Selling Fear in Crude Oil

We last wrote about the crude oil market in early November. At that time, we stated that the market internals did not justify the relatively high prices we were trading at and further added that we believed the $100 per barrel resistance would hold and provide a ceiling to any attempted rally. The market declined nearly 10% by the middle of December and now, here we are again back up to $100 per barrel.

As we mentioned previously, there’s a distinct fear bias in the crude oil futures market that always pumps a premium into prices. This fear bias has recently been fueled by several events in Iran. First of all Iranian students stormed the British embassy in Tehran as retaliation for new economic sanctions imposed upon them by Britain. The U.S. and Canada also followed Britain’s lead. Secondly, the European Union imposed economic sanctions on an additional 180 companies and individuals, prohibiting them from conducting commerce with European Union members. Finally, Iran has threatened to close the shipping lanes of the Straits of Hormuz if economic sanctions are placed on their crude oil exports.

Political games aside, the fundamental issues in the crude oil market can be seen in slackening demand as well as the weakening internal market structure. Global gross domestic product is sure to slow in 2012. The U.S. is just beginning to gain some traction and many economists feel that the best case U.S. outlook will see job growth keep up with population growth. This will leave us at historically high levels of unemployment as stabilizing the workforce will not lead to wage inflation.

The problems in Europe have yet to be dealt with. Recent, credible comments point to a European Union, “minus one small country.” The European Central Bank continues to fight battles rather than implementing a strategy to win the war. The most recent example was their action on December 21st in which they lent more than $600 billion to 523 banks at an interest rate of 1%. The protection of private and corporate bank bad debt at the expense of settling sovereign debt issues is penny wise and pound foolish. Their inaction will lead to a European recession in 2012 and dampen their crude oil demand going forward.

The weakness in the EU has already begun to manifest itself in the BRIC markets. Brazil, Russia, India, and China are all slowing at a rapid pace. Their domestic stock markets have declined by an average of nearly 20% for 2011. The International Monetary Fund expects that these countries will grow by 6.1% on average in 2012. While this is more than enough to be jealous of, it still represents a decline of more than 35% from their recent high growth rates. The projected economic slowdown in BRIC countries can also be seen in other metrics including, valuations, mutual fund outflows and the implementation of easing policies as they attempt to engineer a soft landing for their slowing economies.

Finally, these expectations can be seen in the declining internals of the crude oil market. Technically, strong trends pick up new followers as they gain momentum. We noted in early November that crude oil had been losing market participants on each attempt to push through $100 per barrel. This continues to be the case with each test of resistance between the 50 and 200 day moving averages. In fact, the crude oil market now shows the fewest market participants since August of 2010. The market internals also show that commercial traders have been steady sellers at $100 per barrel and are willing to wait for a re-test of the $90 area to reassess their view of end line demand going forward. Therefore, we expect the crude oil market to fall rather quickly once Iran backs off its threats of blockading the shipping lanes out of the Persian Gulf.

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.

Politics, Deficits and Disaster

The payroll tax cut issues that are locking up Congress
possess the power to create both cultural and economic divides at a critical
point in American history. The senate has overwhelmingly passed a version that
would extend the payroll tax cuts by two months. This vote was bi-partisan and
cleared by an 89-10 vote. The Republican led House of Representatives opted to
bypass a vote all together on the issue. Speaker of the House John Boehner, a Republican
and fellow Ohioan is asserting that a two-month extension is not acceptable and
will not call a vote on anything less than a full year extension.

 

Politically, I believe the strategy is to force a compromise
on the bill from the Senate and to allow the Republican Party an opportunity to
gain some momentum in the coming elections on the jobs issue. Hopefully, job
creation will be one of the main issues addressed during the election
discourse. Additionally, the Senate has already adjourned and returned home for
the Holidays. This may be used by the House to let the tax cuts expire and
blame it on the Senate for taking personal time at the expense of their
constituents. The Democratic Party’s response would most likely lay the blame of
grandstanding at Boehner’s feet and using this to apply political leverage
rather than helping the American people while he had the chance. The cultural
split has the potential to ruin bi-partisan communication just at the time when
our economy will need it the most.

 

Economically, there is substantial disagreement as to whether
payroll tax cuts or direct government spending will provide the greatest bang
for the buck to taxpayers and the economy as a whole. The primary key is the
term, “multiplier.” This is the how much a policy’s contributions are maximized
or minimized in the general economy. Basically, it’s the bang for the buck
measurement. The payroll tax cut is designed to trim the individual’s
contribution to social security by 2%. This saved 160 million average American
workers about $1,000. The current plan will extend this benefit by another two
months saving the average worker about $83 for 2012.

 

Averages can be misleading. The percentage paid into social
security is capped a little above gross income of $100k for 2011. The
percentage basis calculation and cap provides less benefit to lower earning
workers because their entire income is subject to social security taxation. The
Urban-Brookings Tax Policy Center’s work shows that the net benefit to more
than 65% of Americans was actually $178. Basic math using their results as the
effect of spending $78 billion (65% of $120 billion) provides an effective
stimulus of roughly $28.5 billion or, a net multiplier of NEGATIVE .66. Simply
stated, the payroll tax cuts provided 1/3 the benefit they cost to produce to
nearly 2/3 of the work force.

