Tuesday, July 10, 2007

What are Oil & Gold Stocks Telling Us?

XOI Oil Index and Newmont Mining ratio

I'm back for a short while. I'll be traveling alot over the next few weeks so postings might be sparse through the end of the month. I just have to see how much time I have. There is surely no lack of topics. So much so that there have been many topics over the last year that I'd like to write about but haven't actually done so.

One can't help but notice some stark anomalies developing in the gold and oil markets. Typically, gold and oil run within a reasonable band that can be used as a simple entry indicator for those riding a bull market in both as we are experiencing this cycle. From gold's low in 2000, we've seen a relatively large move of about $450 per ounce from trough to peak. Gold's meteoric rise in the middle of 2006 was a typical blow off. That shouldn't be surprising as there have been many times where assets blew significantly higher without underlying events attributable to the move. As we all know, markets are far from rational at times. Just a few years ago it was housing and a few years before that it was technology stocks. Did the world change significantly to see the Nasdaq jump nearly 100% in 1999? Well, obviously it didn't because the Nasdaq gave back all of that 100% and more. But how many people in the financial community were telling you it was different at the time? Nearly every single one. And this time?

There are many factors which make gold appealing to many in this cycle, not the least of which is risk. As I've said before, gold is not just an inflation hedge, it is a deflation hedge, a hedge against overvalued equities, a hedge against a falling currency, a hedge against economic imbalances, etc. It's also followed by alot of speculators and conspiracists. Maybe they will be right this time. One can't be wrong forever. If so, I'll soon be living on the streets and so might you. The risks in the system may not materialize but those ignoring the warning signs of elevated gold will most likely pay a financial price of some sorts before it's over. Amazingly, most people don't understand this simple fact. Living day to day isn't such a bad idea. In the long run, we're all dead.

You might have noticed gold and oil have disconnected since the latter half of 2006. More importantly, the equities associated with the respective commodities have totally disconnected. While gold has levitated near cycle highs, large producers such as Newmont, have cratered over the last year. Newmont was down from $62 to $38 before the bounce late last week. That means you have either lost money or are near break even in the stock if you have bought it over the last five years. That said, there is strong support going back over a decade for Newmont in the $35 to $38 range. Recently Newmont announced they were removing their hedges which capped their profits. A potentially bullish sign for the stock but taken alone that data point is rather meaningless. Alot of gold bugs have been calling for gold and gold stocks to resume their rally for quite some time now. So far that ain't happening.

Conversely, many oil stocks hit new highs yet oil has not confirmed a new high over the last year. That's not too alarming for oil bulls yet because stocks typically lead underlying commodity action. Oil has recently broken above resistance and is moving in on the old highs. This oil rally has been weaker comparatively that the initial assault on $80. Typically, that means a second attempt at a new high will fail. We'll just have to see how events unfold as there has been an unstoppable amount of capital in this cycle. If oil fails at or just above the old price highs, the energy complex will likely fail technically on a false breakout. Ultimately, that will happen whenever the speculation runs out of energy so to speak. Because indeed we are witnessing massive speculation. Even the oil companies have complained to Congress that hedge funds are distorting the oil futures market. I'm not going to start rattling off historical data points but the yammering from Wall Street types who know nothing of oil or the supply of carbon based energy sounds exactly as it has in decades past. Many oil company executives including the CEO of Exxon have repeatedly said there is absolutely no problem getting an adequate supply of oil. Of course, I knew that. I fill up at the gasoline pump quite regularly. Owning oil as a comparatively cheap asset with economic demand hence intrinsic value might be appealing for many but oil is not near $80 because Nigeria is unstable or China's demand.

