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Archive for the ‘Commodities’ Category

*Reference to the ‘Dollar Smile’ theory (explained by Macro Man, coined by Morgan Stanley):

One possible explanation is an emerging school of thought that a US recession/quasi-recession is actually good for the dollar. According to the proponents of this theory, weak/negative US growth is both damaging to the rest of the world and a catalyst to encourage US investors to bring money back home. The upshot is that there is less demand for foreign assets/currencies and more demand for US assets/currency; hence, the dollar rallies.

By gauging the sentiment of news flow in the past week, the answer to the question of continued strength in the Dollar would seem to be no. First, a little history:

The dollar picked up steam back in December once the thesis that the world economy could “decouple” from the woes of the US fell apart — it became clear that the BRIC economies are less equipped to deal with fallout from the credit crisis, and are more likely to default on their own debts. As stated above, this led investors to unwind their investments in emerging markets, and bring them back into US cash (a more liquid asset). Since stocks were tanking, coupled with the Federal Reserve’s  intent to suppress interest rates with its various liquidity programs (TARP, TALF), many investors sought safety and bought US bonds — to at least yield some sort of return while on the sidelines. Since March 9th (the recent bottom in equities), there has been a departure from risk aversion, and more investors have sought the same risk they did last summer in commodities and emerging markets.

here’s a chart of the MSCI Brazil index (a basket of stocks which is representative of Brazil’s economy):

EWZ

Here’s how the 10-year note has performed in the same time:

10 Note

Yields have gone up (which means people are selling) while emerging markets are simultaneously attracting new capital. The dollar has also weakened – although slightly – which raises the question of a weaker dollar going forward with rising inflation expectations. Tony Crescenzi has stated that the dollar may slowly relinquish the status of being the world’s leading currency, as the dollar is now 63% of the world’s reserve assets (compared to 70% back in 2002). However when considering alternatives (particularly China) he says:

China’s renminbi is ascending but not suitable for parking the world’s reserve assets because there is no bond market there. Moreover, the renminbi is not yet widely used for commerce and in contracts.

Well, Tony may have spoken too soon.

From the Financial Times:

Brazil and China will work towards using their own currencies in trade transactions rather than the US dollar, according to Brazil’s central bank and aides to Luiz Inácio Lula da Silva, Brazil’s president.

An official at Brazil’s central bank stressed that talks were at an early stage. He also said that what was under discussion was not a currency swap of the kind China recently agreed with Argentina and which the US had agreed with several countries, including Brazil.

“Currency swaps are not necessarily trade related,” the official said. “The funds can be drawn down for any use. What we are talking about now is Brazil paying for Chinese goods with reals and China paying for Brazilian goods with renminbi.” (Emphasis Added)

FT Brazil Exports China 5-19

The scale of the agreement wouldn’t be enough to dramatically affect the FX markets, but it could if this idea appeals to other foreign countries. Brazil has discussed selling 10 and 30 year bonds in International markets this year, which would add to the currency’s liquidity…which satisfies another trait of a desirable currency.

As many of the world’s economies embrace foreign investment (Malaysia’s FX market is currently closed to outsiders, for example), and as our domestic economy releverages money from this period of zero interest, the dollar may wear a frown sooner than expected.

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After a move from $40 to $50, it looked like oil may have bottomed. We now stand at $38, even after production cuts from OPEC.

Oil extended yesterday’s 8.1 percent decline after OPEC agreed the group’s 11 members with quotas will trim current production by 2.46 million barrels a day to 24.845 million barrels a day. U.S. fuel consumption in November declined 7.4 percent from a year earlier to the lowest for the month since 1998, the American Petroleum Institute said yesterday.

The media describes this as “traders thinking the cuts won’t be enough to eliminate a supply glut.” I don’t necessarily agree with that since it isn’t plausible to say that cutting aggregate output from 87.5 million barrels a day to 81.5 wouldn’t affect the price…there lies the issue. It’s not that the action won’t be enough to boost prices, its that OPEC can’t afford to/doesn’t have the discipline to cut output that drastically since they are having a credit crisis of their own, and oil is the only thing the middle east exports (How else will they finance all of these underground malls?)

Anyway, if you believe oil will sustain these lower price levels for the immediate future, there is no explanation for oil related companies to sustain the rallys they had when oil seemed to have bottomed at $40. The drillers (Schlumberger, Transocean, Haliburton) are still depressed, but the conglomerate companies like Exxon and Chevron are quite high.

xom-cvx-uso1

“USO” is an ETF which tracks the price of crude, “XOM” is Exxon, and “CVX” is Chevron (a company which does the same thing as Exxon). Notice that during the sell off in October, both of these companies dropped at faster rates than crude oil. We see the divergence since then,  however during the sell off in November, we saw the same behavior as the October sell off – the oil companies falling harder than oil itself. Given this increasingly large gap in the past month, I don’t think it’s unreasonable to conclude that Exxon and Chevron will be hit rather hard during the next sell off in the new year.

