Commodity Volatility to Continue

By Benjamin Train
October 15, 2006

The Dow Jones industrial average has recorded record closes on optimism over corporate earnings. Early Friday morning oil prices were showing some rebound, but by market close, lower prices prevailed. It may be difficult for the precious metals to get much support from that action, because energy prices remained within close proximity to the recent lows. Copper has been stubbornly trading at high prices, it now sits at US$3.40 per pound, more than 5x what it was three years ago. Gold is trading at $589 per troy ounce and Silver sits near $11.63.

Falling gasoline prices may have spurred U.S. shoppers last month and consumers' enthusiasm in October, as the drop in fuel costs left them free to spend elsewhere, reports showed on Friday. Overall retail sales posted a fall of 0.4 percent in September 2006, the Commerce Department said, but when a record 9.3 percent drop in gasoline sales was stripped out, they showed a healthy rise of 0.6 percent, helped by strong clothing and department store purchases. Now, if you believe that sharply falling energy prices and marginal consumer spending will save the declining U.S. economy, I suggest you continue to read further.

The housing industry has underwritten consumer spending and the GDP growth in the United States for the last five years. When the housing industry turns down, so do a large number of other things. Economists know this. The link from housing to the US economy is unmistakable. It is more than reasonable to perceive a housing price-led economic recession is here already.

The Mortgage Bankers Association anticipates a $500 billion dollar cutback in mortgage originations this year alone. Foreclosures jumped 24% from July to August, now 53% higher than a year ago. The federal government's tax payers are on the hook for some $55 to $65 trillion in expenses, beyond what the U.S. economy can reasonably generate in revenues. If it were not for Defense spending, the GDP growth would have been even less, because most of all manufacturing has been exported to China and India.

According to consulting economist Walter J. “John” Williams, in which he analyzes the U.S. government's "manufactured statistics",: “what used to be called the GNP but is now widely followed as the GDP, (and) the CPI, and the employment numbers, all have had biases built into them that result in overstating economic growth and understating inflation - - both of which are admirable political goals."

He says, "Real CPI is now running at about 8%. And the real GDP is probably in contraction.""Today unemployment is really up around 12%," Williams notes. Finally, Williams notes; "What I found is that if you adjust the real GDP numbers that the government releases for the myriad revisions and redefinitions…you'll find that there is a happy overstatement of growth of about 3% on a year-over-year basis. The problem very simply is this - - the consumer is the primary driving force behind economic activity and the only ways that consumers can fuel consumption growth are through rising income, debt extension, or savings liquidation, that's where he gets his cash."

Now let's look at what has so sharply reduced energy costs over the last 60 days.

Since early August many key commodities, particularly energy and metals, have been spiraling relentlessly lower. Out of all the commodities, energy is the most pervasive and important single commodity, the stated subgroup represents 23.0% of the CRB, representing Crude Oil, Heating Oil, and Natural Gas.

So, why is the Dow Jones Industrial Average up sharply, near a record 12,000? Is this an election year? Is there pressure to control the House and Senate? Perhaps it is worth spending a minute on what is meant by Central Bank cooperation and whether the government has the capacity to manipulate the markets.

The Federal Reserve Repurchase agreements are loans (at Fed Fund rates) issued daily by the Federal Reserve to primary dealers, i.e. Goldman Sachs, J.P. Morgan, the proceeds of which are used to buy, for example, Dow index futures, if the Fed seeks to boost the Dow. Goldman Sachs, and J.P. Morgan. who apparently work under the Fed's direction are able to use these loaned funds to buy or sell various securities and futures to affect the markets.

Over $100 billion dollars was invested in indexed commodity funds tied to the Goldman Sachs commodity index (GSCI). In the midst of a global energy war to secure oil & natural gas supplies, and without any justification, the GSCI unleaded gasoline weight was reduced from 8.45% to 2.3%.

Large fund managers, brokers, and individuals were forced to sell a lot of gasoline contracts to abide by enforced weightings, which then forced the price of the commodity down into the price range of $1.44 per gallon, and a big drop in crude oil of over 20%.

