With the price of oil hovering around $140 per barrel, the commodity boom can no longer be ignored.

The price of oil is one area where I have been consistently mistaken and dumbfounded over the years. When it first peaked to $60 back in 2005, I openly told friends that I thought it would fall within the year. I even went so far as to investigate options for betting against its continued rise.

Mistakes are human and, though humbling, they are also one of life's gifts because they give us the opportunity to learn.

In the case of oil, what I missed over the last 2 years was that contrary to my naïve intuition, which suggested that oil would be mean reverting like other asset classes, oil's rise is being driven by at least a belief that the supply and demand dynamics have fundamentally altered.

Whether pointing to the industrialization and modernization of China and India, the excess consumption of Americans, or the growing global population, commentators have many options for identifying the "root" of a world where oil is demanded at a greater rate than even a decade ago. At the same time, with a rising Russia, a hawkish Venezuela, and an unstable Middle East, supply has become less certain. Furthermore, doomsday "peak oil" theorists have continued to clamour that we have reached Hubbard's Peak and that as a result we will literally start running out of oil sometime soon.

One reason I have continued to expect oil to decline is that I believe that the economics of scarcity is dynamic and reactive. In other words, I believe that technological innovation can help make previously scarce resources either obsolete (through innovative replacement), less important (through efficiency) or more abundant than we previously believed (through exploration and discovery).

I continue to believe that these factors will help to address the supply-side constraints when we look at the world's oil markets. However, the perhaps accurate market's assessment of the current future demand growth as well as the market's perception of supply issues have combined with the technical dynamics of the financial markets to create the rapidly increasing price of oil we have witnessed over the last two years.

This rise has been exacerbated by the failure of other asset classes, as investors have – like good sheep – chased the positive returns offered by commodities as other previous staples like real estate and financial companies have proved to be unreliable sources of income.

All of this leads me to believe that the price of oil will come down at some point, but given the difficulty in predicting the various factors influencing its rise (including the irrational behavior of herds) it is very hard to say when.

Now is truly a moment where the Keynesian axiom – the market can stay irrational longer than you can stay solvent – is being put to the test.

Positive side effects like a concerted (albeit sometimes insincere) embrace of alternative fuel technologies, a consciousness of consumption, and an awareness of our dependence on other nations make this situation more bearable than it otherwise would be.

However, the rising ticket prices at the airports may make $2.00 increase in gasoline prices seem insignificant as they threaten to slow down the very globalization that has driven demand to the point where it is today…

But then again, perhaps this is Mr. Smith's invisible hand and scarcity rearing its head.

Time will tell. Until then, enjoy your moped.

Sent via BlackBerry from T-Mobile

As if a surprise, The WSJ reported yesterday that those who were worried about CDO ratings at Moody’s (and likely the other agencies) turned out to be correct, and if those with decision making authority had listened to their warnings some of the ongoing market turmoil could have been averted.

This is surely correct in hindsight, and judging from the many commentators who anticipated the cracks in the credit system, perhaps one should shake a finger at those responsible for ignoring such pleas.

At the same time, it is difficult to predict the future with any consistency, and if the current market volatility and conflicting headlines tell us anything it is that a lot of smart people disagree about the next step in the cycle from this point.

One highlight of this increased uncertainty (besides the stomach wrenching moves in the major indices last week) are the massive volume increases in the derivatives markets over the last quarter as reported by Bloomberg here: Exchange Traded Derivatives Rise 30% to $692 Trillion, BIS Says.

The notional value of over the counter credit derivatives has now approached $600 Trillion, a number I cannot comprehend, but as most of you know, this amount overstates the impact this market has on investors as what matters are the fluctuations in this exposure. This equates to a lot of smart money vigorously disagreeing with one another.

My own take is that with the price of oil and commodities continuing to move up as the dollar continues to buckle, it seems very difficult to posit a scenario where consumers are not squeezed to the breaking point under these and credit strains over the coming months. In plain English: it seems that the real people underlying this financial mess will likely continue to have hard times in the short term which isn’t a good sign for those who make money by selling and financing stuff to them.

My eyes remained focused on technology, efficiency and mobility as innovation points to lead us forward out of these tough times.

As I stood in line this afternoon, waiting to pick up a prescription at Walgreens, the person in front of me joked: “which address, I have so many” as the pharmacist sought to verify the nurse’s identity.

When it was my turn, I scanned the memory to guess which of my various “addresses” Walgreens would have in its system. I guessed right, and thankfully I only keep one phone number so I was set.

