What's Behind the Slide in Oil and Commodities?

On the morning of July 15^th, the price of crude oil, the most widely watched commodity in the world, was gyrating in a narrow range  just above $145 /barrel as dealers in London were position-squaring ahead of the Nymex opening. Just a few days earlier, Iran was conducting war games in the Persian Gulf and threatening to shut down the Strait of Hormuz, if attacked. The world watched a fireworks display of Iranian Shahab-3 missiles that were armed with one ton explosives.  

In the background, the global stock markets were entering into bear market territory, having lost $13 trillion of value since their peak set last October. Soaring energy and key raw material costs were squeezing profits of manufacturers, unable to pass the entire cost increases onto consumers, who were themselves getting squeezed by soaring prices for gasoline, food and other basic necessities.  

IndyMac Bank, a prolific mortgage specialist, was seized by federal regulators, in the third-largest bank failure in US history. Preferred stock sold by Fannie at $25 /share fell to $14 lifting its yield 13.50-percent. Lehman Brothers’ preferred stock plunged to $9.50 /share to yield 20.8%, discounting its eventual demise. General Motors suspended its common stock dividend. Hedge fund trader George Soros said the global banking turmoil is “the most serious financial crisis of our lifetime.” 

On July 15^th, the Dow Industrials plunged 250-points in the first-hour of trading to an intra-day low of 10,825, extending its losses to 2,400-points, from eight weeks earlier. Where was the US Treasury’s “Plunge Protection Team” [PPT] with its magical safety-net, designed to rescue Wall Street during moments of gut wrenching panic? “Helicopter” Ben Bernanke was handcuffed by a weak dollar and gold hovering near $1,000 /oz, and couldn’t slash interest rates to rescue the market.  

US consumer prices were increasing at a 5% annual clip in June, reflecting the global commodity boom that the Fed’s rate cuts had set in motion. Then suddenly, at 10:30 am EST on July 15^th, a miracle happened, the Nymex crude oil market began to collapse, plunging $10 per barrel within a span of less than one-hour, to its biggest daily decline in 17-years. What was behind the historic crash in the crude oil market on July 15^th that prevented “Black Tuesday” on Wall Street?  

A few hours later, at 11:30 pm EST, the Bush administration announced a shift in its foreign policy and said it would send a high ranking envoy to Geneva, Switzerland to talk with Iran’s diplomat directly about Tehran’s nuclear program. As long as the diplomatic game continues, there is less chance of any military action against Iran’s nuclear weapons program. At a cost of one round-trip airline ticket to Geneva, Washington engineered a stunning 15% drop in world oil prices. 

On July 16^th, Nevada Senator Harry Reid fashioned a bill to rein-in speculators in the energy markets, who bet on the price of oil, but don’t intend to take physical delivery. “This bill will address the rising cost of gasoline in the short term, and prevent Wall Street traders from gaming oil markets, and insure that American consumers are paying a fair price at the pump,” Reid said.

The bill would restrict the number of oil futures contracts an individual speculator could control. 

Oil prices have tumbled more than $23 a barrel from their all-time high set on July 11^th, marking the biggest decline in dollar terms in the market’s history. The evaporation of the Iranian “war premium” from the oil market, rescued the Dow Jones Industrials with a “miracle rally” of 800-points, from the brink of Armageddon. But could there be another hero who is responsible for the historic slide in crude oil, besides the backroom cabal at the US State and Treasury departments? 

No market travels in a straight line. In the second half of 2006, the crude oil market fell by 35% to as low as $50 /barrel, before hitting bottom in January 2007. Such is the nature of commodity markets, which often fool most people, most of the time. The OPEC cartel was forced to rescue its most precious asset, by slashing oil output one-million bpd in Nov 2006, to put a floor under the “black gold” market.  

But perhaps the real hero behind the latest slide in crude oil is European Central Bank chief Jean “Tricky” Trichet, who has a penchant for fooling most traders, most of the time. The world owes a big debt of gratitude to Trichet and the ECB hawks for objecting to the reckless strategies of the Federal Reserve, the Bank of Canada and England, who slashed their interest rates in a state of panic, and guided the global economy into the “Stagflation” trap. 

