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A Trend Reversal for Commodities?

(September 24, 2009)

Dear Subscribers and Readers,

On Tuesday morning, Carnival Cruises (CCL) – the world's largest cruise ship operator – reported better-than-expected earnings, and concurrently raised its forecast for the rest of the fiscal year based on better-than-expected yields amid a turnaround in the leisure market and the US economy.  Over the last two days, CCL has risen by more than 3%, and is up about 52% since we recommended purchasing the stock in our January 15, 2009 commentary (“Cruisin' Into the Sunset”).

In recapping our investment thesis on Carnival (which subscribers can re-read in our January 15, 2009 commentary), our sole intent is not to brag – but to remind our subscribers (and ourselves) to always think independently with a view towards the long-term.  The bearishness in consumer discretionary stocks were palpable in the early parts of this year, so much so that valuations on many of these stocks dropped to an all-time low on both an absolute and relative (to the S&P 500) basis.  At the time, we did not believe that the financial crisis would have a long-term effect on the global cruise liner industry, given its long-term growth rates (especially stemming from the growth in aging baby boomers) and given the dominant position of the two large global operators – Carnival and Royal Caribbean.  Against all consensus, we highlighted our bullishness on CCL – and thankfully, this bet has paid off.

Let us now get to the gist of our commentary.

So much for the concept of “Peak Copper.”  In our September 7, 2009 commentary (“A Short-Term Correction in Commodities?”), we asserted that a correction in commodities was virtually imminent given the overbought conditions of commodities (especially base metals), the tightening of the Chinese credit market for the rest of this year, and the relentless rise in base metal inventories on the London Metals Exchange.  At the time, LME copper inventories stood at 308,200 tons (per the following chart courtesy of Kitco and the LME).  Since then, LME copper inventories have risen another 24,000 tons, to 331,775 tons:

30 Day LME Copper Warehouse Stocks Level

In our September 7th commentary, we also reported that copper inventory levels on the Shanghai Futures Exchange had risen to a two-year high.  What we did not discuss (and which only emerged a week later), is that a substantial amount of “shadow copper inventory” has been building.  As reported in a recent Bloomberg article, speculators in China (including pig farmers) have now amassed a total of 50,000 tons of copper inventory, or about half the amount on the Shanghai Futures Exchange.  Should credit be tightened further in China, or should copper prices start trending down, the downside in copper prices could really accelerate as speculators start dumping their inventories on the market.

On the crude oil front, the fundamentals are also relatively bearish.  Yesterday's unexpected 2.8 million barrel build in crude oil inventories were especially bearish, as crude oil inventories tend to fall during this time of the year.  On an aggregate basis, total US stocks of crude oil and petroleum stocks also bounced significantly (as evident from the following figure, courtesy of the EIA).  Total US inventories of crude oil and petroleum stocks are now at over 1.1 billion barrels, or more than 50 million barrels higher than the last five-year high:

U.S. Stocks of Crude Oil and Petroleum Products, December 2007 to Present

Most tellingly, and as documented by GaveKal, Chinese crude oil inventories stood at 282 million barrels in early July, based on the most recent published data.  On average, Chinese crude oil inventories have been rising by 240,000 barrels a day.  As of today, there is a strong chance that Chinese oil inventories has surpassed 300 million barrels, equivalent to 90 days of crude oil imports – a record high.  More ominously for the oil bulls, virtually all the growth in Chinese demand has been for inventory building purposes – suggesting that Chinese crude oil consumption has still not recovered to its pre-financial crisis high.  In addition, this inventory accumulation by China will further steady the supply of crude oil in crisis situations – thus helping to keep crude oil prices and volatility in check going forward.

Finally – while yesterday's FOMC statement was not surprising – both stock market and currency speculators “sold on the news” (after a short indecision period) after the FOMC statement was released.  More specifically, the Federal Reserve stated that it would slowly end its “credit easing” policies in order to ensure a smooth transition.  Instead of a target ending date by the end of this year, the Federal Reserve will shift its target date to the end of the first quarter (although sticking to the same amount of total asset purchases).  This will effectively cut in half its recent pace of asset purchases – which implies a dramatic slowdown in credit/monetary creation.

With the US and global economic leading indicators rallying to new highs, there is virtually no doubt that the Federal Reserve will end its credit easing policy once they have finished purchasing their current commitment ($300 billion in Treasury purchases, $1.25 trillion in agency MBS, and $200 billion in agency debt, for a total of $1.75 trillion high-quality securities).  Since this has been one of the most worrying Fed policies among inflation-wary investors, an ending of this “credit easing” policy should provide some support to the US Dollar, especially since the European Central Bank has made no commitment to ending its de-facto easing policy anytime soon (its latest policy has just effectively guaranteed the entire Irish government debt by allowing Irish banks to post Irish government bonds as collateral at the ECB).  I now expect a sustained rally in the US Dollar Index for the rest of this year, with a corresponding weakness in commodities, commodity-related currencies, and of course, the Euro.

Signing off,

Henry To, CFA

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