Flute Thoughts

Peak Oil and Denial

2011-12-08T23:25:00.001+01:00

This is a translation of a post from 2009 on my Swedish blog, with some adaptations and updates.

Many confuse peak oil with running out of oil. This is not what it is about - in 2008 I wrote this.

What peak oil is about is instead that for more than 100 years we have lived in a world of increasing oil supply and cheap oil. This has fuelled an economic expansion unmatched in all of human history. When the peak comes and is passed we will instead have to endure a steadily diminishing oil supply and therefore more expensive oil. The biggest worry among "peak oilers" is how our global societies, completely built around cheap oil and constant economic growth, will handle this. Which economic, political and social problems will this lead to? We already see some of them, but more will come the more expensive oil becomes. Will we instead see an economic contraction unmatched in human history?

And there are no other energy sources that can completely replace fossil fuels. I've written about this in my review of the alternatives (only in Swedish).

Now this is a very drastic change that is happening. Many of the economic theories that form the base for our societies' planning will be turned topsy-turvy, since they have only been tested during periods of long term global economic growth. What happens for example to loans with interest when growth slows or turns into contraction? Or pension funds? The change is so big that it will be a severe shock to many people. So how do people react to this?

Elisabeth Kübler-Ross was a Swiss-American psychiatrist who worked with terminally ill and dying people. She created a description of the stages that a terminally ill human goes through, which can also be applied to other shocking information, e.g. when somebody realises the implications of peak oil. Kübler-Ross divided the reaction into five stages - denial, anger, bargaining, depression and acceptance.

Denial. This is the first natural reaction to shocking information, which entails a loss and/or change. You refuse to accept reality as it is.
Anger. When you gradually have understood that the shocking information really is true and unavoidable the denial is transformed into anger. You become raging and angry at yourself and other people, sometimes including "scapegoats".
Bargaining. After the anger is over you instead try to bargain about the unavoidable that is about to happen and try to find something that can postpone the unavoidable.
Depression. When you can no longer deny, see that it no longer helps to become angry, and see that you can no longer bargain to avoid the unavoidable you fall into depression. This depression can throw you back to one of the earlier stages.
Acceptance. When (and if) you have managed to get through the first four stages you get to the stage where you accept the unavoidable and are ready to deal with it in the best way.

There are many examples of this from real life, for example the debt crisis of Greece, Ireland, Italy, etc., which was first denied, and then met by anger at "evil speculators". At the moment it looks like the EU leaders are in the stage of bargaining, when central banks and politicians try to find ways to "save" countries with far too large public debt.

Another example is Norway's oil production, which started contracting by several percent per year around 2001. This came as a surprise to most people, even those in the business. At first denial was the response, and they believed it was only a temporary production drop. The anger stage is often not seen so much in public in these cases, but I guess that many directors in the Norwegian oil business and oil directorate became very angry that their engineers could not keep the production up. Now it seems that Norway has reached the bargaining stage, where they try just about anything to keep their oil production from falling too fast.

So how do our politicians relate to peak oil? Where are they on the Kübler-Ross scale? Most of them still seem not to have heard of peak oil, or are in the stages of denial or bargaining, since they still mostly talk of how we should create economic growth, although global growth is no longer possible when the global oil production falls. If there are any politicians who have fully understood the implications of peak oil, they still do not want to talk about it in realistic terms, since politicians don't like problems without solutions. Besides it is politically impossible to speak about deteriorating standards for most people. The voters will demand that the politicians "do something about it".

Among other people in power (business directors, central bank directors, etc.) it seems like the situation is similar. It really isn't that strange. All people in most OECD countries who are alive now have lived the most part of their lives in a period of historically unparalleled economic growth and are completely indoctrinated that most things constantly improve.

The "average Joe" has probably never even heard of peak oil and the problems that come with it. When I speak about this with many of my friends and relations they mostly deny that there is even a problem. They start talking about electric cars and solar cells and that "they'll probably invent something new". If you try to counter these arguments you will be classified as a hopeless pessimist.

Journalists then? Well, the peak oil awareness level seems to be low here too. Gunnar Lindstedt is one of the few established Swedish journalists to write about this subject. He has also written the books "Olja" (Oil) and "Svart Jord" (Black Earth), both well worth reading.

In Sweden we happen to have one of the internationally best known researchers in peak oil, Kjell Aleklett, professor of physics at Uppsala University, leader of the Uppsala Hydrocarbon Depletion Study Group and one of the founders of ASPO, the Association for the Study of Peak Oil and Gas. In spite of this Swedish media are rather silent when it comes to peak oil.

On the World Wide Web the situation is better. The first Swedish site about peak oil was energikris.nu, which started in May 2005 but is no longer updated. Nowadays there is the news and discussion site oljepris.se. There are also a number of Swedish bloggers that often write about peak oil (apart from myself), notably Sweden's most read finance blog Cornucopia. ASPO Sweden also has a blog and news.

So it seems to me that most of society does not know about peak oil or is in denial about it.

So where are you on the Kübler-Ross scale when it comes to your view on peak oil? If you've made it to the end of this article at least you are not unaware of it.

Falling Swedish Housing Prices Again

2011-07-05T14:36:00.002+02:00

I think it's about time I updated the English version of my Swedish housing bubble diagram and analysis from September 2007.

The following is based on articles from my Swedish language blog from the past year or so.

At the end of 2010 real house prices in Sweden fell quarter over quarter for the first time since the first quarter of 2009. According to Statistics Sweden's "Fastighetsprisindex småhus" and CPI, inflation adjusted house prices fell from the third to the fourth quarter of 2010. The falling prices have continued during the first quarter of 2011. See diagram below for prices in the whole country and in the Stockholm area.

For comparison I've also included real wages. The Swedish housing bubble is credit driven, as you can see if you compare housing prices, wages and household credit. In 2007 I thought we had seen the top, but during the financial crisis of 2008 the Swedish central bank, Riksbanken, took interest rates down sharply, and since Sweden was relatively mildly hit by the crisis the Swedes started bidding up housing prices even more using borrowed money at low interest rates.

The question now is - have we seen the real top in the Swedish housing market this time? I find it hard to see any factors that could inflate the Swedish housing bubble further, so this time I definitely call it a top.

There are always "fundamentalists" who argue that there is no housing bubble in Sweden, citing for instance supply and demand showing that there is not enough housing in for example Stockholm. However, housing price increases in Sweden are not limited to the large cities. Percentage-wise prices have even increased more in some smaller towns. Sweden also has among Europe's largest dwelling area per capita, even compared to neighbours such as Finland.

What the "fundamentalists" also miss is that this is really a household credit bubble, which happens to manifest itself in housing prices. It also manifests itself in household consumption, which continues unabated in Sweden, though there are recent signs of a softening. This of course drives the strong Swedish GDP increase, which however is largely driven by credit-fuelled household consumption. If household credit expansion should stand still, Swedish GDP will no longer increase.

Now it's not just Sweden that still has an unpopped housing bubble. Our neighbours Norway and Finland also do. Denmark's bubble popped in 2007, however, which has caused the demise of nine smaller Danish banks, but has so far left the large banks relatively unscathed.

Norway's bubble is bigger than Sweden's, and Finland's is smaller, using 1993 as the base year. All the Nordic bubbles are larger percentage-wise than the American one. One cannot help but wonder what will happen to the Norwegian bubble, considering that Norwegian oil production has been falling for about ten years now.

Also read the Australian blog Macrobusiness' recent analysis of the Swedish housing bubble.

Western European Banks' Exposure to Eastern Europe

2009-02-24T12:43:00.006+01:00

This article is a translation of an article on my Swedish language blog.