Instead, Trichet and the ECB hawks refused to be bullied by politicians into a series of rate cuts, in order to bail-out over-zealous speculators in the Euro-zone stock markets. Instead, the ECB held its repo rate steady at 4% throughout the first-year of the global banking crisis. Then, on June 5^th, Trichet and the ECB hawks shocked the global markets by signaling a baby-step rate hike to 4.25% and guided benchmark German schatz yields to their highest levels in six-years. 

If the historic rise in crude oil to $150 /barrel is driven by speculators, as the OPEC cartel and Democrats on Capitol Hill argue, then the world needs a powerful central bank to go against the “Big-Easy” at the US Treasury and the Fed, and the “yen carry” traders at the Bank of Japan, in order to deflate the oil “bubble” with a classic dose of higher interest rates. “The simple fact is that there is nearly $250 billion in America’s commodity futures markets that wasn’t there just a few years ago,” said CFTC commissioner Bart Chilton on July 22^nd.

The ECB’s surprise rate hike to 4.25% is greasing the skids under the Dow Jones AIG Commodity Index, which has tumbled -15% below its historic high set on July 2^nd, including an -18% slide in the agricultural sector. Nymex coal has plunged by $40 /ton. Most importantly, the year-over-year change in the DJ Commodity Index in US$ terms has dropped in half to 20% in just the past two weeks. 

Italy’s central bank chief Lorenzo Bini Smaghi explained on July 22^nd:

 

This teaches a lesson to those who wanted the ECB to follow the expansionary course taken by the Fed. If the ECB had cut rates, today we would also have a much higher inflation rate. European citizens would have been the first ones to pay for such a mistake. You need to fight back immediately against inflation.

ECB chief Trichet wasn’t afraid to engineer a decline in the Euro-zone stock markets, in order to stamp out inflation psychology. He explained on July 17^th:

 

Through the wealth effect, asset prices have an influence on demand, and therefore on future consumer prices. So asset prices are taken into account by central banks.

Furthermore, Trichet rejects the Fed’s practice of ignoring food and energy prices. “We do not consider core inflation as a good predictor of future inflation,” he said. 

So far, the ECB’s rate hike to 4.25% has managed to put a lid on the gold market, and helped to deflate North Sea Brent by 14% in euro terms. Commodity traders dumped corn and soybean contracts, which are linked to the energy markets through the bio-fuel connection. The speculative shakeout in agriculture and energy markets eased inflation pressures, and ignited a rally in the European Banking Index, rebounding +20% above its panic bottom lows set on July 15^th.

German investor confidence had plummeted to a record low, after Germany’s DAX Index lost 7% in the first half of July, and 23% this year. There have been several false bottoms in the DAX that have snared bargain hunters into bear market traps. But the latest rebound in the Euro-zone stock markets is based on sounder footing, with renewed hopes for “price stability” set in motion by the ECB.

However, when Trichet was asked on July 18^th if the worst of the global banking crisis was over, he warned:

 

We are experiencing a very significant market correction with episodes of turbulence, high volatility and hectic market behavior. It is an ongoing process. The risks to growth are on the downside, including the very significant financial market correction, the possible further increases in oil and commodity prices, and the possible unwinding of global financial imbalances.

The ECB’s surprise rate hike is widely seen as a one-off event with the Euro-zone economy is showing signs of fatigue. Industrial output in Germany and France plunged -2.6% in May, the biggest monthly fall since 1992, and Italy’s contracted by 1.4 percent. The Spanish economy could slip into a recession in the second half, after a housing bust pushed-up the jobless rate to 9.9% in May, the highest in the Euro zone. Still, “price stability” is the only needle in the ECB’s compass, and if a wage-price spiral takes hold in Europe, Trichet has vowed to hike rates again.

The ECB cannot handle all the heavy lifting of interest rates that is necessary to tame the powerful “Commodity Super Cycle” over the longer-term. There are signs of a rebellion within the Bernanke Fed, led by Dallas Fed chief Richard Fisher, and joined by Minneapolis’s Gary Stern and Philly Fed chief Charles Plosser, who are calling for a baby-step rate hike to 2.25%, at the next Fed meeting in August.

“Real interest rates are negative, and can’t stay there indefinitely. We’ve got price pressures clearly throughout the economy. Ultimately, rates are going to have to go up, and the only question is the timing. It’s important that we act before inflation expectations become unhinged. We need to reverse course. I anticipate the reversal will need to be started sooner rather than later,” warned Philly Fed’s Plosser.

