Commodity Implosion

Jim Brown
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Fears of weak demand as a result of declining economics combined to push commodity prices to multi-month lows. WTI crude fell -$2.85 on Friday to $91. Brent declined -1.16 to $103.

It is hard to pin a specific cause on the drop in commodity prices because there were multiple headlines. The U.S. Producer Price Index fell sharply suggesting a lack of demand was pushing down prices for consumer goods. The report kindled new worries over the potential for another recession or even deflation.

The Retail Sales report showed a sharp drop in consumer buying in March. The headline number declined -0.4% after being up +1.1% in February. The sequester impact has not yet been felt in the market other than on a limited basis. As we get farther into the summer the impact will be worse.

Consumer Sentiment fell unexpectedly to 72.3 from 78.6 for March. That is the lowest level since July. Falling sentiment normally means slowing consumer sales and the rise of a conservation mentality.

Various reports from Europe suggest the banking crisis is going to worsen, possibly significantly. The recession is deepening and the impact from the Cypriot bank robbery has not yet shown up in the economic reports. It will be ugly. Several other countries are now considering taxes of some sort on bank deposits, retirement accounts, etc and the EU is considering levies on interbank deposits between banks. This is not going to turn out well.

So far in April 18 out of 20 economic reports in the U.S. have missed the estimates. That is not exactly a confidence builder for our growing economy.

The EIA and OPEC have both lowered their crude oil demand estimates for the rest of 2013. I don't give these monthly reports much credence because they are revised up and down every month. However, they always seem to have a short term effect on prices the week they come out. The EIA cut growth estimates by -45,000 bpd to 795,000 bpd for 2013. OPEC cut its estimate by -40,000 bpd to 800,000 bpd. In the overall scheme of things a 40,000 bpd change is not relative given the 90 million bpd consumption rate.

A bigger factor is the current 22-year high in crude inventories in the USA. This period is normally the high point of the year for inventories and we are already 6.5% above year ago levels.

There are a lot of factors weighing on crude prices and the biggest of which is the economic one. Unfortunately I don't see that changing in the near future. The sequester is going to continue to weigh on the U.S. economy and Europe is going to weigh on the global economy.

China is going to release its Q1-GDP estimate on Monday along with retail sales, industrial production and fixed asset investment. These numbers have the potential to move the market.

The spread between WTI and Brent fell to a 15-month low at $10.90 on Thursday but expanded to 12.45 on Friday after WTI declined -2.85. Various production problems in the North Sea have been resolved and weak European economics pushed Brent to a five-month low.

WTI prices have been holding in a range of $85-$97 for the last 10 months. However, the longer term trend has been very choppy over the last three years.

Each year we have seen the economics weaken in the spring and the equity market and crude prices have declined. The drop in crude has been dramatic. It appears that economic weakness is coming back hard this year thanks to the sequester.

Crude prices have uptrend support at $85 but each of the last years has seen the $80 level tested with very short term dips below $80. We should target the $80 level for a long term buy.

WTI Crude Chart - Weekly

Baker Hughes said active rigs rose by 33 to 1,771. Oil rigs rose +30 to 1387 and a 3 month high. Gas rigs rose by 2 to 377. The peak was 936 in 2011. The total rig count for the same period in 2012 was 1,950.

Gold prices were knocked to a 15-month low at $1476 on the weak economics and worries European countries will be forced to sell their gold to raise cash. Cyprus has more than 13 tons of gold and the ECB told them to sell it to raise cash for the bailout of their banks. At least that was the rumor on Friday. Cyprus does not even show up on the list below but Greece, Spain, Portugal and Italy figure prominently. Portugal could be on the verge of an Argentine style default and they have 382 tons of gold. Egypt is rapidly running out of money and could be forced to sell its gold to sustain the government. Western central banks are limited by agreement to keep sales under 400 tons a year and 2000 tons over five years. Some analysts believe the low gold price will spur buying by South Korea and Brazil. Those countries have low gold reserves and buy when the price declines.

World Gold Council Table

Strong support failed at 1550 and the support at 1475 is significantly weaker. Next up is the 200-week averages at 1438 and then 1325. If the banking situation in Europe worsens any further and I expect it will, we could see those lower support levels tested.

The sharp decline in gold prices clearly triggered some technical selling and I am sure plenty of stop losses were hit. There may be more selling on Monday as margin calls are satisfied.

Gold Chart - Weekly

I fear the commodity cycle is broken. There is far too much economic weakness around the world and unemployment in Europe is rocketing higher. Unemployment in Greece is at 27.2%, Spain 26%, Portugal 17% and the eurozone average is 12%. Numbers that big don't improve quickly. It will take years for economic conditions to improve in those nations undergoing forced austerity. That means consumption in those nations is going to be very low for years to come. China, where 35% of their goods go to Europe, is likely to drift lower as well.

Europe has the economic flu and it will spread to the rest of the world. You can't have 27 nations in a recession without it affecting the rest of the world in some way. Europe only represents 15% of U.S. exports but more than half the S&P-500 derive a significant amount of earnings from business in Europe. This earnings cycle is going to be telling for European expectations. As each company issues guidance we will get a better idea about when Europe may recover. Some analysts believe it could be Q4 but others are looking farther out because the banking problems have not yet been resolved. The Cypriot solution of seizing bank deposits is going to have ramifications all over Europe. The flu has already spread to Australia where they are considering taxing 401Ks.

The amount of money Cyprus has to raise grew from 5.8 billion euros to 13 billion last week. That means that nearly all the money in Cypriot banks over the 100,000 euro insured amount will be confiscated. Thousands of businesses will go out of business. Not only in Cyprus but also in the surrounding countries since Cyprus was a banking hub for the southern eurozone. If you were a small business with a million euros in the bank to pay for inventory, raw materials, salaries, etc and suddenly 900,000 was gone what would you do? The majority will go out of business. They can't pay for inventory or salaries or even pay creditors. They are done. On top of that Cyprus is going to try and raise taxes by $1 billion a year. With businesses going out of business this is not going to work either.

With the deposit tax flu spreading this is going to be a critical issue for anyone in any other eurozone country. If there was even the slightest chance of a deposit levy in your country would you leave your money in the bank? I doubt it. Deposits in the eurozone are flooding to safe havens in places like the USA.

The EU just extended the bailout terms for Ireland and Portugal for seven more years. That is not 2 or 3 years but 7. That is an admission that growth in the eurozone is not coming back in the near future. The IMF warned of a possible "lost decade" for Europe and potentially for "western" economies as well.

Credit in Europe is going to evaporate. With deposits flowing out of banks they will have no money to lend to their regular customers. That means no business expansion, no building, no economic progress.

We could be heading back into another global recession and it may not be far away. That means commodities are going to tank and oil demand may slow even further.

The U.S. markets have disconnected from the fundamentals thanks to the Fed's QE programs and recently due to the money flowing in from Europe. How long this can last is the $64 question. If Europe continues to decline and I can't imagine it will recover soon, then the future is clearly negative for our markets. When the current drunken euphoria over new highs finally ends the hangover could be painful. The Fed can't continue to monetize the U.S. debt forever. There is light at the end of the tunnel and it is the reality train headed our way.

Jim Brown

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