 

The expiring program cost the government, and eventually us,
about $120 billion. Therefore, the net multiplier is about 1.3. Taking $83 per
worker out of the economy doesn’t seem like a very big deal. However, by many
estimates this equals about .8% of GDP, which may be half of 2011’s U.S.
production. Due to the tenuous state of our economy and the expected economic
decline by the European Union in 2012, the expiration of this plan could very
well be enough to throw us into recession in the second quarter when the
proposed tax cuts expire in March.

 

The debate over the effectiveness of government spending
versus cutting taxes is heating up. 
Pessimists assume that the payroll tax cut designed to generate new
hiring is really just churning the economic engine. Companies release
dispensable workers and hire new ones at a cheaper tax rate. This creates some
obvious unintended consequences such as new unemployment claims, benefit issues
and finally, no real economic gains.

 

Optimists of the program suggest that payroll tax savings
will spur new hiring, which will become permanent hiring as the economy
improves. The basis of this academic research is that private businesses are
much more efficient and responsive to allocating capital and predicting forward
demand than the federal government. In fact, a study cited by Dr. Gregory
Mankiw of Harvard University in his recent article on Crisis Economics suggests
that the net multiple may be as high as 4 to 1.

 

The government faces some very tough decisions in the months
ahead. The very real concerns over the growth of our own debt must be balanced
against the need to nurse the recovery along. Washington deserves to hear our
voices as we express our own opinions on the amount of debt we’re willing to carry
versus the benefit we’ll receive from its creation. The most important thing is
that we force them to recognize the very real issues at hand and not allow them
to sit by idly as our economy pushes towards our own unsustainable European
outcome.

 

 

 

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.

 

 

2011 – Year of the Farmer

The business of farming has become just as much an operational profession as any other corporation. This year, the Associated Press reported that farm profits are expected to spike 28% to just over $100 billion. The rapid appreciation of agricultural investments was confirmed by research at several Corn Belt universities, including Ohio State, Indiana University, University of Illinois as well as the U.S. Department of Agriculture. Unfortunately, 2011 may have set the high water mark for farmers for some time to come.

The combination of high grain prices, low interest rates and tight global supplies combined to create farmland appreciation north of 7% per year compounded over the last ten years. That’s right, the average price of farmland has doubled in the last ten years. Much of this is due to the income generated by the rising price of crops. Soybeans were trading just over $5 per bushel in January of 2001. They peaked at $14.65 this year and are still above $11 per bushel. Furthermore, yields have continued to improve through bioengineering from an average of 38 bushels per acre to nearly 45. The same general trends are reflected in other grain markets as well.

Unfortunately for U.S. farmers, the time for making hay may be coming to an end due to increases in global production and the domestic housing market implosion. Much of the profitability has been tied to the global demand for U.S. crops and the rest of the world’s production centers are working hard to increase their market share.

The United States’ soybean production is estimated at 90 million metric tons for this year while Argentina and Brazil will combine to produce approximately 125 million metric tons. By comparison, Brazil and Argentina combined to produce less than 50 million metric tons in 2001. Developing countries simply have more, high quality farmland to develop and fewer governmental restrictions in seed types, fertilizers and production techniques than us. This is allowing them to close the production gap at a rapid pace.

Rising grain prices have helped carry profits higher even as the housing bubble collapsed. Previously, the low interest rates that fueled the housing boom were also responsible for taking farmland offline. Housing developments and golf courses have expanded the civic boundaries of townships and cities across the country. This was prime acreage that was easily accessible and typically close to transportation infrastructure. Over the last ten years, it was taken off faster than appreciating yields could compensate for. This also pushed newly developing farmland into less productive and less efficient areas.

Profitability always attracts attention. Increasing global production should put a ceiling on the record prices received over the last two years. Furthermore, a technical study of market bubbles by Steve Briese, also lends a cautionary tone. His study looked at markets that double in price in less than two years and peak at a new five year high. His research shows that the market gives back, on average 86% of its gains within the same time frame. The price of corn more than doubled between June of 2010 and June of 2011. This was also an all time high. Soybeans also followed suit between February of ’09 and ’11.

The United States is still the, “breadbasket to the world” but the rest of the world is catching up. American farmers are facing more complex crop insurance equations with each passing year as weather patterns and commodity prices fluctuate at extreme rates making it harder to predict year-end prices and yields. Insurance companies and the government are less inclined to payoff at recent rates and contribute to enhanced agricultural economic gains. I fear that this may mark the end of the low hanging fruit in the U.S. farming industry.

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.