The energy complex is all inter-related, with contracts for crude oil, heating oil, diesel, gasoline, and natural gas intertwined. The entire industry is now under strain. And now, even the governments have exposure to further revenue reductions tied to reduced energy pricing.

The Commodity Research Bureau, (CRB) is the world's oldest, leading commodities and futures research, data, and a leading provider of commodity market information since 1934.

Traders who have invested the time to become familiar with the indicator's behavior and uses have found it to be an invaluable tool for determining the general direction of stock prices. The Stock Market Momentum Indicator analyzes the price strength of the 500 stocks in the S&P 500 Index.

When the GSCI unleaded gasoline weight was cut to 2.3%, It had a massive impact on the CRB index. The gravity of the CRB commodities index breakdown has been severe.

Independent speculators to seasoned investors and hedge-fund managers have all seen the commodities index support levels all fail over the last six weeks. In mid-August the CRB index trend lines slid well under its key 200-day moving average. CRB's breakdown has now knifed through five-years of sector support lines.

Traders may have very good reasons to be concerned.

The reported U.S. crude inventories rose more than analysts expectations last week, according to data released Thursday by the U.S. Department of Energy. Crude oil stockpiles rose 2.4 million barrels to 330.5 million barrels Distillate stocks, which include heating oil and diesel fuel, fell 1.6 million barrels to 149.9 million barrels, compared with analysts' forecast of a 400,000-barrel increase.

Gasoline stockpiles rose by about 300,000 barrels to 215.4 million barrels, compared with average forecast of a 500,000-barrel draw. Refining capacity fell 0.7 percentage point to 89.2%. Analysts had expected a 0.3 percentage point fall.

No matter what the reported numbers are, continued Middle East tensions will play a major part of what energy commodities prices will be in the near future. The European Union's 25 foreign ministers want to agree at a meeting on Tuesday to ask the U.N. Security Council to impose sanctions on Iran the World's largest stockpile of Oil. Germany's foreign minister told Iran on Saturday it was not too late to avoid sanctions and urged the Islamic republic to return to negotiations over its nuclear program.

T- Boone Pickens, the Texas billionaire and money manager, predicts $70 crude before January 2007 with $100 crude by July 2007. Oil and Gold most often move in the same direction. If Gold rises by these same percentages, the price of gold could become $700 by January 2007 and $980 by July 2007.

Even better, the 70% increase in Oil and Gold by July 2007, could translate into a 100+% increase in the Gold Bug Index (HUI) and possibly a 200+% increase in smaller-cap precious metal stocks that are now building production and/or reserves.

The short-term down trend is working its way to the 200 day moving average, and that target appears near term. I see oil moving down on continued sector weakness, which may further pull PM stocks in that direction. I may be wrong and we may have already seen the bottom, but we shall have to wait and see what the market brings.

The United States Oil Fund ETF (USO) Weekly chart perhaps better illustrates the near term of it. http://stockcharts.com/h-sc/ui?c=uso,uu[h,a]waclyyay[pb50!b200!d20,2!f][vc60][iup14,3,3!ud20!ub14!lc20!la12,26,9]

Looking forward, next week, look for the price of precious metals to decline in face of Options Expiration being held Friday, October20th, energy inventory numbers, Mid-East tensions, followed by the FOMC October meeting, followed by the November 7th mid-term elections. All five of these influences will drive market prices. I am very concerned about the DOW hitting above 12,000. If it reaches that point, I expect to see it fall.

Energy and metals demand growth will exceed supply growth on a global basis for years to come, as rising Asian and Indian demand grows faster than new supplies are being discovered, and delivered to market. Nickel deliveries have already defaulted, Copper inventories are at extreme lows and near default. Look at Zinc to be near term inventory lows. All these factors are forcing higher futures prices, very near term.

This stunning breakdown offers the best opportunity to buy long positions in commodities in years. The moment oil inevitably starts recovering the CRB will obediently follow it. I am looking at the May 2005 support level as a pivot point for oil and precious metals.

I am buying small positions in elite commodity stocks in an array of promising commodity sectors. Stay alert and build positions in crude oil, refining and in the precious metals market on price declines.