Mark Tinker: Blame the chatter merchants for the Chinese whispers that sent the oil markets spinning

News from Norway to Iraq has fuelled a climate of nervousness, while Hurricane Ivan led to genuine disruption

The insatiable demands from the 24-hour financial media mean that every event needs a fundamental explanation. In effect, markets are trading "noise" rather than fundamentals. A noise trader, of course, doesn't much care if the facts are correct, so long as the person the other side of the trade does. In such markets the facts become "true" regardless. So far, so harmless. It becomes dangerous, however, when the fundamentals invented to suit the noise become accepted as facts, and people try to invest on this basis. This is where bubbles build.

The insatiable demands from the 24-hour financial media mean that every event needs a fundamental explanation. In effect, markets are trading "noise" rather than fundamentals. A noise trader, of course, doesn't much care if the facts are correct, so long as the person the other side of the trade does. In such markets the facts become "true" regardless. So far, so harmless. It becomes dangerous, however, when the fundamentals invented to suit the noise become accepted as facts, and people try to invest on this basis. This is where bubbles build.

This happens when the noise traders stimulate trend traders, who need to move prices further than noise traders and so shout louder in the bid to find the bigger fool. The more people hear the fact, the less they feel able to challenge it. The game ends when the fact changes. Despite not being the real reason the market went up, it becomes the reason it goes down.

The latest example of this looks to be the oil market and demand from China, where the dramatic changes in the economy have certainly led to rapid increases in demand for coal, steel, copper, aluminium and oil. There is undoubtedly a long-term bullish trend in most basic commodities, and oil is one of them, but China explains the move from $20 to $40, not the move to $55.

What makes us so sure of this? Well, if you look at the chart you can see the difference between the price of the Texas sweet low sulphur crude required by the US, and the Dubai sour that provides the majority of Chinese demand. Normally the gap is around $4; currently it is nearer $18. Whatever is driving the US benchmark, it doesn't look to be China. We can also look at the trade statistics and see that oil imports have been falling in recent months.

The issue is far more to do with short-term disruptions in the US - no refineries have been built in the US for 20 years. The near-vertical supply curve means that any perceived increase in demand or shortfall in supply immediately produces panic-buying - you have to keep refineries running all the time. The noise and news on disruptions from Norway to Iraq have fuelled a climate of nervousness among refiners while Hurricane Ivan has provided genuine disruption.

This has been further exaggerated by environmental issues - the move to low-sulphur fuels in the US has imposed changes on refineries by year end, increasing disruption. Similarly, the banning of single-hulled tankers has put a capacity bottleneck on the ability to shift crude - the Baltic dirty shipping index (in effect, oil tanker rates) doubled in October.

Opec (an extremely unlikely source) called last week for the US to release stocks from its Strategic Petroleum Reserve (SPR). In so far as the SPR exists to prevent disruptions to the oil price from short-term disruptions to supply, the factors we outline above could justify a release. I wrote about the SPR back in the summer, highlighting its possible role at the margin in countering excess speculation. In fact, the US government has already lent some five million barrels from reserves to help companies hit by Hurricane Ivan, but the nature of bubbles is such that we need to change the "fact" - in this case, Chinese demand.

Last week we seemed to get it. The noise traders had a field day, with an increase in Chinese interest rates. Talk of a slowdown in China was the catalyst to knock oil below $50 - even though, remember that it wasn't actually Chinese demand that had driven it up in the first place. That's noise for you.

But it never stops. The supposed slowdown in China was picked up by other markets. Equity markets sold their "China stocks", meaning metals and mining stocks in particular, and commodities and commodity currencies also fell. Nobody thought to check if China was really slowing down. It was too noisy. Importantly, we don't think it is, and in fact the increase in interest rates in China was part of a wider move that may ultimately lead to more rather than less growth, and better balanced growth at that.

The key fact is that through its exchange-rate peg, China effectively has its cost of capital set by Alan Greenspan, not the People's Bank of China. The whole point of the peg is to allow China to attract and recycle foreign direct investment in order to build its infrastructure rather than fall victim to the hot-money flows that traditionally destabilise emerging markets.

Last week's interest rate move was aimed at the domestic banks, who with large deposits and lots of competition would otherwise lend too much at the wrong price and in the wrong place. For the last year, in fact, the Chinese authorities have banned lending in many areas, not least because there simply isn't the power infrastructure in place to run all the new steel and car plants planned. What many people appear to have missed is that with this rise, the authorities also lifted the restrictions on the amount the banks could lend.

In other words, they are moving towards a more normal banking system. Then, and only then, will they remove the peg, although I suspect that the noise traders will be speculating on this next.

Mark Tinker is a director of Execution Stockbrokers Mark.Tinker@Executionlimited.com

Hamish McRae is away