Therefore if you think this rally will end in January, consider buying “DUG” a 200% short ETF which targets oil companies like Chevron and Exxon, or “EEV” which shorts the MSCI emerging markets index. Emerging market economies rely heavily on oil prices, however the Obama infrastructure plan ignited a rally amongst the Iron-ore companies (iron-ore is the chief ingredient in making steel), which caused this ETF to go down substantially.

Or if you don’t like financials either, there is “SDS” which is the inverse of the S&P 500. Since the S&P is a weighted-average index, moves in Exxon and Chevron (in addition to financials) typically dictate how the S&P will close (since they have the most weight from their share price multiplied by outstanding shares – or market caps).

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As a follow up to my prior post, here’s an interesting chart (courtesy of Fitch Ratings) from Paul Kedrosky’s Infectious Greed:

be-oilprices_2Interesting stuff. I never realized the variance in costs of oil extraction – notice Bahrain is currently underwater for every barrel they sell..

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Crude Oil = $57

(Click for updated quote)

(Click for updated quote)

For the near term, the positive effects of low oil on the economy cannot be overemphasized; with lower costs of gasoline and heating oil, the American consumer has more money to spend on other things. When looking a little deeper and further out, we may see a slightly different story:

From the Financial Times:

The International Energy Agency, or the developed world’s energy watchdog, warned that cuts and delays in investments prompted by the fall in oil prices and the credit crunch were putting the world ”on a bad path”.

Fatih Birol, the IEA’s chief economist, said: ”We hear almost every day about a project being postponed. This is a major problem.”

The IEA suggested current oil prices are too low to guarantee the necessary investment, noting that the cost of the marginal barrel from Canada’s tar sands was about $80 a barrel, more than $20 higher than today’s oil price.

Basically, there is no incentive for private investment in alternative fuel sources when they would cost $20 more than the “equilibrium” market price of oil. The article goes on to point out that our current oil wells are yielding diminishing returns on output, and the newly discovered fields are very difficult to get to – the Tupi and Jupiter fields outside of Brazil, for example, have been the biggest discoveries in over 40 years. The problem is that they lie 3,000 and 5,000 yards respectively below the surface of the Atlantic Ocean (which as one might imagine, is very costly to drill and retrieve) and will not be economically viable with oil trading at anything below $85-$90 a barrel.

There lies the Catch22; Should this move in oil prices be sustained, can we rely on a new administration, one which used the expansion of alternative energy (one component of “change”) as a key selling point for landing in office, to actually follow through when it won’t make economic sense in the near future? Regardless of the answer, I don’t think it should be a reflection of Obama’s character – A LOT has changed since he started campaigning back in late 2006, and the likelihood of effective legislation comes into greater question when coupled with the fact that the depth and cost of the credit crisis is currently unknown.

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I have to first congratulate my old economics professor for nailing the root of the dollar’s weakness in a prior post:

The US economy, rightly, faltered first – With no fiscal policy upon which to draw, Bernanke got it all with not even a blindfold to keep him company. Rates were slashed, time and again. Meanwhile, the UK, Europe and any number of other economies were (i) not faltering, yet, but as importantly (ii) more concerned with inflation which, while still measured dodgily and with political expedience in mind, is nevertheless still measured more accurately, and taken more seriously, everywhere better than in or by the US…Thus my argument. The US dollar is not appreciating in value because it is normalising upward: it is appreciating because the rest of us are normalising downwards.

That was written before the Fannie & Freddie bailout (he doesn’t live in the US, which is why he speaks from a European perspective). If he had an adjusting entry, it may have added an analysis not unlike mine:

1) Suddenly, the prospects of serious inflation are back; this time, not driven by expensive commodities, but by high rates of growth in the money supply…Think of the market for the dollar like a stock: the value of the dollar is driven by factors of supply and demand. However, what happens when a company holds another stock offering…Using Merrill Lynch as an example, they dilute their shares and make each share in the company worth less than before. Adding more dollars into the economy would effectively be the same as a company diluting their share base. When there is more of something, it does not have the same purchasing power/value as before.

The unprecedented $25 rise in oil today is pegged directly to the weakness of the dollar…hmm.

Doesn’t this seem a little strange? Today officially marks the first week of the SEC’s action to ban the short selling of virtually every financial institution, and we see a flood of money going back into the commodity realm. One explanation is the most sensible investment was eliminated (shorting financials), so the market was left to find somewhere else to invest.

  • Retail has already had a run out of its element as a play against falling oil, so that’s out.
  • Technology is the first expense businesses will cut in bad times, so that doesn’t work either.
  • Autos and Airlines? Ha
  • Financials? Well they just rallied 20% in two days, and now they’re selling off.
  • Commodities? Of course. Oil has fallen 35%, and the dollar will be weaker than we thought, in a United States with a $1.1 trillion budget deficit.

