Publication day!

For those of us who aren’t J.K. Rowling, publication day is a bit of a soft concept. None of this opening bookstores at midnight. I thought about releasing it when the markets close, but that was just impossible to engineer and maybe a bit pointless!

Still, it’s always a good day for the hard-working author, and right about now copies of “Crude Forecasts: Predictions, Pundits and Profits in the Commodity Casino” are available on Amazon (US) (UK) and all other online book stores.

Many of my loyal readers on Materials Risk or following me on Twitter will know that I’ve been busy working away on something important. You can read more about my new book here, but in short it tells the story of how commodity forecasts, often driven by powerful narratives have shaped our history, and not always for the best.

My book will show you that forecasters are typically terrible at forecasting prices, even over just 6 months and the reasons (both internal and external) for why that is the case. Ultimately, I hope this book will help you make better investment decisions in commodity markets.

I really enjoyed writing this book and I hope you really enjoy reading it too. Thanks!

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How monetary policy and commodity markets collide

Its been widely acclaimed as being a product of the unique combination of geological, technological and commercial factors that are present in the US. One that has evolved into making US shale producers the short-cycle supplier of the energy market.

What is rarely mentioned in relation to the apparent success of shale is the extent to which it is a product of monetary policy. The U.S. shale oil and gas industry uses expensive drilling methods to extract oil and gas from rock formations. Frackers typically rely much more on debt than big, integrated oil companies. It can be argued that US shale economics are just not viable without a monetary policy regime that created a chase for yield environment. Is it any coincidence that the ‘shale’ revolution coincided with monetary madness of QE followed by more and more QE? Monetary policy created an environment of massive misallocation of capital which funds uneconomical shale producers in the US.

The risk to investors is now being highlighted by investor Jim Chanos. He looked at about three dozen drillers and found that their capital spending would eat up almost all of their earnings, minus certain expenses, this year. That leaves them with little cash to service their debt. Drillers have reduced the amount of capital they need to produce the same amount of oil, but not enough to make many of them profitable.

Capital spending creates a vicious cycle. As drilling activity picks up, so do service costs. Those expenses get capitalized, or spread out over the life of the asset. According to Chanos, capitalising expenses in other businesses can be acceptable, but it is a problem in the oil and gas industry because frackers have to constantly reinvest in new wells to replace cash flow from depleted wells.

“The way to think about it is that unlike other businesses, your assets literally get burned up,”

So whats the end game for shale producers? Well, as US monetary policy starts to normalise the cost of capital for US shale producers should start to become more expensive, making it more difficult for drillers to service their debts. While this could provoke another round of cost cutting and asset burn to fund the additional debt costs, there is no way that this can go on indefinitely.

The shale oil industry and the price of oil as well as other commodity markets are built on narratives. Cuts to Chinese capacity, reflation, etc, etc. But the real narrative is monetary policy and at the moment investors in financial as well as physical markets are undervaluing the risk of that narrative changing.

This shouldn’t just be a worry for financial markets. Expectations of relatively low and stable energy prices continuing long into the future has encouraged massive amounts of investment into petrochemical and other manufacturing and industrial capacity, built on the premise that ‘new economy’ commodity markets will continue.

Related article: Narrative economics

My new book Crude Forecasts: Predictions, Pundits and Profits in the Commodity Casino is now available to pre-order as an e-book on Amazon, Kobo, Apple and Google Play. The book will be launched and available to download on Monday 25th September. The paperback version should be available on or about the same day while the audio version should be coming later in the autumn.

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Narrative economics

Economists, financial market pundits and forecasters often think they are just observers of the facts. Most, I presume, would regard the assumption that the way they think about the world can also change it as being fanciful. Yet it only takes a bit of reflection to see that a lot of economics concerns self-fulfilling (or self-averting) phenomena.

An economy can go into recession when enough people think it will, for instance. Therefore, forecasters of all stripes have a responsibility. The economist Robert Shiller suggests that economics should be expanded to include the serious quantitative study of changing popular narratives in causing fluctuations in economic activity. As Shiller shows, the economics profession has had little to say about the role of narratives compared with other social sciences.

According to Shiller:

[The] human brain has always been highly tuned towards narratives, whether factual or not, to justify ongoing actions, even such basic actions as spending and investing. Stories motivate and connect activities to deeply felt values and needs. Narratives “go viral” and spread far, even worldwide, with economic impact.
Lack of information creates a vacuum for stories to breed, an environment in which a compelling narrative can capture the imagination. The more imprecise the estimate of the fundamental value of an asset, the more room there is for “stories” and “new economy” thinking to justify speculative prices. This same need for information redux is what pundits of all shapes feed on, whether in commodity markets or anywhere else.

Are narratives becoming increasingly based on false ideas or, at least, “alternative truths”? In an information vacuum, such as that which exists in commodity and other asset markets, then this is possible. According to Shiller, “A phishing equilibrium with a certain equilibrium acceptable level of dishonesty in narrative is established.”

False trends can arise when a narrative is founded on untrue assumptions, but the narrative is so strong it moves price action anyway. Then, as prices rise, it confirms the narrative in the minds of investors, which in turn reinforces the view they should buy into the increase in prices.

In the wrong hands, narratives can spread like wildflowers.

Related article: Batteries now included: You’ll meet a bad fate if you extrapolate

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