Setting of the Rising Sun

Japan’s economic crisis has been slowly trudging down a dead end road since their economy collapsed in the early 90’s. Their insistence on maintaining public programs as status quo has been financed by selling government debt to domestic corporations and private citizens. This has cannibalized both private citizen and corporate savings. This tacit deal has allowed Japan to artificially keep interest rates low based on their captive pool of treasury purchasers. This process of spending more than the government is collecting on an annual basis, combined with sales of treasuries to finance the difference has left them ill prepared to handle this disaster at a time of global economic uncertainty.

While some economists are taking the stance that Japan’s rebuilding is just what they need to get their economy back on the right track, I think it’s quite possible that their economy may be too far gone to save. Furthermore, the scale of their disaster will place a huge burden on developed nations who will be called upon to assist them in the process. Many of these nations, including the United States, have no room for error in their own economic policies. The end result could be a localized natural disaster that triggers a global recession.

Professor Ken Rogoff of Harvard School of Public Policy Research wrote a book in 2009 describing the historical relationship between banking crises and sovereign default. His research states that the average historical tipping point is approximately 4.2 times debt to revenue. Once a country is spending 4.2 times more than it is collecting, default is on its way. John Hayman and Lawrence McDonald, cite individually, that Japan’s expenses outpace revenues by more than 20 times annually. Their debt to GDP ratio, their total assets and earnings minus total debts and liabilities, is around 200%. The third largest economy in the world spends 20 times more per year than it earns and owes twice as much as it’s worth. One note of caution, the United States ranks third in the debt to revenue ratio, behind Japan and Ireland and we owe as much as we’re worth. We will be double negative in 2011 if we don’t change substantially.

Debt will surely rise even further as Japan borrows to rebuild. Standard and Poor’s downgraded Japan’s credit rating to AA in January, prior to the disaster. Japan will have to move to the open market to finance their reconstruction. Their domestic lenders will be busy financing their own rebuilding processes. This will force Japan to pay open market rates for most of their new debt. Open market rates will be AT LEAST 100 basis points and most likely, closer to 200 basis points higher.  The interest payments would total more than 25% of the country’s revenue. Japanese credit default swaps will sky rocket.

The strain of rebuilding Japan will affect us whether we lend financial assistance or not (which we will). The demand of replacing 30% of Japan’s energy source will show up in the price of fossil fuels. Japan currently consumes 5.2% of the world’s oil supply. Replacement of lost energy will add another 1.3 million barrels per day plus the added oil necessary for the reconstruction. Their added demands equal Italy’s total consumption. Add this to the global uncertainty of North African fuel supplies and the added fuel that goes into fighting a third global conflict and we have questionable supplies coupled with increasing demand.

Rising oil prices couldn’t come at a worse time for our economy, which had been gaining some traction. GaveKal research published a chart in which rapidly rising oil prices are overlaid with economies growing more than 2% above their leading indicators, which we are. This has happened 5 times in the last 70 years. Four of the five led directly to recession. The fifth was in 2005 and was ameliorated by the credit and housing booms, which may have delayed the recession until 2007. Rising fuel costs act as a tax on the economy.  The latest housing numbers, the worst ever, blame much of it on high gas prices. Furthermore, while the unemployment rate is stabilizing, the length of time people are unemployed is at an all time high of 37 weeks. Finally, the stock market has returned to its upper 10%, in normalized valuations. Japan’s natural disaster could very well mean this is the zenith of our economic recovery.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Trading the Tsunami

The earthquake and tsunami in Japan are tragic and I don’t want to minimize the human devastation, loss and ongoing fear. However, it’s my job to try and explain how this has affected the markets and what I believe is yet to come. The markets’ initial reaction to outside shocks is based on its participants’ fear. The market sells off due to uncertainty. If you or I had direct investments in Japan, we would want to get out and convert to cash while we waited to see how things unfolded. It’s human nature to retreat to a defensive position when confronted with disaster, whether financial, physical or emotional. Japan’s stock market sold off 16% in two days.

The specifics of the disaster in Japan are tied to demand destruction. Japan imports nearly everything it needs to run. The disaster has massively cut imports. Petroleum products, food, manufacturing raw materials and more have slowed to a crawl. Australia is one of Japan’s primary import sources and Australia is an export driven economy.  As a result of this, the Australian Dollar declined nearly 3% immediately.

