Eye on Commodities: Leading Indicators?

We wanted to highlight two commodity related charts here today. The first is the percent change of price levels of the SP500 versus copper and oil over the last three weeks. The second is the longer trend line for oil.

On the first chart, the last three weeks have seen an important signal from commodities as they outperformed domestic equities, even as the US dollar index has strengthened. This to us is an important early signal--just like semiconductor companies saying that “things are less bad”--that global demand is set to pick up from the lows of Q4 2008 / early Q1 2009. There is likely no better leading indicator than basic commodities like oil and copper, and their clear divergence versus domestic equities over the past three weeks is to be noted.

On the second chart, the point is to highlight that there is serious upside to oil on a breakout. Our quantitative model has oil’s trend resistance at $89.84 per barrel for West Texas Intermediate, which is more than 100% upside from the current price. Obviously oil testing that line is far from a foregone conclusion, but we would highlight a number of incrementally positive fundamental data points:

· OPEC – While this is very difficult to measure, media reports suggest that OPEC compliance with the 4.2MM in production cuts announced since September are now near 80% with the potential to reach 90% by the March 15th OPEC meeting. There are also some rumors that OPEC may cut an additional 500K – 1MM barrels per day at this meeting. According to BP’s most recent statistical abstract, world oil production is at ~81.5 million barrels per day, so a 4 – 5 million barrel cut is very significant.

· U.S. inventory building at a lesser rate – Days supply in the United States has increased for 9 straight weeks from December 19th to the week ending February 20th from 21.8 says supply to 24.9 days supply. In the week ending February 27th, we saw the first abatement of this trend as days supply declined sequentially to 24.8.

· China – On March 9th, Zhang Guobao (head of the Chinese National Energy Administration) said in published reports that China should use part of its nearly $2 trillion in foreign exchange reserves to buy more gold, oil, uranium and other strategic materials. Obviously the Chinese have a lot of buying power. If they were to allocate ~4% of their foreign exchange reserves into buying oil, they could buy 500K barrels, at the current price, every day for the next year. As Tim Russert says, that is BIG!

Modeling the projected supply / demand for the global oil balance is a complex endeavor, but focusing on changes on the margin and major shifts in the model (China buying, OPEC cutting production) are important and can impact the supply / demand balance meaningfully. And as we see in the chart below, there is a serious upside if demand begins outstripping supply, even in the short term.

Daryl G. Jones
Managing Director

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