Why did Oil and CRB Index Rise and Fall?

Remember this summer when it seemed like gas prices were on this perpetual escalator of rising prices? Goldman Sachs was reporting that oil prices were headed to $200. T. Boone Pickens was reporting that oil below $100 was far from likely. In hindsight, they were wrong and very wrong. Oil rose to $145 a barrel in late June and gasoline rose to $4. 75 per gallon. As quickly as oil and gasoline rose they fell even harder.Today, oil trades at close to $39 per barrel and gas is less than $1.80 per gallon.

The following paper will examine when commodities will bottom. To understand the bottom, the road to $145 per barrel will be constructed and then deconstructed. The oil bubble began with sound fundamental principles; in this case, it was the growth of the emerging markets namely China and a weakening U.S. dollar.

China was in the midst of preparing to show off their country to the world for the 2008 Summer Olympics. The event would highlight the years of growth and productivity, which helped contribute to the rising commodity prices. As the European economies strengthened and the U.S. was struggling with a housing related recession, the U.S. dollar lost close to 30% versus the Euro. The weak dollar played a major role in the ascent of oil.It was no coincidence that while oil reached all time highs that the U.S. dollar reached all time lows to the Euro. Unbridled enthusiasm started settling into the oil market in late May early June. Commodities were one of the only asset classes that was still growing, and major hedge funds began massively trading them. The hedge funds brought leveraging into play and generated the main catalyst for oil moving from $75 to $145 in the span of a couple of months.

The inputs that constructed the massive run-up in commodities are the same inputs that have deconstructed the commodity complex. Decoupling, the Euro, and leveraging have all taken a breather for now. Did the astronomical prices drive commodity producers to expand and overproduce? This is the fundamental question that needs to be answered first before the industry is safe to reenter. One metric that an investor may want to examine to determine demand and supply stability is the inventory level of commodity producers. A lazier way to figure out a reentry point is an appreciating Euro and a falling dollar.

The commodities market will bottom toward the first half of 2009. Currently many commodity producers are cutting back on production to prevent overproduction. Archelor Mittal the world’s largest steel producer is slashing production by 35% for the rest of this year. Likewise OPEC has announced production cuts for next year. With these production cutbacks coupled with the fiscal and monetary stimulus, the commodity complex should be ready for a rebound in late 2009.

Gyrations of the U.S. Dollar

The dollar has continued to maintain strength relative to many foreign currencies since the collapse of U.S. financial institutions. During the summer of 2008, the dollar was trading at close to $1.60 to the Euro and now, on November 24, it trades at close to $1.25 to the Euro.
The rapid ascent of the dollar caught many traders off guard. The cascading fall of major U.S. financial institutions such as Fannie (FNM), Freddie (FRE), Lehman (LEHMQ.PK), and AIG (AIG) was the catalyst that ignited the dollar rally. Panic permeated the economic climate, prompting many financial institutions and main street businesses to question the soundness of the global banking system. Panic stricken investors pulled their money out of their risk infested banks and found calmer waters by anchoring their money in U.S. treasury bonds. With so many foreign investors purchasing U.S. treasuries, the demand for dollars grew to the point we are at today, $1.25 to the Euro.

The strength of the dollar is the result of panic and what is called an event risk. When the event risk subsides and normalcy returns to global markets, the dollar will revert to the secular bear pattern of the past two years. There is little fundamental reason for the dollar to maintain the strength through this event risk. The dollar should be in worse shape after the event risk than before it due to the massive deficit spending and the expansion of our federal debt.

Moreover, this crisis comes at an inopportune time, when our country will be facing larger and larger structural deficits due to the Medicare and associated retirement costs of the Baby Boomers. I would expect normalcy to start returning in 2009. probably around the early spring.
A catalyst to drop the dollar value might come from the recent announcement that China will spend $586 billion dollars to stimulate their slowing economy, which will most likely cause them to sell U.S. treasuries. This action should put downward pressure on the dollar.