Wednesday, May 18, 2011

JP Morgan's Landon Lowdown: The Real Driver Of Oil Prices

This post was stuck in my Draft for days.. not sure why.

I like his ideas and today's commentary was interesting. 
"Crude prices increasing just because of currency debasement" doesn't really tell the whole story, but behind that...

In my head it makes a lot of sense that a lot of the growth seen in developed economies in the past 2 decades was fueled by more than just population growth and increase in productivity. 

Some of it was fueled by increase in debt, therefore monetary base expansion. 

Debt = money printing somehow. 
Increasing the currency in circulation = SUPPLY. 
Demand for the currency stable means the value of it should go down.

It thrills me to think that supply-and-demand rules all the pricing mechanism. Sometimes SxD imbalances occur, but in the long run, say 5-10 year cycles, things get back in place.

And it scares me to think someday increases in productivity will get closer and closer to physical limits. You can't watch a movie in a miniature 1cm x 1cm TV screen. You can't fit 1 million people in a 1-bed-room house, etc.

from Ken Landon, J.P.Morgan Strategy, NY (May 12, 2011)

* CHINA - The PBOC once again hiked the reserve requirement (RR) by 50 bps. As of May 18th, the RR will hit a record high of 21%.

* OIL - The Senate Finance Committee will hold "hearings" today about oil and gas prices. The target is the oil industry. Executives from the five biggest oil companies will sit before the committee and will no doubt be berated for high gas prices and high profits.
* CHINA - The 50 bps hike in the RR to 21% is having the expected effect in financial markets: equities and commodities accelerated to the downside. This makes sense because in the current "risk off" environment, a supposed "tightening" of monetary policy in a major country should undermine the confidence of short-term traders.

As I've been pointing out since the PBOC started hiking the RR in January 2010, such moves by the central bank are not associated with down-trending risk markets. If anything, and as the attached chart CHINA_RR.gif indicates, China's RR and risk markets are *positively* correlated. In this case, Asian Equities ex-Japan, Industrial Metals, and AUD/USD usually trend higher when China is in the process of hiking its RR. The reason for the high positive correlation is that China hikes the RR precisely when the economy is strong and cuts when the economy is weak. A strong economy is good for risk assets and a weak economy is bad.  Investors should not rear an increase in the RR, but the exact opposite.

Will the increase in RR help contain inflation?  Absoultely not! Recently the Lowdown explained that the key for Chinese inflation is China's currency policy. China's monetary base is highly correlated with the level of FX reserves. The more China intervenes in the FX market by selling CNY against the USD, the more liquidity it creates. That is why inflation is ramping higher in China. Hikes in the RR, 1-year Depo Rate, and administrative measures (i.e., price controls) will not stop the inflation created by the generation of excess liquidity.

* OIL - They're at it again. Politicians are always looking for someone to blame for something that they themselves have more control over. In this case, the Senate is holding hearings for the purpose of gaining political points in its desire to impose additional taxes on oil companies. Somehow, the Senate believes that the American public will not make the connection that if you increase taxes on something, then you will get less of it. Profitability and incentives go down because the after-tax rate of return is diminished.

In any case, the premise of the Senate "hearings" is that oil companies (and, by extension, speculators) are responsible for the increase in oil and gas prices. Nothing could be further from the truth. The main driver of the price of oil is the real value of the dollar itself. I prefer to use the price of gold to measure the real value of the dollar. Since the dollar began its decade-long downtrend in Feb 2002, the price of brent crude oil has risen from approximately $21 in Feb 2002 to the current level of $111. Over that same time period, gold has risen from around $297 to the current level of $1485. In other words, oil is 5.29 times its level of Feb 2002 and gold is up 5 times. (As an aside, why isn't Congress holding "hearings" about the high price of gold?)

The Gold/Oil ratio, which measures the real value of oil, is barely changed since 2002. As attached chart GOLD_OIL.gif shows, the current Gold/Oil Ratio of 13.3 is nearly equal to the ratio of 14 back in February 2002, which was the month before the peak of the USD.

The similar magnitude in nominal price gains in gold and oil indicate that it is a reduction in the real value of the money issued by the US government (i.e., the dollar) that has caused a systemic increase in nominal prices. Another way of saying this is that if gold were now trading at $297 as it did in Feb 2002, then the current price of oil likely would be in the range of $20-$25.

(For readers needing more context about why we can use gold to measure the real value of things, please see the attached two reports, one of which I produced in March 2007 -- GOLD_MAR07.pdf and the other issued by an academician -- GOLD_STOREVALUE.pdf.)

Politicians, who ultimately control monetary and currency policy, should look at the official policy mix as the cause of the sharp increase in commodities prices over the past ten years. It is currency debasement during a period of war and an increase in the welfare state (i.e., guns & butter) that has caused commodities prices to trend higher. The same happened in the late-1960s and early-1970s, which led to the break down of Bretton Woods and the subsequent surge in commodities prices. Blaming the participants in the oil market for the price rise is spurious.

Instead of looking for WHO is responsible for rising oil prices, politicians should investigate WHAT is responsible. They would find that it is the monetary and currency policies of the US government that is the main cause of the surge in commodities.

Because politicians choose to ignore these facts, I assume that they will continue with their current policies -- the very same policies that have been responsible for the increase in commodities prices. I therefore remain bullish toward commodities and view these panic price declines as buying opportunities.

"Whenever a maximum of price has been affixed to grain [price controls], it has immediately been withdrawn or concealed. The next step was to compel the farmers to bring their grain to market, and prohibit the private sales. These violations of property, with all their usual accompaniments of inquisitorial search, personal violence, and injustice, have never afforded any considerable resource to the government employing them. In polity as well as morality, the grand secret is, not to constrain the actions, but to awaken the inclinations of mankind. Markets are not to be supplied by the terror of the bayonet or the saber."  Economist Jean-Baptiste Say, 1803

Kenneth Landon, May 12, 2011

*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. theintriguedtrader AT gmail do com

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