The other major component of demand destruction lies in Japan’s 30 years of dominance in the manufacturing sector. Japan no longer has the competitive advantage it once held in technology over the rest of Asia or, the labor advantage that it held over the United States. There is a great degree of uncertainty regarding which manufacturing facilities will be rebuilt and which will simply be relocated elsewhere in the world. Japan has lost a large share of its competitive advantages.

The massive mobilization involved in the rescue efforts combined with the destruction of Japan’s refineries and nuclear reactors will squeeze global petroleum supplies. I expect Japan to begin importing large amounts of refined petroleum products from the west coast of the United States. Our refineries are running around 85% of capacity, our crude storage tanks are nearly full and our trade relations with Japan are already in place. China’s Sichuan earthquake in May of 2008 killed 68,000 people and left nearly 5 million homeless. The scale of the military operations required to rescue people and stabilize the infrastructure pushed crude $20 higher per barrel in less than a month. Approximately 430,00 people have been relocated in Japan, thus far.

Once the people are safe, they’ll need to be fed. Every piece of food near the damaged areas will have spoiled. The growing radiation fears are already making their way into the food chain. Japanese people are afraid to consume food that may have been tainted. This will place a large strain on current grain and meat supplies. Current grain and meat stocks cannot be increased. Our inventories are what they are. Fixed supply plus greater demand means rising grain and food prices are on their way. Live cattle prices climbed more than 20% immediately following the ’03 blackout and power was only out from 4-8 hours. Obviously, the length of the outage is much greater in Japan while the population base is smaller. We’ll need more data to quantifiably compare the two.

The reconstruction process is the final phase to discuss. Financing the reconstruction will be difficult on Japan’s ailing economy; in fact this topic deserves its own article. Heavy equipment companies like Caterpillar and John Deere have already attracted some attention. Oil refinery companies will also benefit. Nuclear reactor technology is a short term negative as General electric has taken a hit even though Japan may rebuild their reactors. Commodity prices will rise as Japan re-stocks and this will be evident in meat and grain prices. Copper and steel will also see increased demand. The wild card in the reconstruction process is natural gas. The radiation scare may be enough to push the political conversation of natural gas to the front burner.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Crude, Cocoa or Democracy?

Writing about commodities usually means discussing supply and demand issues. The weather may be too hot in one area while another area may be facing labor issues and so on. Rarely is there an opportunity to focus the lens of my research directly on U.S. foreign politics. The events over the last few months in the Ivory Coast and Libya have provided us with an apples to apples comparison of exactly how the current administration intends to position the United States in respecting the national sovereignty of foreign leaders versus the protection of global financial interests in those same countries.

In January, we discussed the politics of the cocoa market. The Ivory Coast held a public election in December and the United Nations recognizes the winner of that election, Alassane Outtara as the rightful leader of that country. However, the former leader, Laurent Gbagbo has refused to step down. He has control of the military and the governmental purse strings. The citizens of the Ivory Coast have taken up arms to force him to step down and recognize the newly elected President as the peoples’ choice for the future. Gbagbo’s response has been to turn the country’s military on its own people rather than step down.

The Libyan situation is in the news every day. The Libyan people are attempting to overthrow their leader by starting a civil war. This is the same leader who assumed the leadership role forty years ago through a military coup. Gaddafi is using his military, made up of Libyan citizens, to forcefully quell the rebellion. Both Gaddafi and Gbagbo stand accused of committing serious crimes against their people to enforce their dictatorial wills.

The primary differences between these two situations are the facts that one leader was the rightful winner of a public election while the other’s leadership is being challenged in the same manner in which he claimed it to begin with. The Ivory Coast is responsible for more than 60% of our cocoa imports while Libya is responsible for 2% of our oil. Libya, who ships much of their oil to old European countries like Spain, Italy, France, Germany and the United Kingdom is being covered by all of the major news sources 24 hours a day. The Ivory Coast, however, rarely makes the crawler on CNN.

The United States is being urged to take action in Libya by much of the world with Old Europe crying the loudest. There are discussions of enforcing a no fly zone throughout Libyan airspace to prevent Gaddafi from bombing his own citizens and economic sanctions have already been put in place. Meanwhile, Gbagbo, whose official presidential term expired five years ago, is using his military power to forcibly put down the protests in which hundreds have died and has cut off all U.N. humanitarian aid to his impoverished people.

