Saturday, December 13, 2008

Giving inflation a chance

All I am saying is…let's give inflation a chance.
(with apologies to the late John Lennon)

OK, so I was wrong about the $100 oil before $150 but $200 before $50 forecast. The commodity markets have been clobbered by this global economic crisis. The World Bank’s latest forecast for commodities is “real food prices are expected to fall by 26 percent between 2008 and 2010, oil prices by 25 percent, and metals prices by 32 percent.” With the news that China’s exports are falling, the Baltic Dry Index in freefall and down over 90% from its peak this year and other signs that the global growth is plummeting, is there any hope for oil and other commodities?

Amidst the devastation, there are numerous signs based on technical, sentiment, macroeconomic and fundamental analysis that the commodity super cycle is not over. There are enough positive indications for me to give the long-term commodity bull the benefit of the doubt. In this post, I focus mainly on oil because of space considerations, as this post is already too long. However, much of my analysis can be extended to other commodities.

Technical underpinnings of the commodity bull
The chart below shows the relative returns of the Amex Oil Index (XOI) compared to the S&P 500. The sector broke out of a multi-decade base in 2005. Given the length of the base, the sector is nowhere near its upside target and it’s likely that this is just a correction within a long-term bull phase.

The chart also shows that the relative uptrend is intact. The uptrend line as indicated by line A is still arguably in force despite the minor trend violation. Additionally, the relative return line could even decline to the uptrend as marked by line B and the bull trend could still be intact.

Sentiment is washed out
As well, excessive bearish sentiment is in evidence for the CRB Index, which is contrarian bullish. When the likes of Macro Man writes little ditties about commodities are a joke and invites his readers to contribute to the theme, you know that that investor sentiment is getting washed out in the asset class.

Blowing another bubble by turning on the printing press
I have already written about the fiscal and monetary authorities stand ready to rescue the world economy. With world trade seizing up because of frozen credit markets, any normalization of conditions should start to facilitate world trade flows again.

It seems the Powers That Be believe the solution to today’s problem is to blow another bubble. There are, indeed, 50 ways to beat deflation. It seems that every other day we hear about new proposals of fiscal stimulus around the world. A recent FT article questions whether governments can actually pay for the rescue:

As governments around the world plan to issue hundreds of billions of dollars worth of bonds in the next year, bankers are questioning whether they will be able to meet their funding needs. "Governments are already running into problems, which does not bode well so early after the recapitalizations and extra funding needs have been announced," said Roger Brown, global head of rates research at UBS. "We do have to ask whether there will be enough investors to buy the bonds, or at the very least over whether this will push yields substantially higher to attract them."
With the likes of China Investment refusing to put any more money into foreign financials, it seems unlikely that the rescue can be financed by anything other than central bank printing presses. Helicopter Ben has indicated in a speech that he has more ammo and will use virtually any means to fight deflation. That seems to be as clear a signal from any central bank that it stands ready to monetize debt issued by the Treasury. With core CPI headed down over the next few quarters, I think that there is a consensus among central bankers that there is room for the implementation of extraordinary measures to avoid another Great Depression.

On the other hand, fiscal and monetary authorities have also shown themselves to be backward looking when looking at measures of inflation. While Keynesian economic prescriptions call for the stimulus to be withdrawn once signs appear that the recovery is in place, it will be difficult as many of the measures will become institutionalized and acquire political constituencies. No doubt that we will have to pay the piper for this wall of paper money pouring into the system in 2010 and beyond.

This downturn hasn’t corrected all imbalances
Usually, economic downturns are supposed to correct the excesses from the prior cycle. Remember all those “imbalances” that analysts like Stephen Roach used to write about? They still exist.

I would have thought that with this crisis, the world would shift away from the US consumer being the main engine of growth. Countries like China would move away from her focus on export oriented policies. Other economies around the globe would become the locomotive for world growth. That way the world could proceed with a more balanced growth path.


Bretton Woods 2 is still alive. The USD hasn’t collapsed but strengthened, arguably for technical reasons relating to demand for greenbacks. Nevertheless, the consensus seems to be that the way to rescue the world’s economy is to revive the US consumer.