Last week I wrote about Eastern Europe's loans from Western European Banks (in Swedish). Now I've taken the latest figures from BIS and made graphs to illustrate how the situation is. Please note that the figures are only for claims from banks. There may be other lenders too, but it's not as easy to find statistics for them.

First I'll present an illustration of which Eastern European countries have borrowed most. The colours indicate which in Western European countries the they have borrowed from belong. Click the graph for a sharper version.This graph shows clearly that we don't need to worry too much about Western Europe's banks if Macedonia, Moldova, Montenegro, Belarus, Albania, Bosnia or Serbia should be hit by a collapse of the economy and currency, since their loan volumes are relatively small. The other countries, however, are potential threats to Western Europe's banks. This becomes especially clear when one Western European country has a large proportion of the lending to a certain Eastern European country, e.g. Sweden to Estonia, Latvia and Lithuania.

Huge figures have been floating around when it comes to the exposure of Western European banks to Eastern Europe, but the total sum of bank lending is "only" slightly more than 1.4 trillion dollars, which should be quite close to the actual figure. This is still, however, a very large figure.

Now I'm going to look at it from "the other side", i.e. divided per lender country instead.Here you can see that Austria is at the top of the risk list for lending to Eastern Europe. As for Sweden we can note that the major part of the lending is to the three Baltic states. Since these three economies risk following each other, Sweden is much more exposed to a single risk factor.

However, absolute numbers don't often say that much. If Italy lends a bit over 200 billion dollars that's a larger share of the country's GDP than if Germany lends the same amount. So below I compare the banks' lending to Eastern Europe to the GDP of the countries (taken from the 2008 GDP estimates from the CIA Factbook).Then you suddenly see what a huge risk Austria is taking! Their banks have lent roughly 64% of the country's GDP just to Eastern Europe! Even a mild crisis in Eastern Europe would thus probably suffice to topple Austria's banks - we don't even need a serious crisis. The biggest Austrian claims are on Czechia, Romania and Hungary. At least Romania and Hungary are already on the problem radar...

By Austrian measures the other Western European countries have taken limited risks towards Eastern Europe, even if they definitely aren't negligible. Belgium's banks have lent about 25% of Belgium's GDP to Eastern Europe, and Swedish banks about 20% of our GDP, most of it to Estonia, Latvia and Lithuania.

Let us also take a look at which Eastern European countries have borrowed the most in relation to their GDP, and thus have taken a large risk. This is according to my usual identification mechanism for potential problems in this crisis. Large loans = large problem risk.Here you can see that Croatia and Estonia are in a risk class of their own. Their claims from foreign banks are more than 120% of their GDP. But Latvia, Hungary, Czechia, Slovakia, Lithuania and Bulgaria are also risk factors that cannot be ignored (the nominal sum of their borrowing according to the first graph in this article also plays a part here). Add to this the fact that GDP for many Eastern European countries is now falling rapidly, and we will quickly get even bigger loans-to-gdp ratios.

Part of the risk is also the currency risk. A large part of the loans from Western to Eastern Europe are denominated in euros or Swiss francs. This causes payment difficulties when the local currency sinks against the euro and/or the franc. Unfortunately I don't have any figures for how much of the loans are denominated in foreign currencies, but we can take a look at how some currencies have moved against the euro since the end of August last year.Here you can see that Ukraine's hryvnia and Poland's zloty have fared worst. We have all heard about Ukraine's problems, but there has not been much mention of Poland during this crisis. Hungary, Romania, Russia and Czechia have also been hit by falling currencies, though not as badly.

To conclude, we can see that the banks of several Western European countries have taken large risks towards the now faltering economies of Eastern Europe. There is an immediate risk that for example a currncy and/or economic collapse in one of the risk countries I've presented above could topple e.g. Austria's banks. This in turn would probably give serious repercussions for the whole euro area (Austria is part of it). As I see it it is only a matter of time before something drastic happens. Exactly what will happen is hard to predict, but Sweden is definitely also in the risk zone.

In this context it is interesting to note that the bank crisis of 1931 had its origins in Austria, where their then largest bank Creditanstalt went bankrupt in May of that year. Will we get a replay?

P.S. I recommend the following two articles by Ambrose Evans-Pritchard at the Telegraph for those who want to read more about the risks from Eastern Europe:
Failure to save East Europe will lead to worldwide meltdown
Eastern European currencies crumble as fears of debt crisis grow

Swedish and Danish Kronas and Interest Rates

2009-02-03T21:44:00.004+01:00

This is a partial translation of my original article in Swedish.

Sweden and Denmark have gone different ways when it comes to currencies. Both countries have kronas, as you probably know, and have not joined the euro. But while the Danish krona is pegged to the euro through the European Exchange Rate Mechanism ERM the Swedish krona has no peg. This can be seen from how the Swedish krona, being a small currency, fluctuates much more than the euro against the dollar.As you can see from the graph above one paid about 9.30-9.50 Swedish kronor for a euro until the beginning of September 2008. When the crisis then gained momentum the krona fell against the euro so that one at times had to pay more than 11 kronor for a euro (today we're at 10.76 kronor per euro). This means that the krona lost about 13% against the euro, just because we have a small currency, which is not attractive to investors in a crisis. Theoretically a weak currency should be good for our export industry (Sweden runs a current account surplus) but in a global crisis where world trade is generally diminishing one can question how much this is worth.

The Danish krona however has been stable around 7.45 DKK/EUR all the time - lucky them, one could believe. But the Danes have been hit by something else - look at the diagram below for the rates of the Danish central bank (red), the European Central Bank (blue) and the Swedish central bank (green):Danmarks nationalbank had to raise their rate at the beginning of October to defend the value of the Danish krona against the euro, when ECB and Sweden instead lowered their rates to cushion the effects of the financial crisis. Even though the Danish central bank rate has been lowered in three steps since then, it is still a good deal higher than the ECB rate, which has also been lowered during this period. The higher interest rate climate in Denmark can also be seen when you look at the interbank rates - Danish 3 month CIBOR was at 3.9317% today, while Swedish 3 month STIBOR was at 2.023%. A rather hefty difference, I would say. So this is the price Denmark pays for its stronger currency.

Now voices are being raised in Sweden for us to join the euro. The Swedish small enterprises association's leader Anna-Stina Nordmark Nilsson and professor of economics Harry Flam have written an article each in Sweden's two largest newspapers where they argue for joining the euro. Well, it might not be very good timing to join the euro now, when it seems the euro co-operation itself might break.

Anyway, Sweden cannot join the euro straight away, since a country's currency must be part of the ERM for two years first according to the rules. So the Swedish euro friends will have to wait for the continuing onslaught of the financial crisis before they get what they want.

Wild Price Swings Could Implode Hedge Funds

2008-02-07T21:55:00.000+01:00

I guess nobody has missed the wild swings during the first weeks of 2008 in the prices of just about everything that can be traded.

S&P 500 stock index from 1471 down to 1388 up again to 1429 down again to 1270 up again to 1396 down again to 1317. A span of about 16%.
Crude oil from 95 up to 100 down again to 86 up again to 92 down again to 87 $/barrel. A span of about 16%.
Gold from 840 up to 912 down again to 860 up again to 930 down again to 885 $/oz. A span of about 11%.
10 year US treasury note yield from 4.05% down to 3.28% up again to 3.74% down again to 3.53% up again today to 3.74%.
And so on...

