Why “Energy Rebalancing” Means Huge Profits This Year

by Dr. Kent Moors 

Marina and I have a little less than a week left on the island before we head back to the mainland. I hope our pipes haven’t frozen back in Pittsburgh!

As we head home to begin the New Year, there are several new wrinkles in the energy market that I have my eye on.
And as always, I’m looking for new ways to profit from them.
These new wrinkles revolve around what I call the “energy balance” – and its changing fast.
It involves big shifts in sourcing and systems that will combine with some major revisions in finance that will alter the landscape for investors.
It’s not about new energy breakthroughs or big oil discoveries. And it’s certainly not about entirely new structures.
Rather, it’s about the accelerating changes in elements you’re familiar with.
Think of it, if you will, as a “rebalancing” of what already exists.
It’s an unstoppable trend that promises to hand us huge profits…

The 2014 Plan: Leveraging a Gigantic Advantage

For us, of course, this “rebalancing” gives us a gigantic advantage: we identified this trend a long time ago. In fact, I’ve discussed it in these pages before.
At present, there are three overarching dimensions to these changes: the energy network itself, the geographical considerations, and the financial arrangements.
As as the market rebalances, it will require we change our investment strategy to profit from it -especially the with first two.
As for the third, we have just about single-handedly revised the approach to finance all by ourselves.
Today, however, I want to talk about the networking dimension.

Networking involves the entire sequence of energy (oil, natural gas, electricity) transmission from production, through gathering and transit, to refining, distribution and retail. This remains the upstream-midstream-downstream sequence that has become a mainstay of the energy sector.
In the case of operating companies, our target interests will consider the basins worked, the company’s focus, market cap and field size, along with the more or less traditional considerations of management style, balance sheet, and market position.
We will also see some interesting rebalancing in the refinery space, as those processors able to bridge the domestic market and rising oil product exports, as well as the conventional/unconventional sourcing mix, will have a substantial advantage.
And then there are the huge transport revisions that are on the way. We have talked about two of these primary developments before, but will be watching their progress with added interest this year.

Fundamental Changes = Big Opportunities

The first is the fundamental change in the worldwide balance occasioned by the rapid expansion of the liquefied natural gas (LNG) market.
This remains the single most significant revision globally to take place over the next decade. The rise of LNG exports from the U.S., fueled by the largess of shale and other unconventional gas sources, will be fundamental to this revolution.
On the other hand, there is another revision that may be just as significant in generating investor profits from the export trade.
I’m referring to crude oil, but with some new elements contributing to another change in the balance. I’m talking about oil exports.
In the future, we will see a concerted move to export oil in new directions – starting with transit from the U.S. For some time, exporting oil from the states has been considered a national security issue, making the trade very difficult.
In this case, two exceptions have been allowed: one permitting the export of heavy, lower quality crude from California (for which the argument can be made of an insufficient domestic demand); the other allowing certain tolling contracts.
Tolling is a process whereby raw materials are exported to be processed abroad with the finished product then imported back in. The justification for this allowance has been the concern over maintaining sufficient domestic stock of oil products, especially diesel. That concern has now abated with the advent of significant reserves of tight oil (“shale” oil actually being only one category of such unconventional sourcing).
None of this would have been considered possible only a few years ago. Being dependent on imported oil, American policy makers were understandably dismissive about allowing the export of finished products from U.S. refineries.
But not any longer…
As is the case with natural gas and LNG, there is now ample local supply. That opens up the market for rising oil product exports.
As a result, I suspect that tolling will rise again – owing to the limitations on overall U.S. refinery capacity – but will increasingly service a jump in the exports of those products. The cost differential in utilizing foreign processing facilities makes this approach quite profitable.

The Big (And Profitable) Global Changes Ahead

Then there is the expanded use of the completed East Siberia-Pacific Ocean (ESPO) pipeline in Russia.
An earlier spur from ESPO has for several years moved oil south to China. But the new impact of the pipeline on wider Asian demand will become far more pronounced.
ESPO export oil will become a new benchmark crude rate, a major development for all of Asia. As this develops, the ESPO benchmark will replace London’s Brent as the standard for trade in wide portions of that market.
This is what makes this so significant. End users in Asia have paid a premium over what it costs to buy the same quality oil for delivery to Europe. ESPO will undercut that tradeoff and provide a genuine boost to Asian economic development. ESPO oil has a lower sulfur content as well meaning it is “sweeter” than Saudi export. That is another big advantage for Asia.
Other export changes will come from a number of geographic market-specific revisions. Western Europe will be importing more LNG as nations like Germany also phase in a wider usage of renewables.
These LNG imports will add pressure on the pricing points for long-term pipelined gas contracts, while improving prospects for investments in the expanded liquefied trade.
What’s more, a matter I have addressed before and had meetings about over the last several weeks, has begun to change how people view oil and gas sourcing in the Caribbean.
It involves the emergence of China as a major conduit of energy funding in South America and the rapidly accelerating networking of production, refining, and transport throughout northern South America and the Caribbean basin.
The combination rising Chinese influence and an existing system called “Petrocaribe” will produce some major changes that will impact North American markets. 

Thomas Edison's secret war with the Federal Reserve decades back has led to a new currency rising up today. It threatens the dollar, EURO, Pound, and the entire international monetary system. But it's also making everyday Americans rich. A Silicon Valley venture capital veteran investigates this exciting phenomenon.

