Tuesday, November 24, 2009

Market Trend in Oil Trading

This article was first published on 8/31/2009.

Market Trend in Oil Trading

Introduction

There is not one person alive today that does not benefit, directly or indirectly, from products derived from crude oil. The most common, and logical, use of oil is fuel, that is, fuel for transportation, heating and the generation of electricity. Common uses derived from crude oil include plastics (from alkenes), lubricants, wax, tar and asphalt. Essentially, crude is the life blood of the modern developed society.

 Top Oil Producing Counties

In 2007, Saudi Arabia was the largest oil producer, extracting an average of 10,234,000 barrels per day. Russia and the United States follow with a production rate of 9,876,000 and 8,481,000 barrels per day respectively.

Oil consumption per capita 
Oil consumption per capita

The top three oil consumers are the United States, China and Japan with rates of consumption of 20,687,000, 7,201,000 and 5,197,000 barrels per day respectively. Immediately you will notices that the United States has a 10,000,000 barrel per day trade deficit. Or in other words, the United States currently consumes twice as much oil as Saudi Arabia is extracting from the ground.

Oil exports
Oil exports

Oil imports
Oil imports

It may not be surprising that Saudi Arabia and Russia are by far the largest exporters of crude oil at a rate of 8,651,000 and 6,565,000 barrels per day. Norway, Iran and the United Arab Emirates follow with approximately 2,500,000 barrels per day.

This paper will address the topic of crude oil trade, analyze recent price fluctuations and attempt to predict the short term price trend.

Trade

Crude oil is traded at both the New York Mercantile Exchange (NYMEX) and the Chicago Mercantile Exchange (or the “Merc”), both of which are owned by the CME Group. Both exchanges offer trading in commodities and commodity derivatives. In fact, the Merc is the world’s largest commodity trader. Both exchanges have pit floors where independent traders use the “open outcry” system of announcing, negotiating and agreeing to sales. Open outcry uses verbal calls and elaborate hand signals to communicate information. Today however, approximately 70% of all commodity trades at NYMEX and the Merc are conducted on Globex, an electronic around-the-clock trading system. This system allows almost anyone anywhere to trade commodities and commodity derivatives. During one day in 2004, Globex recorded more than one billion transactions.

Crude oil derivatives are also traded at the Tokyo Commodity Exchange (TOCOM) and the Multi Commodity Exchange (MCX) in India. Another organization that trades almost exclusively in energy commodities and derivatives is the Intercontinental Exchange (or ICE), an American firm based in Atlanta, Georgia. Unlike the other exchanges, ICE operates exclusively electronically.

Price

The price of petroleum is highly dependent on the grade of the fuel. Grades are measured by American Petroleum Institute gravity (or API gravity) which is essentially the density of crude relative to water. Fuel prices stated in the media are normally one of the following:

  1. West Texas Intermediate traded on the NYMEX for delivery at Crushing, Oklahoma, or
  2. Brent traded on the Intercontinental Exchange delivered at Sullom Voe, Scotland

 Brent monthly spot price
Historic oil prices

For most of the past decade, prices have been fairly consistent in the $30-$50 per barrel range. Obviously the past few years have been the exception but let’s first examine the slump that occurred almost a decade ago when the price fell to $16/barrel in January 1999. This drop has been attributed to the over production in Iraq and the fallout from the Asian Financial Crisis. The crisis caused an immediate drop in demand, leading to an oversupply and a global price decline.

The infamous (and financially painful) price spike in 2008 which culminated in the July 11 record price of $147.27 per barrel started in 2007. The exorbitant fuel prices can be attributed to a number of international events, such as:

  1. June, 2007:
    Changes in US Federal oil policies,
  2. September, 2007:
    OPEC announced lower than expected output,
    US stock prices fell lower than expected,
    Six oil pipelines in Mexico were attacked by leftist guerillas,
  3. October, 2007:
    Political tensions in Turkey,
    US dollar depreciates
  4. June, 2008:
    Libya threatens to cut output,
    OPEC’s president predicts a price surge to $170/barrel
  5. July, 2008:
    Iranian missile tests.