“The Fed cannot wait until financial and housing markets stabilize before raising interest rates,” said Minneapolis Fed chief Gary Stern on July 18^th. “Headline inflation is clearly too high, and could feed through to core prices,” he warned.

The hawkish remarks by the Fed rebels spooked the US Treasury market, and yields on the 2-year note jumped a quarter-point to 2.75%, but are still far below the inflation rate.

Combined with Trichet’s hawkish outbursts last week, the gold market lost its nerve, and surrendered $50 to $920 /oz. Crude oil slumped to $124. Clearly, a trade-off between a half-point Fed rate hike and the 15% slide in commodity markets is a deal worth taking for US central bankers. But the Fed rebels are in the minority amid a flock of doves at the Bernanke Fed, who dare not lift interest rates, while the US economy is losing jobs and home prices are falling ahead of an election. 

The rebels at the Bernanke Fed talk tough about fighting inflation  in order to keep gold bugs off balance, but eventually their rhetoric dissipates into thin air. However, the Bank of Brazil has joined the ECB’s sound-money crusade, and is acting aggressively to tackle inflation in Latin America’s largest economy, The BoB hiked its overnight Selic rate 75-basis points to 13% on July 23^rd, and futures markets in Sao Paulo are projecting another half-point increase to 13.50% by year’s end.

The Bank of Brazil is the world’s top inflation fighter, and has guided its currency, the real, 16% higher against the US dollar from a year ago. As a result, the Dow Jones Commodity Index is only 4% higher than a year ago, in local currency terms. “Having stable prices is the best path to economic growth,” said Henrique Meirelles, Brazil’s central banker. “It is important that the central bank take timely measures so that the country can continue in its course of growth with low inflation." 

Backed by the central bank’s massive build-up of foreign exchange reserves, the Brazilian real has become a top-flight currency to own, and might start to attract the interest of sovereign wealth funds. However, the ballistic Brazilian Bovespa Index is sliding into bear market territory, weakened by the downturn in global commodity markets and the central bank’s tighter monetary policy.

Comments

[Lovenow]

Fascinating, thanks.

[Sean Maher]

A nice summary of tumultuous events; both the decision to engage the Iranians and ban naked shorting in many financials (soon to be extended to the rest of the market I suspect) probably reflect the growing role of Hank Paulson in managing this crisis and were perfectly timed for maximum impact; the Fed is pretty much out of ammunition (just look at their balance sheet) and more muscular market intervention is now required. Goldman Sachs has taken over the US government, and it's no bad thing...

[freefall51]

Compelling. Good one.

[CharlieStromeyer Jr]

Good piece, Gary, and here is a question:

Just right before the all time peak in the price of oil, hedge funds reduced their net long oil futures positions to the lowest since February 2007. What do you suppose these hedge funds suspected that ended up being so correct? Thanks.

Disclosure: still long the Brazilian real and still short oil since a price of 145.2, but I will reevaluate my oil short position if oil gets down to my target price of the low 120s.

[fxtrader07]

'Goldman Sachs has taken over the US government, and it's no bad thing...'
@Sean maher: It#s probably the worst thing. You can be sure Goldman made sure to have gotten heavily short commodities before the administration took its steps. As sure can you be that goldman had a large hand in the oil-price bubble. these guys now drive markets up and down however they want and they make a ton of money. The interests of people, of the nation count exactly zero when it comes to the crooked investment bankers who created this whole mess and try to make a bundel of money even from the last drop of blood of any american or any human being. goldman sucks - and that is a really bad thing, that they run the govt. and the fed by now

[Stephjen]

this article clearly and correctly shows that oil is simply an inverse of bad equity markets, sentiment, and general economic fears - people are reaching for a "safe" asset class with some sort of intrinsic value. People that claim that supply/demand was the entire story at $140/bbl are foolish.

[CharlieStromeyer Jr]

fxtrader07, I once heard that Goldman is the largest U.S. trader of oil futures so you might be right, but their own internal hedge fund has really crappy performance.

[SeekingTruth]

Well Done! We must not ignore prior historical facts as we seek the truth. The two prior election seasons of 2004 and 2006 saw deep plunges in oil prices, only to bounce strongly upward in the immediately following January . I am just a lay observer with no particular skills, but this has strong implications to me. If the oil price decline continues thru the fourth qtr. of 08, then this will be the third election season in a row with major oil price declines. Could the Bush admin's "brothers - in- crude" i.e. the Saudi's and OPEC be working their "surprising and unexpected" oil supply magic again?