Hedge Funds Reduced Exposure Ahead of Big Rally

Hedge funds and large investors continued to reduce their long exposure to commodity futures and options last week. The data compiled 3 October showed a  4.2 percent reduction to 920,000 lots, the lowest level since July 2010.

This also helps to explain the strength of the rally that followed as funds scrambled to rebuild positions. The rally that began Wednesday was the biggest three-day rally of the year and was helped by increased efforts in Europe to deal with the debt crisis and signs that the U.S. economy may avoid recession.

The energy sector saw an increase in net longs of 20 percent primarily helped by a sharp reduction in the Natural Gas short position. The WTI crude position meanwhile continued to be scaled back, moving below 200,000 lots just ahead of the rally which began last Wednesday when U.S. inventories showed a much bigger draw than expected.

Exposure to the grains sector was cut by 2 percent to 242,000 lots, the lowest level since July 2010 and much below the 2011 peak of 890,000 lots back in February. The “World agriculture supply and demand estimates” report will be released this Wednesday and any signs of tightening could attract new buying given the sharp reduction of long positions over the last month.

The metal sector was flat on the week with a small increase in gold longs - the first in four weeks - being off-set by another increase in short copper positions.

The soft sector also saw a reduction in speculative longs as positions in sugar and coffee were reduced while the cocoa short position increased further. 

Background information: The Commitments of Traders is a report issued by the Commodity Futures Trading Commission every Friday with data from the previous Tuesday. It comprises the holdings of participants in various U.S. futures markets split into "commercial" and "non commercial" holdings. The non commercial or speculative holding are typically institutional investors such as hedge funds and CTAs. Analysts and investors follow changes in these positions because such transactions can reflect an expectation of a change in prices.

Commodities Weekly Update : Commodities Sink into Red as Confidence Saps

Riskier assets such as commodities and stocks were seriously shaken this week as the U.S. Federal Reserve failed to lift investor confidence. At its long awaited meeting it delivered the now famous “Operation Twist” whereby it will be supporting the long end of the yield curve thereby attempting to keep borrowing costs low. What spooked the market however was the comment that the U.S. economy was facing “significant downside risks”.

As my colleague wrote after the announcement: “With the Fed launching Operation Twist Bernanke furthermore runs the risk of arriving too late at the party with a solution for the second time in 10 months as his QE2 programme last November came so late that the economy had long rebounded and the programme fuelled a massive commodity rally instead, which ultimately weighed on U.S. consumers in the first half of this year and forced the economy into a halt yet again.” Full text here.

By avoiding a new QE2 style liquidity injection Bernanke at least removed the fear that another round of galloping commodity prices could be on the cards. This could help consumers and manufacturers who have been struggling amid higher prices of anything from copper to gasoline but at the same time confidence is being hit by the ongoing sell-off in equities.

Changing investor attitude towards dollars
The European debt crisis helped the dollar climb to a seven-month high thereby weighing down the whole commodity complex as it became more expensive for buyers using other currencies. Last week the speculative dollar position held by hedge funds through IMM currency futures moved into positive territory for the first time in 14 months showing how the attitude towards dollars has changed dramatically over the last few weeks.

Commodities suffered the worst setback in more than four months on worries that a global recession could hurt demand for metals, energy and food. The Reuters Jeffries commodity index lost 8 percent in the week as every single commodity moved into the red. Interestingly gold, which has otherwise been viewed as a safe harbour amid stormy seas, also took a beating.

Gold falling victim to excessive volatility
Over the last month gold has made a new record high twice but has also been exposed to three 100+ dollar corrections. This has at least near-term reduced the safe haven flows as the increased volatility has made it increasingly difficult to trade and has prompted some gold bulls moving to the sideline to wait for lower prices and hopefully calmer trading conditions. During the same time investors in ETFs and futures have reduced exposure to gold by nearly 300 tonnes to 2,935 tonnes as cash and/or bonds have met increased demand.

LBMA expects gold at 2,019 next November
This week bankers, traders and investors at the gold industry’s largest annual gathering in Montreal predicted that the decade long Bull Run would continue into 2012. The 500 people attending the conference of the London Bullion Market Association predicted that gold would be trading at 2,019 dollars per troy ounce in November 2012. Last year when gold traded at 1,298 they predicted a price of 1,450 at this meeting, a 25 percent undershot from the 1,805 traded this Tuesday when the poll was made.

Having dropped more than 10 percent from the record high support is again being sought with 1,650 followed by 1,600 being the next major levels to look out for. Further dollar appreciation could trigger such a move but the positive long term projections for gold should help cushion any further setbacks.

Industrial metals suffer the most
Metals related to industrial use however have been the main losers with copper, silver and palladium suffering deeper setbacks. Silver lost an unprecedented 20 percent in just two trading days while copper, a gauge for global economic activity, fell into a technical bear market having lost more than 20 percent from the February high. Platinum is trading at the widest discount to gold in almost two decades as recession fears has removed some of the demand from industrial users which normally caters for more than 50 percent of platinum consumption. Investors looking for an economic recovery should watch this ratio closely as platinum has traded at an average premium to gold of nearly 40 percent over the last decade.

Oil markets confined to wide range
Crude oil, having failed to break higher last week, was caught up in the torrent of negative macro-economic news and dropped the most in two months. The surging dollar and the U.S. Federal Reserve’s failure to pull another rabbit out of the hat left traders focusing on reducing exposure. The moves go somewhat against the fundamental background as continued tightness especially in Brent crude, combined with a continued fall in inventories at Cushing, the delivery hub for NYMEX WTI crude, failed to receive much attention.