These wild swings in prices of equities and commodities have been very hard to predict. Now, hedge funds all around the world are making bets all the time on the direction that certain prices will take, and these bets are often highly leveraged (i.e. they borrowed a lot of money to bet). This means that a number of hedge funds have probably made bad bets over the last few weeks, some of them maybe bad enough to "implode" the fund, because prices have quickly and unexpectedly moved in the "wrong" direction. So I predict that we will soon see a number of hedge fund failures, and some of them might be rather spectacular.
We have already seen an example of what can happen when big trades go wrong in the case of the "rogue trader" at the French bank Société Générale. The losses in this case were about €4.9 billion, enough to topple most hedge funds.

Oil and Other Commodity Prices

2008-01-12T00:09:00.000+01:00

I haven't had time to write for a while, but now I'm back with this year's first post.

One of my favourite bloggers, Stefan Karlsson, wrote about rising commodity prices today. I feel I have to comment on what he said, but since this comment is much longer than his blog post, I post it here on my own blog instead.

Stefan says "anyone who tells you that the commodity price boom reflects the alleged 'peak oil' doesn't know what they're talking about". I would instead say they are parallel developments.

Now why does Stefan say "alleged" peak oil? Isn't Stefan Karlsson convinced yet about the imminence of peak oil? I'm not saying he has to believe all the doomer stuff you can read on many peak oil sites, but I do hope he has read enough facts to understand that peak oil is here, and will most probably have profound effects on our lives.

In my opinion, the oil price does (partly) reflect "peak oil", because demand has outpaced supply. Take a look at the second chart at http://oljepris.se/statistik and you will see that world production has been essentially flat since April 2005, after rising until then. Many experts who have studied oil production, e.g. Matt Simmons, argue convincingly that the world has passed peak oil and is now on a "plateau" of oil production. Even if the peak is a number of years away, most of the "easy" oil is already taken out of the ground. What is left is (on average) much harder to extract (e.g. in remote regions, have to use more advanced techniques to extract, under deep seas etc). Extracting a barrel of oil on average costs much more now than 10 years ago. There are also other factors involved in oil prices, e.g. military conflicts etc. But price action alone does not refute the fact of "peak oil". Not even when compared to other commodity prices.

But peak oil definitely plays a strong part in oil prices. The inability to increase production in spite of rising demand and sharply rising prices over several years confirms this. If you want more detailed analysis of peak oil, you can get all the information you want (and more) from The Oil Drum and Energy Bulletin.

So why have other commodities shown strong price gains too?

Just like for oil, demand has outpaced supply for many commodities (e.g. metals). Starting up new mines is a long process. It takes years of prospecting, government permits etc. The global economic boom of the last few years seems to have caught miners by surprise, with a demand for commodities that by far exceeded most predictions (remember, most "predictors" are notably bad at predicting things like this in advance).
Many other commodities are probably also near their global production peaks, e.g. platinum. The production of any finite resource can be Hubbert linearised to get an approximation of the production curve. A notable example of "peaked" commodities is uranium. Just take a look at a graph of global production and you will see that global production seems to have peaked in 1980, and since 1985 the shortfall in production has been made up by using military stockpiles (see for example the chart at the bottom of this article). The price action of uranium over the last few years confirms this situation.
Just like for oil, the "best" ores for other commodities have been extracted first. Take the example of copper. When copper was first discovered during the stone age, naturally occuring pure copper was used. Then somebody discovered how to extract copper from certain ores, and the best ores were mined first. Gradually over the years, ores with lower and lower percentage grades of copper have been mined. During the last century we have rapidly mined our way through most of the good ores for most commodities, at a pace never seen before in history.
As for food prices, we seem to have reached "peak food" rather close to "peak oil". It seems that the world is simply not capable of producing more food simply for reasons of ecological limits. Global grain stockpiles are now at something like 27-year lows. And population still growing. And demanding more and better food.
Increased affluence among large parts of the world's population has created a stronger demand for everything from meat to diesel to microwave ovens. This is actually strongly connected to number 1 above.
Food prices have become (loosely) connected to oil prices because of the grain-to-ethanol boom.

Now, even if we have passed "peak oil" (which I believe we have), that does not mean that oil prices cannot sink from current levels. Since the margins for world oil supply are so tight today, small differences in production or demand make big differences in price. With the coming recession, I think we will see a lot of "demand destruction", as it is euphemistically called. I therefore guess that oil prices will decline substantially later this year. $65/barrel is not impossible. This is of course blasphemy to many of my fellow "peak oilers", most of whom seem to be convinced that we will see $150 or $200 per barrel oil soon. But I predict that "demand destruction" over 1-2 years will be faster than production declines. Of course a swift economic downturn might also have a similar effect on many other commodities. Though not uranium, I suppose, because nuclear reactors will not be shut down, even if we have an economic crisis.

First Card of the CDS Game - ACA Downgraded to Junk

2007-12-19T21:26:00.000+01:00

Now the whole house of cards built from Credit Default Swaps (CDS) is starting to come down. Yesterday the credit insurer ACA had its credit rating by Standard & Poor's cut all the way from "A" to "CCC". As I said last Friday the New York Stock Exchange announced they would delist them, so today's news was rather expected. A credit rating of "CCC" essentially means "bankrupt". This means that all the bonds they insured get their credit ratings lowered, and there will be big writedowns and maybe forced sales. Now we'll get to know who's been doing business with ACA. Canadian bank CIBC came out straight away and said that they have "insured" $3.5 billion of subprime loans with ACA. I suspect Merrill Lynch and Bear Stearns are feeling the heat too, because they have discussed "bailing out" ACA (to save themselves, I suppose). Even if this is possible, which I doubt, it would probably cost them billions. Then what happens when they have to bail out the next credit insurer that goes bust. FGIC, MBIA and Ambac are good candidates for this.
I started writing this post yesterday - and sure enough here we go today (the day after their AAA rating was affirmed by S&P) MBIA comes out and says that they "insured $8.1 billion of so-called CDOs-squared, which repackage other CDOs and securities linked to subprime mortgages". For those who don't know, CDO-squareds are considered very risky.
Things seem to be happening very quickly right now. What next? Will things quieten down over Christmas, or will we see more problems building up every day?

Potential problems in the CDS markets is something I mentioned already in my first post in August. Now it's starting to get serious.

The moral of the story is:
No insurance is safer than the insurance company itself!