Price declines following the peak were significant, most notably following a statement by then Federal Reserve Chairman, Ben Bernanke, regarding what he termed “demand destruction”. Prices in 2008 continued to drop as the US dollar appreciated and the credit crisis worsened.

One somewhat controversial practice undertaken by some Wall Street firms like Morgan Stanley was the purchasing and storage of oil. Morgan Stanley leased storage silo filled with oil purchased at the current spot price and entered into future contracts. When prices escalated, they earned enormous returns without having to move a drop of oil as the contracts were settled. This practice is controversial because it can be argued that the stockpiling of crude oil may have contributed to the increased demand, or Morgan Stanley may have “manipulated the market”.

The speculation bubble was exasperated by financial reports from Goldman Sachs and Gazprom that prices could peak at $200 per barrel. Speculation in oil derivatives was only “fueled” by investors leaving a declining stock market. Earlier this year, the television current affairs show, 60 Minutes, profiled the apparent speculation in the oil market. The following quote demonstrates the amount of speculation.

“In a five year period, Masters said the amount of money institutional investors, hedge funds, and the big Wall Street banks had placed in the commodities markets went from $13 billion to $300 billion. Last year, 27 barrels of crude were being traded every day on the New York Mercantile Exchange for every one barrel of oil that was actually being consumed in the United States.”
(CBS News, 2009)

Sixty Minutes also proved that there was no economic justification for the price spike.

“A recent report out of MIT, analyzing world oil production and consumption, also concluded that the basic fundamentals of supply and demand could not have been responsible for last year's run-up in oil prices. And Michael Masters says the U.S. Department of Energy's own statistics show that if the markets had been working properly, the price of oil should have been going down, not up.”
(CBS News, 2009)

To combat alleged market manipulation, the US Commodity Future Trading Commission (CFTC) announced initiatives to prevent price manipulate in the oil futures market.

The Future

The current economic recession has substantially reduced the predicted annual growth of global oil consumption to 0.6% per year. It is anticipated that oil producing countries will respond by reducing supply and hence their stockpiles. Reduced stockpiles will have a profound effect on the volatility of world oil prices, for example.

“WTI futures for August rose $2.33 to $71.49, after an attack on a Royal Dutch Shell oil platform by Nigerian militants.”
(Hoyos, 2009)

Surprisingly, a report by Chen (2009), based on ten years of economic data stated that emerging economies like China have an insignificant effect on the international oil market.

After last year’s peak, the price dropped below $60 and is now $69.95. The current rise is due, primarily, to the depreciation of the US dollar. Most economic analysts predict the price of crude to fluctuate between $60 and $70 in the short term.

References

Sunday, November 8, 2009

iTunes – Gateway to a media empire

In 2001, Apple launched iTunes, a simple music player. Today iTunes is the gateway to the largest music store in the world. This essay will examine this technology in detail.

Introduction

Founded in 1967 by Steve Jobs and Steve Wozniak, Apple Inc. is best known as an innovator in consumer electronics and software. Apple’s flagship product, the Macintosh was released in 1984 and featured a mouse and graphical user interface (GUI). Other successful products include the iPod and iPhone, first released in 2001 and 2007 respectively. An iPod is a digital media player and an iPhone is an internet enabled cell phone with iPod capabilities.

The subject of this essay will focus on a free software application called iTunes, developed by Apple to organize and play digital media. However the most important feature is its ability to manage content on an iPod and subsequently, the iPhone.

Features of iTunes

Since the initial release in 2001, iTunes has progressed significantly. In 2003, iTunes could be installed on windows based operating systems making it easier for iPod owners to synchronize music with their PCs. In 2005, iTunes added support for video content and the capability to stream content to other computers running iTunes on the same subnet.

But the capability that I would like to highlight is the introduction of the iTunes Store in 2003. The ITunes Store allowed users to purchase downloadable digital content. Initially only music was available, however this changed in 2005 when apple introduced video content. To protect the publisher’s copyright, iTunes used a propriety digital rights management software (or DRM) called FairPlay. Whilst this may have prevented piracy it also prevented the content from being played by other software application and devices. In 2007, to appease mostly European critics, Apple started to remove DRM from iTunes music. Apple defends this action by stating that DRM-free audio is available on traditional audio CDs.

iTunes Store Today

On the 4th of March 2008, iTunes Store replaced Walmart as the largest music vendor in the United States. As of March 2008, iTunes Store has sold more than five billion songs from a catalog that exceeds eight million songs. On Christmas Day in 2007, more than 20 million songs were downloaded.