The overall worry is that demand for energy in the U.S. and China, the world’s two largest consumers, may fall as their economies slow down. These two nations, according to BP Plc, were responsible for 32 percent of global oil demand in 2010 and if adding the 17 countries using the euro this percentage rose to a total of 44 percent.

The civil war in Libya, which removed high quality crude from the market, has now almost ended. Experts on the ground are now predicting that oil could begin to flow in decent quantities much sooner than originally expected. These additional barrels will hit the market at a time where demand is softening and could force OPEC to address their current output levels. They do not want to see a repeat of the price collapse from 2008 to 2009 given the much higher need for revenues to balance their budgets.  

For now the most likely outcome of the market action is one of continued range trading. Brent Crude having been rejected at 117 went looking for support and should find some at 100. Meanwhile WTI crude having revisited the 80 dollar mark will now find resistance at 85 and support at 75.70, the August low.

Grain speculators suffer blowout
Hedge funds and large investors, who up until recently increased their long exposure to soybeans and corn, suffered heavy losses this week as the commodity deleveraging also hurt the grain sector. The price of new crop soybeans which only recently traded at 14.65 dollars per bushel suffered its biggest weekly loss in more than two years touching 12.50, as the surging dollar combined with signs of demand destruction took its toll.

The stronger dollar has led U.S. growers to face stiff competition on the international grain market with Russia still winning the big wheat tenders while Brazil, having seen its currency drop 16 percent, has stepped up its export of soybeans at very competitive prices.

Europe's New Economic Crunch (Oil Prices Sure Aren't Helping)

As we sit down here in Krakow to begin government sessions on shale gas policy, and European Union ministers meet in the southwestern city of Wrocław, Poland, thoughts are turning once again to oil pricing…

In case you haven't been watching, Brent prices in London trade are accelerating, approaching $113 per barrel, while the West Texas Intermediate (WTI) benchmark traded in New York is about to break the $90 per level again.

The spread between the two remains at all-time highs, indicating that Brent will continue to appreciate quicker than U.S. pricing, although both are rising.

That spread is "in favor" of Brent.

This creates a continuing problem for the E.U., which is faced with mounting eurozone currency and liquidity problems, weakness in its banking sector, and a European Central Bank that's experiencing dissent – within its own ranks – over the proper course of action.

Today's meeting in Wrocław concerns whether Greece will receive the next tranche of a bailout package. That package is already widely perceived as being insufficient to prevent some sort of Greek default. Plus, the Germans are taking a hard line on what is necessary for that largess to keep coming.

Meanwhile, the internal dispute is getting intense.

A good example is the decision made this morning by the ministers. Or actually the non-decision. The ministers decided… not to decide until next month.

The prospect of higher prices for Brent further complicates matters with the common currency.

The euro has been losing ground against the dollar throughout the latest period of the debt crisis. Of course, that says less about the dollar's strength that it does about the euro's enduring weakness.

That, combined with a rise in the cost of energy, means Europe is facing the prospect of a new economic crunch.

This one has the potential of completely derailing this continent-wide recovery already distinctive for its anemic performance.

In Krakow, Too, Our Problem Is Oil

There are essentially three reasons Poland has decided to expedite decisions on developing its domestic shale gas.

First, they may well have a lot of it. The estimate I will be giving them puts the extractable reserves in the five basins already identified in the country at more than 187 trillion cubic feet, or five times the rest of Europe combined.

Second, Poland is dependent upon Russian imported gas, introducing the latest stage in a political disagreement 500 years in the making.

But it is the third reason that is most compelling…

Russia sells that gas to Europe according to long-term (20- to 25-year) contracts, and two provisions are causing great concern in places like Poland.

First, the contracts contain a "take or pay" provision. That requires an importing country either to take at least 80% of the contracted gas… or to pay up anyway.

As grating as that is, though, it is less significant than the second aspect of these contracts.

Second, they set the price for gas according to a basket of crude oil and oil product prices. This means, as the price of oil increases, the price of natural gas increases right along with it. With Brent pricing levels moving up, Europe is looking at a more and more expensive attempt to keep warm this winter.

That is, of course, if the latest row between Russia and Ukraine does not turn into a repeat of January 2009. Then, a similar dispute prompted Kiev to cut gas passing through its territory to Europe. You see, 70% of all Russian gas going west crosses Ukraine.

It could get ugly.

While we were sitting down to a late lunch today, a reminder of the massing problem began to circulate: Goldman Sachs just issued a report forecasting the price of oil to exceed $130 a barrel in the next year.

Most of us just smiled.

There wasn't anybody at the table who thought the price would be that low 12 months from now.

Sincerely,

Kent Moors.

A Warning for Poland's Shale Gas Developers

I am leaving for Krakow, Poland, early Wednesday morning.

That means the next Update will be coming to you from one of the most enchanting medieval cities in Europe.

During this trip, I will present what we have learned thus far in North American shale gas development before a meeting organized by the Polish government and chaired by President Bronisław Komorowski.

What will take place in that room, however, is more than a simple exchange of data.

The Shale Gas Revolution Has Hit Eastern Europe

It began only a few years ago, in places like Texas, Arkansas, British Columbia, Alberta, and Pennsylvania… but the shale gas revolution is now sweeping the world.

To date, 142 basins and more than 680 shale plays have been discovered worldwide. In them are sitting a mind-boggling 6.6 quadrillion cubic feet of natural gas. Even if only 10% of that can be lifted, we are still looking at huge new reserves.

