile weather patterns globally (hugely negative in the short term, mildly positive in the long term).
4. Geopolitical events which were deemed regional but are now becoming potential global tipping points (broad-based street revolutions across the Middle East).
While we could focus on any number of topics that influence commodity pricing, there is one very interesting anomaly that highlights (a) the divergence between developed and emerging economies, (b) supply concerns for key commodities, and (c) geopolitical events such as Black Swans.
This is the growing disparity in pricing between West Texas Intermediate Crude Oil (more commonly known as “WTI”) and Brent Crude Oil (“Brent”). The following graph, care of Deutsche Bank, highlights the recent divergence between these two pricing mechanisms for one of the barometers of global growth.
Traditionally, WTI Crude was the benchmark oil price as the US was the largest consumer and changes in demand in the US had a major impact on oil prices. Additionally, WTI is a slightly better-quality oil, and thus traded at a slight premium to Brent.
The recent divergence highlights a number of structural changes in global markets, and is another sign that the world is slowly turning East;
- Too much oil from Canada, flowing into the delivery point in Oklahoma, has meant that the WTI benchmark price has not appreciated as supply is far outweighing potential demand for this landlocked source of oil.
- Alternatively, Brent Crude Oil is the oil reference for Asia and the Middle East, and with demand increasing in emerging economies, and geopolitical concerns rising in recent times, lack of supply of this now key oil is at risk.
- America is no longer the major source of marginal demand. Marginal demand is now dominated by the ever-present growth of the ‘emerging’ economies (a term by the way which should perhaps be rephrased to ‘newly emerged’)
- Production of conventional and unconventional oil from Canada is growing in importance, highlighting the growing need for oil coming from deeper waters or tar sands.
- The realisation that the Middle East could move in unintended directions.
- Brent Crude is now the global standard for oil pricing, not WTI Crude.
- The relatively high level of complacency in markets – ie risk is only now being correctly priced.
It is the last point above that is of particular concern to us. Unbridled optimism in stocks, a feeling that debt problems will be solved without any painful adjustments being needed, and that the Middle East will work things out all provide potential for unintended shocks to stock, bond and commodity portfolios. The recent divergence in the WTI-Brent spread is simply another sign that markets are looking more East than West in determining the price of all manner of things, and secondly, there are a lot of risks in the world today which markets may not be paying sufficient attention to.
We believe that 2011 will potentially be a very volatile year in all major classes, and in particular in commodities, and would recommend caution in all activities financial.
Mathew Kaleel is a director of H3 Global Advisors, an absolute return manager with offices in Sydney and London. H3 is one of Australia’s leading investors in commodity futures with approximately $575 million under management.