Taking this topic aside, the U.S. has the technology to be energy independent today. How the market refines that technology or yet to be discovered energy technologies and packages it for mass consumption remains to be seen. As I've written before, America is awash in oil. The last time we had this much excess supply? Oil was $15 a barrel. Traders arguing that gasoline refinery capacity being tight have lost a sense of reality. That might technically be accurate but when was the last time you were rationed gasoline? If we were rationed gasoline, I might be willing to say gasoline at this level is driven more by fundamentals. But, the last time we had rationing was over thirty years ago. With such a glut of oil building, eventually Wall Street will run out of any rationale to bid up oil. Yet, as I wrote last year, I don't expect oil to have a very significant correction until oil traders and hedge funds have successfully killed the global economy. They will. They have a perfect record at historically accomplishing said fact. They are lulling everyone into a stupor with the subliminal messages of how resilient the consumer is. Oil traders making millions or billions don't have a clue what the consumer is feeling. Not that I fault anyone for making a living. If you can make billions trading oil, that's eventually good for me in some obtuse way. A little timely hint: Crude oil builds and gasoline consumption are each heading in the wrong direction for the energy bulls. Both have broken with long term patterns. Expected draw downs in crude over the summer driving season are not materializing but in fact are still building and gasoline consumption is down year over year. These data points had better reverse quickly or this is another ominous sign that the economy is failing and energy assets will fail in sympathy.

One must understand the dynamics underlying these two commodities to get some idea of what is driving their price action. I really haven't read anyone's thesis that I believe accurately reflects the macro factors at work. So, without blathering on as to why, I believe gold is a proxy for credit and oil is a proxy for Merrill, Goldman, Morgan Stanley and their hedge fund compatriot's ability to create liquidity. Don't assume re my statement of credit. I didn't say too much credit nor did I say too little credit. Think about it. You'll figure it out. Anyhow, credit contractions lead liquidity contractions. From what I model, we are at a very heightened risk of a credit crunch developing in many economies over the coming months. Actually, I expect there is a reasonable probability for some bizarre events to come to pass in the credit markets as I intimated last year. Maybe I'll post more on that another day. By the way, any statements on this topic have no relevance in China. I don't really pay alot of attention to the data in China because it's all massaged by the Ministry of Propaganda before release anyway. Don't think I'm kidding either. The data is likely much worse than reported. In a society where transparency and freedoms are generally muzzled, you can be assured the Politburo doesn't want to appear as dolts for policy incompetence hence massaged data. China appears to be a runaway train and no one has control of the economy. I suspect the government in China is going to have to really get serious before the music stops. To date, they aren't even close to being serious and that will mean the ultimate mess is simply getting larger. So, based on the lack of effective policy, I expect the Shanghai Index has a reasonable probability of going higher regardless of the recent single day corrections of 3-5% and the official communist manifesto of pricking the bubble. 4400 is a key level to watch in Shanghai. A break above 4400 could send the index soaring again.

The chart above is a ratio chart of the oil index to Newmont mining's stock. It's not difficult to see that oil stocks have significantly left Newmont and other gold stocks in the dust. Big money is in oil not gold. Oil equities, oil futures, oil, oil, oil. This divergence is simply not sustainable. If you are a stock market bull or an oil bull, you had better heed the warning signs. With gold stocks and energy stocks disconnected, one of two things must happen in some variation. Gold assets must strengthen comparatively or energy assets must fall or both. Must? Yes, because it is the will of the market gods. Now there may be fits and starts along the way or it might happen suddenly. But, it will happen.

How this actually unfolds is likely a gauge of where central bankers stand against the unbalanced forces at work in the world's financial markets. If you haven't figured it out by now, the central bankers in Europe, Japan and the U.S. are not fighting inflation per se. They are trying to moderate the massive imbalances financial institutions are creating with incredibly lax risk management practices. Forget about the lip service given to inflation, financial institutions are causing the inflation. It's your friendly financial institutions that central bankers are attempting to reign in. Don't ever doubt the central bankers will be successful. They most certainly will. "Don't fight the Fed". Does that seemingly distant quote still ring a bell? Oh, yea I remember that quote. That was before the new world economy kicked in. It's so passe'. It really is different this time. Uh huh.

Ten year Newmont Mining chart
posted by TimingLogic at 9:11 AM

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