Europe has its fair share of these basins, with five major ones located in Poland alone. And that is the reason for the meetings this week.

The government in Warsaw is about to open up these shale plays to major investment.

Before they do so, however, the authorities must set regulations for drilling, determine what environmental impact will take place, weigh the potential economic benefits and problems, and discuss how this newfound energy wealth is going to change lives.

Turns out that's pretty much my job in Krakow; I will be advising on the policy challenges in each of these areas.

Still, they are not likely to expect my first comment…

That we haven't figured out all the answers to these questions, either.

It's an Exercise in Tightrope-Walking

For Poland – and Ukraine next door – there are major political considerations at hand.

Both remain dependent on gas being piped in from Russia. And, because virtually all Russian gas exports must cross over these two countries, so is everybody else in the European Union.

Both Poland and Ukraine desperately need to find alternative sources to offset reliance on Moscow. Shale gas seems to be the ready answer. Yet there are time pressures involved that we do not have in North America.

For one thing, Russia has already cut crude oil exports to the major refinery base in Gdansk – sending a clear signal to Warsaw that they should expect other retaliatory actions if the Poles renege on long-term contracts to import gas from Russian giant Gazprom.

Poland's shale gas basins do hold considerable promise, but they will not allow the country to cut imports of Russian gas.

Warsaw knows that. So does Moscow.

The advice I will give on this matter is an exercise in tightrope-walking.

If, in the next five years, Poland could develop an additional 3% to 5% of its domestic gas needs from new sources, it could force Gazprom to improve the contract particulars.

This should be the objective, because – in addition to the shale gas – Poland will begin importing liquefied natural gas (LNG) by 2014, at the now-under-construction Swinoujscie terminal near Szczecin in the western part of the Polish Baltic coast.

LNG has already created problems for Gazprom elsewhere in Europe, especially after the opening of the Rotterdam Gate complex, one of the largest LNG receiving facilities in the world. Russia bases prices for gas on a basket of crude oil and oil product prices. As the price of oil goes up, so does what Europe must pay for its imported Russian gas.

The introduction of LNG from places like Qatar and Algeria, however, is changing the landscape. It has created a local spot market, where consignments of gas can be traded quickly, at discount to pipeline prices.

Gazprom has been forced to consider renegotiating some of its contracts with major European utilities – Edison and ENI in Italy, EDF Suez in France, REW and E•ON in Germany – as a result.

Poland would like to be on that list, as well.

They just need a few years to increase LNG and shale gas volume.

Of course, one does not upset the Russian bear until the other pieces are first in place.

For Ukraine, The Problem Is Even More Acute

Two weeks ago, Ukraine approved its first shale gas contract development agreement with Royal Dutch Shell (NYSE:RDS-A) in the western portion of the country.

However, it is confronted with another Russian gas war.

Once again, Kiev cannot afford to import Russian gas. Moscow, on the other hand, remains dependent on throughput across Ukraine for some 70% of its gas going to Europe. The last time this came to a head was January of 2009. During a very cold snap, the gas was completely cut off to Europe as Moscow and Kiev traded accusations.

That fight was resolved by a new multi-year contract. The one Ukraine now cannot afford to pay.

Russia has also completed the first line of its new Nord Stream pipeline under the Baltic to Germany and is moving on the South Stream to move gas into southeastern Europe. Both lines bypass Ukraine, accentuating the crisis.

Kiev is taking about building an LNG receiving facility near Odessa, but that terminal exists only on paper. It cannot meet the current energy shortfall.

Ukraine is moving into opening shale gas (and coal bed methane development) as quickly as it can. And that is one of the cautions I am compelled to give to a Polish audience in Krakow…

Enormous Potential, Significant Problems

Ukraine will usher in drilling with little regulatory oversight of any consequence… and no environmental protection.

They are looking squarely down the barrel of a gun: They must make a short-term hard choice between a clean environment and staying warm during bitterly cold winters.

I intend to tell the Poles that shale gas has enormous potential – but it also carries with it significant policy problems in how it impacts infrastructure, labor and service usage, economic dislocation, land and water usage, and especially the environment.

This will also require a concerted move into the technological and planning changes needed to offset these negatives.

One of the other suggestions I will make is to set up special economic zones to encourage joint venture development aimed at meeting such problems.

That, of course, will provide some significant opportunities for U.S.-based companies to profit from what is opening up in European shale gas.

But that will need to be the subject of a later column.

Sincerely,

Kent Moors Ph.D.

Commodities looking for direction from Bernanke

One year ago Ben Bernanke raised the curtain for QE2 in his speech at the gathering of central bankers at Jackson Hole. Once again his speech late Friday CET could set the tone for financial markets in the months ahead as the potential for QE3 has helped trigger some market reversals during the past week.

The Reuters Jefferies CRB index is up just half of one percent at the time of writing bringing its annual return close to flat. Last week’s winners are this week’s losers with gold and silver sitting at the bottom while energy and base metals had a better week. In the agricultural space attention turned to wheat. A deteriorating outlook for U.S. and European production had wheat prices on both sides of the Atlantic performing strongly.

Weak longs washed out of gold
Gold finally succumbed to a sharp correction as weak speculative longs were flushed out sending the price lower by more than 200 dollars in just two days. What triggered the sell-off was probably a combination of a market that had become too overstretched combined with a 55 percent margin increase by the CME which handles the global benchmark gold futures contract.

