choobeebo is the nick of a commodity trader I met in the Finance Manila forum who expresses his views regularly on commodity markets as well as technical analysis. He was kind enough to email me his ongoing views on crude oil as the prices fluctuated this month and I’m posting those views here as a sort of virtual journal of a commodity trader both as an illustration of how a trader can react to dynamic and changing conditions alongside the use of their preferred strategies: in this case technical analysis.

So choobeebo, take the floor:

 July 7th Closing Comment: The blue uptrend line is intact. As long as prices stay above this line, technical traders would buy minor corrective breaks or declines into support areas – - which in the current case is in the $137-139 zone. To trade the bull channel, buy when the price nears the blue diagonal uptrend line and sell when the price nears the yellow diagonal line. Cut loss or get out of long positions if the market trade below the blue diagonal line as this indicates a deeper price decline is likely.

July 17th Closing Comment: In our previous technical commentary ten days ago, I advised cutting loss or getting out of long positions if the market trades below the blue diagonal line (“the uptrend line” in technical market analysis parlance) as this event indicates a deeper price decline. This is exactly what happened. The market is now about $8 below the uptrend line. Bulls need a quick market snap back to above $132 in order to maintain a sideways tone and to minimize the bearish implications of the uptrend line violation. A failure to do so in the next two sessions would confirm the market breakdown. Technical measurements point to the $118-122 zone as 1st bear target if the technical breakdown is confirmed.

July 25th Closing Comment: The bears continued to press the downside after breaking the market below the uptrend line. We are now very close to the 1st bear target. In our previous commentary we mentioned that technical measurements point to the $118-122 zone as 1st bear target. Further declines could not be ruled out. Other than the technically oversold condition of the market, there is no hint of a bullish reversal yet. After having reached the 1st bear target, a corrective bounce to $132 could not be ruled out either. The market is likely to go into a consolidation mode (sideways trading) after sustaining those sharp losses. I would like the market to post a higher low before confidently taking the bull side.

Many thanks for the blow by blow analysis choobeebo. As markets change, so does our anticipation, in what can only be described as a never ending dance.

Others prefer solid convictions that never change despite already clashing with reality. Those are the people who get their head handed to them when the markets swing wild.

The latest ITF Report On Crude Oil is an excellent resource on the oil market and recent developments.

For me the highlight of that report is a statistical study they featured at the end which tested the correlation of oil price movement to changes in market participants positions. They did a two way correlation: first if oil prices tend to lead changes in portfolios, and second is if changes in portfolios lead oil prices.

I’ll maintain the suspense and urge you to read the report yourself to know their answer.

Meanwhile, I’ll feature three snippets from that report that merit attention. These graphs are from the section of the report on the Structure Of Crude Oil Markets. These are comparative graphs of the the open interest (i.e. contracts held) by various market participants over the years.

The first group are what the CFTC refers to as non-commercials which are the traders and speculator camp:

The second group are the commercials which include the oil producers and manufacturers, as well as middlemen dealers, which don’t produce their own product but act as intermediaries:

Now, from the looks of those two graphs, isn’t it a simple visual guess to decide which market participants account for the largest volumes of Oil Futures contracts? Not the manufacturers or producers (which are the physical supply and demand folks) but the middle men and traders–which are focused on the paper supply and demand.

Nonetheless, the report does shed further light on the subject including an analysis of crude inventories with relation to rising price scenarios, as well as the correlation studies I mentioned earlier.

I hope I’ve whetted your appetite enough but before I leave you in peace to read the Oil report, here’s one last snippet, this time showing the net positioning (long and short) of the commercials over the years:

Most of the commercials are really sellers into this market, with only the swap dealers net buying, but are actually reversing going into 2008.

If all the commercials have always been selling, and prices have been rising, by definition demand has been exceeding the selling. Someone’s buying–but who’s buying?

The traders of course.

Question is, are those guys really intent on taking delivery of physical oil? There’s only two ways to offset a long oil contract. One is to take the physical delivery and consume the oil while the other way… well you know that already. Is it happening now? Oil is at $123 as I write this. Down from $145 just two weeks ago.

Some group has been very naughty.

Earlier this year, I posted on Finance Manila about the relative value of gold against currencies other than the dollar. This is sort-of a follow-up to that, focusing on the actions of world central banks.

I just received via email the latest data from the World Gold Council on the gold reserve holdings of central banks, and the trends on the central bank actions are quite interesting.

