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September 12, 2008

Commodities and Oil
by Adam Hamilton

After starting to recover a bit in mid-August, commodities have just been crushed in September. Selling is overwhelming and universal, shattering countless technical support lines. Investors' capital is being destroyed at a breathtaking rate. Fears are running very high and the financial media is gleefully declaring that "the commodities bubble has burst".

Being heavily invested in this commodities bull myself, the intense selling in the last couple of weeks has indeed been painful. From the blizzard of e-mails I've received, it's apparent that even long-time investors are losing faith in this bull's longevity. As always during such a brutal hammering, capitulation is tempting. That's our natural human instinct when the markets move against us fast and hard.

But successful investing and speculation demand total emotional neutrality, that we actively suppress and ignore our own greed and fear. Yes, the selling has been relentless and painful. Yes, commodities and their producers are bleeding rivers of blood. But much more important than lamenting the present is handicapping the future. Are commodities likely to head higher or lower from here?

To game these odds, we first have to understand what drove the selling and whether or not this driver is likely to persist. As long as this primary driver remains in force, commodities weakness is likely to continue. But once it's gone, bullish fundamentals can reassert themselves.

After watching all the September trading action on the edge of my seat, I'm growing convinced oil is the culprit. Rational or not, it seems like most major commodities are now following crude's lead on a tactical basis. The oil selling is bleeding into the entire commodities realm, poisoning sentiment. This is leading to traders dumping the whole spectrum of commodities, in sync with oil, regardless of how unrelated to oil they happen to be.

This whole September mess started when hurricane Gustav petered out before hitting the Gulf coast on Labor Day. Even though oil wasn't bid up in the week before the storm, and was dead flat the Friday before, it was sold aggressively as soon as Gustav failed to live up to its hype. Oil was down 2% to 3% for much of Labor Day, a logical response to minimal damage to oil infrastructure.

The next morning, Tuesday the 2nd, September trading formally began. Oil was down 5% to 6% pre-market, despite no Gustav runup. That spooked commodities traders, who started selling everything. This wasn't very rational though. Sure, the hurricane affected oil and gas. But copper? Or gold? The storm was totally irrelevant to global fundamentals. But it drove the oil selloff that sparked broad commodities technical breakdowns.

After so many key technical levels were breached on the 2nd, the selling just continued and accelerated. Once support is broken, traders relying on it have to sell. That drives prices lower of course, breaking additional lower support levels that other traders are nervously watching. So the initial technical breakdown can easily ignite a nasty vicious circle where selling begets even more selling as prices spiral lower.

As a student of the markets, oil's utter dominance over all commodities sentiment in the last couple weeks felt really odd. Sure, oil is the most important commodity without any doubt. But commodities as a whole have often ignored oil in the last 8 years, as they should. Each individual commodity has its own unique fundamentals and market, so they are generally fairly well-insulated from fast oil price swings.

To investigate this newfound perfect correlation, I looked at oil versus the Continuous Commodity Index. The CCI is the extension of the old ninth-revision CRB. It is the only major commodities index perfectly comparable across this entire commodities bull. It is also the only one that doesn't assign crude oil an excessively heavy weighting. It varies radically from the new CRB, as I've proved in past essays.

Since it is an oil correction driving the CCI's intense weakness today, I focused on the CCI's performance during the last 5 major oil corrections stretching back to 2004. While I didn't think the CCI was usually so susceptible to oil weakness, I wanted to make sure my memories weren't failing me. On this first chart the axes are zeroed too, so the absolute upslopes of oil and the CCI can be compared without distortion.

Oil is already down 29.9% since mid-July in its current correction, which makes it the third largest of oil's bull at this point. In lockstep, the CCI has plunged 19.8%. This is a gigantic move in light of the CCI's construction! Its 17 component commodities are not only equally weighted, but they are geometrically averaged which greatly smoothes this index. Crude oil only accounts for 1/17th of it, or 2/17ths if you include the crude-oil distillate of heating oil.

Since this latest oil correction, which is incidentally the 10th of this secular oil bull, began, the CCI has been incredibly highly-correlated with oil. Their correlation r-square over this span ran 96.8%, meaning 96.8% of the daily price action in the CCI can be directly explained mathematically by oil. The CCI's other commodities somehow got sucked into this oil selloff even though 15 of them (88%) have nothing whatsoever to do with oil.

This oil correction was normal, very necessary, and anticipated. I wrote an essay on the upcoming oil correction back in June, when it was heresy to even suggest. We actively traded this oil correction in our subscription newsletters too, netting realized gains on USO (oil ETF) puts over this span running up to 109%. In Zeal Speculator, a calls trade on a short-oil-stock ETF had 272% unrealized gains as of this week. We saw the oil correction coming and traded accordingly.

But unfortunately I didn't anticipate oil bleeding over into general commodities sentiment to such an overwhelming degree. This chart shows why. Oil's last major correction ending in January 2007 was the largest of this bull at 34.5%. Back then, like today, CNBC eagerly declared commodities dead. Sentiment was horrendous. Yet despite the intense oil weakness, the CCI casually shrugged off this dire selloff.

