Geopolitical turmoil

The Middle East is an informational black hole. Is Libya calmer or not? Is Bahrain flaring up? Are the riots in Saudi Arabia under control? Where’s Iran? All of the unknowns are pushing oil higher, and the threat of supply disruptions are becoming all too real, even as domestic inventories rise.

In the meantime, China currency talk is getting louder as leaders try to push for yuan reserve currency status. Why? At this point, I’m inclined to believe that the Chinese leadership might be thankful for unanswered prayers. With social unrest increasing, the yuan getting revalued higher may increase any slowdown, bring the real estate bubble to its knees, and actually increase social unrest in the short term. True, inflation might be mitigated, but it’s all about the speed and unintended consequences, 2 things that I’m not sure the government will be able to control.

Lastly, I can’t help but be amazed at the big, pink elephant in the room that is being totally ignored: the euro is unsustainable, yet it’s getting stronger!?!? Can anyone say “Ireland”? Great. Now that we know that Irish bondholders are getting a haircut, what about the rest of the complex? Spain is about to go back 30 years in terms of development. With already high unemployment and a real estate bubble that is not being priced on anyone’s balance sheet, Spain is the big risk for the euro now, but no one is talking about it. Instead, the euro is getting some relief bid that it’s not collapsing. Well, it should…and it will – at least in its current form.

WTI-Brent

This spread is once again heading south. Is it signaling new/increased tensions in the Middle East on the horizon?

WTI-Brent spread

This has been making it’s way around different trading circles, so I figured I would share it.

The spread between WTI and Brent oil is beyond all time lows (highs, depending on your ratio). The spread has completely blown out and I have not found any good explanation for it. I therefore can’t even begin to know whether this is a structural change or will face some mean-reversion pressures. Either way, something is happening in the oil markets:

(source: Bloomberg)

As a point of reference, looking further back it looks like a range of -2 to +2 is the norm.

Relevant ETFs: USO, BNO

Separating the noise from the louder noise

There’s obviously been a lot of news since last night and I’ve been trying to wrap my head around it, but for starters let’s mention some of the big items:

Belgium and Spain are only the latest, but not the only(!), reasons for the euro to fall…and fall it did. We’re back to a 1.32 handle. Why do I say that they’re not the only reasons? Well, for starters, I thought the euro was structurally flawed before any downgrade, and continue to think so. The euro is now trading by default since there’s no alternative in Europe. Imagine for a moment if Germany came out tomorrow and said that it would start issuing Marks. The euro would be DOA.

On our side of the pond, we have treasury yields continuing to move up. 10 year yield is now above 3.5%! We’ve discussed the phenomenon before where we can have deflation AND rising yields at the same time. Locking in 3.5% for 10 years isn’t that attractive afterall. We’ve been calling it biflation, but I’ve been researching some underlying elements to help explain the phenomenon. Each time I come to the same issue: What cause yields to rise?

• If yields are REACTING to inflation and inflation expectations, then they are lagging commodities, but still part of the same message we’re getting from other asset classes. This could be bullish for equities and real estate, as well as supporting the runup of commodities in general (such as copper, industrial commodities, etc).
• If they are LEADING and are a result of fear over solvency, or frontrunning the pack (e.g. fear China will sell their holdings), then the recent run-up could be part of a debt-deflation cycle which is very negative and could be a harbinger of increased real costs of borrowing, economic slowdown, deflation across asset classes, etc. This would be very bearish for industrial commodities such as copper, but still supportive of precious metals as stores of value.

This dichotomy is the debate being had across the street. The first case is easier to deal with – we have the fiscal and monetary tools to stop inflation, and while painful down the road, we know it. The second case is similar to what happened during the Great Depression (and I don’t use that comparison lightly). It’s a world where fiscal and monetary policies are powerless, and it’s the scenario Bernanke fears most. Unfortunately, increased government spending does not and will not stop scenario two from occurring, so it just leaves us more vulnerable. We are maintaining our short treasury exposure.

Gold down. Oil up. Noise for me, since these are long term positions.

Muni bonds have gotten hit recently (as we predicted a few months ago). Noise for me at this point since we cut all exposure. At some point, yields will become attractive enough to take long term positions, but for me, not yet.

Tax bills, healthcare constitutionality, and WikiLeaks – all noise.

David Rosenberg (Rosie) discussing the rise of inputs versus no retail pricing power causing the mother of all margin squeezes?

The U.S. PPI, at +0.8% MoM in November and the core (which removes the effects of food and energy) at +0.3%, were both above expected but skewed by a seasonal rebound in auto pricing. Outside of that, core would have been as expected at +0.2%.

