by Kevin Klombies, Senior Analyst

Friday, September 14, 2007

Chart Presentation: The SPR

The chart showscrude oil futuresfrom April into September back in 2000. We have included to this to make a point about the difference between psychology and fundamentals.

In April of 2000 crude oil priceswere trading around 24- 26 but by September prices had increased by close to 50%. Around September 21st it was reported that President Clinton was considering tapping the Strategic Petroleum Reserve (SPR) to dampen the impact of rising heating oil prices going into the winter. The plan was denounced by everyone from Treasury Secretary Lawrence Summers to Alan Greenspan and the American Petroleum Institute also came out against the proposal and stated that the SPR’s purpose was to address supply disruptions and should never be used to manipulate prices.

Presidential candidate George Bush, as one might expect, criticized the plan and called it an election year political ploy which, we imagine, it undoubtedly was.

Experts, as they always do, offered a variety of opinions but most seemed to agree that the problem was not a lack of crude oilbut a lack of refining capacity so adding supply would be of no help. Others suggested that this would lead to an escalation of oil prices although we have to admit that we have trouble following that logic.

We have observed on occasion in the past that most (if not all) of the significant trend changes for oil prices have gone with a policy changes with regard to the SPR. We argued, for example, that the mid-January lows for crude oil this year occurred just days ahead of the State of the Union address when George Bush announced his intention to double the size of the reserve.

So let’s take a step backwards and see what happened after September, 2000. Strangely enough the unassailable fundamentals pushing crude oil prices higher and the well known fact that adding oil supplies to a market short on refining capacity seems to have worked as oil prices declined by 50% over the following year. Of course the U.S. economy was also slowing but, we will argue, this is likely not that much different than today. Did the fundamentals change in 2000 or did the proposal only serve to break the psychology of the futures market? Was it a master stroke of timing, a lucky but ill intentioned bit of politics, or simply something that happens in September during cycle peaks?



Equity/Bond Markets

The dominant theme within the markets since the end of the Asian crisis in 1998 has been relative strength by energy prices. Tech and telecom have had their day, of course, but through close to the last nine years the enduring theme has been energy. The chart at right shows that the ratio of the DJ AIG Commodity Index to crude oil prices has declined steadily over this time period to the detriment of the autos and the benefit of the commodity currencies.

We tend to believe that the markets moves in cycles instead of everlasting trends so one day- perhaps in our lifetimes- the trend will change. When it does we imagine that the autos will begin to long march back towards respectability as they manufacture and sell energy efficient vehicles and move out from underneath the crushing pressure of their legacy burdens.

The chart at bottom right compares Valero (VLO), Caterpillar (CAT), AMR, and the sum of two U.S. home builders (DR Horton and Hovnanian). HOV announced an auto-like series ofrebates for new houses yesterday.

The argument that we have made on a number of occasions is that last year the bottom and subsequent upward pivot for the home builders and airlines occurred when CAT and VLO sank below their respective 200-day e.m.a. lines. At present CAT is sitting on right on its line while VLO has been on the bounce as crude oil prices have pushed to 80.

The chart compares Genentech (DNA) with the ratio between the oils (XOI) and airlines (XAL).

DNA turned nicely higher recently only to run right into resistance at the moving averageline. Notice how DNA crossed down through this line last spring as the oils/airlines ratio pushed up through its line.

The argument is that if DNA isn’t leading the turn then it is going to struggle at present levels until we finally get some break in the relentless upward grind by the oils. Not on the same day, perhaps, but in general both should move back through their moving average lines at roughly the same point in time.