The four major recording labels, Sony BMG, EMI, Universal and Warner, continue to sell music through iTunes Store however Universal, the largest music corporation, recently announced that it reserves its right to withdraw from iTunes Store if it disagrees with Apple’s pricing structure.

The music available on iTunes Store is currently a mixture of DRM and non-DRM content. However all content from EMI is DRM free as of April 2007.

Effectiveness of Technology

The combination of iTunes, iTunes Store and iPod prove to be an unbeatable combination, that is, the seamless integration of hardware, software and web services. It is likely that the sale of music (and other content) from iTunes Store is a large contributor to Apple’s 2007 revenue of 24 billion dollars.

Piracy is a cancer that has plagued the music industry for the past decade. This plague, in my opinion, is partially self-inflicted by the music industry’s stubborn refusal to adopt digital products in the 1990’s. Piracy is inevitable but may decline as digital media prices continue to drop.

Competition

Today there are many free media players and online music stores like Amazon MP3, Napster and Rhapsody, each with catalogs exceeding five million songs. Whilst they may encroach on iTunes market space they nonetheless indirectly promote iPod sales, as Menn and Quinn (2007) state,

A robust market for digital songs should translate in to more demand for the music players on which to play them, and Apple's iPod is the runaway leader.

The Next Generation

On the 29th of June 2007, Apple released the iPhone which is better known as the “Jesus Phone” (Economist 2007). The iPhone is essentially a cell phone with an integrated camera, iPod and web browser with Wi-Fi connectivity. Like the iPod, users can use iTunes and the iTunes Store to download, purchase and transfer music and video to their device.

However if the iPhone is connected to the internet using a Wi-Fi connection then it can use the built-in Safari web browser to purchase and download content directly from the iTunes Store website.

Less than a month ago on the 11th of July 2008, Apple launch the latest device, the iPhone 3G. The new iPhone includes an integrated GPS device but also the ability to download (and purchase) custom applications from iTunes Store.

This is an exciting development in mobile technology. iPhone 3G users can selectively modify the behavior of their mobile devices. For example, using an application called “AirMe”, users can take photographs that are automatically geotagged using the built-in GPS receiver and the uploaded to Flikr or the AirMe website.

Conclusion

The iTunes application started life as a vehicle to transfer music to the iPod. It has since morphed itself into a comprehensive media player and a gateway to the iTunes Store, the largest music store in the United States. ITunes and it’s online partner have transformed digital music from a forbidden commodity to a respectable multimillion dollar industry.

ITunes initially included proprietary DRM software to discourage privacy but this in fact became counterproductive as hacker found workarounds and Apple was accused of being anti-competitive.

ITunes has continued to provide value to its customer base by diversifying from music into other products like video and applications for the new iPhone.

References

The collapse of the Soviet Union

Coat of arms of the Soviet Union

Image from Wikipedia

Introduction

This post will discuss the collapse of the Soviet Union and its transition from a planned economy to a market economy.

Planned Economy

A planned or centrally controlled economy is often stereotyped by long lines of people waiting for consumer goods and daily commodities. Based on feedback from two of my colleagues (and good friends) this seems to be fairly accurate. LK, formerly from Russia, made the following comment regarding the scarcity of goods.

When you saw your friend wearing new jeans or reading a new book, the first question was not "where did you buy it?", but instead of "buy" we used another Russian verb "dostat'", literally "to obtain, to fetch, to reach for", because almost anything good or interesting wasn't easily available.
(LK 2008)

Unlike a market economy, a planned economy is less flexible and is slower to respond to changes in consumer needs. WF made this observation about some state run clothing stores in Poland.