This is when the “Free market” guys look really smart; the government came in, made an enormous intervention, enforced new regulations which limit our flexibility, and ultimately caused more problems (at least for now).

I think the only good way to look at the ban, is it provided Morgan Stanley and Goldman Sachs time to become holding banks. Now that they have a deposit base (the FED, and any commercial bank they choose to acquire), their business structure is no longer flawed, and bearish investors will have a much harder time justifying shorting these guys to oblivion.

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August 13th:

I’ll be starting class again soon, so I’m not sure how much blogging I’ll do going forward (barring anything fun to write about).

This will be one of my last posts before school, and I think this is a good time to write what I’ve been feeling about the markets for a while.

Well, the Olympics have begun and oil is down 22% from its all time high. (The timing of my prediction was right, but my reasoning was incorrect…I guess its better to be lucky than good)

As one would expect, this was welcomed with open arms (the consumer may be saved from demand destruction, the Fed can keep rates at 2%). The rotation out of all things pertaining to commodities (oil, agriculture, metals) have provided an interesting situation: there is now nowhere left to hide, and there is nothing which is untouchable from the downward trend of the broader market. In other words, there are no bullish “momentum” stocks to park your money in, as all of those have gone into free fall at one point or another, and have since stabilized at a lower price. At the same time however, because of the fall in oil, there have been some unfounded gains in certain places (chiefly anything financial), until today!

If you notice from the chart, financials have sort of, drifted higher recently. The rally which occurred after the bottom on July 15th was sustained because of the simultaneous drop in oil…The only thing is that, some day oil will also stop falling, and will stabilize. Many say that will happen at $110/barrel. I think that is a sound prediction, but believe that it can be around $85-$95 through the winter. Winter is 4 months away though, and once oil stabilizes, the hot money has to go somewhere. More importantly, there won’t be anything fueling the rally in financial services, because they are still in horrendous shape.

Finally, the prediction….

I think the saying “markets do not repeat themselves, but they rhyme.” applies to our current situation. In case you have repressed this information (I did, until today) the last sell off in financials was sparked by none other than a series of downgrades…on Tuesday, we had another round of downgrades and cuts in earnings estimates (Goldman, JP Morgan, Morgan Stanley).

While we do not have as negative a catalyst such as rising oil prices, we do have, what I believe to be a drying pipeline for good news now that commodities have dropped big. This also means that Financials are in the spotlight because they can no longer share the blame of a bad environment with high oil prices. TO TOP IT OFF, a more severe catalyst for financial services can emerge, and that is the deterioration of banks like JP Morgan, which have been virtually unscathed…until Tuesday. If they were believed to be the fortress from this whole mess, and they come out in bad shape through 2009 (which was picked up by their press release, hence the biggest drop in 6 years) we can see a serious sell off.

Finally, by now we must know that the news of Merrill Lynch selling their CDO’s was a bad sign, not good, and John Thain might go down as one of the worst CEO’s in finance history because of it. Not only did he sell the pre-2006/2007 CDO’s – which represent the better quality basket simply because debt from that time frame is more likely to get paid back – but the good CDO’s within that tranche were undoubtedly cherry-picked by the guys who bought them. (Honestly: if you were spending billions of dollars on such a toxic investment, wouldn’t you make sure you got the best ones?)

The inevitable realization of losses in Level-3 assets/off balance sheet assets, coupled with instability amongst the bulge bracket banks, will result in another sell off, and another bottom (no one can really say if it will be worse than the last one, and I surely won’t begin to speculate)

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I didn’t want to write anything, because I was afraid of jinxing the drop in crude:

chart

To cover myself In defense of this happening tomorrow or next week, I’ll have to site Jim Cramer, (by doing that, I’m definitely marking the end of this pull back) He says a typical bear market rally lasts 3 days, and if the inverse relationship between equities and oil continues, then I won’t be off the hook (I don’t know where he got that number, but then again I don’t know how he concluded that natural gas should track oil at a pricing ratio of 1:6…maybe by historical averages?).

The interesting thing about looking at oil futures further out into the winter, is that the slope of the prices is still slightly upward (as I write this, its $129.50 a barrel, and is around $135 for March) …that seems pretty rudimentary, but the way I interpret that information is that the market views this development in crude as a mere pullback, and only that.

One must say though, the fundamentals for $145 oil have to be starting to come into question…I think since it is still the “summer driving season” (as if people use less oil in the winter…who heats their house anyway?) we could expect another testing of $150 before a more sustained correction.

On a related note, a colleague of mine had actually heard about the theory that Oil should come back after the Olympics are over, supposedly because the Chinese have been hoarding oil in preparation for all of this activity (the mindset being that they didn’t want to look stupid by having an energy crisis in the middle of their renaissance)…naturally the hoarding should stop when they no longer need to do so.

On an unrelated note, I saw Mike Bloomberg at the Billy Joel concert last night…he was surrounded by security guards, but I think I saw him signing an autograph…He looks exactly the same as he does on TV.

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