But the experience stood out to me not only because I have been bouncing from city to city lately having arrived in LA for my summer job Sunday, but also because I think this relative “homelessness” is becoming more common across our society (including among humble billionaires: The Homeless Billionaire).

As the Internet allows us to connect and become more mobile while retaining the productivity and communication we require, I would imagine that such home-mobility will continue to become more common.

Maybe Walgreens should start asking for websites or email addresses…maybe the idea of “home” will continue to be de-constructed and become defined more by those we care about and share our lives with, than by wherever we may physically be located.

Don’t worry, mom, your cooking will always mean home to me. And Texas will probably be the State…at least until my imagination completely takes over.

This is just plain shady if true: leveraged, leveraged buyouts?

From the sounds of this article Guy Hands Rejects Bank LBO Debt Offers, Sees Subprime Parallels it seems that banks are participating in a ridiculously sketchy-sounding practice: they appear to be bridging sales of bridge-loans that they can no longer sell to the same private equity firms to whom the loans were originally pledged.

In effect, they are loaning money to the same firms to whom the original loans were made.

This is analogous to a 2nd Mortgage Holder on a home loaning a home buyer money to buy the mortgage on their own house.

It is unclear from the article if the bridge^2 are coming from CLO's but if so, this is really 3 layers of leverage to consumate these transactions.

I am hoping the author either misunderstands or is mistaken about the financing for these deals, but given the last year's events, it is probably accurate. Especially when considering that all involved get paid fees based on a percentage of the total $ value of these transactions, there are issues beyond issues all wrapped up in a shady looking box here.

I am willing to bet that there is a group of radicals huddled up in a cave somewhere with half-eaten cans of beans muttering to one another “see…we were right!”.

According to them, the horrible earthquake in China today, the tragic storm in Burma, and the financial calamities on Wall Street are all part of the same massive scheme…

And they are right! Only the scheme is wrong.

One of the things I noticed today as news of the horrors surrounding the earthquake in China started hitting my Twitter-stream a few minutes after it happened is that it is pretty amazing how fast news travels nowadays. It is only recently with services like Twitter and blogging before it that we have started to utilize this sweet tool called the Internet to its fullest potential.

So, I think the crazy dudes watching the TV screen are witnessing something revolutionary, just they are like those in Plato’s cave watching shadows. You and I, reading these words together on these devices and sharing them with “strangers” half-way around the World – we are outside in the light making that revolution the great thing it is.

Now we need to figure out how to use it to help our friends in China, Burma and elsewhere. Then maybe we can even convince those dudes to get out of the cave.

I guess another way to stop the bleeding is just to stop valuing assets.

Merrill Says Level 3 Assets Jump 70% in First Quarter

Merrill Lynch & Co. said so-called Level 3 assets climbed 70 percent in the first quarter, as the largest U.S. brokerage reclassified commercial mortgages and other assets as hard to value.

Merrill’s Level 3 assets, the firm’s most difficult to value, rose to $82.4 billion as of March 28 from $48.6 billion at the end of December, according to a regulatory filing today. The New York-based company’s ratio of Level 3 to total assets rose to 8 percent from 5 percent.

As the article goes on to discuss, these so-called “level 3” assets have continued to spike across the street, including at places like GS, which is well known for having very large private equity interests – a major component of its’ level 3 exposure.

One should note that among the $82.4 billion at MER includes a 20% stake in Bloomberg – in other words it is not all toxic hard-to-hold paper.

Though enough of it probably is that I keep holding SKF as an insurance policy as there are surely some shoes plummeting from far above just waiting for an unsuspecting chart-following optimist.

But nevertheless I am keeping the positive hat on another day.

One might wonder how a rainy May afternoon in the midst of finals produces optimism, but somehow this afternoon, as I trudged through an overly-gloomy Cambridge afternoon, I felt another twinge of optimism start to bite.

It was surely not hindered when I turned down to my “device” a few moments later to see yet another optimistic headline from our good friend Mr. Buffett (Buffett Says Credit Crisis Ebbs for Wall Street Firms). However the causation was from another source, with this being yet another example of easy mistakes when like outcomes correlate in expected ways.

Instead, the source of this optimism arose from a somewhat unusual source; in the midst of a recent revisit to the existentialist angst of my undergraduate years over the last few weeks, I realized that one of the implications of the imperfect system of our financial markets is that one can err both on the downside and the upside. The same inability to predict the markets that caused quantitative hedge funds driven by the minds of brilliant PHD’s to crack creates the possibility for better than expected outcomes if we all band together in optimism.