…frequently there were surpluses of all kind of clothing that would be easily sold if produced 5 years earlier. Even in the communist system (at least in the 60-ties and 70-ties that I remember) most people didn’t want to wear stuff that was out of fashion. Yet the clothing factories were producing a plenty of out of style jackets, shoes, coats, etc. The stores were full of such obsolete stuff. The store staff was not allowed to reduce their prices until it was well too late.
(WF 2008)

WF also elaborate on how the supply system was deeply flawed. WF described how produce from a bountiful harvest was often discarded due to strict government quotas and farmers were unable to store surplus produce. Additionally during poor harvests, Poland was forced to purchase expensive foreign grain from the international market.

Gorbachev

During the 1980’s there was a growing feeling of dissatisfaction in the government of the Soviet Union. The Soviet-Afghanistan war that commenced in 1979 was far from over with mounting casualties. Oil prices in the mid 1980’s dropped considerably, depleting the Soviet Union’s access to foreign currency which was needed to purchase imported grain. In addition to this, the cold war had a significant social and economic effect on the Soviet people as funds were diverted from social programs to the military.

In March 1985, public desire for change forced the politburo to elect Mikhail Gorbachev to the office of General Secretary of the Soviet Union. Gorbachev introduced changes to the soviet administrative command economy with his programs of glasnost (political openness) and perestroika (economic restructuring).

The policy of glasnost permitted significantly greater freedom of speech, including the media. The intention of glasnost was to encourage debate and participation by the public on all aspects of the economy and government. Glasnost also gave pardons to political prisoners and allowed government records to be released to researchers, scholars and the media.

The most radical of changes occurred in May 1988 with the introduction of the Law of Cooperatives which permitted private ownership of businesses.

But the most surprising development came in 1987 when Gorbachev publicly announced his intention to pursue the democratization of the Soviet Union. To gain independence from the Communist Party of the Soviet Union (or CPSU), Gorbachev created a new political position, President of the USSR. Gorbachev became the USSR’s first and only president in March 1990 which effectively reduced the influence (and power) of the CPSU.

The unintentional consequences of Glasnost

Whilst the original intension of the relaxed media was to foster healthy debate on political reform, the unintentional consequence was  the exposure of current social and economic problems. The media reported on the poor housing, corruption, alcoholism and even the historic crimes of Stalin. LK had this to say about the bleak media reports.

When Gorby relaxed the media, there were so many movies and books with negative contents, that a new word was coined to describe them "chernukha", derived from "cherny" (black). It was all doom and gloom and no light at the end of the tunnel. Very depressing stuff, without any redeeming values.
(LK 2008)

The “cherny” reports revealed a darker side of soviet life that was not previously known. This caused a significant weakening of the communist party’s popular support.

The Collapse of the Warsaw Pact

The declining support for the CPSU in Russia quickly spread to the Warsaw Pact countries. The Warsaw Pact was an alliance of eight European communist countries formed in 1955 to counter the North Atlantic Treaty Organization (or NATO).

The communist governments in the Warsaw Pact were removed by popular vote, or in the case of Romania, a violent uprising. After East Germany withdrew from the pact in October 1990 to unify with West Germany, the alliance mutually agreed to dissolve in March, 1991.

The Failure of Perestroika

Perestroika introduced unprecedented changes into the Soviet economic system but this was insufficient to kick start the economy after the depression in the mid 1980’s. Whilst revolutionary in some respects, Perestroika in the minds of many did not go far enough; for example, the state still controlled prices and individuals were still unable to own property.

What followed was systematic economic breakdown. The Soviet government continued to subsidize industries as tax revenues declined. This decline was partially due to a successful campaign to teach alcohol moderation that severely affected revenues from liquor tax. The economy was further exacerbated by dismantling of the traditional supply chain, a result of Gorbachev’s decentralization, but unfortunately there was no system to replace it.

The Dissolution of USSR

In February 1990, the CPSU agreed to relinquish control over the fifteen USSR republics. Republics subsequently held elections to select national representatives and then proceeded to enact laws to assert their own sovereignty. This included laws to withhold tax revenues from the USSR and pass laws contradictory to those in the USSR.

YELTSIN

Boris Yeltsin won 57% of the popular vote in June 1991 to become Russia’s first president. Interestingly, Yeltsin did not advocate (or mandate) a move to a market economy prior to coming to office. His only mandate was to ease prices increases.

