September 21, 2006
Super Cyclist’s Staring out their Windows

Philip Verleger says that it is not ‘unthinkable’ that crude will fall to $15 barrel, and Barron’s argues that the explosion of commodity based investment products (i.e. ETFs) could mark the end of the boom times.  To note: Verleger isn’t some crackpot that feeds Kudlow sound bites.  Rather, Dr. Verleger is an acclaimed energy market consultant whose historical forecasts have proven exceptionally accurate (publications).

"In a market like this, if things start falling ... prices could take you back to the 1999 levels. It has nothing to do with production.” Seattle Times


With commodity prices dropping rapidly and many analysts climbing aboard the ‘commodities bust’ express (Roach, BCA, FN Arena), why I am hesitant to join the crowd?  It is definitely not because I am bullish on commodities - longer term I believe that any misstep in the China growth miracle will spark a disproportionately large decline in commodities prices.  But this is exactly the point: China has defied slow down expectations many times in the past, and previously unthinkable speculations have become serious points of discussion today.  To wit, maybe China’s banks are not insolvent after all, maybe Chinese consumers can step up to the plate just as the U.S. economy strikes out, and maybe the super cycle story will not suffer a deadly set back until after the 2008 Olympics.

Along with the China growth story there are other potential conflicts with the ‘commodities bust’ theory.  Specifically, historically low inventory levels in things like copper, aluminum, and nickel persist, the Baltic index has yet to signal slow down, and there is even the possibility that the US economy is not racing down a one way street to recession.  On this last point the story goes that falling energy prices will line the consumers pocket with some spare money (as the housing market goes bust it is unsurprising that this story is receiving extra attention from the ‘soft landing’ crowd today).

Needless to say, things did get ridiculous in the commodities markets in 2006, and many latecomers to the party have been hurt. But let’s not forget that since 2004 commodity prices have marched higher just when the boom threatened to go bust. Also don’t forget that there is not enough evidence to conclude that $725 an ounce gold in May 2006 is akin to the $850 an ounce peak reached in 1980. Quite frankly, volatility in commodity prices may have more to do with the recent newcomers losing their nerve than a rational interpretation of the fundamentals.

The flip side to this contention – and one that I am leaning towards – is that the super cycle speculators are standing by their windows threatening to jump, deflationary forces are about to build in response to to global overcapacity/economic slow down, and falling commodity prices are a leading indicator of a U.S. economic recession.  Again, I don’t think there isn’t enough evidence to sink your teeth into this conclusion right now, but if Verleger’s $15 a barrel proves closer to the price of crude than Merrill’s $100 a barrel call say a year from now, a U.S. recession may be already in the cards.
 
“Again, barring a major recession, we think oil prices will average at least $70 per barrel over the next year…we think that bullish trend will continue over the next six months and (natural) gas prices will average closer to $10 per Mcf in 2007.” Raymond James