What is striking, however, is how cost trends are accelerating at the early stages of production in lagged response to the recent leg of the commodity boom. The “core crude” PPI jumped 3.1% MoM and is now up 30.2% on a year-over-year basis. This is the very early pipeline stage.

At the same time, core intermediate PPI leapt 0.7% and is up 4.7% from a year ago. When we get to final core goods PPI, the YoY trend is running at a mere 1.2% (and -0.7% on a three-month annualized basis).

In other words, the closer you are to the commodity complex, businesses have greater pricing power. And, the closer you are to the consumer at the final stages of production, the less pricing power you have. (emphasis mine)

That’s not noise. It’s just further confirmation that equity valuations are too high.

Oil and energy

We’ve been highlighting it for months, and I believe there is a lot more room to the upside. Here are just a few of the places we’re looking (without making any specific recommendation):

I inserted USO as a weekly chart, just to give a longer perspective on the space. I believe that with increasing geopolitical instability, coupled with the peak oil statistics we’ve been discussing recently, the energy space will retain a strong bid, certainly on a relative basis, and has the potential to rise significantly from here.

Interview on The Wall Street Shuffle

I was interviewed this past week on The Wall Street Shuffle and focused on energy.

The main theme focused on conclusions from the recent IEA Oil Market Report. This was the first year that the IEA discussed the fact that the world probably reached peak production of “conventional” oil in 2006 and that going forward the growth in oil production to meet demand will have to come from “unconventional” oil (ultra deep water drilling, natural gas alternatives, etc.) but that this growth will not make up for the dropoff in conventional production. Which obviously means that shortages are coming in the next few years, prices will remain high even as we go into another recession. Add to that geopolitical conflict and debasement of fiat currencies, and energy looks like it has potential to outperform going forward. I mentioned that i prefer the producers and explorers to the straight commodity for long term investors. Additionally, I prefer coal and nuclear energy companies to oil since I think massive investments will need to be made in those areas.

Related ETF’s: XLE, XES, NLR, KOL (I already have exposure to some of these areas through ETF’s and individual companies).

10 o’clock briefing

Markets are under pressure again. Dollar is holding up though and might have found a bottom.

In the meantime, banks continue to be under pressure from fraudclosuregate:

While the market awaits the Fed report on currency manipulation. This report will probably say nothing of substance, hope to put some shallow pressure on China, and leave it at that. But treasuries are selling off anyway with yield rising:

Elsewhere, oil is holding up remarkably well, GOOG is holding up the Nasdaq with a 10% gain after last nights earnings report, and consumer sentiment declined more than expected.

Let’s see if this is just profit taking or the beginning of the realignment we anticipate.

Going where the crowd isn’t

If you’ve ever watched 6 year olds play soccer, you’ll recognize the phenomenon – 20 kids constantly running towards the ball. Where-ever the ball goes, so do the kids. Investors are often quite similar in their need to go to the ball, and we often discuss some of the heuristic biases that lead us to follow that pattern. While there are numerous studies to support the value of some momentum strategies, I prefer the more staid value strategies that tend to produce better results without as much running.

In that light, let’s examine where the crowd is and isn’t. Certainly, the days of gold being a side-show are over. Can gold go to $5,000? Maybe, but it was easier to get in when it was at $800 than it is now at $1,300 when everyone is talking about it. I still hold gold and gold related shares, but as I wrote about a year ago, I also hold silver, platinum, and palladium. I’m not selling here, but not buying more either.

Where is the crowd definitely gathered? Treasuries are one place. Institutions have no choice but to be buy the little yield that is available to them. So we’re not only staying away, but staying short. It has been a difficult position to hold, but then again, standing alone on the field while everyone is running to the ball can feel lonely. At the same time, everyone is running away from the dollar. And to what? To the yen? To the euro? Well, we should have focused less on G3 and G8 crosses, but I continue to maintain that the picture is worse for Europe and Japan long-term than the US.

So what is the crowd really missing? I think geopolitics continues to be the most underpriced risk/opportunity in the market. Oil, energy, and defense companies are not much appreciated. We have positions in all, including specific names (such as NOV, RTN and others), ETF’s (such as NLR – nuclear – and others, etc. Oil is just starting to awaken, and I think it has a lot more room to go:

Commodities such from corn to coffee have also been all the rage, but I think if you don’t have a position already, you might be late to the party.

In a debt deflation cycle, I think there are also opportunities for companies with strong balance sheets, low debt, and an ability to maintain some margins. Companies that are issuing a lot of debt, even at cheap prices, are putting themselves at risk if their margins get squeezed. In a rising inflation period, levered companies are in a better position, but retailers are dropping prices, which means that the debt will become relatively more expensive. The new debt issues seem like a high risk low return trade to me.