Anyway to start, it isn’t a mystery that gold, along with other commodities, have been rallying for some years now:

Unlike other commodities however, gold isn’t really consumed, but rather held as a reserve currency against existing fiat currencies. From the reserve asset statistics of the World Gold Council, it’s possible to have a look at Central Bank reserves for the same period as the rise in gold above. Here are the top 16 holders of gold, as measured in metric tonnes, as of 1st quarter 2008:

The first Central Bank Gold Agreement (also known as the Washington Agreement on Gold) was announced on September 26, 1999. The agreement to limits on central bank sales of gold was reaffirmed five years later; the second agreement came into force on September 27th 2004 and will run until 2009.

The agreement was a communique from the following banks:

Oesterreichische Nationalbank
Banca d’Italia
Banque de France
Banco do Portugal
Schweizerische Nationalbank
Banque Nationale de Belgique
Banque Centrale du Luxembourg
Deutsche Bundesbank
Banco de España
Bank of England
Suomen Pankki
De Nederlandsche Bank
Central Bank of Ireland
Sveriges Riksbank
European Central Bank

In the interest of clarifying their intentions with respect to their gold holdings, the above institutions make the following statement:

1. Gold will remain an important element of global monetary reserves.
2. The above institutions will not enter the market as sellers, with the exception of already decided sales.
3. The gold sales already decided will be achieved through a concerted programme of sales over the next five years. Annual sales will not exceed approximately 400 tonnes and total sales over this period will not exceed 2,000 tonnes.
4. The signatories to this agreement have agreed not to expand their gold leasings and their use of gold futures and options over this period.
5. This agreement will be reviewed after five years

In light of this agreement, from the data above, it’s possible now to construct a table that computes the net change, quarter-on-quarter of the gold holdings of those respective reserve banks. This can be charted as a quarterly change:

One trend is that, at least for the largest holders of gold reserves, they have been largely selling into the gold rally. Note the large selling of the Swiss early in the early stages of the gold rally, and the French and ECB in the more recent years.

Actually, comparing the average gold spot price with the level of gold reserves shows along with France and the ECB, it’s been the European banks who have been selling into the gold rally.

You can contrast this with reserve banks of Venezuela, China, and Russia, who have been buyers into the rally.

From this data, there are a number of questions that arise? Why are the European banks selling gold?

Julian Philips wrote an article last June 2007 about the Swiss National Bank’s annoucement then about their planned sale of 250 tons of gold. From the data above, looks like this is already taking place as we speak. The reasoning cited by Philips was that Switzerland, being a haven country for a lot of foreign capital, so has vested interest in maintaining a spread of foreign currencies as reserves.

So does the same logic hold for the other European banks, who have joined the selling? A more recent article argues that Europeans are defending the Euro from following the dollar’s decline. So the gold sales help drive european reserves to help protect the Euro considering the value of the dollar has also declined against the Euro and Swiss Franc over the same period as the rise in gold.

In 2007, Matt Caruso conducted an interview with popular trader and author Larry Williams, and there was a good point raised by Williams about the change in the mix of commodity participants now:

MC: After reading your book The Secrets of the Commitment of Traders Report, I understand that the position of commercial traders, the seasonality, and trend of a security are all important factors. Would you like to explain these tools?

LW: Yes, but first let me interject here – a great change that has taken place since that book was written and that is that we now have these basket commodity funds where they buy a bunch of commodities and hold them with the belief that the commodity will go higher. Jim Rogers started the whole idea I guess, but these index traders now account for about 25% of the market volume. When you’re looking at anything that has to do with COT (commitment of traders) positions, and I don’t know the answer yet because we haven’t had the data long enough, it’s not the same old game anymore since you have a huge number of perpetual longs, these index funds, and we’ve got to figure out what to do with these guys. Like I said, I don’t have the answer to that yet because I only have sixteen months of data with it.

The question remains, “How do we still use the data?” I think that what people need to understand, the biggest misnomer is just because the commercials are long doesn’t mean the market is going to rally. You have to understand that they don’t speculate in the market, they’re using the market to facilitate their business. They’re not taking positions in the market like you or I as speculators, they’re hedging their business by pre-selling their production, so you need to understand that their function in the marketplace is not the same as ours. They’ve been selling a lot in the grains now and it looks like the grains should come down – the reality is that a lot of guys are selling forward production because at these price levels they can produce a lot of crop; it’s priced to make money so they’ll sell it. It doesn’t mean they’re short the market – they just sold their future production. We really need to put their commercial position into phase with the trend of the market as well.

MC: So you would basically wait for a trend reversal before acting on the commercial short position.