The August Coup

On the 20th of August 1991 Gorbachev was scheduled to sign the New Union Treaty that would effectively convert the USSR into a federation of independent republics. The treaty was supported by the Baltic States but not by some in the communist party who believed that the reforms had gone too far. On the eve of the treaty, a group of conspirators barricaded themselves in the Russian parliament in an attempted coup. The goal was to try to persuade Gorbachev to declare a state of emergency to restore order.

Three days later, the coup leaders surrendered, this result is largely due to the Yeltsin’s popularity and support from the Russian people.

End of the Communist Party

In November 1991, following the failed coup, Yeltsin banned the communist party (in Russia) and disbanded the Soviet Union. This effectively terminated the Soviet government and left Gorbachev without a job.

Commonwealth of Independent States

On the 12th December 1991, Russia, Ukraine and Belarus signed the Belavezha Accords that formalized the end of the USSR and the formation of a new union called the Commonwealth of Independent States (or CIS). A week later all remaining former soviet republics joined the commonwealth with the exception of the three Baltic states of Estonia, Latvia and Lithuania.

On Christmas day 1991, Gorbachev formally resigned as President of the USSR and signed over all remaining power to Boris Yeltsin, President of Russia.

Restructuring

Starting almost immediately after the collapse of the Soviet Union, Yeltsin implemented drastic economic reforms including the abolition of price controls and subsidies. Yeltsin’s government also implemented new taxes and reduced government spending.

It must be noted that many entrepreneurs profited heavily from the restructuring process. This new class of Russians is sometimes referred to as the Oligarchs, many of whom had links to Yeltsin and his administration.

Restructuring problems

After 4½ years, the restructuring results were mixed. The Russian GDP declined by more than 50%, this is larger than the decline experienced by the United States during the Great Depression. Heaviest hit was the defense industry that experienced an enormous reduction in government spending. There had also been a proliferation of crime due to high unemployment and the ineffective police force.

The privatization of state assets was supposed to revitalize the economy. This did not happen immediately due to the immature banking industry that was not prepared to finance individuals and organizations.

High inflation led to high lending rates of up to 250% in the early 1990’s. The hyper-inflation caused by the “shock therapy” policy had effectively wiped out the savings for most Russians. This made capital investment by Russians almost impossible.

Shortages of capital and finance forced many industries to resort to bartering. This practice, whilst illegal (and untaxed), was tolerated by the government as it allowed key customers such as the military to be supplied with goods.

Many professionals in Russia experienced significant salary cuts, delayed payments and job losses. With relaxed travel, many Russians emigrated to the security and well paid jobs in the West.

PRIVATIZATION

As part of Russia’s economic reform and a condition of foreign investment, some 200,000 industrial enterprises needed to be privatized. Three quarters these enterprises employed more than 1,000 people. The Russian authorities had three methods to privatize state assets. The first was an employee buyout (or lease with right of buyout). A second method was through competitive bidding. The last method involved converting the enterprise into a corporation and selling at a later date.

Despite allegations of corruption and favoritism, international experts (in 1996) have deemed the transition of state assets to private individuals and organizations to be a success.

The employee (or “inside”) buyout scheme has been criticized by economists like Marshall Goldman and Joseph Stiglitz as it unfairly favored industrial management. It is argued that employee owned enterprises are less competitive because employees would improve their own working conditions without necessarily increasing their output or becoming more efficient. But employee-owned enterprises have been credited with keeping unemployment low.

Shock Therapy

Shock therapy refers to the rapid transition from a planned economy to a market economy. Jeffrey Sachs, a prominent economist recommended this approach to former communist countries. Shock therapy was first used to liberalize post-war Germany (specifically West Germany). The 1947-1948 reform eliminated price controls and other government support programs. These reforms were successful in kick-starting the war-torn economy. Critics are mixed as to the success (or otherwise) of Shock Therapy. Naomi Klein in her book “The Shock Doctrine” is probably the most critical; she asserts that shock therapy causes mass unemployment, increased crime and introduced a class struggle. A noteworthy nation that embraced shock therapy is Poland. Of all the former Warsaw Pact countries, Poland was the first to exceed pre-1989 GDP. This could partially be explained by Poland’s culture of private enterprise that quickly adjusted to post-communism economy.

