Two Intriguing Contrarian Viewpoints

Many investors whose judgment and long-term performance I respect have been warning for a while that some kind of serious trauma eventually will be the price to pay for the excesses and complacency of recent years. But, as in “The Boy Who Cried Wolf,” their warnings have become progressively discredited as economies and financial markets brushed off successive crises. Under pressure from public opinion, the number of boys crying “wolf” has been melting like ice under the sun.

But, as Victor Hugo wrote in a pamphlet against Napoleon III, “If but one remains, I shall be that one”.

These views, expressed in my May 14 letter (“The Boys Who Cried Wolf”) have become distinctly less contrarian since the summer. Even my periodic references to the possibility of a recession have now found company, with Alan Greenspan and the president of Sallie Mae recently joining the list of worriers.

In my ongoing search for contrarian ideas, two recent articles have recently tickled my curiosity.

The first was an interview in Barron’s of Mike Rothman, the energy expert at ISI Group, who daringly foresees the possibility of $45 oil, down from a current price of around $80. In doing so amid all the talk about “peak oil” (the exhaustion of existing reserves) and the un-quenchable thirst for oil of China, India and other large, emerging economies, Mike represents a very lonely viewpoint. He does not really argue with the validity of others’ arguments, but points to a counter-intuitive decline, in recent quarters, in the global demand for oil. He traces back this decline to a combination of conservation, substitution (natural gas, coal, and even bio-fuels) and greater-than-anticipated production from outside OPEC – all of which he documents. Clearly, the advent of a recession in the United States, with unknown but not negligible effects on other economies, would increase the odds of such a scenario.

Why $45? Essentially because the rising prices of the last couple of years have caused significant, precautionary oil-stocking by corporations and countries. In addition, there seems to have been very substantial speculative buying by hedge funds and other trading entities, which have added a large but potentially volatile element of demand. Neither of these groups consumes oil, and both are likely to stop buying or even to start selling once it looks like rising oil prices no longer are a one-way bet.

Mike Rothman’s views are particularly attractive to me because I still remember the second oil crisis, following the fall of the Shah of Iran in 1979. Then, all the “experts”, who has pitifully failed to foresee the quadrupling of oil prices after the first oil shock, in 1973, were busy predicting $100 oil. Only Arnold Safer, a relatively less-known analyst had articulated a scenario where a combination of conservation, substitution and enhanced recovery from older reservoirs would cause the price of oil to decline.

As can be seen on the graph above, after peaking at $39.50 in July 1980, oil prices were almost cut in three over the following six years. Moreover, except for a brief spike in 1990, they did not significantly break above their 1980 peak until 2004 – almost a quarter of a century later!

I try not to over-rate historical parallels. But a lone, credible voice amid a crowd is always worth some attention.

The second article that caught my attention was by George Friedman, of Stratfor, a global intelligence service. Friedman argues that the recent forceful criticism of the European Central Bank (ECB) by French President Nicolas Sarkozy should not be dismissed lightly, which has been the attitude of most observers.

Sarkozy argues that the ECB refusal to lower interest rates and its related acceptance of a strong Euro are favoring Germany and frustrating his efforts (and his electoral mandate) to jump-start the French economy.

His plan is “to liberalize the French economy, and thus make it more dynamic. In order to achieve his goal, he needs lower interest rates to facilitate entrepreneurial activity as well as general business expansion -- and he needs a cheaper Euro to facilitate French exports.”

The problem is that Germany likes high interest rates because they encourage capital inflows by depositors and lenders – hence the strong Euro. It also is a large consumer of oil. Since oil contracts are dollar-denominated, the stronger the euro, the cheaper the oil. In addition, German exports, built around advanced capital goods, are less susceptible to currency fluctuations than are the more diversified French exports. Hence, the Germans are prepared to live with an increase in the price of their exports in return for an influx of foreign money and cheaper imports.

Friedman thinks Sarkozy has a point: “As complicated as the idea of a central bank is in a democracy, it is further complicated in Europe by the question of exactly which country the ECB is supposed to be serving. Europe is not a country, but a federation of sovereign nations that are said to have a single economy. But while Europe is highly integrated, any one country -- its people and its elected government -- may be interested in pursuing divergent economic policies.

A sovereign country has the right to craft its own social and economic policy. It has a central bank that is supposed to manage the currency -- particularly interest rates and liquidity -- on behalf of the country and in tandem with the broad social policies being pursued. The ECB serves multiple sovereign countries, many of which have divergent interests and desires and, therefore, need different monetary policies from the central bank. One size cannot fit all these sovereign countries.”

While not forecasting a breakdown of the European Union, Friedman takes Sarkozy’s words seriously enough to imply that there may be increasing talk of such an eventuality in coming months. This, if this happens, it would be enough to cast a shadow over the seemingly unstoppable Euro.

Fortunately, so to speak, recent statistics seem to point to a slowdown of the German economy, which might incite the ECB to pursue a more stimulating monetary policy. If, on top of that, Mike Rothman prediction of lower oil prices came to pass, it might further weaken the bank’s determination to keep fighting inflationary pressures and any decline of the Euro could be larger than is now envisioned by most observers.

The attractiveness of this scenario, whatever its odds, is that it is the opposite of what financial markets (and especially stock markets) are currently pricing in. It might therefore become a contrarian investor’s dream. But remember that a large source of funding for hedge funds, private equity and other speculative entities has been the oil-producing countries. With oil on the way to $45, this source of liquidity would likely dry up quickly.

François Sicart

Paris, October 3, 2007