With daily price swings above three percent the CME felt that the cost of holding a contract worth nearly 200,000 dollars had to be increased. This brought back memories and fears of a collapse similar to the one that hit silver back in May which also occurred after a steep rally was followed by an aggressive margin hike.

Support now at 1,700 dollars
The sell-off however did not go further than 1,705 just short of retracing 50 percent of the recent rally before buyers returned, spurred on by weaker stock markets. The severity of the sell-off has primarily been due to the amount of speculative positions having been built up over the last month and with much of that now out of the way traders felt more comfortable entering the market again. The factors that have been driving gold higher over the last year have not gone away and as such the medium to long term prospect for higher prices hasn’t either.

The Jackson Hole speech by Ben Bernanke of the U.S. Federal Reserve Friday could easily set the tone for the coming months, just like it did last year with the announcement of QE2. High expectations, especially for another round of quantitative easing, have been dwindling over the last couple of days. Given that gold would be the main beneficiary of QE3 a lack hereof could add to the downward pressure. 

Support in the market is now at 1,697 dollars which represents a 50 percent correction of the recent rally followed by moving average supports at 1,570 and 1,480. The uptrend is still firmly in place above 1,450 so even a major drop would not ruin the long-term prospect for gold.

High volatility points towards a bumpy road ahead
Thirty day volatility as measured by the CBOE gold VIX index has been rising steadily over the last month and the current reading of 34.4 percent is some 64 percent above the 2010 average which was another year of strong gold performance. This is telling us that despite the uptrend firm violent corrections like the one experienced this week can easily occur again. Investors who want to benefit from the gold “bubble” therefore need to show discipline in order to avoid being burnt by a market that has become more erratic.

Oil markets driven by Libya and Irene
Early in the week the prospect for high quality Libyan oil returning to the market initially sent oil prices, especially Brent crude, lower. The “relief” sell-off was short lived despite rebel forces entering into Tripoli and thereby bringing forward the potential downfall of Colonel Gaddafi. Traders are fully aware that it could still be many months before oil begins to flow in decent quantities. Many obstacles need to be addressed first, such as establishing security around major fields, pipelines, refineries and ports, a renegotiation of existing contracts and the return of foreign personnel.

The price of Brent crude initially dropped to 105 dollars on the news from Libya but spent the rest of the week recovering back towards 110 as possible sanctions in Syria and force majeure in Nigeria supported prices. Oil demand, especially for diesel, from India and China picked up in July lending support to a Brent crude price above 100 dollars. The spread over WTI crude initially narrowed but has since widened back above 25 dollars as increased U.S. and Canadian production is not easily moved out of the producing regions to the coast from where it can enter into the global market place.

Irene could become the worst in fifty years
Irene, the ninth hurricane of the season is threatening to disrupt gasoline supplies along the U.S. East Coast over the coming days and this helped gasoline putting in a strong performance on the week rising by nearly four percent. It has the potential for becoming the worst hurricane in 50 years and although it is expected to weaken Saturday into Sunday it will probably not happen fast enough to prevent serious problems from wind, rain and ocean water.  

Wheat outperforming corn
The price of December CBOT wheat has risen strongly once again approaching 8 dollars per bushel after touching a low of 6.5 dollars back in July. Record high corn prices are causing livestock farmers to switch to wheat feed. A year-long drought from Texas to Kansas has created the driest conditions on record for farmers who should now be preparing to plant winter wheat. Meanwhile, in Europe the corresponding Milling wheat contract rose the most on the week as Western Europe continues to experiencing tough harvest conditions after a very wet summer. Continued rainfall could result in a higher percentage of wheat being used for livestock feed instead of human consumption thereby adding upside price pressure on high quality wheat. 

 

Weekly Fundamentals - Macroeconomic Turmoil Sent Gold to New All Time Highs

Financial markets had another volatile week as economic data in the US and renewed sovereign debt concerns in the Eurozone continued to shake confidence. Earlier in the week, risk appetite was boosted by better-than-expected US retail sales and Japan's GDP data. M&A news (Google's purchase of Motorola Mobility) sent stock prices higher and in turns boosted risky assets. Sentiment turned sour again in the middle of the week and deteriorated further on Thursday with stocks, commodities (except for gold) and higher-yield currencies facing another big selloff amid disappointing US data. While weaker-than-expected initial jobless claims, housing data and manufacturing index gave further signals that the country may have a double-dip recession, rising inflation pressures indicated it's getting more difficult for the Fed to implement measures to stimulate growth.

The Franco-German meeting failed to come up with solutions to settle the debt crisis. Leaders of biggest economies in the 17-nation region proposed to create a 'true European economic government' which will eventually lead to a common tax and fiscal policies within the Eurozone. Concerning fiscal issues, Germany and France will create a common corporate tax base and tax rate between the 2 countries from the start of 2013. Moreover, they will propose in September the imposition of a new financial transaction tax across all Eurozone members. While the details of the types of taxes were not provided, investors were obviously irritated by the financial transactions tax as the euro and equities plunged after the announcement.

