COMMODITY FUTURES FORECAST WEEKLY REPORT
A Message From Gold
Philip Gotthelf
(March 9, 2006) As I have pointed out, oil and gold are highly correlated. Aside from the fact that both are quoted in U.S. Dollars, there is a parity link that appears undeniable when examining side-by-side long-term charts. Although gold's daily chart has not made a head & shoulders, we see a declining double top with strong support indicated at $540. The distance from the 58000 high to support is $40. Coincidentally (or not), gold's next strong support comes in at 50000 as seen on the chart...$40 below the current support.
Can gold suffer such a collapse? Shouldn't investors be flocking to gold as protection against the Iranian showdown?
According to some market analysts, rising interest rates are responsible for falling housing demand. This, in turn, is squeezing debt-based liquidity. Thus, we should expect an economic slowdown coupled with lower inflation and, hence, lower gold prices.
The debt burden is constantly in the news. It is taking a subtle toll on gold enthusiasm in a strange way. The new generation of gold traders cannot remember the reasons to own gold that date back to the last boom in 1979/80. Those were different times. The new gold trader is also a stock, bond, and real estate investor. He or she will go to where the returns are.
Recent surges in certain high-profile issues like the New York Stock Exchange and the new high achieved in the 10-year Treasury are tempting money away from gold. For the moment, gold does not confirm a panic over Iran. We all believe that this situation will work itself out. After all, who would be crazy enough to send the world into an economic tailspin?
To this question, the answer is, "Iran." This month will be critical!
The Oil Surplus?
Hints that U.S. and European crude oil inventories are significantly higher than "anticipated" sent prices crashing several dollars this week. When you consider forecasts for spikes above $100/bbl., the latest weakness seems enigmatic against the backdrop of Iran, Iraq, and threatened Arab solidarity in a boycott of Israel and even the U.S. The news tells us one story and the market displays another. How can we possibly determine market direction?
This is not a unique subject for the Forecast when you consider how frequently I recommend crude oil ratio spreads. Yesterday, a new subscriber who is enthusiastically pursuing energy profits called to ask, "What now?" He was referring to our April crude ratio strangle that is long the 64 put and short two 62 puts while balanced with a long 72 call, short two 74 calls. The trade was placed for a 120-point credit $1,200 in premium.
Obviously, we're not worried about the 72/74 call ratio, however, it is worth noting that this was the leg that initially generated the most concern. Now, we are in the money on the two 62 puts, putting us net short one 62 (since the other is covered by the long 64 put). The economics remain positive on an expiration basis all the way down to 5880. Thereafter, we are long one futures contract. On Monday, we were sitting pretty with April crude smack between 62 and 64. This is ideal because we can profit up to 200 points on the long April 6400 call, hoping the 6200s expire worthless. Alas, crude's massive slide on inventory news dropped us into the red yesterday. It figures! Just before expiration!
I was counting on a worst-case scenario with everything expiring out of the money to yield a $1,200 gain. Best case would be for expiration at 6201 or 7399. Last August, we actually nailed our crude ratio spreads after suffering a bit before expiration. With today's rally, we are back in the black as we head down the home stretch. At 6000, we make the $1,200 premium plus the $2,000 on our 6400 put that offsets the distance from 6200 to 6000. It would be the same as if the options expired between 7200 and 6400.
I reiterate this because ratio spreads are among the most misunderstood option strategies. There is a major fear that the outside short positions will exercise. More confusing is the potential for the open trade to appear horrific in comparison with the value upon expiration. This is because the outside positions will appreciate more as the price approaches and delta increases. This is why ratio spreads are usually placed with an eye toward expiration and not an interim liquidation.
All this being said, energy markets face a fascinating fundamental dichotomy with the threat of a Middle East shutdown on one side, and building surpluses on the other. Lest we forget, the China syndrome was a major catalyst in oil's rise above $50/bbl. and remains a factor in the general consensus that crude will continue to rise through the decade. We have all seen the experts argue on television and we have read the articles. The world is running out of oil.
The missing question (or answer) is, "When?" In my humble opinion, there is no near-term crude oil shortage and only a limited refining bottleneck. Even after Katrina and Rita, the U.S. gasoline supply has remained relatively stable and well stocked. We have discovered that energy products have truly gone global with the ability to borrow refining capacity outside of the U.S. with purchases of non-U.S. refined gasoline.