Credit Insurers in Trouble

2007-12-14T21:01:00.000+01:00

Reuters reports today that ACA Capital Holdings will be delisted by the New York Stock Exchange. ACA "provides financial guaranty insurance products to participants in the global credit derivatives markets, structured finance capital markets and municipal finance capital markets." In other words, it is a "monoline" credit insurer, just like MBIA and Ambac, that I have mentioned before on my "black list". ACA's shares have fallen from about $15 in June to about $0.50 today. Their latest economic report (from September 2007) is rather interesting - a net loss of about $-1 billion for the last quarter - total equity now about $-0.88 billion - meaning they are essentially bankrupt. The interesting thing is they have "insured" about $68 billion of "collateralized debt obligations" (CDOs), a form of repackaged debt. Now all that "insurance" is basically worthless. Who owns on all those "insured" CDOs? How did a company that had about $6 billion in total assets at the end of 2006 get to "insure" more than ten times as much in debt? It doesn't take a very high default rate on the underlying loans to erase the company. And who was stupid enough to pay for "insurance" from them? And by how many billions of dollars will they have to write their CDO assets down?
Now ACA is a comparatively small player in the CDS field. Ambac is one of the two biggest "monolines", and yesterday Bloomberg reported that Ambac reinsures $29 billion with Assured Guaranty Ltd., to "avoid the crippling loss of its AAA credit rating". On 5 December, Moody's basically gave Ambac and MBIA two weeks to raise more money or risk a credit rating downgrade. Ambac "guarantees" a mind-boggling $556 billion of securities, with total assets of only $22 billion and total equity of only $5.6 billion (as of September economic report). And they are losing money ($0.36 billion last quarter - I expect much more this quarter, cf. estimates for MBIA below). The deal with Assured Guaranty doesn't really change that much for Ambac - the riskiest debts are not included in the deal. And Ambac have so far not managed to raise any more money.
MBIA seems to be slightly better off - they managed to raise $1 billion from Warburg Pincus. MBIA "guarantees" $652 billion of securities, but their financial status is stronger than Ambac's - $45 billion in total assets, $6.5 billion in total equity and only lost $37 million last quarter. However, Barclays Capital expects MBIA to post losses of between $2.3 billion and $4.2 billion, which would of course make their financial situation precarious to say the least.
Now the string of credit insurers going bust seems to have started with ACA, and I expect Ambac to follow within a few months. MBIA could survive a year, perhaps. Some people might even think this is optimistic. According to Bloomberg "If all the companies were to falter, $2.4 trillion of insured securities would be thrown into doubt, costing as much as $200 billion". My guess is that cost is underestimated, as with all costs so far in this credit mess. However, the biggest risk if the credit insurers falter is that many of those who now hold the "insured" debt are only allowed to hold investment grade rated debt, or have a maximum percentage of non-investment grade debt that they may hold. This means that they would have to sell the "insured" debt if the insurers fail or are downgraded. This sudden selling would lead to lower prices for these classes of debt, thereby increasing losses, if buyers can be find at all in these frozen credit markets.
Ironically, Ambac announced yesterday that "International Securitisation Report (ISR) has named Ambac Monoline Insurer of the Year". Wow! Sounds really great, doesn't it? And it gets better: "Ambac has had an active year closing many noteworthy transactions. This award underscores the company's ability to use our in-depth knowledge and expertise to help issuers and financial advisors structure innovative transactions across a diverse range of asset classes and jurisdictions." It's a pity this award comes just as they seem to be on the brink of bankruptcy.

Norwegian Oil Production

2007-12-11T14:25:00.000+01:00

The Norwegian Finance Minister Kristin Halvorsen is quoted today by Verdens Gang as saying "our oil can become worthless" because of "climate taxes" on burnt oil. She said this in Bali, where she flew for the climate meeting. Of course this climate meeting burns loads of fossil fuels just to get all the politicians there. But I suppose it is important that they get to discuss this, and shine a bit in the press before reality comes swooping in and they can't fly that much or that far any more. Later a spokesman for Halvorsen denied "considering cutting oil production for environmental concerns" and that "There is nothing in the government (program) declaration about a reduction in the pace of production" and "it was not an problematic issue".
However, reality says that the pace of oil production in Norway is problematic. Today Norway is the world's fifth largest oil exporter, pumping roughly 2.4 million barrels per day. However, production has fallen sharply since the top around the year 2000, and is not likely to reverse that trend. So even though what Kristin Halvorsen said was a bit confused, it is likely that they will have to use some kind of cover-up for why they are reducing their oil production.
Also, implying that their oil will become worth less in the future is pure nonsense. With world oil production probably in permanent decline, the remaining oil will on average just become worth more and more. Of course prices will jump up and down, depending on economic factors, but the main price trend for oil is up. It might even make sense for some big producer countries to voluntarily reduce their production in order to boost the price, thereby making even more money in the long run, and saving some of their reserves for hard times. So far, however, nobody seems interested in doing this, but time will tell whether we will see such policies in the future.

Shanghai Bubble Finally Bursting?

2007-11-27T22:20:00.000+01:00

As I have mentioned before, the Shanghai Stock Exchange has had one of the biggest bubbles in history over the last two years. The SSEC index has gone up from a low of 1067 on 28 October 2005 to a high of 6124 on 16 October 2007, an increase of 474% over less than two years!

Click the graph for a larger version.
Since then it has declined to close at 4861 on 27 November. Is this drop of more than 20% the popping of the bubble, or just another false alarm? There have been two previous big scares for Chinese investors this year, the first one in February-March, the second one in June-July, but the Shanghai Stock Exchange recovered from both of them and kept on chugging upwards. However, this latest drop is bigger (percentage-wise) than any of the previous two. If it continues, we could very well see one of the most epic stock market crashes in history.

Internet Bubble Version 2.0

2007-11-23T11:23:00.000+01:00

Don't think the Internet bubble of 1999-2000 scared all investors away from hyperinflated Internet stocks. I'm thinking of for instance Google, currently trading at $660 per share. Alright, down a good bit from the top of $742 two weeks ago, but still dizzyingly high at a price/earnings of about 52. This means that if they manage to keep their earnings as high as now and give all of their earnings back to their shareholders (which they of course don't), it would take about 52 years for a shareholder to get his money back in dividend. Now, what if earnings start dropping, with a recession coming on? Other Internet bubble stocks right now are Amazon, with a price/earnings of about 93 (!) and Yahoo, with a price/earnings of about 50. Price/earnings this high of course means that the markets expect the earnings to increase, but just how many more advertisers want to advertise with Google or Yahoo? Or are they going to pay more for advertising there? And how many more books and CDs can Amazon sell per year? Or are they going to take higher profit margins on each sold book?
For comparison, Microsoft and Cisco both have a p/e of 22, which is still considered to be on the high side. How long would you like to wait to get your invested money back? 22 years? Make that 10 and it starts to sound like a reasonable investment.

100 Dollar Oil Soon?

2007-11-22T12:28:00.000+01:00

I don't think anybody has missed the fact that oil prices have risen sharply over the last years. This is not only due to the drop in the dollar, but mainly caused by supply not keeping up with demand. Last spring the world had an "oil shock" when prices of crude oil (WTI) went above $75 per barrel for a while. Then prices dropped back to as low as $50 per barrel in January 2007, only to continue their climb all through the year. WTI oil was up to $98.50 per barrel on 7 November, then fell back to just above $90, and then went back up again to $99 per barrel yesterday morning, and fell back a bit later during the day.
Here's a graph of WTI oil prices since January 2006 for you:
Today, trading in oil is probably not so heavy in the USA, due to the Thanksgiving holiday. However, the North Sea Brent oil jumped up by $4 per barrel today, so if the same trend continues tomorrow, we might very well see WTI oil over $100 dollars then. This is probably a very important psychological barrier, and might cause serious repercussions across financial markets. Expect all major newspaper to have $100 oil as first page news the day after it hits us.

Oil is a major driving factor behind today's inflation, so expect to see higher inflation. Oil prices affect the price of everything. Not only will filling up your car be more expensive, but also air travel, food, and everything else. It will take longer time for the higher oil price to trickle through into some areas, but eventually it will raise prices of everything, because oil is needed to produce stuff, to transport it from the factory to the consumer, to build new factories, to build and maintain infrastructure (e.g. railways, roads, sewers). Air, car and diesel train travel will of course be hit rather fast by higher oil prices. In the long run, however, electric train travel will become more expensive too, even if the electricity comes from hydropower plants. This is because the maintenance of the railways requires diesel-driven machines. New locomotives, carriages and wagons also require oil to build them, to run the mining equipment for the raw materials, etc. In the end, maintenance of hydropower plants also requires oil.

There has been speculation over how much the price of oil has been inflated lately by hedge funds and other investors speculating in oil futures. However, there is a simple reason for the higher prices, and that is supply. The International Petroleum Monthly for October from EIA provides the simple answer that world oil production has actually declined since the top in July 2006, see chart below:
Meanwhile demand is increasing steadily, especially in places like China. The supply situation is most likely not going to improve other than temporarily, since it seems we have actually passed "peak oil" now. Many experts believe this, among them Matthew Simmons. So how is the world going to solve this problem?