Energy – by the time you read about it…

When the BP spill occurred, I wasn’t able to blink without energy being mentioned. Every article, every economist, and every politician wanted a piece of the PR feeding frenzy. The problem was that the focus was completely misplaced; I said it then and I’ll say it now – a spill was not surprising!

Given our energy dependence, the fact that oil is getting harder to find and extract, and the lax government regulations, it was only a matter of time before some major spill happened somewhere. So it happened to be BP and it happened to be in the gulf. Immediately, everyone wanted a piece of BP’s massive cash hoard. I get it and I’m happy to fine them, but there are bigger issues at stake. No effort has been made to analyze the underlying issues of energy – but a bigger issue is looming and the rest of the world is aware of it more than the US.

Iran is going nuclear, and whether we like it or not, energy dependence will once again take a front row seat, with no one to pay any fines, as we face a massive squeeze in oil prices.The front page of The Atlantic Monthly brings to light one (of numerous) scenarios that might drive this squeeze:

The rest of the world is more aware of it that the US, and is taking the appropriate actions – investing in domestic energy supply through alternatives and nuclear. By far, nuclear energy offers the best option to gain long term energy independence. Even Finland, with its strong environmental and bureaucratic structure has found a way of burying nuclear waste, so how come we can’t?

The geopolitics of energy are about to trump the global slowdown.

Alert: Oil just moved lower

Oil just went down 1.5% in about 5 minutes. Not sure what the news is out there, but something is spooking the market.

BP – The clock has already started

What happens if BP goes bankrupt in the next few months? Setting 20 billion aside in a private deal with the White House surely won’t survive a judges review. What about paying out small claims to thousands if not tens of thousands of shrimp boat captains and motel operators? Will they be clawed back? How can they not be? What will that do to the small business owner? And what about all of their bilateral trades? I am not sure people realize just how many trading shops that could ensnare.

I am not a bankruptcy attorney and this is not my area of expertise, but I did trade through a number of counter-party bankruptcies and I know how hairy things can get. I can see it now – Florida vs bondholders vs shareholder lawsuits vs their NYMEX FCMs and banks vs gulf residents – a legal battle royal if their ever was one.

No judgments here – only a question.

Around the markets in 6 charts or less

With so much noise and conflicting news, we’ll try to boil it down to some of the interesting areas (by no means an exhaustive review). While we’re not technically inclined, a picture is often worth a thousand words, so without further ado:

Chart 1 Gold:Euro

As troubles in the eurozone mount, markets are looking for outlets – heck, Europeans themselves are looking for outlets. We’ve mentioned the euro:yen pair and have maintained our usd:euro position, but gold in euro terms is hitting new all time highs and is acting as a real fear gauge for the European markets.

Chart 2 EEM

Speaking of fear gauges, the emerging markets were all the rage just a few short months ago, with strategists discussing divergence and internal growth metrics. Money poured into EEM as the USD was going down. Oh, how the world is changing. EEM now looks like it’s rolling over and while I am not posting it, Chinese equities, long the poster children of emerging growth, look poised to continue their downward spiral. Turns out valuations matter and government direction of the economy isn’t all that great.

Chart 3 IWM

I have to admit that IWM has been surprisingly strong and stable so far. I guess everything is up for interpretation: either you believe the markets are always right and the strength in light of bad news is a bullish signal, or you believe that markets are inefficient and haven’t yet priced in just how bad things are. Guess where I am…

Chart 4 10 year yield ($TNX)

I have a long term fear of the government inflating our way out of debt, but in the shorter run, treasuries are still offering a safe haven. I have a small exposure to short treasuries (through TBT), but it has moved against our portfolios; yet, I am not changing it. I believe longer term, treasuries are in a very dangerous position. While deflation might be in our future, I don’t think there is too much upside here. That said, I have been wrong so far. I’ll be looking to add to this position if levels go to the extreme levels of late 2009.

Chart 5 Oil

As we continue to think about the inflation/deflation debate, oil is a good place to start looking. At least at the moment, it doesn’t look like it’s pointing to rampant inflation. Might this be the final deflationary play? Maybe, but I’d at least point out that it can go a long way down and stay down for much longer than inflationary-minded investors would have you believe – peak or no peak.

Chart 6 Agriculture:REIT

And then, as if I wasn’t confusing you enough, I’ll refute my own deflationary assessment, and point out that agriculture has been lagging REITS. At first blush, this might suggest that agriculture is poised to rebound relative to the REITS sector, which sounds quasi inflationary. Au contraire… There is a big disconnect which we’ve pointed to before. In this new world order we can have deflation AND increasing yields. We can have inflationary pressure from ags AND deflationary pressure from real estate as credit gets unwound.