The United States is being forced to set a moral standard by which it will be judged throughout the world. The current administration also has an opportunity to set an example with our own people by defining its focus on the balance of foreign versus domestic political asset allocation. The U.S. may be able to offset some political ills by proportionately supporting the United Nations in its attempts to install the rightful and recognized leader of the Ivory Coast while avoiding the baited hook of spearheading another oil filled military conflict with no end game in sight.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Over Priced Crude – Not Our Problem

The fall of dictators in North Africa and the refusal of others to leave has created a political mess throughout the oil producing regions. Tunisia, Egypt, Libya, Iran and others are all facing internal military conflicts. Some may turn into civil wars while others may squelch civil unrest through political concessions or direct government aid to their people. However, when it comes to the world’s supply of oil, the method of reconciliation isn’t nearly as noteworthy on the open markets as the fact that there are issues to reconcile in the first place. The era of instant press and relatively equal opportunity to generate information has created millions of on site reporters in the form of the common man producing cell phone videos, Tweets and Facebook networks.

The news has created an oil spike. The manic pursuit to grab the headlines has brought speculation in oil futures trading to new heights. Libya is responsible for 2% of global oil output. Egypt and Tunisia are irrelevant and Iran produces a sour crude of such low quality that they don’t have the domestic capabilities to refine it themselves and have to import 40% of their gasoline. Saudi Arabia has already broken ranks with OPEC and volunteered to increase output to appease the market and I wouldn’t be surprised if Obama tapped the strategic reserves.

There is a fundamental disconnect between the price of oil on the open markets and the fundamentals that move prices over the long term. The crude oil traded in the U.S. is typically referred to as West Texas Intermediate (WTI) while the oil that is produced and traded in the North Sea, Iran and Russia is Brent Crude. Brent crude is a lower quality crude that is both produced and consumed throughout Europe and Asia. WTI is easily refined and produced in the Gulf of Mexico, Alaska and the Black Tar Fields of Canada.

WTI crude oil is stored in Cushing, Oklahoma and the storage tanks are nearly full. Commercial traders of WTI strongly believe the market will not support these prices. In fact, they have accumulated a record short position. They have never sold so much of their future production at market prices as they are doing now. This is exactly opposite the of the Commodity Index Traders (CIT’s) and small speculators who have jumped on board the news events. History has shown that no one knows their market like the people who make their living in it. Therefore, it is not wise to bet against commercial traders for very long.

It is comforting to believe that the commercial traders may be right and that oil won’t stay at these levels for very long. However, Middle Eastern politics is a wild card game at best. The Schork Report states that we could have $4 gasoline with WTI crude trading at $115 per barrel. This is due to the refining and crack spread issues we discussed two weeks ago. Gas didn’t hit $4 in 2008 until oil traded over $145. This would have a serious effect on our economy. Ball State released a paper on January 21st, stating that GDP will decline by 2% if oil climbs to $110. Furthermore, 10 of the last 11 recessions accompanied rapidly rising oil prices.

It’s already been speculated that Obama may tap the strategic reserves to prevent higher energy prices from dragging down our struggling economy. Saudi Arabia isn’t the only oil exporter aware of the bearish fundamentals of the oil market and I suspect that other oil producing countries will sell all the forward production they can at these prices. I don’t expect energy inflation to dictate monetary policy. Ben Bernanke co-authored a paper in 1997 stating that the correlation between high energy prices and recessions had more to do with the over tightening of fiscal policy to clamp down on inflation than did the actual price of energy. Therefore, I don’t expect to see knee jerk rate hikes in response to the howls of inflation hawks.

Currently, the primary beneficiary overseas is Russia. They have the reserves, refining capacity and infrastructure to supply old world Europe and Asia. These are the areas most greatly affected. They are fully industrialized and their economies are heavily reliant on oil imports. The question we should be asking ourselves is why we spend between $50 and $100 billion a year to protect roughly $35 billion dollars worth of the oil we import. This amounts to the 15% of our total U.S. imports that come from the Golden Crescent. Two separate pools of academic research, nearly 10 years apart, 1997 and 2006, have addressed this issue and gone nearly unnoticed. Why is it that we pay the bill to keep the oil flowing overseas to other countries?

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.