If you think nuclear power is a solution, just take a look at how uranium prices have increased over the last years. And don't forget that since 1985, uranium production has not kept up with demand. The gap has been filled by stockpiles mostly from military sources, but that cannot go on forever.
If you think wind power is a solution, just contemplate that it would take 3 million large "wind mills" to replace the 85 million barrels of oil used per day in the world today.
If you think hydropower is a solution, remember that there aren't all that many rivers left to harness around the world. And do we really want to sacrifice the last free running rivers?
If you think solar power is a solution, maybe you should be aware of the fact that the silicon required to produce them is in short supply in the world today, and the situation is not likely to improve over the next couple of years.
Biofuels are out of the question as a replacement, because even if we used all available farmland, we would still only be able to replace a few percent of the oil used today.
Natural gas is not a very good replacement for oil either, because it is becoming more expensive too.
Coal might be a feasible replacement for oil for a decade or two, before supplies start declining there too. However, it is very dirty!
Saving energy is a solution. There are lots of ways the world, and especially the rich countries in the world, can save energy.

Higher oil prices will force the world to use energy more efficiently, but will create a lot of economical havoc in the process. Be prepared for $100 oil, and then $150 oil, and then $200 oil.

Swedish Housing Still a Bubble

2007-09-27T11:02:00.000+02:00

My view is still that Sweden is in a housing bubble, like most western European countries. Signature "ju" asked me on a forum why I don't compare to incomes, which have risen in Sweden over the last years. So I did some more number crunching, and here's an improved version of my Swedish housing bubble graph, with a green line for inflation adjusted mean income. I've also included housing price data up to Q2 2007 and trend lines (thanks to "Kons" for suggesting trend lines).
(Data source SCB. FPI=Fastighetsprisindex småhus, Mean Income=Sammanräknad förvärvsinkomst. 1975=100 for housing prices, 1999=100 for incomes)
As you can clearly see, housing prices in Sweden have risen much faster than the average income (I only have income data for 1991-2005), so while inflation-adjusted incomes have indeed risen, we are still in a housing bubble. How far will housing prices fall?

A fall down to the trend line is about 30%.
A fall down to the average for 1975-2003 is about 45%.
A fall down to the lows of the early 1990's is about 55%.

This is the whole of Sweden, and obviously the bubble is worse in "hot" housing spots. So I've made a corresponding graph for housing prices in the Stockholm area (thanks to "Kons" for suggesting this).
As you can see the graph is slightly more "bubblish" than for the whole of Sweden.

A fall to the trend line is about 30%
A fall to the average for 1975-2003 is about 55%
A fall to the lows of the early 1990's is about 65%!!

Many people will of course say "it can never happen, there will always be a strong demand for housing in our capital city", but I boldly predict today that inflation-adjusted housing prices in Stockholm will probably on average go down by 65% over the next few years. Be warned, and don't forget where you heard it first. And I might even be optimistic. Considering the excesses on the upside, we could very well have similar excesses to the downside when the bubble finally bursts. And if you don't believe it could happen, don't forget that history has proved that all bubbles eventually burst, even though few believe it is possible when on the upward slope of the bubble.

Now housing bubbles burst slowly, so the process will take a few years to play out. I expect "experts" to call a bottom in housing many times during the coming years, but prices will still keep on falling.

Now what effects will such a large fall in housing prices have on the economy? Large effects, of course. Many people will be stuck with loans way bigger than the value of their home. But maybe we should ask the question the other way around - what economic events could trigger such a large fall in housing prices? Read what I have previously written on this blog about potential dangers in the world economy, and you will get some hints about what might cause such a powerful recession.

Speaking of housing bubbles, the top economic advisor of the Spanish prime minister came up with some unbelievable quotes last week:

A residential real estate slump in Spain, where prices have almost tripled since 1997, is "unthinkable," the top economic adviser of Prime Minister Jose Luis Rodriguez Zapatero said. [...]
"To talk about severe adjustments or a meltdown in prices is ridiculous," Taguas said in response to reports pointing to an end of the Spanish real estate boom. "That sort of crisis is unthinkable." [...]
The Spanish banking system is also solid enough to withstand rising financing costs triggered by the fallout from the surge in defaults in the U.S. subprime mortgage market. A run on mortgage- lenders such as Newcastle, U.K.-based Northern Rock Plc or funding difficulties like those at Countrywide Financial Corp. in the U.S. are "unthinkable" in Spain, Taguas said.

Remember those quotes and remind Mr. Taguas about them in a few years' time!

Extreme Events

2007-09-21T13:22:00.000+02:00

For now, the global financial markets seem to have calmed down. But the "background noise" of bad news is still there. Since late 2006, 159 US mortgage lenders have already broken down in some way, and new ones are added to the list every week. Housing prices are still falling in the US, and the bubble seems to be about to pop in Europe too, where Spain and the UK seem to be first in line for a major housing bubble correction. Prices of oil and cereals are still rising sharply. The US dollar continues its fall. The interbank rate (e.g. LIBOR) is still well above 6 percent. Many businesses find it hard to get loans or to roll over their loans. Bloomberg reports:
"The U.S. commercial paper market shrank for a sixth week, extending the biggest slump in at least seven years"
"Commercial paper investments have declined $354.5 billion, or almost 16 percent, since the week ended Aug. 8"

I can't believe that everything is now well after a number of extreme events in August and September:

At the beginning of August, some banks obviously had major problems, and central banks all over the world had to inject liquidity to keep the wheels going, on a scale not seen since September 2001, and in some cases never seen before.
The US FED unexpectedly lowered the discount rate by ½ percent on 17 August.
There was a "run on the bank" in British Northern Rock 14-18 September. When was the last time we saw a run on the bank in Britain? This was so serious that US Treasury Secretary Henry Paulson suddenly decided to fly over to London to meet the British Chancellor of the Exchequer Alistair Darling. On 18 September the British Government announced that they would guarantee all deposits at Northern Rock. Whew! Crisis averted for some time.
Little more than a month after Ben Bernanke said that inflation was his main worry, he lowered the Fed Funds rate and discount rate by ½ percent on 18 September. This of course caused the US dollar to fall like lead.
Saudi Arabia did not lower the interest rate this time. They have so far followed interest rate changes in the US, and their currency is pegged to the US dollar. This of course raises fears that they will now unpeg their currency from the US dollar, which would cause mass exits from the US dollar and possibly a dollar collapse.

So what are we in for next? Crude oil is now definitely above $80/barrel. The US$ has dropped about 3% in one month. Foreclosures in the US jumped up by 36% in August, which is up 115% from August 2006! And there are still loads of ARM mortgages awaiting interest rate resets over the next couple of months.

I guess there will be a few weeks of calm before we see the next extreme event. How many extreme events can the world financial markets handle before an avalanche is set off? Don't forget that everything is tied up by trillions of dollars in derivatives.

If we get bankrupts increasing because of the problems for companies to get loans, we will see a test of the credit default swaps (CDS). The amount of CDSs outstanding is equivalent in size to total world GDP. It's already doubtful whether many issuers of CDSs can live up to their promises. And who holds all these CDSs? Default by a big enough company somewhere in the world could thus cause a cascade of bankrupts and defaults, since both the issuer and the holder of a CDS might go down, in their turn bringing down other holders and issuers of CDSs.

There are even more interest rate swaps and currency swaps than CDSs. What happens to the issuers of these when interest rates and currencies start to move quickly and in unexpected ways? And don't forget that many hedge funds speculate in these kinds of financial instruments.

Like the Chinese curse says: "May you live in interesting times..."

