by Kevin Klombies, Senior Analyst

Thursday, January 31, 2008

Chart Presentation: Out of Gas

At the very least the markets aren’t boring these days. We might wish for something a bit less interesting, however. From the post-Fed rate cut rally to the decline in electronic trading after the close the S&P 500 Index futures traced out a 50-point swing representing close to a 4% change- intraday- in the value of large cap U.S. equities. Certainly anything but a humdrum session.

We show oil refiner Valero (VLO) and the ratio between crude oil and gasoline futures prices below.

The oil/gasoline ratio tends to trade in wide swings between roughly .27 up to .41. At the upper end of the range oil prices are ‘high’ relative to refined products prices while at the lower end oil prices are ‘low’ relative to refined products.

The point is that refiners use crude oil a feedstock to produce gasoline so when the ratio is ‘high’- as it is at present- the profit margins of the refiners get squeezed. This explains why the two charts are virtual mirror images of each other.

About a year ago the ratio was also ‘high’ but it resolved lower into the Memorial Day holiday (the start of the summer driving season) through rapidly rising gasoline futures prices. The ratio can decline either through strength in refined products or conversely through weakness in crude oil prices.

The chart at bottom right compares crude oil futures with the stock price of oil driller and service company Schlumberger (SLB).

SLB has recently returned to the 75 level which, when last hit, was consistent with crude oil futures prices closer to the low to mid-60’s.

Our point is that crude oil prices north of 85 but south of 100 appear to be negative for just about everything. There is not enough rising oil price momentum to drive the energy sector higher and certainly not enough downside momentum to unleash the non-energy sectors. Either crude oil prices have to decline by a substantial margin to widen the refining spreads and ease the pressures off of sectors like the autos and airlines or… the energy complex led by gasoline futures will have to swing powerfully higher. Our preference, of course, is for lower crude oil prices with a break below 86- 87 on the way back towards the low 60’s.




Equity/Bond Markets

The chart below shows the ratio between the stock price of Merrill Lynch (MER) and the CRB Index.

From 1999 into 2008 the ratio has held in between two extremes. The peaks for the financials relative to commodity prices were reached at the start of 2001 and then again at the start of 2007 while the bottoms were hit at the lows for the S&P 500 Index in the autumn of 2002 and spring of 2003.

The point is that all things being equal- and they are seldom are but we can always hope- the major U.S. banks and brokers are now at levels consistent with a bottom given current commodity prices. The odd thing is that decline in the ratio over the past 12 months has equalled the damage done during the entire equity bear market from 2000 through 2002. Put another way relative to general commodity prices the financials were as ‘high’ one year ago as they were at the bull market peak in 2000 and are now as ‘low’ as they were at the absolute bottoms for the S&P 500 Index in 2002 and 2003.

Below are two comparative charts of Merck (MRK), Coca Cola (KO), and Wal Mart (WMT). One chart runs from 1993 into 1999 while the other chart below starts in early 2004.

The pharma stocks- Merck, Schering Plough, Bristol Myers, etc.- have been bludgeoned this year and while we try to remain as neutral as a Swiss banker when it comes to individual names if this continues it is going to do real damage to one of our theses. Our argument was that MRK and KO turned higher back in 2005 similar to start of the rising trend in 1994 that preceded the upturn for WMT in 1997 once oil prices had peaked. Ideally MRK and KO were supposed to hold above their 200-day e.m.a. lines during corrections but similar to 1997 when the Hang Seng ‘crashed’ we see MRK now below support.