by Kevin Klombies, Senior Analyst

Thursday, October 25, 2007

Chart Presentation: Crude Thoughts

The Energy Department reported yesterday thatcrude oilsupplies declined by a rather surprising 5.29 million barrels and in response oil prices rallied back towards $88. Perhaps we are naive but to us this makes little in the way of sense. The reason inventories declined was because oil imports fell by roughly 1 million barrels per day from the week previous. With crude oil futuresprices in rather serious backwardation it makes perfect sense to use current inventories- currently 5% above the 5-year average- in lieu of purchasing and importing additional oil. Our point is that U.S. demand did not rise by 5 million barrels compared to the week previous and global supply was not reduced by that amount. If imports were reduced then we imagine that inventories somewhere else rose by an equivalent amount.

In any event at right we show the CRB Index and the sum of short and long-term U.S. Treasury yields (3-month yields plus 10-year yields). The charts have been shifted or offset by 2- years.

The argument is that commodity prices follow thebond marketby two years so that falling yields from the end of 2000 into early 2004 led to risingcommodity pricesfrom 2002 into early 2006. This is a perspective that we have shown on many occasions over the years.

The point was that rising yields from 2004 into 2006- 2007 should lead to a negative trend for commodity prices from 2006 into at least the middle of 2008 and very likely well into 2009.

With the CRB Index still below the peak set in the spring of last year the argument remains valid even though on most days it certainly feels as if we remain mired within a rampagingcommodity bull market.

From the spring of 2006 into January of this year the commodity trend was clearly negative but for most of this year prices have been recovering as the dollar has declined. At bottom right we show the ratio of heating oil(energy prices) and the U.S. Dollar Index (DXY) to make the case that the strong commodity/weak dollar theme has gone directly with the deteriorating trend in the financial sector.

The peak forstocks like Bear Stearns (BSC) was made in January at the very lows for energy prices and now more than nine months later the markets are shocked by the size of Merrill Lynch’s $8.4 billion loan write down on the same day that it is shocked the by the size of the decline in oil inventories. The link between downward pressure on thefinancials and upward pressure on energy prices remains rather stubbornly intact.




Equity/Bond Markets

The chart below shows Japan’s Nikkei 225 Index and theJapanese yenfutures from 1987 into 1992.

We read daily comparisons between the equity markets in China today and those of Japan during 1989. Some view the strength in the Chinese markets as the early stages of a long-term trend similar, we imagine, to the initial rise in thestock pricesof companies like Microsoft, Research in Motion, or even Starbucks. Others are convinced that when a Chinese bank’s market cap exceeds that of General Electric that this is more like the end of cycle action generally attributed to the internet bubble through 1999. Both sides make compelling arguments but from an intermarket point of view we will suggest that all of this has much to do with the FOREX markets.

One would think that Japan’s bubble market during 1988 and 1989 would have attracted or fed off of massive capital in flows but the opposite was true. The bubble actually began when the yen reached a peak at the end of 1987 and ended even as the yen was making new lows. By late 1991 the Nikkei had returned to its late-1987 levels and the yen had also swung back to its original starting point.

TheNASDAQ and British pound futures are shown below right. The NASDAQ began to lift in 1998 as theEuropean currenciesturned lower and peaked around the time the British pound was working at a bottom in late 2000. In both cases shown the entire equity market bubble was mirrored by an offset decline in a major currency.

Our point is that the offset to rising Chineseshare prices(we use Hong Kong for our example below) is the weak U.S. dollar. The trend began in late 2005 is now already close to 2 years old. Two years as a time frame is interesting because that is almost exactly the length of the bubble from start to peak for the Nikkei (January 1988 to January 1990) and the NASDAQ (October 1998 to October 2000).