Alarm bells at the commodity top?

By Murray Leith
Globe Investor Magazine Online, June 12, 2008

Murray Leith is the director of research at Odlum Brown in Vancouver. This note was written for Odlum Brown clients on June 11.

It is said that alarm bells are not sounded at major market turning points. Nonetheless, several developments over the last week send a loud (and we think clear) message that the investment tide is changing.

Monetary policy has decidedly shifted, with central bankers sounding more concerned about inflation than the credit contraction and economic growth.

Last Thursday, European Central Bank President Jean-Claude Trichet indicated the ECB could raise rates at their next meeting in order to anchor inflation expectations. In a speech on Monday night, U.S. Federal Reserve chairman Ben Bernanke said that growth risks had not worsened and inflation risks had increased.

Tuesday, the Bank of Canada surprised investors by not lowering administered interest rates as expected. Bond yields are up (and prices are down), as bond investors have concluded that the inflation fighting rhetoric means tighter monetary policy is around the corner. Indeed, futures markets are now pointing to higher administered interest rates later in the year.

This week China announced that it is increasing bank reserve requirements to 17.5 per cent, indicating that it is very serious about reining in growth and containing inflationary pressures.

Oil prices remain firm, despite the inflation fighting rhetoric and actions of central bankers. Furthermore, there is mounting evidence that high oil prices are having a negative influence on oil demand.

Oil demand in the Organization for Economic Co-operation and Development countries contracted in 2006 and again in 2007, the first back-to-back years of negative demand growth since the '80-'82 recession. This year is shaping up to be another large down year for OECD oil demand, as high oil prices are starting to have a real impact on consumer behaviour. Americans are driving less, SUV and truck sales are plummeting, and auto manufactures are closing truck plants.

Overall world demand for oil continues to grow, albeit at a slower pace, thanks to brisk demand in the non-OECD countries. However, that may start to change as fuel subsidies in emerging markets are reduced. Increasingly, developing countries are starting to reduce subsidies as they become prohibitively expensive. The International Energy Agency estimates that subsidies in China, India and the Middle East - the main engines of demand growth - cost $50-billion last year and could total $100-billion in 2008. While China is holding out on reducing subsidies, Malaysia and India recently followed Indonesia, Taiwan, Bangladesh and Sri Lanka in raising fuel prices.

Delegates from the world's leading economies and oil consumers met in Japan on the weekend and pledged greater investment in energy efficiency and green technologies to control their spiralling thirst for petroleum. In a joint statement, energy ministers from the Group of Eight countries, joined by China, India and South Korea, also urged oil producers to boost output, which has stalled at about 85 million barrels a day since 2005, and called for co-operation between buyers and producers.

The price of oil should not be going up in the face of recent developments. Growth is already slowing in the developed world as banks reduce leverage and rein in credit. Now that monetary policy is poised to be less accommodative, it is more likely that the credit contraction will have a lasting influence on economic growth.

Monetary policy in the developing world is getting increasingly restrictive, particularly in China where their interest rates, bank reserve requirements and currency are all rising. Oil demand destruction is very apparent in the developed world and a similar trend may emerge in developing countries as subsidies are removed.

In our opinion, the economic gears for a shift in the direction of oil prices have already been set in motion. All that is left is for speculators to wake up and hear the alarm bells. They are loud and clear to us.

A drop in energy prices would be welcome news for equity markets, as lower prices would have a positive influence on inflation, interest rates and equity valuation multiples.

Special to The Globe and Mail