Peak Oil With a Dash of Politics

We were not planning on doing this post today but after a few conversation that I have had with people that consider themselves informed I thought that it would not hurt.

Oil is in the headlines again as both West Texas and Brent crude have been consistently over $100 for a while now. Of course this isn’t the whole story as we are also in an election year. The price at the pump matters more than normal around elections as voters like to blame or praise whoever is in power for any and everything that is going on.

This is a good time for a disclaimer-Some people might call me right of the right wing when it comes to personal views and voting. When it comes to trading politics absolutely need to be put aside. I take a pragmatic view of things and never confuse politics with policy.

Getting back to oil we keep hearing that when Obama came into office prices at the pump were so low. Well that is a half truth. As you can see in the chart below the price of Crude is in fact higher than when Obama took office.(Click on chart to enlarge)

What we never see however is what oil was doing before Obama took office. If we pull up a 10-Year of crude we can see that not only was oil at its cycle lows when Obama came in but it had just dropped from its all time high of $150 a barrel. Oh and do you remember why oil dropped like a rock? There is a thing called demand destruction. It tends to happen when the globe loses about a third of its wealth inside of a year. Since then we have had a recovery, even if it has not been as robust as we would like, the central banks of the world have pumped in trillions of dollars into the global economy, the Middle East has been in its “Arab Spring” for over a year, and we still have no long term energy policy.(Click on chart to enlarge)

No energy policy? Hah Obama must be doing this to us. If he had that much power then unemployment would be at zero. Fortunately the President while the most powerful man in the world is not that powerful. Until the office of the Presidency includes some grand wizard of alchemy he, no matter which party he is in, will have that power. Obama is responsible for higher prices only to the extent that he like his predecessors have failed to formulate any type of long term energy policy. Just like the developed worlds central banks and their debt can, we keep kicking the energy can down the road as well. T Boone Pickens is not lying when he says that every President since Nixon has declared that we will be energy independent and then has proceeded to do nothing.

So while there are definitely several shorter term issues driving oil such as the problems in Iran and current supply issues to both coasts, the biggest issue is that long term supply is not as strong as we once thought it to be. Most of the world has always thought that Saudi Arabia would always be able to boost production in times of crisis. Well as we saw when Libya had their revolution Saudi Arabia either does not have, or just doesn’t want to use, any spare supply. That fear coupled with more immediate issues is what is keeping oil above $100 and what will likely keep it above $80 for a long time if not forever. What’s that you say? Saudi Arabia can never run out of oil you say? In the chart below we present Middle East oil as a percentage of total global production. As you can see their share of production has not moved since the late-eighties.(Click on chart to enlarge)

What about the rest of the world? Brazil and Russia have a lot of oil don’t they? Well to certain extent they do but that does not mean they have enough to supply the world or to make up for missing supply in times of war or crisis. Here is a chart of global oil production along with the average annual price of crude oil. As you can see during the entire rise in price, production levels were not able to rise to keep prices in line, or to further enrich whatever country has this huge hidden supply of oil the world seems to be banking on.(Click on chart to enlarge)

Getting back to the United States can’t we just drill our way out of this mess? If we got rid of Obama we could drill everywhere and then we would have all the oil we would ever need. As much as some pundits would want you to believe that the truth is that our oil production peaked back in 1970. If in 40 years we have not been able to find enough oil to keep up with our demand then good luck finding all of this supposed oil today. Yes, there is untapped oil but do you really think that it will be enough? Peak oil people could be wrong and we could find Ghawar 2.0 in your backyard?(Click on chart to enlarge)

Oh but what about offshore production? Can’t we just go drill of the coast of California? They have already tried that and while they definitely did
find some oil and some is not currently being pumped there was nothing to lead oil experts to think that there were any mega-wells out there. While on the subject what was happening to offshore oil drilling before the BP spill? Yes, as you can see in the chart below even before the spill oil production was dropping like its hot for almost five years. Not only that but that is coming off levels not surpasses since 1995, an entire 15 years earlier.(Click on chart to enlarge)

So while Solyndra is obviously not the solution to anything, except how to lose taxpayer money, the President can not just wave a wand and have oil start seeping from the ground. Global peak oil is as real as United States peak oil. We are not working towards a long term solution which means that every time anything happens in the Middle East, Russia,
or even Brazil the price of oil will rise. Because of global energy uncertainty oil probably has a long term floor in the $80 area.

What can we do to change this? Well some items that would fit into an energy policy would be natural gas, rail, solar, etc. But until we admit that oil doesn’t grow on trees we will continue to revisit the spot where we now stand and it will happen more often and probably with more force each time. In our work and model portfolio we have a bias towards being long of energy as the long term risk reward is definitely slanted to the upside.

Happy Trading,

Disclaimer-In our model portfolio we are long OIL, XOP, and short some refiners.

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More Bad News For China

Not only did China stall out in mid-2009 but it has now surpassed the lows set in mid-2010.