The American Consumer is Throwing in the Towel

The November Unemployment Report showed a decline in the unemployment rate to 8.6% as well as 140,000 jobs added in the private sector, which was partially offset by a decline in government payrolls of 20,000. Sounds good at first blush, private payrolls are adding jobs and the size of the government is declining. While it is encouraging, there are two major problems with accepting this at face value. First, employment is up, but not enough relative to where we should be more than two years into the economic recovery(?). Secondly, consumer spending indicates desperate behavior that is further weakening the underpinnings of this recovery.We’ve discussed before that the economy needs to add approximately 125,000 jobs per month just to keep up with population growth. This month’s net number of 120,000 still leaves more people unemployed in the long run. The reason the official unemployment rate dropped to 8.6% is primarily due to the 317,000 people who haven’t actively looked for a job in the last four weeks and have therefore, fallen off of the unemployment report. Had those people sought employment, the continuing claims number would have been negative by nearly 200,000 and created a significantly different headline picture.

I question the impact of this recovery and have concerns about its ability to continue to gain traction due to the historical perspective of the jobs situation and our population’s spending habits. The Federal Reserve Economic Database is accessible by anyone. Looking at their employment graphs we can see that since 2007, the number of people not in the workforce has grown by more than 10 million. Conversely, when we look at the total employment level in the United States it shows that we are at the same level of employment as we were eight years ago. This ties in well with the thesis that American businesses and American workers are more productive than ever. This has led to healthy corporate profits while the domestic demographic spread continues to widen.

The American public on the other hand, is a bit of a concern. CNBC released a survey detailing the economic expectations of the American population versus our expected spending habits this holiday season. Retail sales have surged to all time highs, surpassing even 2007’s high, which was fueled by credit. This year, CNBC’s survey is expecting holiday spending to be 22% higher at the individual level. This would represent a 4.6% gain in total holiday spending over 2010. This makes no sense when 61% of American’s polled believe that the economy is in poor condition with equally dismal expectations for 2012. This is the worst reading in the five-year history of a poll that includes the euphoric ’07 highs as well as the desperate ’08 lows.

My fear for 2012 is not the Mayan end of the world. My fear is that Americans are dipping into the minimal savings they’ve built up in the last two years on one last party of a holiday season. According to CNBC, 74% of this year’s holiday purchases will be made with cash. This will leave most people skating on thin ice. The idea that we are spending more while expecting less just doesn’t jibe with the narrow cushion we stereotypically hold. When we combine this with the fragility of the European Union situation and its ability to quickly throw us back in recession, I’m afraid that this holiday’s spending habits may simply be the average American giving up and throwing ourselves a party while we still can.

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.

Excess Liquidity Treats the Symptom but Prolongs the Disease

The crisis in Europe is coming to a head. This can be measured by the overnight index swap (OIS) rate, which measures the floating risk between the central bank overnight rate and the swap or, insurance rate. The wider the spread is, the more concern there is regarding the borrower’s ability to repay the short-term loan.

This week we have also seen credit default swaps among the largest European banks move to new highs and yields on Spanish and Italian bonds have hit new highs above the previous July high water mark. Finally, risk is starting to spread as German, Japanese and Chinese credit default swap prices have run to the highest levels since the credit crisis of late 2008.

Meanwhile, the ongoing standoff between an economically strong Germany versus a crumbling Eurozone periphery has once again been prolonged. The joint action of the U.S. Federal Reserve bank along with the European Central Bank as well as those of Britain, Japan, Switzerland and Canada to ensure Dollar liquidity to European banks facing a credit crunch has simply provided market relief rather than issuing any type of resolution.

The Eurozone’s economic death spiral is beginning to affect other economies as well. China lowered its lending reserve requirement in an attempt to kick-start domestic demand in their economy and avoid a hard landing as their second largest market, the European Union is quickly heading into recession. The European Union is also responsible for the absorption of approximately 20% of our exports. Therefore, it is very likely that the severity of their recession will determine the likelihood of a recession here in the U.S., which I expect around the second quarter of 2012.

We’ve seen a huge shift in the global economic outlook between this summer and today. This summer’s revolutionary fires of democracy did not release the pent up demand for goods and services on the free market that was expected. North Africa, the Mediterranean and the Golden Crescent are still struggling to establish stability and develop a unified voice in the world’s financial markets.

The change in economic outlook is perhaps best viewed through the lens of international interest rate policies. This past June there were 18 global economies that either raised rates or were in the process of raising rates. More than 20% of them have completely reversed their position with more expected to follow by year’s end.

European banks are believed to own as much as $3 trillion in bad debt and be leveraged by as much as 40 to 1. Currently, this debt is carried on their books at face value. Even a small haircut would completely wipe out their lending reserves.

The joint venture by the central banks to guarantee liquidity is one more attempt to treat the symptom rather than the disease. The real disease is deflation. That’s right, deflation. The added liquidity that is fueling the rallies will not contribute to inflation until the economies of Europe, China and the U.S. can work through the excesses of the 2000’s. There is simply too much capacity in labor, production and capital to be absorbed by economies with declining employment.

The reality is that we’re going to see Dollars, Euros and Yen printed at alarming rates, as the only way to pay back the sovereign debts will be to print more currency. The repatriated currencies will be rolled into government debt, which will artificially suppress interest rates while artificially inflating other asset classes like food, energy and individual stocks. We will continue to race each other to the presses until we work through these excesses and then, lookout. Global inflation will hit like the late 70’s were just a warm-up.

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.