…almost 80% of Polish arable land remained in private hands of farmers. In towns there were small businesses, which were sometimes doing very well economically. There were small private stores. There were private car mechanic shops and private carpenter, blacksmith, plumber, etc. shops in every town. Except of Yugoslavia, which technically did not belong to the soviet controlled states, this was totally unique. Legally, as a private company owner, in Poland prior to 1989, you were not allowed to employ more than 10 people. In comparison, in the SU, Romania, Bulgaria, etc. people were not even allowed to sell what they grew in their backyards. Yet, there were thousands of those little private shops in Poland that survived many years. With that kind of training that Poles were practicing during all these years under the communist rule, they had an advantage in the “know-how” of how to run a private company and how to be a productive individual farmer. After 1989 many small businesses (with less than 10 personnel) were able to grow without any red tape barriers. That was what most of this small businessman wanted for years! Consequently, these little businesses exploded in number and started growing like crazy.
(WF 2008)

Globalization

This section will analyze three aspects of globalization, specifically security, the European Union and trade.

Security

Following the collapse of the Warsaw Pact, the Czech Republic, Hungary and Poland joined NATO during the Fourth Enlargement. Later in 2004, during the Fifth Enlargement, the former Soviet Republics of Estonia, Latvia and Lithuania (also known as the Baltic States) joined NATO. Naturally, Russia opposed the expansion of NATO into Eastern Europe.

The European Union

All former communist countries that are now part of NATO are also members of the European Union. These countries joined the union in 2004 with the exception of Bulgaria which joined in 2007. The apparent delay joining the European Union compared to NATO can be explained by certain economic and political pre-conditions commonly known as the Copenhagen Criteria. The criteria includes a democratic government with associated freedoms. Accession to the Union is also conditional on acceptance from all existing members and the European parliament.

Country

European Union

NATO

Albania

 

 

Bulgaria

ü

ü

Czechoslovak

Czech Republic

ü

ü

Slovakia

ü

ü

Hungary

ü

ü

Poland

ü

ü

Romania

ü

ü

Soviet Republics

Armenia

 

 

Azerbaijan

 

 

Belarus

 

 

Estonia

ü

ü

Georgia

 

 

Kazakhstan

 

 

Kyrgyzstan

 

 

Latvia

ü

ü

Lithuania

ü

ü

Moldova

 

 

Russian Federation

 

 

Tajikistan

 

 

Turkmenistan

 

 

Ukraine

 

 

Uzbekistan

 

 

East Germany

ü

ü

Trade

The Soviet Union was largely self sufficient in fuel, metal and timber but it did import machinery, consumer goods and occasionally grain. More than half of the Soviet Unions’ trade was with the Council for Mutual Economic Assistance (or COMECON) which was basically the Warsaw Pact countries with the addition of Cuba and Vietnam. The liberalization promoted in the perestroika reforms allowed the Warsaw Pact countries the freedom to trade with non-COMECON nations (namely the West). This naturally, was economically advantageous as these countries could acquire hard currency and have access to a larger and more affluent market.

Conclusion

Few in the early 1980’s predicted the collapse of the Soviet Union and/or the demise of communism. Unquestionably this was not the intention of Gorbachev but he was definitely the catalyst of change. The policies introduced by Gorbachev and continued under Yeltsin were aggressive. Many argue that the changes were too rapid however the “shock therapy” ultimately proved effective even though it had a heavy social cost.

It is interesting to compare the changes occurring in China with those in the former Soviet Union. The Chinese consciously avoided the Soviet-style “shock therapy” and decided to progress cautiously to evolve their economy without the complication of political changes. Clearly the Chinese method has been effective as they emerge in the 21st century as a potential economic superpower.

It is evident that communism created a lethargic economy that was slow to evolve and slow to adjust to change to market and consumer needs. Adam Smith’s assertion that the market requires competition to balance the selfishness of sellers with the needs of society is true today as it was three hundred years ago.