Whether characterized in terms like: consumer confidence, irrational exuberance, or more simple ones like enjoying the weather; people’s perception of world events have very real impacts on how those events materialize in the world. One can see this in concrete terms in the area of quantum mechanics where our observations of subatomic particles literally impacts where they appear in the world. So if we can impact particles, why can’t we make waves in the financial markets?

I would argue that we can, and we will. Whether through the herds that almost submerged Lehman after Bear broke or the dot-com mania of people’s first introduction to the Internet, we have clearly observed that crowds move markets – both on the upside and the downside.

So although we will surely see way too many people lose their homes over the next year, and unfortunately we will also see friends and neighbors lose their jobs. Maybe we can reach out a helping hand to brush off our collective dirty knees…and get back to making this country the great place that it is. Because you never know, it might be sunny tomorrow, or it may rain.

Today’s announcement by Bank of America is the second in a series of recent rational decisions by private entities seeking to address some of the concerns that exist in the markets.

Bank of America to Modify Mortgages, Help Homeowners

Bank of America Corp., seeking approval of its Countrywide Financial Corp. takeover, said it will modify at least $40 billion in troubled mortgage loans over the next two years to keep customers in their homes. The move would help as many as 265,000 homeowners…

While clearly different in many ways than the industry-wide announcement of a privately orchestrated derivatives clearinghouse (discussed here), BofA is also pro-actively responding to the financial crisis facing millions of American homeowners that has had ripple effects across the globe.

A cynical perspective might suggest that these measures are simply an attempt to prevent direct intervention by regulators in a system in obvious need of repair, or perhaps they just want the merger to be approved.

However, if one considers that such a move is not only the right thing to do, but also economically-rational, then it appears more likely that this was purely an example of the free-market working. Private market participants are nimble and knowledgeable, and at least if we take BofA at their word, they sometimes do the right thing.

While helping 265,000 homeowners is not going to solve the foreclosure crisis we are facing, it is surely a step in the right direction. Now let’s hope they follow through.

Although this is unsurprising, it is now official that the housing slump is entering into record territory nation wide.

New-Home Sales Fall to Low Last Seen in 1990s

The NYTimes today said:

Buyers vanished from the housing market in March, as sales of new homes plummeted to the lowest level since the housing recession of the 1990s, the government said on Thursday.

Builders are now faced with the biggest backlog of unsold homes in more than a quarter century, a sign that home values may continue to drop.

One thing that the article does not mention is the growing amount of foreclosures that are continuing to squeeze homeowners, reduce the demand from future buyers and create an even greater amount of excess supply.

Lets hope innovation can pull us out of this mess.

On that note, I had an interesting, but random conversation with a researcher this evening who told me about the use of genetically modified bacteria to make biofuel.

Perhaps best known for food poisoning, E-coli, have apparently been modified by scientists to make biofuel.

I never thought I would be blogging about E-coli, or that if I was it would be good news, but sometimes life surprises you in unexpected ways:

Efficient Biofuel Made From Genetically Modified E. Coli Bacteria

Here’s hoping creators keep creating.

The WSJ has a great article today suggesting the benefits of a central clearinghouse for derivatives contracts that are currently traded over the counter.

Here is the article: Street Seeks Credit-Default Safety Net: Banks, Exchanges Speed Effort to Launch Clearinghouse to Back Derivatives Swaps

For those of you who have been reading this blog for awhile or have talked to me for more than 10 minutes about the credit crisis, you probably know that my biggest fear for the markets involves a doomsday scenario where a major institution fails, leaving a variety of counterparties holding CDS contracts without anyone on the other side (earlier post: The Fan).

It seems like one step towards averting such a potential disaster is to have more transparency in this very opaque market so that people can have a better idea about what risks their counterparties are taking.

According to the article:

More than a dozen firms including investment banks, brokerage firms and futures exchanges are accelerating efforts to create a clearing entity that would function as the middleman between firms on both sides of a credit-default swap. The clearinghouse would guarantee payment on the contracts it handles, reducing the risk of a catastrophic ripple effect if one or more firms were unable to make good on their trades.

While there are issues around continued innovation (e.g. the creation of new derivatives), standardization (e.g. which contracts would be used), and internationalization (e.g. people could potentially trade elsewhere), this concept sounds promising.

It is also an excellent example of the market offering a solution to a regulatory failure. Let’s just hope that the Fed keeps their hands off or at least encourages these sophisticated players as they develop this promising market-based solution.