The ECB said that it has recently lent US$ 500M in its 7-day liquidity-providing operation to a bank at above market rates. This was the first time since February that the facility was used. Fears that more banks will seek ECB's funding because of their heavy exposure to debts of Greece and other debt-ridden countries increased and would make the market outlook negative. Concerns over contagion of Eurozone's sovereign crisis have spread to the US. The WSJ said that US regulators are taking a closer look at the US units of Europe's biggest amid concerns that the region's debt problems will spread to the US banking system. The report said that the New York Fed is 'very concerned' about the issue and has been seeking information about the banks' ability to access funds to maintain their US operations. New York Fed President Dudley denied the officials are watching a particular group of banks closely and reiterated that the central bank treats US and European banks 'exactly the same' and is 'always scrutinizing banks'.

Tremendous uncertainties in the economic outlook and banking system in both sides of the Atlantic will persist for some time. Investment banks such as Citigroup and JP Morgan downgraded their forecasts on US growth while Morgan Stanley trimmed its global growth outlook, warning the US and Europe are 'dangerously close to recession'. We expect financial markets will remain fragile in coming weeks.

Crude Oil: The front-month contract for WTI crude oil erased gains made earlier in the week amid worries over US recession. The selloff was exacerbated by the unexpected stock-build. Crude stockpile surprisingly rose +4.23 mmb, to 353.98 mmb as stocks in Gulf Coast surged a huge +6.26 mmb in the week ended August 12. Brent crude was strong despite a similar trend as disruption in the North Sea, Nigeria and Libya supported price. The front-month contract ended the day gaining +0.55%.

Nymex natural gas slipped with price plunging to a 5-month low of 3.843 Thursday before settling at 3.94 Friday. The benchmark contract lost -2.96% on weekly basis. According to the DOE/EIA, gas storage climbed +50 bcf (consensus: +48 bcf) to 2833 bcf in the week ended August 12. Stocks were -175 bcf below the same period last year and -73 bcf, -2.5%, below the 5-year average of 2906 bcf. As far as rig count is concerned, Bake Hughes reported that the number of gas rigs rose +4 units to 900 in the week ended August 19. Oil rigs added +11 units to 1066 and miscellaneous rigs remained unchanged at 8 units, sending the total number of rigs to 1974 units during the week. Directionally oriented combined oil, gas, and miscellaneous rigs fell -13 units to 227, while horizontal increased +15 units to 1138 and vertical increased 13 units to 609.

Precious Metals: With the exception of palladium, all commodities under our coverage jumped during the week. Silver was the best performer, followed by gold and platinum. The strength of these precious metals was attributed to the slowdown in global growth outlook, large fiscal deficits, low interest rate-environment in developed countries, heightening inflationary pressures and political and economic uncertainties. The issues, despite governments' resolutions, will persist (low interest rate-environment will persist for several years) and will continued to support the precious metal complex for some time.

Gold price surpassed platinum price earlier in the month for the first time since December 2008 as demand for safe-haven assets drove investors to the yellow metal from risk assets. In 2008, gold price exceeded that of platinum four times (December 12, 15, 17, 18) and we would not be surprised to see gold trade above platinum more sustainably this time.

While both metals are categorized as precious metals, industrial demand makes up over 80% of total platinum demand (with autocatalytic demand taking up more than one-third of total demand) but it only accounts for around 10% of total gold demand. The 'industrial' characteristic in platinum makes its price movement more synchronized with stocks, oil and other 'higher risk assets'. Therefore, it tends to lose its glitter to gold during economic turmoil and uncertainty. On the contrary, gold is often considered as a store of value and a hedge against inflation. It's especially attractive when global central bankers are competing to devalue their countries' currencies so as to stimulate growth.

World Gold Council released its latest gold demand trend last week. According to the council, total global demand fell in 2Q11 fell -17% y/y in volume terms but increased +5% in value terms. Strong growth in jewelry was offset by a drop in investment demand, especially from ETF and similar products. We believe the apparently underperformance in ETF investment was due to high base effect as ETF demand in 2Q10 was the second large one on record.

Geographically, Indian and Chinese demand grew +38% and +25% respectively in 2Q11 from the same period last year. World Gold Council expects the growth to continue in the second half of the year, thanks to 'increasing levels of economic prosperity, high levels of inflation and forthcoming key gold purchasing festivals'. Other factors supporting gold demand in 2H11 include sovereign debt problem in the Eurozone, downgrading of US debts, inflationary pressures and the for economic growth outlook in developed countries. These factors will continue to support official sectors in remaining net purchasers of gold and are all likely to 'drive high levels of investment demand for the foreseeable future'. 

Weekly Fundamentals - Gold Still Looks Cheap in Inflation-Adjusted Term

Commodities moved with great volatility in the past week, driven by intensifying concerns of US double-dip recession, spreading of sovereign crisis from the European periphery to core economies, speculations of Fed's easing measures and somehow supportive macroeconomic data. During the week, the front-month contract for WTI crude oil plummeted below 80 for the first time since October 2010 while the equivalent Brent crude broke below 100 first the first time since February 2011. Both benchmarks recovered later in the week in tandem with the rebound in equities. Gold remained the best performer as investors fled to the yellow metal for safe-haven investments. The benchmark Comex contract gained +5.54% during the week with price surging to a new record high of 1817.6 Thursday before retreating after the SME announced margin increases. While further correction in likely in the near-term, gold will still be the biggest beneficiary of low interest rates, rising economic uncertainties and a new round of central bank easing.

