The Weekly Wrap: May 6, 2011

Speculation: how oil prices (often) happen in the real world  Over the last couple of days, there has been a bloodbath in the oil market — a "flash crash" as they call it. Today, prices are dropping further. What is going on? Well, the traders in the casino whom we’ve been discussing the last several months are taking their winnings off the table in a seriously panicked way and stampeding out the door. Oil is now in the mid-$90-a-barrel range. If this keeps up, gasoline will fall back from $4 a gallon here in the United States.

I raise this because of the news, but also because elsewhere we are seeing pushback from those who argue — as similar individuals did the last time we had a price runup, in 2008 — that not trading (speculation) but supply and demand are the motive drivers of oil prices. These folks’ refrain goes like this: "People who say traders are behind the whole runup in oil prices are wrong wrong wrong, besides being paranoid and conspiratorial."

What’s the problem with this argument? Nothing on its face — after all, how can any one single factor be responsible in every case of a particular outcome? The law of averages tells you the dice won’t come up sevens every time. But when you look underneath it, it falls apart. Why? Because its formulation is faulty. Speculation isn’t always responsible for price swings. But often it is.

Back in 2008 — and now — a debate raged over steep increases in oil prices. Traders from Goldman Sachs and elsewhere, along with many observers, asserted that this was all about supply and demand (actually they use the code word "fundamentals"): There in fact were traders buying and selling cargoes and futures, but they had no or little ultimate impact because (gobbledygook alert!) "for every buyer, there is a seller," and "futures prices cannot be persistently high without the support of physical fundamentals." On the other side of the debate were lots of screamers using epithets against speculators (spit, spit), in addition to ordinary commodities analysts and reporters who simply watched the action before them, compared that with the movement of prices, and made their own assessment: Psychology drives the price of oil futures up, and down. Traders are aware at all times of supply and demand, but it is what they expect next that propels their trading, and hence prices of futures. After that, their decisions converge directly with what buyers pay in the physical (spot) market.

Again, let’s use a betting metaphor. A group of men and women are sitting in a casino playing poker.  The pot grows larger as each player discards and picks up new cards, betting in rounds along the way. The question: What is causing the pot to grow? The bettors or the cards in their hands?

The first crowd — the traders and absolutists — will say it’s the cards (the fundamentals): no cards, no bets. The second crowd will say, sure there are the cards — no one would bet without their presence; but in the end, it is the bettors whose hubris, knowledge of their own cards, guesswork about others’ cards, susceptibility to bluffing, and experience in the game drives how much they do or don’t put on the table, and thus how large the pot grows.

Listen to Frank Cholly of Lind-Woldock, speaking after yesterday’s selloff with the Wall Street Journal: "It’s a mass liquidation. I think it’s just hedge funds got scared and everyone’s running for the door right now. It just seems to be contagion." Now listen to Douglas Hepworth of Gresham Investment Management, who spoke with the Financial Times:  "You want to be the first one out the door because the trip down can be even faster than the trip up."

Finally, watch this video featuring Liam Denning of the Journal, and Oppenheimer’s Fadel Gheit, the dean of Wall Street oil analysts. Then look me in the eye and tell me traders and their day-by-day speculation are not singular and dominant factors in the oil price.

As for the morality of all this, are speculators bad people? No. Should they have to pay more to bet in the casino? Yes. Would that higher fee-per-bet cause a catastrophe to "the liquidity of the market," as the gobbledygook purveyors will argue? No.

Read on to the jump for Libyan tribal politics, Iraqi oil, and Afghan roads.

Libya, Qaddafi, and tribal ties: When I look at Libya, I think of Afghanistan. In 1989, the Soviets left Afghanistan to blanket assertions by the United States and the whole West that President Najibullah would fall "like a house without girders," as U.S. charge Jon Glassman colorfully put it at the time. Yet he held on against the mujahedin onslaught. Why? Because unlike any other Afghan leader, Najibullah knew how to balance the tribes. Paying off this clan leader, massaging that one, Najibullah managed to stay on top. Until he didn’t. Three years later, a financial dispute lost him the support of the northern Uzbek leader Rashid Dostum (the colorfully dressed figure pictured above), who went over to the other side (specifically to Ahmad Shah Massoud). Najibullah was kaput. It turned out that his power structure — that house metaphor that Glassman invoked — was in fact reliant not on no girders, but on a single one. Najibullah spent the rest of his days in a United Nations compound in Kabul, until four years after that, when the Taliban rolled into town, and hung him from a lamppost.