[zenalgorithm]

Goldman Scams upgraded oil services about 2 weeks ago, when oil services were reaching the top of their range. Great upgrade for a firm trying to exit a long position quickly.

[ussmls7]

Goldmans has ran the Fed for years! Google Energy Non-Crisis"by Lindsay Willams, then you will know the rest of the story! Goldmans is trying to get all the assets they can,befor shi@ hits the fan, dollars are the crap paper, as PMs are low, fill your pockets full!

[BrunoT]

In the future a summary of your thesis would be useful. Charts and more charts are great, but at the end, like in any paper/column/article, you need to summarize your main points. Some of us are too dumb to read between the lines and my eyes glaze over after about the 3rd chart.

[User 51117]

You provide good insight into global attitudes. Your only glich was suggesting that Harry Reid had anything to do with the cost of oil.

[oldfogey]

Ok after the applause, you need someone to holler at so here I am.

We know that energy, commodities and precious metals all go up and down and that is normal. What I see is a lot of noise as a disguise for the perilous condition created by bankers and hedge funds.

My gosh up 750 points in 3-4 days on continuing bad news.
C'mon folks this is earnings season, with banking failures in an election year .... that offers socialism or fascism, the loss of the constitution and enslavement via inflation and future taxation.

Paint: everything is beautiful

[benzden]

I suspect the fact that a whole lot of new money is chasing not a whole lot of new investment opportunities, too, has something to do with non-experts getting involved in commodities, hedge funds and whatever else is out there to handle very large sums of cash.

Were not those tax cuts to the wealthy supposed to help the business climate and thereby the economy!? Seems to be that too much of that extra money is being placed into non-productive investments instead of into those which would create more jobs and help sustain the housing (affordability) market.

[paultaut]

Rosy, must be the color of those contacts.

All I see is short term charts for short term traders.

Will the Fed hike interest rates any time soon? Highly unlikely if Freddie and Fannie are to survive as independent entities.

Is the Eurozone that much stronger? Yes, but do they want the dollar to appreciate if the dollars' decline has been due to all those extra dollars floating around?

You know, its called supply. If the dollar appreciates, at a time of high inflation in Europe, will their Central Banks give up and reduce their interest rates to further strenghten it?

Your Call...I do not have a clue. I do know that the Markets do not like uncertainty.

[Kunst]

"the Nymex crude oil market began to collapse, plunging $10 per barrel within a span of less than one-hour"

Nope, no speculation here, just good old supply and demand.

[TinyTim]

"Jean “Tricky” Trichet, who has a penchant for fooling most traders, most of the time."
Tricky only as a mandate to control inflation, nothing else, like the Fed.

On July 16th, Nevada Senator Harry Reid fashioned a bill to restrict the number of oil futures contracts an individual speculator could control.
I wonder if Reid last tried this in 1979, when the Hunts' tried to corner silver. The big winner there was Rich Dennis, who easily worked around this minor issue by forming the Turtles.

[EL-GRECO]

Great observations. However they are short term movements and one can't yet conclude that these factors have set new trends. China has been raising interest rates over and over for the last three years. they still have rising inflation and the only reason they can do in the first place is because they have 10% growth every year so far. Second, demand destruction has to be global for the oil price to have a meaningful and sustainable reversal. There is no evidence yet that developing nations are going to change their aspirations to own cars and to mimick the aspirations of the typical western consumer. Cutting government subsidies for petrol in these countries could conceivably create the desired global demand destruction. Time will tell. For the moment energy companies are some of the best performing companies anywhere and the drop in crude to $100-$120 might even suit them better.