The R Word

2007-09-08T22:54:00.000+02:00

Some really bad US job statistics hit the news this Friday. Non-farm payrolls were -4000 jobs instead of the expected +100,000. This is the first time in four years that job growth was actually negative. On top of that the preliminary figures for June and July were revised downwards substantially. And, to make matters worse, 592,000 people left the workforce, meaning that they have probably given up trying to find a job. Now the "R word" is sure to come any day soon - recession.

Treasury Secretary Henry Paulson's comments on the job statistics are priceless. He's desperately trying to instill comfort when this news has probably convinced even the most hardened optimists that the US economy will make a hard landing, and pessimists now predict a crash landing. Some quotes:

"it takes a while for confidence to return"

"A while" - ha - it will probably take years to sort this mess out.

"The economy will continue to grow in the second half of the year"

Oh yeah? That would be sensational. First this "unexpected" drop in jobs, and then he expects us to get another surprise when we suddenly see job growth again in September or October. Does he actually believe this himself?

Paulson, who had a regular breakfast meeting with Fed Chairman Ben S. Bernanke today, said he had "great confidence'' in the central bank.

"Helicopter Ben" is probably glad to hear that there's still at least one person who has not lost confidence in him.

"But I feel quite strongly that we have a resilient economy."

Well, let's hope that, but don't bet on it. Things might break quicker than Paulson can say "resilient economy".

The Mortgage Situation
Higher unemployment will of course lead to more people falling behind on their mortgage payments. Foreclosures have already hit an all-time high of 0.65 percent during the second quarter of this year, making this the third consecutive quarter in which a record is set. Delinquencies are also up - 14.82 percent of subprime loans are behind in their payments, but delinquencies in the prime area are also up from 2.58 to 2.73 percent. Expect this to turn worse.

Housing prices are sinking, partly because it has become much more difficult to get a loan. More foreclosures will also mean more houses for sale on an already saturated market. Expect housing prices to sink much more.

To make matters worse for the poor foreclosed home-owners, if the house sells below the amount of the loan, and the rest of the loan is forgiven by the lender, the amount forgiven is taxed as income for the borrower. This could lead to really serious problems for many people who are already in trouble.

There have been proposals (notably from George W. Bush) to bail out home-owners in some way to alleviate the effects of the current housing mess. However, with a recession coming on, where is the government going to find funds for such a bailout? A recession means less tax money coming in, so the only alternative is to borrow money. But borrow from whom? Most Americans don't have any surplus to put into US bonds, and foreign investors will be unwilling to invest more in US government paper if there is a major inflation risk. And that brings me to the subject of...

Inflation
Apart from moving the stock markets down, the bad jobs news on Friday also took the US dollar down by more than 0.6 percent. The US dollar index (against other currencies) is now definitely below 80 and has now broken its 15-year low. Expect it to fall further unless some miracle news turns up. This means that all imported stuff will be more expensive in the USA.

To counter this bad trend for the US$, the only thing the FED could do would be to increase the interest rate, but what's really needed to alleviate the current domestic economic situation is an interest rate cut, which is what everyone expects the FED will announce on September 18. So the FED basically has its hands tied behind its back when it comes to fighting inflation.

Besides, there are two inflation factors over which the FED has no control - food and energy. I know that the "core inflation" figures the FED prefers to watch exclude food and energy, but in the real world food and energy prices have strong effects on the economy. People just cannot live without them. Food prices are rising sharply, as I have said before, due to a global shortage of wheat and other grains. President Bush could do something about this inflation factor, however, by cutting all subsidies to the grain-to-ethanol business. Of course this would mean a disaster for that business, but it would probably be a big help in fighting inflation. Though I don't expect him to do this, since he's too committed to it.

Oil prices are also rising, in case anybody failed to notice. On this Tuesday (11 September) OPEC will have a meeting to decide their production quotas. It is highly improbable that they will increase their production, since they probably cannot (this has been thoroughly analysed at The Oil Drum). OPEC will probably keep production at the current level, thereby keeping world market prices high. This means that the slightest disruption in this tight market could send oil prices upwards. Goldman Sachs already expects oil prices to hit $95/barrel this year (they're at about $75 now).

Many Companies in (Potential) Trouble
The current credit crunch is also a severe threat to the economy. Even if the FED lowers its rates, many loans (commercial and private) are tied to the LIBOR. The 3-month LIBOR is currently up to 5.70 percent, thereby increasing interest payments for all loans tied to it. It has also become much harder to actually get a loan. Outstanding commercial paper has contracted by nearly $300 billion over the last four weeks (source: Credit Bubble Bulletin). So many businesses will have a hard time due to either higher interest payments, lack of funding, or both.

Of course, all businesses connected to the housing boom are in even worse trouble. For example home builder Beazer received notices of default this week from a bondholders' group, while luxury home builder Hovnanian reported losses for the fourth quarter in a row.

For mortgage lenders you can watch the Implode-o-meter to see them going down one by one. The biggest one, Countrywide Financial, announced on Friday that they will cut 12,000 jobs (20% of their workforce).

Countrywide also seem to have been into some shady stuff too. They even seem to have neglected sending required paperwork to the IRS. Is this the beginning of another Enron-style scandal?

It is also getting harder for mortgage lenders to get funding. Citigroup announced that their First Collateral Services unit won't accept new clients for "warehouse" credit lines, which provide cash to mortgage banks so they can fund home purchases and refinancings. Does this also imply that Citigroup sees problems with their current clients? How many bad housing loans are actually connected to Citigroup in some way?

Citigroup also might have other troubles. Like many other banks, they have so-called SIVs (Structured Investment Vehicles) and conduits, which operate separately from the bank and are not on its balance sheet, but generate investment profit (hopefully) for the bank. According to Wall Street Journal, Citigroup "owns about 25% of the market for SIVs, representing nearly $100 billion of assets under management". If these SIVs start going bad Citigroup might have to help them out or take on some of their losses. Now according to Wikipedia, Citigroup, apart from being the world's largest bank is also the world's largest company (by assets), so hopefully they can sort out quite large amounts of problem debt.

Venezuelan Overnight Rate 120%

2007-09-06T21:56:00.000+02:00

Bloomberg reports today that "Venezuela's interbank overnight rate soared to as high as 120 percent after the central bank said it would halt some of its lending operations to financial institutions." This has led to a serious liquidity crisis. It also seems this was a very quick decision that surprised some banks. Ouch! When will we begin to see banks toppling there?

This liquidity crisis does not seem to be isolated to Venezuela, but is a trend that is showing up in other "emerging markets" countries too. According to Marketwatch Russia also has problems with little or no liquidity in the markets, and several smaller banks have had to shut down lending.

Don't forget that Russia and Venezuela are two of the world's biggest oil producers. So trouble there could mean higher oil prices. Ouch again!

And if a couple of "emerging markets" experience financial crises, this could well have effects worldwide, cf. the crisis of 1997/98.

Grain Crisis?

2007-09-04T14:34:00.000+02:00

Recent world news on grain supplies is definitely not comforting. Planet Ark (Reuters) report that drought is once again hitting the Murray-Darling basin in Australia. This will probably mean another bad harvest, unless they get rain over the next few weeks.

As I have reported before, wheat and other grain prices on the world market have recently been rising considerably. This is due partly to bad harvests in many parts of the world, but a surging demand for grain to make ethanol for fuelling cars is one of the most important factors in these rising prices. The ever increasing population on this poor planet of course also increases demand for grain, as does the increasing affluence of some countries, such as China and India, which creates more demand for meat, thereby increasing demand for grain to feed the livestock. Global grain stocks are now at a 26-year low after several years of harvests not keeping up with demand.

