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For those that are long of commodities, in particular oil, the last 5 trading days have been unpleasant.   Unfortunately, we are in that camp as we are long of oil in the Virtual Portfolio via the etf OIL, and are currently down -3.7% in the position.  As we noted on our morning call today, we will stick with our long oil position to a price and that price is our TREND line of support on WTI of $98.63 per barrel.  Our current levels for oil are highlighted in the chart below.

Oil Price Volatility Isn’t Transitory - 1

While price has obviously corrected, which is an important factor in our models, there has only been a marginal shift in our other key factors of geopolitics, supply / demand, and monetary policy.

As it relates to geopolitics, the significant event over the last week was the killing of al-Qaeda leader Osama bin Laden.   While the longer term implications of this event are still being analyzed, broadly across the Middle East social unrest continues to percolate and with it the intermediate future of stability in the Middle East remains largely uncertain. A few points to highlight:

  • Protests continue across Syria, which are being aggressively cracked down on by the government. U.S. Secretary of State Clinton also gave her support for EU Sanctions against Syria this week;
  • Foreign Ministers are meeting in Rome to discuss continued plans to fund Libyan rebels.  In addition, both Britain and France have expelled Libyan diplomats.  The International Criminal Court is also reputed to be in the process of issuing warrants for the arrest of Gaddafi;
  • Hundreds of thousands took to the streets in Yemen to protest against Yemeni president Saleh, who called the protesters “outlaws”; and
  • In Bahrain, four anti-government protestors were sentenced to death.

From a supply and demand perspective, the deluge of negative economic data points (employment, ISM and housing prices) from the United States continues to support what our models had already indicated, which is that growth is slowing domestically.  The United States is the largest consumer of oil globally, so as domestic growth in the United States slows, so too does its consumption of oil.  By way of a proxy, in 2009 U.S. oil consumption declined 4.9% year-over-year, while global consumption was down 1.7% year-over-year.  This highlights the potential impact of a slowing global economy on oil demand.

In terms of the direction of global growth, we continue to get mixed signals.  The market-oriented proxy of growth is the Baltic Dry Index, which implies that we are setting up for a sequential slowdown in global growth on the back of tightening global monetary policy due to inflation concerns.  In the chart below, we’ve highlighted the 1-year plot of the Baltic Dry Index, which is down 64% year-over-year and 26% year-to-date.  This is not a reassuring picture as it relates to future economic growth.

Oil Price Volatility Isn’t Transitory - 2

That said, based on our modeling, the key driver of the price of oil continues to be the price of the U.S. dollar.   Over the past three months, the correlation of the U.S. dollar to WTI is -0.89.  Dollar down equals oil up, or, as we saw this week, just the opposite with the dollar rallying against global currencies and commodities correcting sharply.  On the back of the ECB not raising rates this week and appearing incrementally dovish, the U.S. dollar rallied +2.9% versus the Euro this week from trough to peak.  Over roughly the same time frame, WTI declined -8.4%.

Oil Price Volatility Isn’t Transitory - 3

Currently, based on slowing growth and the rally in the U.S. Dollar, we are seeing a Deflation of the Inflation, but interestingly the tepid economic news could actually lead to every inflation investor’s dream . . . Quantitative Easing 3.   With continued printing of money via debt monetization, the inflation trade should continue . . . until it doesn’t.

Daryl G. Jones

Managing Director