Lastly, I don’t have a chart for it, but I do want to highlight one other thing: geopolitics have been surprisingly calm in the news, pictures of civil unrest from Greece notwithstanding. But…Thailand is facing civil unrest, Israel and Iran are at a critical juncture, Russia is getting bolder, and today South Korea officially held North Korea responsible for the sinking of their boat a couple of months ago – just to name a few situations ready to provide fodder. Geopolitical risks remain and getting more contentious with the eurozone teetering, the US administration inwardly focused (misfocused?) and perennial troublemakers like Russia stepping it up.

Crude Oil

If crude hasn’t gone down by now, do you think it will? Unless demand crumbles, what will push it down from here? Oil is now in limbo and I believe geopolitical tensions will provide a support.

Here are a couple of scenarios:

We’ve seen inflation remain tame. If jobs do not pick up, inflation may remain tame (Phillips curve), at which point oil should stay stable, as it has. If jobs do pick up, then inflationary pressures may ensue, at which point you probably want to be long oil. So let’s assume that oil goes down to 30% from here to the $55 range, which isn’t unlikely if there’s major deflation or continued global economic slowdown. If there’s inflationary pressures and even some geopolitical plays, then oil could easily surpass any previous high. Then you have to put weights to get an expected return. It appears to me that at this stage, the risk/reward for oil might be attractive. I do not have any direct exposure at the time of this writing, but this is one of the areas we’re exploring now.

For those interested in Phillips Curve stuff, click here for the latest research from the San Fran Fed.

Look who’s back in the spotlight: Ahmadinejad

As we have been noting, with the Obama administration failing to make a strong stand on any international issue, and with Europe as weak as ever, there is room for Ahmadinejad to maneuver. And now with Dubai World scaring Europe (especially) even more of any instability in the region, the game theorists in Iran figured it was time to make some bold statements. Iran vowed to develop 10 new enrichment sites: http://www.washingtonpost.com/wp-dyn/content/article/2009/11/29/AR2009112900992.html.

We are now left with the prospect of a nuclear Iran, which will lead to a nuclear region as Saudi Arabia, Egypt, etc. will be forced to go nuclear, or have Israel make a move against US public officials (although probably favored behind the closed doors). Either way, there’s a base for oil prices here.

Peak Oil Revisited, or Is the IEA Lying to the World?

The International Energy Agency (IEA) puts out reports and estimates for both supply and demand on a regular basis, with estimates going out as far as 30 years forward. Recently, the accuracy of their numbers has been brought into question, not just by outside watchers and industry professionals, as was the case previously, but by a whistleblower inside the organization. See the full story from The Guardian (http://www.guardian.co.uk/environment/2009/nov/09/peak-oil-international-energy-agency). A few highlights:

The world is much closer to running out of oil than official estimates admit, according to a whistleblower at the International Energy Agency who claims it has been deliberately underplaying a looming shortage for fear of triggering panic buying.

The senior official claims the US has played an influential role in encouraging the watchdog to underplay the rate of decline from existing oil fields while overplaying the chances of finding new reserves.

The allegations raise serious questions about the accuracy of the organisation’s latest World Energy Outlook on oil demand and supply to be published tomorrow – which is used by the British and many other governments to help guide their wider energy and climate change policies…

…Now the “peak oil” theory is gaining support at the heart of the global energy establishment. “The IEA in 2005 was predicting oil supplies could rise as high as 120m barrels a day by 2030 although it was forced to reduce this gradually to 116m and then 105m last year,” said the IEA source, who was unwilling to be identified for fear of reprisals inside the industry. “The 120m figure always was nonsense but even today’s number is much higher than can be justified and the IEA knows this……A second senior IEA source, who has now left but was also unwilling to give his name, said a key rule at the organisation was that it was “imperative not to anger the Americans” but the fact was that there was not as much oil in the world as had been admitted. “We have [already] entered the ‘peak oil’ zone. I think that the situation is really bad,” he added…

…Matt Simmons, a respected oil industry expert, has long questioned the decline rates and oil statistics provided by Saudi Arabia on its own fields. He has raised questions about whether peak oil is much closer than many have accepted.A report by the UK Energy Research Centre (UKERC) last month said worldwide production of conventionally extracted oil could “peak” and go into terminal decline before 2020 – but that the government was not facing up to the risk. Steve Sorrell, chief author of the report, said forecasts suggesting oil production will not peak before 2030 were “at best optimistic and at worst implausible”…