Earlier in the week, the Group of Seven Nation issued a joint statement, pledging to 'take all necessary measures to support financial stability and growth'. However, this failed to restore confidence and financial market tumbled in response to S&P's downgrades of US' debt ratings. After trimming the credit rating of US debts' from AAA to AA+ on August 4, the rating agency also lowered the AAA ratings of a number of US-backed bonds, including Fannie Mae and Freddie Mac, by a notch to AA+ on August 8. The agency said the downgrade was due to their 'direct reliance on the US government. In a statement in the midday, S&P also warned about the Asia-Pacific outlook, citing 'uncertainties in the global financial market and weakened prospects in the developed economies have further undermined confidence. The potential longer-term consequences of a weaker financing environment, slower growth, and higher risk aversion are negative factors for Asia-Pacific sovereign ratings '.

The market was in a 'risk-off' mode until the Fed announced to keep interest rates low at exceptionally low levels at least until mid-2013 at the FOMC meeting. The central bank also decided to maintain its existing policy of reinvesting principal payments from its securities holdings and will regularly 'review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate'. Although the Fed did not explicitly signal it will adopt QE3, the change of language in the 'extended period' phrase, maintenance of the reinvestment program, inflation expectations and discussion of 'the range of policy tools available to promote a stronger economic recovery in a context of price stability' indicated that the Fed will resume outright asset purchases, should economic outlook deteriorate further. The next key event would be Fed Chairman Ben Bernanke's speech at Jackson Hole on August 26 The market has been speculating that the Chairman will announce further easing policy on that day.

In the coming week, US' data including CPI and industrial production will be in focus as the outcomes will be deterministic of Fed's monetary policy. The BOE and the RBA will also release minutes for the August meeting. We expect both central banks to show worries over rising downside risks on global economic outlook.

Energies: EIA, OPEC and IEA released their latest oil demand forecasts last week. In light of economic slowdown and heightening global uncertainties, oil agencies revised modestly their outlooks for oil demand growth. The OPEC lowered the demand estimates for both 2011 and 2012, the IEA trimmed this year's outlook but raised next year's and the EIA raised demand from 2010-2012 but the size of growth in 2011 was lowered as a result. All 3 agencies warned of the great uncertainty in global economic outlook. The IEA stated that 'concerns over debt levels in Europe and the US, and signs of slowing economic growth in China and India have spooked the market and raised fears in some quarters of a double-dip recession'. The OPEC cited 'dark clouds over the economy are already impacting the market's direction...The potential for a consequent deterioration in market stability requires higher vigilance and close monitoring of developments over the coming months'. Together with reduction of the price forecasts, the DOE/EIA said that 'there is significant downside risk for oil prices if economic and financial market concerns become more widespread or take hold'.

Notwithstanding weaker headline growth forecasts, demand in non-OECD countries remains resilient and its share of total global demand is indeed revised higher. For instance, the EIA's estimate of non-OECD as a percentage of total oil demand was upgraded to 48.02% in 2011 and 48.48% in 2012, compared with 47.91% and 48.78% respectively in July's projections. The OPEc also forecast non-OECD as a percentage of total oil demand to increase to 47.67% in 2011 and 48.43% in 2012, compared with July's projections of 47.62% and 48.38% respectively. China will continue to be the biggest oil consumer in the emerging market. Therefore, the economic developments in China and emerging markets will be more determinative for oil prices in coming year despite short-term volatility.

Nymex natural gas price rose +3.02% last week as inventory increased less than expected. Storage climbed +25 bcf to 2783 bcf in the week ended August 5, compared with consensus of a +37 bcf gain. Stocks were -197 bcf below the same period last year and -80 bcf, or -2.8% below the 5-year average of 2863 bcf.

In the Short-Term Energy Report, the EIA forecast that total natural gas consumption will increase +1.8% to 67.4 bcf/day in 2011, driven by industrial and electric power demands, and then to 67.8 bcf/day in 2012. Gas production is expected to increase +5.9% y/y to 65.5 bcf/day this year and then by +0.9% to 66.1 bcf/day in 2012. Domestic production has been so strong that it contributed to net exports.

During the week, the Baker Hughes also reported the number of gas rigs increased +3 units to 896 units.

Precious Metals: Gold extended its rally last week, recording the biggest weekly gain since 1Q09, amid global economic uncertainty and speculations of Fed's QE3.The metal surged to a new all-time high of 1817.6 Thursday before sliding after the CME Group announced margin increases. The CME raised the initial margin requirement to 7425 per contract from 6075 and the margin for hedging to 5500, up +22.2% from 4500.

While gold's correction may continue next week, CME's margin adjustment would not reverse the metal's uptrend. Indeed, the market only used that as an excuse to take profit from gold's recent exponential rally. Gold's accelerated rise might have been a bit overextended in the near-term. The chart below shows that the metal's close on Friday has already exceeded the upper 3 standard deviation. It's reasonable for the metal to have a correction before resuming the rally.

The market has been talking about gold price bubble as the metal has risen more than +26% since the beginning of the year and almost 80% of the gain was made over the past 6 weeks. Nominal gold price has indeed risen to a record high and exceeded levels in 1980. However, after inflation is adjusted, gold price remained -20% below those levels. While many people also compare the current economic situation with the one in 2008 when Lehman Brothers collapsed, the current pattern of gold price is more similar to the period from 3Q07 to 1Q08. If gold is to resemble the movement at that time, price will need to rise +20% more as the metal soared +50% back then.

Weekly Fundamentals - Gold has Further to Go...