As world market prices keep rising, we will probably see more big producer countries protecting their own interests, as they don't want to export so much grain that they don't have enough for their own people. Ukraine, the world’s sixth largest wheat exporter, has already introduced prohibitively high export tariffs. Now Russia also considers stopping wheat exports. This has led import-dependent countries such as India and Egypt to panic buy, leading to still higher wheat prices on the world market. What we will see soon might be some LIFDCs (Low-Income Food-Deficit Countries) totally priced out of the market. As I said the other day, Zimbabwe already seems to be there. This in turn would lead to severe economic stress on international aid organisations providing food relief.

What is currently just a spike in world market prices for grain might quickly turn into a disaster for some countries. Even not-so-poor countries that are dependent on imports might find themselves in a difficult situation. If there simply is no grain for sale on the world market, it doesn't matter how much you are willing to pay for it - you just cannot get any!

Zimbabwe Breaking Down

2007-09-03T15:25:00.000+02:00

Zimbabwe is in big trouble. They have just failed to raise money to pay for 36,000 tonnes of wheat, which is currently sitting in the harbour of Beira in Mozambique. Zimbabwe needs about 450,000 tonnes of wheat per year, but are currently producing less than 80,000. This is because of insufficient power available for irrigation. Agricultural production has fallen sharply over the last decade. Besides, Zimbabwe lacks foreign currency to pay for diesel and petrol needed for power generation, tractors, etc.

The prospects for this country are bleak. Just take a look at the following figures:

Official inflation rate currently at more than 7600%. This means that what cost $1 a year ago now costs $77!
Unemployment rate of 80%.
More than 40% of the population have HIV/AIDS.
Life expectancy is 37 years for men, 34 years for women - lowest in the world.
25% of the population have fled abroad. Another 4% are displaced within the country.

The political mess is just getting worse, with human rights violations in every imaginable area. It's just a matter of time before the country disintegrates in riots and civil war, as I see it.
Someone said "Any society is just nine missed meals from anarchy". If no grain shipments reach Zimbabwe soon they will be there soon.

Shanghai Still Chugging Upwards

2007-08-21T13:33:00.001+02:00

The recent turmoil in the financial markets worldwide does not seem to have hit the Chinese. The Shanghai Composite index keeps on rising and is now at 4955, which is a gain of nearly 400% over the last two years. Has the world ever seen a more obvious stock market bubble? There was a bit of a scare in February, when everybody thought the Shanghai stock market would crash and drag the world along with it. Since then it has gone up by about 70% more! Even when global markets have plunged over the last few weeks, the Shanghai stock market has kept on chugging along upwards, after a bit of a wobble in June and July.

When is this house of cards going to come down? Nobody knows - many analysts have been calling a top since the beginning of this year, but Shanghai keeps on ignoring these warnings. But when it does come down many Chinese investors (big and small) will learn the hard reality that stock markets can actually crash. What effects this eventual popping of the Chinese stock bubble will have is hard to predict, but be sure that they will be big in some way. The Chinese do everything in a big way - the Great Wall, the Three Gorges Dams, and so on.

Stocks over Time

2007-08-18T16:51:00.000+02:00

With the recent turbulence on the stock markets, many people are wondering if they should keep their money invested in stocks and mutual funds. The mainstream advisors all say something like "investing in stocks is always good in the long run". This has been true during the period 1982-2000. However, it has not been so for other time periods. Someone who invested $100 on the US stock market in 1929 did not get his money back until 25 years later, in 1954. If you invested in the stock market during the spring of 2000, you didn't get your money back until 7 years later, this summer of 2007. And what has inflation done to that money during those periods? Definitely not good investments I would say. Although the very long trend of the stock markets has been up from 1901 to 2007, there have been long periods where the long trend has been sideways or down. Adam Hamilton explains it well in his article Long Valuation Waves.

If you look at the Swedish stock market the long trend from 1950 to 2000 looks like it went more or less up all the time. Here is a graph of AFGX (Affärsvärldens generalindex) 1950-2006.
However, if you look at the graph adjusted for inflation, the picture is quite different.
As you can see, the Swedish stock market actually went down from 1965 to 1980, if you adjust it for inflation. Not until 1982 did it come back to the same level as 1965. This means that during this period of 17 years, stocks were not a good investment in the long run. As you can see we have also gone more or less sideways 2000-2006 too (first down and then up). I'm convinced we've now entered another 17-year period when stocks are not a good long-term investment. As Adam Hamilton says in his article, these bear market periods have historically been about 17 years long. The latest bull market of 18 years from 1982 to 2000 also fits in very well with these long cycles.

The problem now is that most people giving financial advice at banks and in the media don't remember these long waves, since most of them have started working after 1982.
They have read about these long bear markets, alright, but most of them seem to think we're living in a new age where these long waves don't exist any more. So far all expectations for a "new financial age" have been brutally hammered down, in 1929 as well as in 2000.

Harvests, Floods and Droughts

2007-08-14T21:55:00.000+02:00

News is just out that North Korea has been hit by floods with hundreds dead and widespread damage. Tens of thousands of hectares of farmland have been destroyed. This means a bad harvest this year for a country that already needs to import grain during good years. North Korea usually does not readily admit having problems, so the fact that they ask for help probably means the situation is really bad. Read more about it in IHT.

The floods that have hit two-thirds of Bangladesh for the last three weeks are now receding, but have destroyed nearly 133,000 tonnes of rice that was about to be harvested. Read more about it in Daily India. These floods have also hit nearby Bihar in India, damaging crops on more than 1 million hectares and destroying food grain stocks. Read more about it in Daily India.

On the bright side, it can be noted that Afghanistan has doubled its production of cereals in the six years since the Taliban regime fell, according to an article from FAO.

However, global stockpiles of wheat are at 30-year lows, and the price of wheat has climbed 34 percent this year. Maize (corn) and wheat are being used as feedstocks for ethanol plants both in Europe and USA, which has driven up the price of these grains. Other food crops have also increased in price, either because they are used to produce biodiesel, e.g. canola/rapeseed, or because higher prices for corn and wheat have made farmers sow more of these and less of other crops. The prices of meat and dairy products have also risen, because the animals are fed on grain. All this will of course lead to higher food prices, which will have a number of effects.

- Emergency food relief programs for places like Bangladesh, Bihar and North Korea will cost more, leading to tight budgets for aid organisations.

- Higher food prices mean higher inflation. "Core" inflation in the USA excludes both food and energy, but this inflation measure is a scam - who can survive without food and energy? Look at the real price inflation figures instead.

- Higher food prices lead to consumers having less money left to buy other stuff. Good for mother nature, because less consumption means less resources used up. Bad for our consumer-driven economy.

The current trends of more grain converted into ethanol and harvest problems in many places in the world are likely to continue, sending food prices still higher. Add an ever-increasing world population and things are starting to look pretty grim.

Now one of the easiest things the world could do to improve the current food situation would be to stop the whole grain to ethanol business. I doubt whether the grain to ethanol industry would actually survive if it were not for government subsidies.

Additionally, it is doubtful that converting grain to ethanol actually produces any net energy gain to speak of. To produce the ethanol you need a lot of energy. Diesel to run the tractors, natural gas to produce fertilisers, more diesel for transports, etc. An important concept for all fuels is EROEI (Energy Return On Energy Invested), i.e. how much energy you need to put in to get your fuel. For crude oil EROEI is very high, about 10 to 1 for good fields. This means that you need to use the energy equivalent of one barrel of oil for every ten barrels produced. This energy is used for drilling, transports, etc. There are a number of studies of the EROEI of grain to ethanol, and they all show an EROEI close to 1. This means that you actually have to input nearly as much energy as you get out of the whole process. Some studies show an EROEI of 1.2, which means that the ethanol only contains 20% more energy than all the inputs. Is it really worth all the adverse side effects of rising food prices to get that measly extra energy? Other studies (e.g. by Patzek and Pimentel) even show that grain to ethanol has an EROEI below 1, which means you actually loose energy in the process!