Is this Libyan leader Moammar Qaddafi’s future? I emailed some Libyan experts to ask — who is the Rashid Dostum of Libya? Fortunately for Qaddafi (but not for his detractors), there may not be a Dostum moment to come. According to Professor George Joffe of Cambridge University, there are three key tribes on — the Warfalla, the Qadhadhfa and the Maghraha — but no identifiable tribal, clan or subgroup leader whose fealty is pivotal. "We shall not know who the significant figures are until after the regime falls through their actions — if, indeed, [the tribes] decide to intervene," Professor Joffe told me by email. That seems right. There is much analysis of the tribal structure (such as this piece by Robin Wigglesworth in the FT), but nothing granular. In Najibullah’s collapse, no outsider seemed to realize how vulnerable he was until Dostum actually pulled away. But we may not know about Qaddafi’s particular working structure at least until he is gone.

For now, the conventional wisdom is that, over the last four decades, Qaddafi has created a tribe all to himself, so that he is not susceptible to tribal vagaries. The Warfalla appear to be the largest, but Professor Imad el-Anis, a lecturer at Nottingham Trent University in the United Kingdom, told me that the relationships gets pretty confused after that:

Many key figures in the Qaddafi regime come from the Warfalla tribe, so there is a measure of vested-interests in the survival of the regime. But at the minute, it seems something like half of the Warfalla tribe is with Qaddafi and half is against him (but those who are against him are not necessarily actively engaging in the rebellion). If the tribe as a whole goes against Qaddafi, then we won’t see the total collapse of the regime (or what is left of it), but it would probably be a major step on the way to reducing Qaddafi’s control over Western Libya. He may only end up having Tripoli if that happens. I don’t know if it will happen though. I think eventually it could happen, but there is a lot of loyalty by some in the tribe to Qaddafi, and that loyalty has already been tested a lot but it has not broken. 

Iraq’s coming (smaller) bonanza: For a long time, Iraq has said it is going to boost its current oil production more than four-fold — to 12 million barrels a day. Smart people have smiled, shaken the Iraqis’ hands, patted them on the back, then turned to the camera and said, "Mmmm, no. Iraq will never produce 12 million barrels a day. Maybe half that." It appears that Iraq is about to concede publicly that the smart people win. The Times of London reports in an unsourced story that Iraqi officials will soon publicly reduce the production target to around 6.5 million barrels a day. This issue is important because Iraqi’s bonanza has been good news in an oil patch short of it. It’s been viewed as a potential new Saudi Arabia — a swing producer that can bring large new volumes of oil onto the market in a pinch. The Times report, if accurate, brings some sensibility to the story — Iraq can help; but it isn’t anyone’s salvation.

Afghanistan and the nightmare of infrastructure: The New York Times‘ Alissa Rubin and Jim Risen produced a really good piece this week on the absurd scale of problems besetting the construction of a 64-mile length of road between the Afghan cities of Khost and Gardez. The road is meant to undermine local insurgents, including the all-powerful Jalaluddin Haqqani. I traveled between the cities overland quite a long time ago (to visit with Haqqani’s brother, Siraj), and can agree that a road would be useful.  But the cost has skyrocketed, security has degenerated, and the road is still not finished. The NYT piece lays much of the blame on an alliance formed with a local strongman named Arafat, but the problems go deeper than that. There have been serious lapses of judgment in the selection of personnel all around. At the core, because Congress insists that war spending go to employ Americans, and not to ensure that the war is actually fought effectively, the U.S. Agency for International Development didn’t hire a local construction company with intimate on-the-ground knowledge of the working terrain. Instead, it gave the contract to two American companies — a New Jersey outfit named the Louis Berger Group and a Kansan company called Black & Veatch. Incredibly, they subcontracted the work to two Indian companies, BSC and C&C Construction. Let me repeat that — to two companies from India, the blood enemy of neighboring Pakistan. Predictably, matters have gone downhill from there.

I emailed an American official in Afghanistan and asked why U.S. AID didn’t subcontract to a Pakistani company — Pakistan has excellent roads, and serious experience working in high altitudes (witness Hunza). There would be corruption, as is endemic in the region. Pakistan’s intelligence agency, known by the acronym ISI, would burrow into the mix. But the road would be completed. Here is what the official told me by email:

Say that the U.S. does open this up for international bidding. The Afghans can’t be competitive and, let’s say that it does go to a Pakistani company. The Afghans will squeal that the damned Pakistanis are benefiting again at the expense of the Afghans. … This Khost-Gardez road has been a nightmare for years. … [But] I can assure you that any option you propose will have inherent in it the seeds of its failure in a place where there isn’t legal recourse, and the Afghans know that we don’t have the guts to enforce contracts the way that Afghans enforce their contracts.

Josh Foust thinks the problem is an obsession with roads. I’m not sure about that, but can say with certainty that there is a lack of focus on building them realistically. The Khost-Gardez story also is a parable about a mindless fixation on grandiose Afghan infrastructure that has seized certain powerful generals in the Pentagon, fed by the romantic showman professor Fred Starr of John Hopkins University.