We're In A Long-term Commodity Boom Market

We saw dramatic movement in the price of crude in the recent past. What are the factors which resulted in the sharp rise and abrupt decline in the price of crude oil?
Until recently, we were expecting 1.1-1.2 million barrels per day growth, but that obviously is going to be somewhat slower. Of course, in summer we had record oil prices, peaking at 138 dollars or so. We had bit of an unusual circumstances in summer. The US dollar was falling, almost hitting 160 vis-à-vis euro and there was a concept developing among financial players that one can short dollar and use commodities – oil being one of them - as a hedge against dropping currency. This was true for copper, oil and many other resources. During that period, inventories were actually on the rise, the US was starting to slow, Europe had actually hit a recession (as we found out later), and there was demand destruction in the US where demand for gasoline was dropping, China and India reduced subsidies on oil, and as time unfolded, oil started trading lower as it became quite apparent that the US economy was slowing and later in the summer we were convinced that the European economy was slowing as well. Then, the idea that the European Central Bank (ECB) was going to increase interest rates died off, and we were at the inflexion point of the short dollar long commodity trade and that was the beginning where these trades started unfolding because the interest rate spreads were now no longer seen as too wide to be very supportive of the euro and negative to the dollar. With European economies posting negative numbers, we no longer believed that the ECB would be hawkish. We said the ECB is not going to move any more because their economy is getting to be a problem. Then, of course, we had this credit crisis in summer and we saw a surge in the dollar. Then US authorities securities agencies around the world had outlawed naked short trades on financial equities. That eliminated the rationale behind short dollar, long commodities trade because as the credit crisis precipitated, the dollar actually surged as funds were being repatriated from all over the world. We were into an extreme risk-aversion mode and as commodities unfolded, the US dollars moved up.

So, basically the oil prices were speculator-driven…
I don't know about speculation, but it was trader-driven. But later on, as it became quite apparent that the US and European economies were slowing, the market started getting concerned about growth in China and India. Then we said we already have an inventory increase in the oil market and the anticipated growth in demand was being whittled down. Of course, the unwinding of the short financial trade saw unwinding of the commodities. Then, you had the unwinding of the yen carry trade and I think that was the trigger. But then it moved on beyond that. You also had the financial market trigger, market sold off, and the market got concerned about the demand prospects.[PAGE BREAK]

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The announcements by OPEC countries suggests that they want to control production. So where do you see the prices settling at?
I don't officially forecast the oil prices. But I think in the short run, the prices could still go lower. We've probably seen the worst of it, but who knows what can happen from now to the next month? But, generally speaking, OPEC makes the announcement and things get a little worse till they make another announcement. But once we are over this slowdown globally, I'm confident that energy growth is going to be high again because people in North America will drive again and continue to drive, there will be more cars in India, China and Asia hitting the roads every year and so the demand will go up. At the same time, the global economy may stop declining in maybe some time in second quarter of next year. So it's not going to be bad forever. Then, we'll be at an inflexion point again when there is growth again, with strong growth in the BRIC countries. The evidence from previous cycles is that the prices don't go up immediately. The market has to be convinced that the inventories are well-contained.

Do you still believe that crude can again go above USD 130 per barrel?
Well, I don't want to make that call at this moment, but I think around USD100 per barrel is going to be feasible. It's consistent with what it costs to bring a marginal unit of oil in high periods of demand and scarcities. I think the overall market is well-built long term and there'll be slight constraints on the supply side. I think the erosion in prices will in fact is structure out, if not prevent, large-scale development.

Indians love gold very much. So how do you see the prices of gold moving?
Yeah, India is the biggest consumer of gold. I think in the short run, gold would be range-bound on account of two factors. Gold is a fairly decent hedge against inflation and against market instability - there is a negative correlation between equity market valuations and gold. Also, there is an inverse relationship of gold vis-à-vis the dollar. So, with interest rates shrinking, the US dollars benefitting from all those funds being repatriated. Another reason which has prevented gold from taking off is the inflationary aspect in the short run. I would have expected gold to perform stronger in this turmoil. But in the short run, oil prices have fallen, commodities have fallen, housing prices have fallen and major economies around the world are functioning below their potential, which means those are all deflationary forces. So, to the extent that gold is used as a hedge against inflation, it's tough to present a picture n the short run at least why gold will take off greatly at a time when these pressures are[PAGE BREAK]

present. However, to get ourselves out of this financial crisis, we are in the West issuing trillions of dollars of paper and we run the risk of having above-trend inflation in the long run. It could be very difficult to mop up that liquidity once inflation gets started. But first we have to get out of the slump - it's like a patient who has a serious disease has a heart attack – we have take care of the heart attack first to make sure he survives and then you can cure the disease later. So over the long term, we see gold moving towards marginal cost of production. But gold is very cheap relative to oil and equities. It's true that gold didn't have a huge rally, but when you look at it relative to international equities and other commodities, it has been a good store of value. So as an asset class relative to everythings else, it kept its value even while everything collapsed.

How do you see the commodity cycle unfolding going forward?
I think we are still in a long-term commodity boom market and once this recession is over and done with, the commodity demand story globally continues to be on, especially in developing BRIC countries. Also, supply is going to be constrained. To that extent, we'll get a recovery and stay at much higher historic levels than we have in the past.

You and Marc Faber believe that commodities market is in a very bullish phase and one of the underlying assumptions is that developing economies including China would rive the growth.  What is the probabilility of the assumption about Chinese growth going wrong?
I don't believe that the government in China with two trillion dollars of foreign exchange reserves will alow things to go wrong. We might see a couple of quarters that aren't particularly good, but they will spend as much as they need to. Chinese growth will slow down, but it's not going to be disastrous. It's going to be about 8-9 per cent and that's consistent with positive demand for commodities. That doesn't mean that for the next two quarters we don't get inventory adjustments because you went from very high growth to lower growth. So you hit an air pocket of sort, but it's well supported over longer term. However, it could have a rough quarter or two and from a policy perspective that's exactly they are trying to offset.