In any case, even if it turns out grain ethanol has an EROEI greater than 1, we would need so much farmland to grow enough grain to feed all our cars that there simply isn't that much farmland!

So, please, could all governments stop their subsidies to the grain to ethanol business now.

And Europe?

2007-08-13T23:36:00.000+02:00

It seems that U.S. financial institutions have managed to export some of their worst tranches of subprime loans to Europe. This can be seen from the size of the interventions by the central banks. On Thursday last week the European Central Bank had to inject €95 billion in liquidity into the markets (about $130 billion), whereas the U.S. FED only had to inject $24 billion. We still don't know the whole map of who sits on what bad credit, but it will be revealed eventually.

It is now obvious that the subprime mortgage mess is not "contained" in any way, and is definitely not contained within the country of origin, the U.S.A.

There has been a lot of news lately about U.S. housing and mortgages, but I expect all this to turn up in Europe too. Housing prices have been rising like a bubble here too, and many people are up to their ears in mortgages, and have no margins in their economy. Inspired by Robert Shiller's graph of inflation-adjusted U.S. home prices, I compiled one for home prices in Sweden. Unfortunately I could not easily find data before 1975, but here it is:
I've taken the FPI (Fastighetsprisindex småhus) divided by KPI (Consumer Price Index) and multiplied it by 1000 just to get some nice round numbers (figures from SCB). You can see that the prices have gone up and down in waves more or less like the U.S. prices from 1975 to 2000. Then, just like in the U.S. since 2000 they have risen above any previous tops, though the bubble is not as big as in the U.S. The situation is similar in most other western European countries - worse in some (notably UK and Spain), maybe better in others.

Now that lending standards have suddenly tightened up, I expect housing prices to fall in Europe too, and soon we will have our own version of the subprime mess. All major Swedish banks have said last week that their exposure to U.S. subprime mortgages is minimal, which I believe. What they do not mention is their exposure to the Swedish mortage market, which could quickly turn sour.

We definitely haven't seen the last fallout from the global tightening of credit. There are lots of pockets of bad credit all around the globe and in all kinds of markets, just waiting to pop up.

Credit Derivative Woes

2007-08-12T18:50:00.000+02:00

My first Flute Thoughts are on what's currently happening in the financial markets, though I'll go into other subjects later. This article is a summary of stuff I've written on various forums over the last few days. I'll try to include links to pages explaining any difficult terms I'm using.

Last week was eventful in the financial markets, to say the least. Read about it in Financial Times for example.

As I see it it's just a matter of time before we get the next bad news that will sink the markets. A hedge fund or bank will come out and say that they have big problems. Maybe already tomorrow, Monday? Or Tuesday?

Though we might see a short rally up in the stock markets until the next bad news comes out.

The liquidity injections into the markets by the central banks on Thursday and Friday probably averted a number of acute liquidity squeezes and gave banks and and funds a chance to get out of their most catastrophic positions. The biggest injections were by the ECB (€95 billion on Thursday, €61 billion on Friday) and the U.S. FED ($24 billion on Thursday, $38 billion on Friday). The ECB action was the largest one ever. Some really important institutions (e.g. major banks) must be in big trouble. To quote Erik Nielsen, the chief European economist at Goldman Sachs: "Someone must have called them and said 'we need liquidity now,' They did what a central bank is supposed to do."

These liquidity injections are extreme measures, that the central banks only take in extreme situations. These actions have a number of effects. First of all they save the banks from sudden unexpected liquidity crunches, which could very well topple them. Public faith in the banking system is vital, without it our current economic system won't work. Secondly it temporarily stabilises the markets, and might also imbue some optimism. But it also signals "danger", since it is an extreme measure, and many investors become scared and sell off their equities. In the long run, of course, it might lead to other side effects, such as more imbalances in the financial system. Anyway, these emergency actions by the central banks might mean that we won't get a fast financial crash, but rather a slow scenario.

However, I see some serious problems building up:

1. "Hedge Fund" has suddenly become synonymous to "toxic waste" and many investors will withdraw their funds from anything that smells of hedge funds. Since the hedge funds work with high leverage, often borrowing 5-10 times their capital, or even more, this means that they must sell off a lot to redeem those who wish to get out. Selloffs = markets down. Besides, certain financial instruments cannot currently be sold, since nobody wants to buy them, so they'll have to sell more liquid instruments, such as stocks or commodities (oil, metals, etc). If enough investors try to withdraw from a hedge fund, it could go bust, leading to more panic among investors. There's already a Hedge Fund Implode-o-meter to report on hedge funds that have hit the wall. The French bank BNP Paribas stated quite clearly what the problem was when they suspended three of their hedge funds last week: "The complete evaporation of liquidity in certain market segments of the U.S. securitisation market has made it impossible to value certain assets fairly regardless of their quality or credit rating,".

2. What's happening in the credit default swap (CDS) markets? These have not been mentioned much yet, with most of the focus being on the U.S. subprime mortgage markets. Mike Shedlock wrote a good article about a month ago which mentions the CDS problem - "Who's Holding the Bag". The global market for CDSs is mindbogglingly huge. As of 2006-12-31, there were $34 trillion in CDSs outstanding globally. For comparison, the total world GDP was $48 trillion in 2006. Now that the global credit markets are drying up investors and funds will start reviewing their positions on the CDS markets too. It's already doubtful whether many issuers of CDSs can live up to their promises. Besides CDSs were never very liquid instruments to begin with, and even less now. This could lead to a crisis where further liquidity injections by central banks won't be of much avail. Note that the CDS market has grown explosively over the last few years - in December 2003 there were only $3.6 trillion in outstanding CDSs.

3. So far only a few hedge funds of a few billion dollars each and one smaller bank (German IKB) have gone belly up, and also a large number of subprime lenders (see the Mortgage Lender Implode-o-meter). The markets can handle this, but what happens if a larger bank hits the wall? There will be an unprecedented domino effect, considering the fact that most major banks and insurance companies in the world are interconnected by various loans and other contracts. Besides, there are probably lots of credit default swaps connected to banks, see #2 above.

4. Another issue connected to lending is that over the last few years there have been many loans issued to companies with bad credit ratings, so called junk bonds, and to rather low interest rates, since credit spreads have been so narrow. These are the company equivalent of subprime mortgages, and not much has been written about them yet. But there will be bad news soon here too, rest assured. Many funds and banks are now probably trying to get rid of these loans and their derivatives, e.g. collateralized debt obligations (CDO) and other funny abbreviations. This before the searchlight starts illuminating this part of the credit markets.
During the last few years, the percentage of company bankrupts has been low in the world (including the USA) because it was easy and cheap to get a loan. Now when credit spreads are increasing and credit is drying up we will instead see bankrupts increasing to above their historic averages. Especially since there is a "backlog" of companies with problems that have been saved by the easy credit of the last few years. This, of course, will be a long process, since all badly run companies don't run into problems at once, but rather gradually. Then remember that many of these junk bonds are "insured" through credit default swaps (see #2 above).

Number 1 is probably already happening. Number 2 can happen any time. We might have to wait a couple of weeks or months for number 3, or even a year. Number 4 will probably evolve slowly over the next year, gradually replacing the subprime mortgage crisis as a major concern for the financial markets.