Body Of The Snake (part 2/3)

We find ourselves in the midst of an economic crisis. Bears abound, growling about a multitude of problems including stagflation, financial failures, rising commodity prices, and capitulation to name a few. These issues are no picnic in the park, but have become so overwhelmingly redundant that the masses seem to take the negativity in stride. As opposed to accepting defeat, allow me to dissect the crisis at hand, ending at the root of the problem. Once we find the root, we will be able to identify the signals of a bottom.

The following is the second section of a three part segment focusing on the economic crisis at hand. I move from the tail to the head, or root, of the situation. We continue with the main cause of high oil prices, and how this allows us to dissect the body of the crisis.

Body Of The Snake (part 2/3)

As we slither from the rattle to the body of the snake, it is essential to look behind the curtain of high oil prices, exposing the forces supporting its rise.

Do not be distracted by the political manhunt for commodity speculators. This is a puppet show orchestrated by the government in an attempt to soothe social unrest over high gasoline prices. Traders are merely the scapegoats.

The primary culprit analysts point to concerning oil prices is the basic theory of supply and demand. Though a reasonable explanation, I believe the rising demand for oil to be only a partial piece of the puzzle. To further examine the demand theory, let us review some data. According to BP Statistical Review, the top five oil consumers by country in 2006 were:

As one can see, the United States still sits at the head of the table, with China finishing a distant second. In fact, although close, India does not even crack the top five.

Though Chinese demand for oil continues to rise, any recent increase in consumption this year has been mitigated by a substantial decrease in demand in the United States. According to Lehman Brothers, oil consumption in China is expected to increase by 4.5%, or 340,000 Bbl/day in 2008. However, the United States Energy Information Administration reported that U.S. oil consumption decreased by 3.9% to 19.77 mill. Bbl/day in April.

On the supply side, OPEC and Venezuela have increased production, while militant attacks in Nigeria have shut down up to 30% of its oil production. As a result, shortages in supply have been countered by additional production. However, we must keep an eye on the militant activities, for Nigeria is our fourth largest source of oil. Overall, considering the above, one would be hard pressed to conclude increased global demand for oil is the main driving force behind the commodity's unprecedented climb.

I believe the above supply/demand analysis has led some analysts and government officials to place the blame on speculators, or futures traders. Although increased futures activity may lead to higher volatility, oil prices ultimately follow supply and demand market forces. Therefore, any over-valuation will be valued by regular data releases of government entities, oil producers, and refiners. If global demand and market speculators have only partial responsibility for oil's flying price, then who or what is to blame?

We have now reached the body of the snake, the weak dollar. The U.S. Dollar has depreciated significantly against major currencies. Since January 2007, the dollar has fallen 77% against the Canadian Dollar, 22% against the Euro, 10% against the Yen, and 5% against the Mexican Peso. The appreciation of the Canadian Dollar is highly significant considering Canada is responsible for 18% of goods imported into the United States. Furthermore, the U.S. Dollar is beginning to depreciate against the Chinese RMB. China is shifting their economic policy, no longer linking their currency valuation to the dollar. Instead, China is implementing a managed float exchange regime. Meaning the government will appreciate the RMB against the U.S. dollar in calculated increments.

The aforementioned currency pairs represent the top five trading partners of the United States. The U.S. runs an increasing account deficit with each of these countries, importing more than exporting. As a result, while the U.S. dollar weakens, the cost of imports for U.S. companies rises, further squashing profit margins. Additionally, more U.S. dollars flow out of the country to pay for these imports, placing more downward pressure on the domestic currency.

The United States imports nearly half of the oil it consumes. Therefore, as the U.S. dollar falls in valuation against major currencies, the price of oil increases. As oil moves higher, more U.S. dollars fly out of the country. This devalues the currency further, resulting in an increased upward pressure on the price of oil. It is a vicious cycle, fueled by the weakening of the U.S. Dollar. Oil is the rattle distracting us from the body of the problem. Hence, until the dollar begins to stabilize and appreciate against major currencies; commodities, and the overall cost of imports will continue to rise with a vengeance.

Phew, now take a deep breath, and let's look at our conclusions thus far. With rising prices of commodities and imports, consumers feel their wallets lighten, while companies watch their profit margins shrink and earnings erode. We identified the plummeting dollar as the body of the snake. However, as all farmers know, the best way to kill a snake is to chop off its head.

The final segment of my blog will locate the head of the snake, and find the best way to remove it.

Risk Disclosure: This market commentary is provided for information purposes only and under no circumstances should be regarded neither as an investment advice nor as a solicitation or an offer to sell/buy any financial product. I assume no responsibility or liability from gains or losses incurred by the information herein contained.