by Kevin Klombies, Senior Analyst

Wednesday, February 13, 2008

Chart Presentation: Energy Spreads

Feb. 11 (Bloomberg) — Crude oil rose to a one-month high after Valero Energy Corp. shut its Delaware refinery because of a storm-related power failure yesterday and cold weather moved across the northern U.S.

Feb. 12 (Bloomberg) — Royal Dutch Shell Plc’s Scotford refinery in Alberta is running at reduced rates, prompting a shortage of refined products in some parts of western Canada.

It almost feels like deja vu all over again as we start the year with a series of planned or unplanned maintenance shut downs for refineries. We suspect that this has quite a bit to do with the fact that crude oil prices are extremely high relative to refined products prices as was the case early in 2007.

The crude oil/gasoline ratio tends to range from around .41 down to .27. In other words when crude oil is trading around 93 gasoline prices would be ‘low’ anywhere close to 2.27 and ‘high’ in the vicinity of 3.44. On the other hand with gasoline futures trading at 2.36 crude oil prices are at an upper extreme close to 96 and a lower extreme around 64.

The crude oil/gasoline ratio can decline in one of two ways. First, gasoline prices can rise and second, crude oil prices can decline. A third option would be rising gasoline prices and falling crude oil prices but… typically crude oil, heating oil, and gasoline trend in the same direction.

At the start of 2007 the crude oil/gasoline ratio was ‘high’ which led to a never ending series of refinery shut downs which convinced the markets that perhaps there might not be enough gasoline to meet the demands of the summer driving season which officially kicked off with the U.S. Memorial Day weekend in May. The chart at top right shows that from January into late May the trend for gasoline prices was relentlessly stronger even though, to the best of our knowledge, the threat of a shortage was more threat than shortage.

With the ratio ‘high’ once again the refiners are responding about as one might expect. Our thought is that this could still go either way as less refining means reduced demands for crude oil but either way we expect the ratio to have fallen significantly by late in the second quarter of this year and our argument is and has been that it will do so through lower crude oil prices instead of higher gasoline prices which will, in turn, help ease the burden currently being shouldered by the beleaguered Wal Mart shoppers.



Equity/Bond Markets

The U.S. dollar was somewhat weaker yesterday but the chart at right shows that the dollar has done little more than trend sideways since November of last year.

The chart compares the U.S. Dollar Index (DXY) futures with the Asia ex-Japan etf (EPP).

Our view is that the dollar is inherently a weak currency even as the Japanese yen is basically a strong currency because the U.S. runs a chronic trade deficit while Japan runs a trade surplus. The kicker, however, is the direction of capital flows so when excessive amounts of money are moving away from Japan the yen will weaken and when capital inflows in the U.S. are reduced the dollar will also tend to decline.

The point, however, is that capital was most definitely flowing away from the U.S. towards ‘hotter’ sectors like Asia (ex-Japan) and Latin America. However, as soon as capital stopped pouring out of the dollar into foreign markets the game came to a rather abrupt end. The chart shows that the flat dollar from November into February went with a 25% decline in the EPP. Obviously new lows for the DXY would support the argument for higher Asian equity prices while the DXY resolving back up through 78- 79 would support our basic U.S. and Japan/large cap/growth scenario.

For good or for bad we return to one of the arguments that we have been making for the past several months. The idea begins with the chart below from 1999- 2000 of the ratio between the stock price of the Bank of Montreal (BMO) and the Nasdaq Comp.

The last major cyclical trend came to an end in March of 2000 with the bottom for the BMO/Nasdaq ratio. With the trend heavily focused on ‘tech’ money was draining away from the financials resident in commodity producing regions (like Canada). The recent trend has been focused on ‘commodities’ so money has been moving away from the financials of commodity-using regions (like Japan). The end of the current trend should be marked by a bottom in the ratio between Japan’s Mitsubishi UFJ (MTU) and gold prices (GLD).