LW: Yes, that’s really critical. They’re heavily short, but that doesn’t mean sell today – it means I want to focus in on that market. The ideal thing would be a big smack on the market and then some technical rally back where you look to take your position.

Williams was one of the first traders to examine the possibilities of using the Commitment of Traders Reports (COT) from the CFTC to spot trading opportunities. In the same interview he shares his view on using the data:

MC: This is very interesting. Do you plan on releasing an updated version of your COT report to include these new developments in the market?

LW: We don’t have enough data yet but I’m doing something for my subscribers in March about what I think we need to do. I think we need to create a true COT index so that it’ll ferret out all these index traders, option people and other data in there. We need to have a true COT index, a true open interest index, and a true large speculator index.

MC: So until these adjustments are made, do you still feel that there is still a lot of value in the numbers we get from the CFTC?

LW: Oh yeah! I also look at just the net position of the commercials. I put it into an index and I also look at their net position versus open interest. A classic example would be open interest is really peeling off in the marketplace. If you just look at the open interest you don’t know what that means. However, if you go inside that report and see the commercial long position is declining and the large speculator position is increasing rapidly we know that there are a lot of large trader longs coming in and they tend to be buyers of highs. So that would be a bearish scenario since open interest is down and without the large traders, open interest would be way down. If, on the other hand, you have open interest coming down and commercials are increasing their longs, that is very bullish because the only player in the markets on the long is the commercials. That’s how I like to look at the commercials in regards to open interest.

People can access the Commitment of Traders Reports here.

Just a follow up to a previous post on interest rates and the stock market.

I encountered David Chapman’s article on Oil recently. He makes a case for Oil not being in a bubble and that the idea that speculators are driving the commodity prices as too overrated.

What I found interesting however, were Chapman’s charts on the patterns of previous rises in asset classes and the movement of the US Dollar. I borrow these charts and post them here for illustration.

Consider the previous dot-com boom and bust, and the NASDAQ Index:

Compare this with the recent trends in Oil alongside the US Dollar:

Can you spot the difference? The stock market boom in 2000 was accompanied by an appreciation in US dollars. Contrast this with the commodity boom now which is accompanied by a depreciation in the dollar.

The original rise in Oil in the classic inflationary period of the 70s and 80s is even more succinct:

The spike in Oil was accompanied by a declining dollar, just as the subsequent crash was accompanied by an appreciating dollar.

Two simple insights from the above:

• Stock Markets are positively correlated with the Dollar
• Commodities are a hedge against inflation, which is essentially a falling dollar

Corrollary to the above:

• The dollar falls during inflationary threats, fueling a boom in commodities, and a slump in the stock market.

My previous post wondered at the positive correlation of US interest rates to the stock market, and the reason could be that rising US rates, make the US dollar more attractive, which could fuel movement of capital from hedging in commodities and back into Dollar-denominated assets like (corporate) stocks and bonds.

The historical performance of commodities have always been rapid spurts and rises, while that of stocks have been a gradual uptrend over a longer period. I take this to suggest that commodities are always the temporary safe-haven for speculative capital during times when the stock markets are in distress. Once crises abate, speculative capital quickly leaves the havens and resumes their former trend (although the swings get wilder and wilder, relative to the previous crises).

FED kept rates steady last night, ending a downward trend bias we’ve had since the mortgage crash last year. On the Bloomberg Commodity Page, we see selling on metals and energy futures:

Of course one day does not reverse a trend, but this reaction is an important indication that the run up in commodity asset prices have been speculative in nature: traders have been using commodities as a hedge, not really against inflation, but more against the losses in stocks and mortgage assets.

We’ve also been talking about interest rates lately. From the chart below, we know that the FED rarely overturns a previous decision in consecutive meetings, but policy is fairly consistent every time a change happens. It’s been down for the past few meetings, now a flat policy trend is emerging, and with inflationary threats brought about by the surging commodity prices, eventually it will be an upward bias.

For stocks, the issues now that liquidity problems have abated, focus will shift back to corporate earnings–and how (a) companies will be dealing with higher production costs, and (b) consumer spending and consumption will be affected by higher prices of goods.

However, for me a significant driver will be how large hedge funds and institutional speculators will begin reallocating assets differently because of the change in the interest rate trends and for inflation. Eventually the dollar will have a bounce, and this will trigger movement in capital from where it is now (commodities) towards the other battered assets. Currencies which have also been strong recently against the falling dollar are poised to retrace some of their gains. All these movements are simply tracking the movement of capital back and forth from where the profits have been exhausted to other sectors that look promising.