Perhaps I am misinformed or not up to date in my analysis, but our lack of U.S. refining capacity and/or gasoline availability is more an eco-political patent issue than a lack of physical plants. Several states have enacted stricter tailpipe emissions standards that require oxygenated gasoline blends. A Unocal patent apparently covers these blends and cross-licensing refining technology has not been sufficiently liberal to keep pace with consumption. In effect, we are held hostage by patents.
Oil companies have been very skillful in keeping the patent situation out of the news. It does not make good public relations. Yet, it is the American way. The adverse impact of the patent-generated bottleneck was subtly revealed when we lifted the ban on lower emission gasoline blends from Europe. Without the pollution restrictions, we can buy all the gasoline we need at favorable prices from Europe while they swap for diesel. Everyone wins except the environment.
So, do we need more refineries? Yes, but there is no immediate danger that we will run out of capacity in the immediate future. Should we plan ahead? Of course, but not in a falsely induced panic. I've used the analogy before The California energy crisis could not have developed in less than 18 months. The problem was the bottleneck caused by Enron (among others). A world energy crisis absent a Middle East shutdown cannot develop in a single year or even two and three years. It takes time to build consistent consumption in nations like China and India. Their economies are growing, but not to the extent of needing a 20% or 30% hike in global crude oil supplies.
I Ran From Iran!
Yesterday, I listened to a heated debate over the Iranian nuclear threat. The prevailing opinion was that military intervention would eventually be required. As an aside, some believed Israel would (will) repeat its successful attack upon Iran in the same way it neutralized Iraq's nuclear program.
Unfortunately, Iran represents a far more complex problem because its nuclear program is spread among many facilities and locations that are heavily fortified against air attacks. Iran's strategists read the book on Iraq and have compensated accordingly.
Whereas China was to blame for the oil price spike last year, Iran is the culprit this year. Iran makes the difference between surplus and shortage. This is why we are not so quick to use military intervention. No one wants to run from Iran, just yet. However, a close examination of the numbers suggests that a complete shutdown of Iran's production could be weathered by the world with only modest discomfort. Iran produced 3,962,000 barrels of oil per day last year and is running at the same...just under 4 million barrels. Of this amount, domestic consumption accounts for about 800,000 to 1 million barrels a day, leaving approximately 3 million for export. These numbers probably include natural gas and other liquid components, however, the basic impact remains the same.
Iran's Oil Production And Consumption
1971-2002E
Note: 2002 values are estimated. Oil includes crude production and natural gas liquids.
In contrast, Caspian Sea output has increased to more than 3 million barrels a day and Kazakhstan has a 2 million barrel per day pipeline in operation. There is excess capacity to take up Iran's slack if it suddenly shut off supplies. As with any supply dislocation, we would see a price spike. But, like Katrina and Rita, the dislocation lasts only as long as it takes to develop alternatives. At $75/bbl. and higher, there are considerable incentives to pump. Furthermore, a price above $75/bbl. marks a theoretical boundary that is presumed to slow global economic growth. OPEC does not want to sow the seeds of their own destruction.
Notice, too, that Iran's production in the 1970's was as high as 6 million barrels per day. What happened? Why didn't the decline from six to four rocket oil prices? We learn that OPEC had and has overcapacity. The decline in production is not for lack of reserves. It represents the ravages of war with neighboring Iraq, poor management, and technological stagnation. Like Saddam, the priorities are twisted. Rather than concentrate on building a domestic agenda, Iran wants to threaten war and spend its oil revenue of weapons accumulation.
We see that there is really no need for Iran to develop a nuclear program to satisfy energy requirements because there is plenty of oil to run their country. In short, we can run from Iran with little danger of a lasting global economic problem.
What about the spike? If Iran is challenged by the West or Israel and the oil card is played, expect to see a jump above $70/bbl. Yet, if we divorce ourselves from fundamentals and concentrate on the chart, a bearish argument exists for a head & shoulders with a 7000 head and 5900 neckline. This implies a potential for a test as low as 4800! That is not a very supportive formation. And, we have a precedent for the success of the head & shoulders when looking back at the August-October pattern when left and right shoulders were made at 6800 with a 7100 head and 6500 neckline. From the neckline to the head measured $6 and the late summer bust below this level eventually tested 5900...a $6 decline.
Now, we have a much broader formation with an $11 range from head to neckline.
Current inventories and the next wave of mild temperatures would normally take oil straight down to $48 and perhaps as low as a $42.50 second objective. But for Iran, this would be the overall technical consensus based upon the chart, too. In the meantime, everyone is screaming $100-plus oil. It makes for a very interesting proof of technical formations and patterns.
March 10, 2006
Philip Gotthelf
Commodity Futures Forecast
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