[Borgie One]

THIS IS ONE OF THE BEST ARTICLES I'VE READ ON THE ECONOMY OF THE WORLD AND COMMODITY MARKETS. OUR INEPT FED. RES. HAS EVERYTHING SCREWED UP WITH INTEREST RATES AT AN UNREAL RATE OF 2%, WHILE AT THE SAME TIME SAVING THE BIG JEW BANKERS AND WALL STREET FIRMS BY PUMPING MONEY INTO THE ONES THAT THROUGH GREED SCREWED EVERYTHING UP IN THE FIRST PLACE. WITH MORE THAN $3.2 TRILLION SITTING IN M.M. ACCOUNTS AT 2% WE LITTLE GUYS WITH RETIREMENT SAVINGS ARE TAKING A $3,000 HIT ON A 100K FROM WHAT IT USED TO BE.
OUR FED GOVT IS AS DYSFUNCTIONAL AS IT EVER HAS BEEN, BUT WE DUMB BUNNIES KEEP RE-ELECTING THEM WHEN MOST OF THEM SHOULD SHOULD BE TARRED AND FEATHERED. AMERICANS NEVER DO ANYTHING UNTIL THERE IS A CRISIS AND WE HAVE A BIG ONE NOW. IT IS SO HARD TO KNOW WHERE TO INVEST IN OUR VOLATILE AND GREEDY ATMOSPHERE THAT EXISTS TODAY. SORRY THAT I GOT ON THE POLITICAL BAND WAGON HERE ON THIS FINANCIAL WEB SITE.

[MuddlingInvestor]

Too much unrelated information. Commodities were in unsustainable bubble. Now bubble popped. There is nothing more to it.

[Kunst]

Come on Borgie, I know you have a caps lock on that keyboard.

[Vikram]

Missed the Key: That Tricky/ECB hinted that they were done with the rate hikes due to the rapid decline in the Euro zone economy. This is likely to end Euro's run against the USD, which will also gain from the end of the Bush era. Plus the $150 spike target was almost met, and July it traditionally a slow month for oil.

The key is where it bottoms. Does it stay firmly above $120 or does it test $100.

[Meerkatt]

Greenspan started the housing bubble with 1% interest rates. Congress then pushed it along with welfare programs in the form of FHA and the GSEs and their policy of everyone can have a new house, no income or assets required. Then Uncle Ben takes the rates from 5.25 to 2% to "solve" the problem. That worked well, didn't it?

While the rest of the world watched this Fed fiasco they decide our dollar was being printed fast enough to make it worthless. Oil zooms to compensate for this.

If the Fed keeps rates at 2% the dollar will remain weak and oil with stay above $120.

Raise interest rates and oil will plunge.

[peteF]

lots of words...many really contrary to other smart people without much substantiation....You say Trichet a hero in curbing oil prices? what of the argument that Trichet's high rates are killing the dollar and boosting oil priced in dollars?...I could only skim this article...please get an editor so we don't have to...best regards

[BrianPursley]

Supply and demand.

The supply is infinite: oilismastery.blogspot..../

[Dame Daxx]

Terrific article.

@peteF, get some Ritalin.

[techy]

holy cow...i thought i wanted to know about what happened to commodity and oil....but got hit by 100 other information.

so can we conclude from above article that, oil and commodity got hit because:

1. ECB's and brazil hawking approach lends credibility to currency rather than commodity and gold?
2. Bill by lawmakers to limit speculation?
3. ease of tension between Iran and US/Israel

wait a second did i miss the fact that maybe demand is falling of faster than expected?

[Kunst]

Brian Pursley, you never cease to amaze me. If the supply is infinite, why aren't we finding enough to replace what we produce? Every major production area, starting with the US, has exhibited the same peak-and-decline pattern. New field discoveries don't begin to compare to decades ago.

[BrianPursley]

Kunst, in order to increase production it is necessary to drill. Hydrocarbon drilling is currently illegal on over 10,000 miles of US coastline.

[Kunst]

Sure, might as well drill there. But it isn't going to change the overall picture. Maybe we'd be better off saving what oil we have for later when we really need it. Oh, I forgot, oil is infinite. Duh!

[User 164588]

too long and too boring

[wolfmaned]

To BP and K...real issue is not the potential supply of oil 7-10 years from now, but the political will to unhinge us from oil cartels here and abroad now. There is practicable, sustainable energy tech's available NOW, and some that will be available much sooner than what can be produced from offshore drilling in 7-10 years. Also, on the issue of banking crisis: One of McCain's long-term buddies and still a primary economic advisor to his campaign and possible presidency (horrors!)is Phil Gramm, the author of the most recent banking deregulation legislation, the likes of which we have not seen and endured since before the great depression. Another misguided conservative ideology--'privatize everything and deregulate it'. It didn't work in Iraq and it clearly doesn't work here.
Why? GREED. We have a finite planet; we need to learn to live on it sustainably.