Shanghai Index

One of many indicators pointing to more troubles ahead, the port data out of LA and Long Beach is showing that trade has been slowing down for some time. Usually traffic peaks in August-October but this year we hit a high in May that we were not able to break.

LA and Long Beach Port Traffic

The bottom line is that Europe may be getting all of the headlines but China has been slowing, is still slowing, and looks as if it will continue to slow. With Europe and China basically in recession how much longer can the United States hold out?

Happy Trading,

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And the Slowdown-Crash Continues

Right now we think it highly likely that going forward we see an increase in the rate of economic deterioration. Europe is already in a mess but the economy in the United States is now showing signs of its last gasp of growth. One indicator that we track is the Citi Economic Surprise Index. In the chart below you can see that economic numbers have been coming in very strong for the past few months. Based upon previous history it is safe to say that we have peaked or are very near peaking and that economic numbers going forward should start to turn lower.

Citi Economic Surprise Index USD and G-10

Not only are economic numbers expected to turn lower but we are also seeing several signs that inflation is dropping. One relationship that we follow closely is that of the CRB Raw Industrials Index against the SP500. As you can see in the chart below the two are usually very correlated. When the industrials are moving higher stocks usually follow and when they turn down stocks tend to do the same. Right now there is a disconnect, one that we expect to be resolved with the SP500 moving lower.

CRB Raw Industrials Index and SP500

This relationship matters because if inflation moves lower the stock market will as well. We can see this very clearly in the next chart where we have overlaid the weekly SP500 with the 10-Yr TIPS breakeven rate. As you can see these have a very tight relationship. What you can’t see is that this relationship goes back long before the crisis. When inflation expectations rise the stock market rises and when they fall the market falls.

SP500 and 10-Yr Breakeven Rate

Other signs that inflation is not upon are that government bond yields are hovering around historic lows. As you can see in the next chart the 2-Year Treasury yield has been low and headed lower. Despite all the hype regarding hyperinflation we have not seen any of it, and based upon the messages from the bond market we are not seeing it anytime soon. In case you are wondering we are seeing the same thing farther out on the curve with 10 and 30 year yields also near their lows.

2-Yr US Treasury Yield

Another sign that we have been following is this chart of the Shanghai composite and the CRB index. As you can see the two indexes peaked within two weeks of each other and have been steadily working their way lower for the past eight months. As the nation of commodity stockpiling has slowed down so have their stockpiles. As this huge underlying commodity bid has vanished it has allowed industrial commodities to drop.

Shanghai Composite and CRB Index

Whether it becomes an all out crash, ala 2008, or not is not known but we are confident that the global slowdown will continue. So what have we done with this view? In our model portfolio we are short the AUD/USD as we expect the Australian Dollar to move lower as commodity prices and Asian demand continues to falter. We are short the EUR/USD via options in a trade we placed back in August. Recently we bought the USD/CHF as we expect the Swiss Franc to weaken considerably from here. We are also short the SP500 via options and long the Lehman/Barclays Aggregate index which is highly weighted with US Treasuries and investment grade credits.

Happy Trading,

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As Goes China….

While the crisis in Europe and the slowdown in the United States seems to get all of the attention lately, the other big story is of course China. China has been a leading indicator for global markets for some time now and as you can see in the chart, and hopefully have noticed for some time now, they peaked over a year ago. We are seeing the same signs in raw materials such as copper and oil just as we are seeing them in everything but US Dollars and US Treasuries. Until we see a firming up in either the US, Europe, or emerging markets most notably China we won’t be seeing a lasting rebound in global equity markets.

Shanghai Stock Exchange and SP500

Happy Trading,

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Not A Holy Grail But A Very Useful Tool

Many new traders spend a lot of time looking for the holy grail of trading. The secret Gann angle, the right wave count, the perfect valuation model, etc. What we have found is that while a lot of new and even old traders spend countless hours searching for the holy grail very few, if any, successful traders have found it. Instead they figure out at some time or another that instead of a magical tool they should spend their time looking for useful tools that do a reasonable job of either lowering risk, increasing return, or increasing their hit rate.

One tool that we have found useful in looking out towards the future is that of the ECRI Weekly Leading Index. While by no means a holy grail it has historically done a fairly good job at forecasting stock market returns. As you can see in the chart below it has been very accurate over the past few years as it has led the SP500 by several months at important turning points. (Click on chart to enlarge)

SP500 Year Over Year % Change and ECRI WLI Growth Rate

So what is the WLI saying right now? Going along with our long held deflation thesis the WLI is now pointing towards slower growth in both the economy and particularly in the so-called “risk markets”. This of course matches what we are seeing in several other indicators and relationships that we follow. We have covered a few indicators in previous posts such as how junk spreads point to higher unemployment claims and how the PMI is pointing towards slower growth. In addition to these we are seeing many other signs such as the drop in commodities, take a look at the CRB Raw Materials Index, and in the rise of the US Dollar. Of course none of these are holy grails, just signposts in the fog.

Happy Trading,

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