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Who Will be the Casualty in a Slowing Economy? (Part II)

(September 7, 2006)

Dear Subscribers and Readers,

In Part I of this commentary (published on August 3rd), we discussed what asset classes could be the first casualty in a liquidity squeeze and a U.S. economic slowdown, concluding: Readers should also keep this in mind: In a declining liquidity environment, the assets that get hard the most are those assets that saw the most speculation during the last bull cycle.  Asset classes that come to mind include commodities (such as crude oil, gold, copper, etc.), real estate, U.S. small and mid caps, and emerging market securities (both equities and fixed income).  In the case of crude oil, the Energy Information Administration (EIA) does not see any new spare capacity effectively coming online until late 2007 at the earliest, but again, please keep in mind that the EIA is not taking into account a U.S. or a global economic slowdown.  Such a slowdown – especially in China – could potentially increase spare oil capacity as early as the beginning of next year.  Moreover, as I have mentioned before in our June 11, 2006 commentary, the chances of an oil or natural gas supply disruption in the U.S. Gulf Coast this hurricane season is next to impossible, given the latest weather forecasts for this hurricane season.

Is liquidity still declining in the world today?  Yes, at least when it comes to Central Banks withdrawing liquidity anyway – as evident by the huge declines in the Japanese monetary base and in the very weak growth numbers of the U.S. monetary base.  Moreover, the ISI has also counted 103 rate hikes across the world in the past 12 months, compared to a mere “78” going into the 2001 recession.  At the same time, however, the private sector is still relatively easy on doling out credit – while retaining a sense of risk-taking – as evident by pension funds seeking “alternative asset classes” such as hedge funds, private equity funds, and commodities.  This divergence between the Central Banks and the private sector is evident in our “MarketThoughts Excess M” (MEM) indicator – as shown below (for folks who want a refresh of our MEM indicator, please go to the following commentary):

The MarketThoughts Excess M Indicator vs. Monetary Base. vs. M-2 outside of M-1 plus Institutional Money Funds (April 1985 to Present) - Speculators continue to be aggressive in the face of the Fed reining in the monetary base. Has the domestic or the international markets discounted this tightness in the Fed - especially when it comes to *negative carry* speculations such as commodities or high yield corporate and emerging market debt? Subscribers should continue to tread carefully here.

The logic in using M2 outside of M1 plus institutional money funds as a “velocity indicator” goes like this: The monetary products as measured by this monetary aggregate has historically had a higher turnover – suggesting that whenever this monetary aggregate has increased faster than the monetary base, it means that speculators have been more active than they should be.  In other words, the speculators are now fighting with the Fed.  However, it is important to keep this in mind: The speculation has not been on the U.S. stock market – especially when it comes to large cap or even growth stocks in general.  In reality, the speculation had mostly focused on U.S. housing, commodities, and emerging market securities.  For the last year or so and up to a few months ago, this author had discussed the “upcoming pop” of the housing bubble, and U.S. housing subsequently turned out to be the first “casualty” of a squeeze in global liquidity.  My guess is that commodities (mostly metals and energy) will be next.

Let us now begin our discussion about commodities.  In our August 3rd commentary, we rebutted the concept of “Peak Oil” with the following discussion: Just like the “new era” of the late 1990s, the concept of peak oil used to be a good structural story until it turns into a cyclical one.  As the price of crude oil surpasses $70 a barrel, what was once classified as non-recoverable is for the first time counted as reserves.  New supply or old supply that was not economical is gradually brought online.  Similar to the amount of new stock offerings that emerged in 1999, the new supply will inevitably overwhelm demand – no matter how great the story is.

Since that commentary, the media has reported a very promising find in the Gulf of Mexico that could potentially increase U.S. oil reserves (estimated at 29 billion barrels until this find) anywhere from 10% to 50%.  As I mentioned in our discussion forum, the entire U.S. today has a 5.4 million barrel per day of capacity. If this find increases reserves by 50%, then under the most optimistic scenario, this could potentially mean an additional 2.7 million barrels a day in additional capacity - which is about the three times the size of current Alaskan production. This will also increase spare world oil capacity anywhere from 200% to 300%.  We are hearing stories that drilling may not occur until a few years from now – but with oil still at $67 per barrel today, who wouldn't want to get that oil out of the ground as quickly as possible?

And in the more immediate term, we are now getting confirmation that the Asian refiners are losing money hand over fist – forcing major oil refiners in both Japan and Korea to significantly curtail production.  What is the culprit for declining gasoline and fuel oil prices?  The old saw: Too much supply.  Quoting the article:

Those cuts may help rebalance an oil market that dealers say is in danger of an extended autumn slump, with gasoline losing its premium to crude oil as the summer driving season ends and stocks of winter heating fuel already brimming in Asia.