Over the same 6-month span to the day, the CCI only fell 2.6%. Its r-square with oil was just 1.6%, which means general commodities and oil were totally uncorrelated during oil's worst performance of this bull. This is all the more remarkable considering the sheer magnitude of oil's decline. Most of the other 15/17ths of CCI component commodities had to rise during this selloff to help offset oil's massive decline.

The major oil correction before that ended in November 2005. While oil fell rather sharply, 19.6% in less than 3 months, the CCI actually rallied 3.6% over this identical span! This led to a modestly negative correlation between general commodities and oil and a trivial 15.5% r-square. Oil was able to correct, a normal and healthy event, without destroying the sentiment in the rest of the commodities realm.

Four corrections ago, oil had a rather modest 15.3% decline. Interestingly the CCI fell 6.4% that time and had a fairly high r-square with oil over that span of 74.9%. This correction, labeled 4 above, is interesting on multiple fronts. Before the CCI corrected with oil, it had surged with oil. This implies that the same speculative forces driving oil higher spilled into general commodities. The same phenomenon unfolded in early 2008 before today's brutal oil/CCI correction.

But even despite this upleg-then-correction parallel trading, the CCI's magnitude of correction was modest compared to oil's. The CCI only lost about 4/10ths as much as oil did and that was the worst CCI reaction to an oil selloff of this commodities bull. Until today's mess that is. Since mid-July the CCI has plunged 2/3rds as far as oil, an event totally unprecedented within this bull.

Five corrections ago, ending December 2004, oil fell 26.2% in its second biggest correction of its bull at that time (fourth biggest ever). It was an exceedingly steep correction too, happening in under 7 weeks. Fears also ran very high then, yet the CCI didn't let oil lead it around by the nose. General commodities only fell 3.5% over that exact span, and with a 20.1% r-square were essentially uncorrelated with oil.

Now realize all these CCI results are oil-optimized, taken from exact oil correction dates. If instead they were CCI-optimized, taken from CCI interim lows or highs near the oil extremes, these results would look considerably better. So even in the most conservative possible light, even sharp oil corrections have not posed a problem for general commodities until today. Usually the CCI largely ignored periodic oil weakness.

While this knowledge doesn't ameliorate the losses we've all suffered in September 2008, it still offers several important takeaways. First, there was no reason to believe even a major oil correction would spill over into general commodities to any serious degree based on bull precedent. So if you are kicking yourself, as I am kicking myself, about not realizing oil was running the whole commodities show back in late July, relax. The markets are full of surprises and we can never anticipate them all.

Second, the general commodities selling of the last couple months is anomalous. The CCI should not have followed oil and it should not have fallen so far so fast based on bull precedent. The great thing about anomalies is they are never sustainable. Emotional extremes drive anomalous technical extremes, but once the driving emotions inevitably burn themselves out the technical extremes abate too.

Third, oil is the key to this general commodities weakness as the stellar recent CCI/oil correlation indicates. This is great news. If oil selling is driving the sentiment leading to general commodities selling, then whenever oil hits its 10th major interim low of this bull its selling pressure will end. When oil stabilizes, all the fear driving heavy broad-based commodities selling should rapidly evaporate. Oil is not going to zero!

I want to drill down into this recent oil dominance of all things commodities, but first there are a few more critical observances to wring out of this initial chart. Note that even though oil and the CCI have fallen hard, both remain above their multi-year secular support lines. Without those being decisively breached, the integrity of these bulls remains beyond question. Bear technical arguments at this point are baseless.

Next, check out the conservative uptrends of the CCI and oil. Before late 2007, the CCI was just climbing modestly. This is as far from a bubble as you can get. And in 2007, during the last bout of irrational pessimism oil was driven well under trend even though the CCI held solid in its own. Based on this, you could argue that oil's above-trend surge in 2008 was simply an exaggerated response to its preceding dismal below-trend anomaly. And the CCI only started surging for the first time in this bull in 2008.

Bubbles have very distinctive characteristics. Prices rocket vertically on long-term charts because the general public, average investors, starts to believe the hype that a sector will do nothing but rise forever. This definitely didn't happen in general commodities. I'd even argue that 2008 was the first time the general public even started thinking about these commodities bulls. We've seen no bubble mania yet.

Many times in this bull, including back in late 2006, Wall Street boldly declared that a nonexistent commodities bubble had burst. Wall Street has always hated commodities because they compete with the general stock markets for capital. CNBC talking heads in particular have declared these commodities bulls over so many times in the past 5 years that I've lost count. We won't see a real bubble before Wall Street comes to love commodities as much as it did tech stocks in late 1999 and early 2000. That is years away!

While secular technicals make a mockery of the oft-abused commodities-bubble thesis, our task at hand is examining oil's recent dictatorial influence on the CCI in the hopes of determining whether it is likely to persist. This next chart zooms in a bit to better understand the beginnings of this new oil dominance of general commodities.

This chart really highlights the importance of making distinctions on how long oil's influence tends to last on general commodities. While there are plenty of small (a day to a week) tactical features that are common, there are plenty of larger features that are not. Oil's extreme weakness straddling the dawn of 2007 is the best example. While the CCI mirrored oil quite a bit day to day, it continued climbing on balance over the period of oil's correction.