Commodity price movements continue to be directed by macroeconomic concerns in the near-term. Gold jumped to a new record high of 1637.5 on Friday as US growth missed expectations. The yellow metal's rally to new highs in 3 out of the past 5 days signaled market worries over uncertainties. The debt ceiling debate in the US has dominated the news headline for the whole week. The latest development is that House speaker Boehner's revise plan was passed in the House but was defeated in the Senate. Meanwhile, the majority Senate leader Reid modified his proposal, incorporating Minority Leader Mitch McConnell's '2-step' process (the loan will be provided in 2 installments of 1.2 trillion, one immediate and another when the nation is near the debt limit again) to raise the debt ceiling. Economists generally do not expect the new plan to be the resolution for the debt problems.

On Friday, market sentiment was deteriorated further as US economic growth disappointed in 2Q11. GDP expanded an annualized +1.3% in 2Q11. The market had anticipated a strong expansion of +1.7%. For the first quarter, GDP growth was revised lower to + 0.4% from +1.9% estimated previously. Economists have revised down their forecasts for this year and 2012 after the report. For example, Bank of America Merrill Lynch cut US' growth by -0.6% to just 2.3% in 2012 and pushed back the first Fed hike to 2013. Barclays Capitals reduced the country's growth forecasts to +1.7% and +2.4% for 2011 and 2012 respectively.

As the August 2 debt limit deadline approaches, the market has increasingly worried about a government shutdown and debt default. While our central view remains that lawmakers will compromise on a plan to avoid default, any deal will only be able to solve problems in the short-term, rather than in the long-term. Against this backdrop, as well as slowdown in economic growth and delay in Fed' rate hike schedule, gold should remain well-supported and be able to rally higher from current level later this year.

We have a busy calendar next week. While the market will be closely monitoring developments in the US debt ceiling debate, RBA, BOJ, ECB and BOE will be meeting on monetary decisions during the week. PMIs will also be released and moderation in manufacturing activities in China, the USD and the UK will probably weaken sentiment further.

Energies: WTI crude oil price was pressured last week amid debt uncertainties. The decline accelerated on Wednesday after unexpectedly large stock-builds and on Friday after downside surprise in US growth. The front-month contract declined -4.18% during the week. Brent crude oil price also dropped, recording weekly loss of -1.63%, but price remained within recent trading range of 115-120.

According to the DOE/EIA report, crude stockpile increased for the first time in 8 weeks, by +2.30 mmb, to 354.03 mmb in the week ended July 22. Current level of oil inventory has stayed at the top end of the 5-year range. However, with the release of SPR eventually reflecting in inventory data, the level is expected to rise further and exceed the 5-year range in coming weeks. Fuel demand has been soft. Gasoline demand has averaged 9.09M bpd over the past 4 weeks, down -3.31%, from the same period last year while distillate demand fell -3.51% y/y to 3.48M bpd over the last 4 weeks. The coincidence of SPR release and seasonal weakness in US fuel demand should result in further widening of the WTI-Brent crude spread.

US gas price lost more than -5% during the week. Gas storage increased +43 bcf to 2714 in the week ended July 22. The addition exceeded market expectations and triggered a slump in gas price. Stocks were now -201 bcf less than the same period last year and -65 bcf below the 5-year average of 2779 bcf. Separately, Baker Hughes reported the number of gas rigs fell -12 units to 877 units in the week ended July 29.

Precious Metals: Reuters' biannual poll of precious metals price forecasts indicated that investors are more bullish on gold's outlook than 6 months ago. The survey showed that over 50% of the respondents expected gold price to average 1500/oz or more this year, compared with just over 20% in a poll conducted in January. The median gold price forecasts are 1510 in 2011 and 1575 in 2012, up from January's forecasts of 1453 and 1425 respectively. Macroeconomic uncertainty is the main reason driving investors to Gold.

Although European finance ministers agreed on new measures to contain sovereign debt crisis in peripheral countries, market worries have not been alleviated, as indicated in widening yield spread and CDS spread. Meanwhile, rating agencies S&P and Moody downgraded Greece's rating last week despite the new bailout plan. Both agencies warned that a default is inevitable. These suggest that the measures announced after the EU summit can at most soothe the situation in the near-term while core problems remain unresolved.

In the US, the deadlock over US debt ceiling has hurt confidence. Although in the event that the Congress eventually agrees to a debt ceiling rise, the US still lacks a long-term and feasible plan to reduce deficits. We expect investors, be it official, institutional and retail, to reinforce their efforts to diversify their asset away from USD. This provides a good opportunity for gold investment.

The deteriorating economic condition in the US will lead the Fed to delay its tightening schedule. While the market has been worrying about a default in US debt, any agreement in raising the debt ceiling and deficit cutting will only lift USD temporarily. Fiscal tightening may trigger the Fed to extend and expand monetary easing to stimulate the economy. Even if there's no QE3, the Fed funds rate will stay at exceptionally low level for a longer period than previously expected. As long as interest rates remain low, we believe gold will surprise to the upside.

Gold is also appealing as it protects investors during periods of inflation and deflation. Elevating inflation pressure is what the global economy is experiencing. In China, CPI jumped at the fastest pace in 3 year to +6.4% y/y in June from 5.5% y/y in May. Australia's latest report shows that headline CPI eased to +0.9% q/q% in 2Q11 from +1.6% a quarter. The moderation was not as much as expected. On annual basis, inflation rose to +3.6%, up from +3.3% in 1Q11. New Zealand's inflation has continued to overshoot the central bank's 1-3% target. In the US, core inflation was strong although headline CPI unexpectedly declined in June. The rise in global inflation should lead to the rise in gold demand.

source:Baker Hughes