This recovery path suggests that the adjustment in the next cycle is a fall in the US Dollar, which is commodity bullish.

Remember Peak Oil?
Remember the thesis that the world is reaching the Malthusian limits of oil production, otherwise known as Peak Oil? The latest IEA Outlook forecasts that we will not see peak oil production until 2030. However, there are some important caveats to their forecast [emphasis mine]:

The projected increase in global oil output hinges on adequate and timely investment. Some 64 mb/d of additional gross capacity — the equivalent of almost six times that of Saudi Arabia today — needs to be brought on stream between 2007 and 2030.
There are some other brave assumptions on how supply evolves:

Modern renewable technologies grow most rapidly, overtaking gas to become the second-largest source of electricity, behind coal, soon after 2010…

Ultimately recoverable conventional oil resources, which include initial proven and probable reserves from discovered fields, reserves growth and oil that has yet to be found, are estimated at 3.5 trillion barrels.

The supply response will put a floor on oil prices
A lot of IEA’s projected supply increase is based on the assumption of massive energy infrastructure investment. How likely is that in the current environment with oil prices in the $40s? Might some production capacity even get shut down in the current climate? Estimates today for the Gulf States indicate that breakeven oil price is between $40 and $70 for current production. Saudi Arabia is the lowest at between $40 and $50. For the more expensive projects such as the Alberta tar sands, we are already seeing a supply response as large energy companies like Shell and Statoil have announced curtailment of new capacity addition. Promising discoveries such as the ones in offshore Brazil will no doubt face similar problems.

With the reduced and curtailed investment in the production pipeline, what does that mean for the demand-supply picture? The IEA indicates that [emphasis mine]:

We estimate that the average production-weighted observed decline rate worldwide is currently 6.7% for fields that have passed their production peak. In our Reference Scenario, this rate increases to 8.6% in 2030.
At $40 to $50 oil, there aren't going to be a lot of supply additions. What happens when current production falls 6.7% a year? Does nominal world growth falls 6.7% a year to match? Already, we are seeing a demand response as US gasoline demand recovers.

Isn’t all this bullish for oil prices over the medium term?

Europe is already worried about gas supplies
Europeans already recognize the supply threat. A recent article in the UK’s Guardian states [emphasis mine]:

Russia's four major energy companies – Gazprom, LUKoil, Rosneft, and TNK-BP – depend heavily on debt to finance operations, and are scaling down their investments. They have already been forced to seek an allocation of more credit to refinance their external debts. But with Russia now facing a $150bn shortfall in its spending plans for 2009 and where Russian markets have lost 70% of their value in just six months since May, it is all too likely they will be forced to slash their investments further.

The consequences of this for the EU and the UK are very serious. Since the EU gets 40% of its gas from Russia, where 70% of the gas fields are already in decline, any further major cutting-back in future oil and gas investments could act as a pincer on EU and UK energy supply. Indeed, the Russian energy industry has warned that if the decline continues, Russia may not be able to service even its own domestic gas needs by 2010 – this from a country where Gazprom is the largest extractor of gas in the world.
There is already the threat of government nationalization in Russia. Should that happen, Russia's energy industry will become less efficient as government owned entities tend to optimize for revenues, current cash flow and for employment, not profitability. This would further serve to further constrain supply additions in the future.

Investment implications: Too early to buy aggressively
What does that mean for investors? One of the first things I learned about technical analysis is that resource stocks are late cycle plays (where interest-rate sensitive names are early cycle). Despite the long-term bullish case on commodities, it is probably too early to be buying aggressively in these sectors.

The commodity stocks have corrected but they need some time to base before launching a new bull leg. I would expect that resource sectors to be volatile and trade sideways for the next year or so. As an example, the point and figure chart of the Energy Select Sector SPDR (XLE) below shows that the sector has trying to bottom at these levels. It has broken out of a downtrend and is undergoing a sideways consolidation pattern.

Better opportunities lie elsewhere for now, including a bet at the appropriate time on the Phoenix effect. I would wait for the certainty of a market and economic recovery before seriously overweighting the hard asset plays. The time to do that is probably the late 2009 or 2010 timeframe.

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