In Q4 2007, the CCI ignored oil's first two attempts at breaking above $100. Other commodities weren't being bought in response to oil's strength. But then on the third attempt at the end of 2007, the CCI suddenly surged with oil. By early 2008, speculators were flooding into general commodities as well as oil and raw materials were off to the races. The CCI did advance rapidly enough in 2008 that a correction is certainly justified.

Speculators, primarily in the form of hedge funds, were the main drivers of the commodities surge in the first quarter of this year. With oil over $100, which was uncharted territory like sailing off the edge of the map, commodities really captured the attention of large investors and traders (but not the general public). Such high oil prices had never been witnessed yet the global economy didn't collapse. Couple this strength with weak general stock markets entering a cyclical bear, and capital flooded into the commodities realm.

During this pan-commodities surge, the CCI had a high 90.2% r-square with oil. While this chart makes it look like the CCI's surge had parity with oil's, it is only an illusion of axising. From January 2007 to July 2008, crude oil rocketed a staggering 188.8% higher, nearly tripling. Meanwhile over this same span the CCI was only up 54.2%. So even if commodities were due to correct, the magnitude of that decline should have been nowhere close to what faced oil.

I suspect a major reason general commodities became so closely-linked with oil in traders' minds this year is due to the new CRB index. The CRB is the flagship commodities index as far as the financial media is concerned. Yet it was created from nothing in July 2005. While it was technically the 10th revision of the classic CRB, it was radically different from anything before it. It threw away equal weighting and geometric averaging.

In the 9th-rev CRB (today's CCI), oil weighed in at 5.9% with oil and all its products together at 11.8%. But oil's weighting alone ballooned to 23.0% in the 10th-rev CRB! And if you include heating oil and the new addition of gasoline, together oil and its products now account for a staggering 33.0% of the CRB! For all intents and purposes, today's CRB is effectively an oil index. Oil utterly dominates the CRB.

So when oil started surging above $100 in February, the CRB naturally soared too. Hedge funds and other large traders, already wary of the very weak general stock markets, increased their capital allocated to commodities. As oil continued higher, its 1/3rd weighting in the CRB dragged this index higher and ignited increasing buying interest in a broad array of commodities. Thus oil gradually came to dominate the entire commodities realm this year through its massive influence in the new CRB.

So when oil started selling off in July, all these new longs got concerned. The CRB was falling fast thanks to oil which exacerbated their fears that a broad commodities selloff was underway whether true at that time or not. So traders started dumping all kinds of commodities and commodities stocks. This is called "deleveraging" by the financial media even though much of this exposure was probably not leveraged.

The lower oil fell, the lower the CRB went, and the more key technical levels were broken in all kinds of commodities and producers. This drove ever more selling, igniting that vicious circle I discussed earlier. Oil's big selloff on Gustav failing to live up to its destructive expectations on Labor Day simply accelerated these already-active trends. And the financial media, as usual late in selling episodes, have really stoked these fears with all their endless talk claiming the commodities bulls are over.

But they can't be over until global production growth catches up with global demand growth. And this is years away yet, nothing fundamental at all has changed since mid-July. Mining is still exceedingly challenging yet global demand is big and growing fast as Asia industrializes. And oil, since it is destroyed forever upon consumption, has the most bullish fundamentals of all. The thirsty world wants vast amounts yet big new deposits are only rarely discovered despite high prices and enormous exploration budgets.

So sooner or later, as inevitable as the sun rising tomorrow, oil is going to stop correcting. Its 10th major correction of this bull isn't any more likely to end it (only fundamentals can) than the previous 9. And once oil stabilizes, the whole catalyst for this massive broad-based commodities selling just evaporates. Then reason will gradually return to traders and they will see beaten-down bargains among commodities and commodities stocks. And that will mark the dawn of the next major commodities upleg.

The timing of this upcoming major buying opportunity could not be better. For the past 4 months at Zeal, we've been painstakingly researching commodities ETFs and ETNs. Commodities investing and speculation has never been easier for stock investors thanks to these great new trading vehicles. We've almost finished a comprehensive new fundamental report on our favorites. We hope to publish it in the coming weeks, just in time for what could be the best general commodities buying opportunity in years.

In the meantime, we continue to study, analyze, and trade these markets and document our ongoing analysis and resulting trading campaigns in our subscription newsletters. Subscribe today to our famous monthly newsletter and check us out! We offer many years of hard-won market wisdom applied to the current turbulent markets to help you better manage your own emotions, expectations, and trades.

The bottom line is general commodities got tangled up with oil's speculative surge earlier this year. This linked general commodities sentiment with oil, and the anomalous CCI correction since mid-July is the ugly result. While oil needed to correct, most other major commodities did not. Nevertheless, traders sold commodities universally since they have come to believe that oil drives this entire realm.

While painful, the silver lining of all of this is oil's correction is getting long in the tooth. As soon as oil stabilizes at its next major interim low, most of the irrational selling pressure in other unrelated commodities should abate. Then once again bullish commodities fundamentals will reassert themselves.

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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