The real drag on margins has been fuel oil, now in its deepest slump ever amid a tide of imports from the West, flat demand in China, the biggest consumer of the residual fuel and switching by U.S. users into cheaper natural gas.

Subsequently, U.S. gasoline refining margins (what is known as the “crack spread”) have declined significantly as well – plunging from $20 a barrel in early August to only $1 to $2 a barrel today.  Wasn't it a mere three weeks ago when the CEO of Lyondell (remarking on the total buy-out of the Lyondell-Citgo refinery from Citgo) stated that this cycle should be longer than usual and that we will “enjoy” higher-than-normal margins for the near future?

For now, the fact that many refiners are reducing production of gasoline and fuel oil from crude oil suggests less demand for crude oil – which should cause the price of crude oil to decline going forward.  Moreover, the price of crude oil is now sitting right at the 40-week moving average, a long-term support level, as evident from the following chart courtesy of

WTIC - Crude oil sitting at long-term support right at the 40-week moving average. Two weekly closes below $65 a barrel would mean *sayonara.*

Interestingly, the P&F count for oil right now suggests an ultimate target price of $58 a barrel, although this author would not be surprised if the price of crude oil ultimately declines below that level.

In prior commentaries, this author had discussed the supply response in the production of crude oil – with the EIA projecting the growth of oil supply to outpace the growth of oil demand from the first quarter of 2007 and onwards.  The fact that this cycle has “played out longer than usual” is not because of “Peak Oil,” but because of the delayed reaction in the supply response in oil E&P companies – which is not surprising given that so many of them have been burned in the past by drilling as much as possible when the price was high.  With the current EIA projections and with the significant discovery in the Gulf of Mexico a couple of days ago, it looks like the supply response has finally turned the corner.  We are now also witnessing this supply response in metals as well, as evident by the following Bank Credit Analyst chart showing the amount of historical and current mining investment in Australia:

The amount of historical and current mining investment in Australia

Note that this scenario is now being played out across the world.  Quoting the Bank Credit Analyst: The latest Australian investment data, however, points to an eventual surge in output. Mining investment rose by 80% year-over-year in the second quarter, and has doubled as a share of Australian GDP in the past few years. Bottom line: structural demand trends remain favorable, but improving supply prospects should ultimately dampen commodity prices.

At the same time, demand from emerging markets has also been declining – as evident by the 23% decline in copper imports by China for the first seven months of this year (compared to the same time period in 2005).  The decrease in demand is also evident in the LME Warehouse inventory numbers, as shown in the following chart: courtesy of

1 Year LME Copper Warehouse Stocks Level

While LME warehouse stocks still remain low on a historical basis, it is encouraging to see that copper inventories actually have been steadily increase since November 2005.  In other words, there has been enough supply to satisfy demand (and then more) – and any increase in the supply response should further accelerate this inventory accumulation and serve to drive prices significantly lower.  Moreover, the weakness in the U.S. homebuilding sector should also serve to undermine copper prices, given that the construction sector is the most prolific consumer of copper.  And finally, much of the price increases in copper (and other metals) has been driven by pension funds in the last six to nine months – and pension funds are usually the last investment vehicle to get into an appreciating asset class.  Expect copper prices to decline soon.  My guess is that this decline will occur once the LME inventory surpasses the March 2006 highs – readers please stay tuned.

As for emerging markets, this author expects this region of the world to collectively weather any financial storms in a much better fashion than they have in the past – given a much stronger banking system (through a combination of better governance and the entry of foreign banks), the significant accumulation of U.S. reserves since the late 1990s, a generally much “healthier system” of floating currencies (foreign debt is now only 60% denominated in U.S. dollars as opposed to 90% right before the Asian Crisis hit), and the development of local government debt and corporate debt markets over the last five years.  The Bank for International Settlements recently compiled a report in this area entitled: “The Banking System in Emerging Economies” – which is a must-read for those who can read like Jon von Neumann or who likes to read this for fun (this author professes that I am not in either of these categories).  That being said, this author would like to leave you with the following chart from the BIS paper.  In short, we are now in a much healthier financial system than we were in 1995.  From a risk-adjusted capital standpoint, the countries that were hit by the Asian Crisis and Latin America in general are even better equipped to deal with a financial crisis than the United States – although that is to be expected, given the higher volatility of economic growth and inflation in those countries.  However, I still expect emerging market securities to underperform U.S. securities over the next few years – given the immense amount of speculation that has gone on in these countries since October 2002.

Macroeconomic volatility and risk-weighted capital ratios

Signing off,

Henry To, CFA

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