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The Energy Report for Friday, May 8, 2009

Phil Flynn

May 08, 2009

The Energy Report for Friday, May 8, 2009

The day the commodity world changed.

Energy bears are stunned. They say it is impossible and there is no reason for it. Energy seems to be defying gravity. The bears and the rest of the world are waking up to the fact that something has changed in the energy complex. Petroleum and now natural gas are soaring despite the fact that the supplies are overwhelming. There's shock and disbelief that oil and gas can defy the normal historical reactions to supply and demand. Traders are calling me and are stunned with no idea of what is happening.

But of course readers of this column and watchers of the Fox Business Network are not surprised because we have reported to you that the world had changed. And we even told you the day it all change. It was the day the Fed made the move to quantitative easing. That was the day that the Fed printed a floor under oil as well as many other commodities. The day after that decision I wrote a little ditty called, "I fought the Fed and the Fed won" and it went something like this..."I fought the Fed and the Fed won. I fought the Fed and the Fed won. Needed money so they printed some, I fought the Fed and the Fed won."

What is that they say about never fighting the Fed? Well at the very least do not underestimate the way this Fed can change the marketplace. The Fed's timing of this move to quantitative easing still has the market coming to grips with the shorter and longer term effects on the economy and the markets.

The one thing that is for sure is that the rules of the game have changed. And when it comes to a knife fight and Fed power there are no rules. Someone say one, two, and three, gold! In a blink of an eye the Fed, with its unlimited power to print money, can change the dollar value of a commodity or its long term trend in an instant. By creating inflation and money out of thin air they can change the entire commodity trend as we know it and drive away the deflation demons of that particular moment. Being short commodities has become a more dangerous proposition and the Fed has put us on notice. At anytime they can run the printing press and change the fate of a commodity. They do this not because they created a global shortage of a commodity or because of sky rocketing demand. It is because the Fed has the ammunition to make it so.

Oh sure you can say that the Fed's policy of quantitative easing is as simulative to the economy as a good old fashioned interest rate cut. But at the same time, it has the potential to be much more inflationary. And now that the Fed has opened that Pandora's Box, the markets are now from this point forward having a more complex element to them. And in light of these developments, you should be opening your trading account with me. Call Phil Flynn at a800-935-6487.

The day I reported that the Fed won I also said, "There are two possibilities. One is that the economy is much worse than it appears. The other is that the Fed thinks things are getting better and wanted to give some shock and awe stimulation to this feeble recovery with the hope it will turn into a full-fledged spurt of unbridled economic growth. Inflation can be ok as long as it comes with economic growth. The Fed's gamble is that this will stimulate the economy by removing the deflationary risk and drive down yields to get businesses and mortgages moving again. The problem is that if we don't get the growth to overcome the inflation risk, you get dreaded stagflation. The fear is that the Fed move might not be simulative enough or will not have the desired effect. For commodities and oil this is just an inflation play. If oil is driven higher just because the Fed is printing more money as opposed to improving demand, then their move may actually damage the economic recovery. If the dollar continues to plunge against other major global currencies then the Fed will be in the same weak dollar position they lamented about earlier on in this crisis. In other words, if the inflationary effect on oil outweighs the economic stimulus effect of lower long term rates, the oil drag on the US economy could then be headed towards the dreaded stagflation scenario. Stagflation is a real danger for the Fed and its unending arsenal of money. This is the Fed's biggest gamble. It is like the Feds version of the surge in Iraq. It is make or break time. If the printing of money cannot change the direction of this economy, then get out the wheel barrels to fill up with cash and try to pave your portfolio with gold and oil. If it works and the economy starts to grow, the Fed will have to put on the breaks and commodities will fall. If commodities stay strong and the recovery does not keep pace, the prices will start to fall again. That is until of course the Fed starts to print again."

In recent days the inflationary impact of Fed policy is now apparent. We are seeing gold and oil rise. They are rising in part due to expectations of a strong economic rebound and also due to the gearing up of inflation. And despite the economic optimism that has blanketed the marketplace, we are not out of the woods yet. Some of the concerns that I raised the day after the Fed's move to quantitative easing still stand. For now oil demand is still tepid and the rising prices may still hurt demand. The lousy bond action is once again raising yields. If yields rally too fast it may slow lending and higher commodity prices could hurt consumer spending. Things are looking better yet real risks remain. We need to see continued strong trends of economic recovery to justify and overcome the inflationary effects of Fed policy. And we should not be surprised if in the short term that oil and other commodities continue to fly.

And as stunning as oil was yesterday, one has to be impressed with the dramatic turnaround in the natural gas market. Natural gas got back above 4400 and plunging rig counts seemed to finally overcome the realities of ample supply. Bloomberg News Margot Habiby and Aaron Clark reported on a Baker Hughes report from that the world's rigs decline for 7th month. They said that the number of oil and natural gas rigs operating around the world fell 11 percent in April, the seventh consecutive monthly decline, according to data published by Baker Hughes Inc. Rigs exploring for or producing oil or gas dropped by 258 to 2,055. The rig count declined in Canada by 62 percent and in the U.S. by 10 percent. More than half the world's operating rigs are in North America. The global rig count has fallen 42 percent from a 22-year high of 3,557 in September, as the prices of natural gas and crude oil have plunged. That's the biggest drop since OPEC boosted production amid the onset of the Asian financial crisis in the late 1990s. Operating rigs fell more than 50 percent from December 1997 to April 1999, and oil touched $10.35 a barrel. The consecutive monthly decline in the rig count is the longest since the first seven months of 1986, when production disputes within the Organization of Petroleum Exporting Countries triggered a global supply glut and a price collapse. Canadian rigs fell by 122 last month to 74, and U.S. rigs decreased by 110 to 995. These kinds of drops in production in response to oversupply are also very bullish when demand starts to improve and usually are indicative of a bottom. Another reason to look ahead and be bullish. Bloomberg News reported that Exxon Mobil shut down a gasoline making unit at its Baton Rouge refinery, the second largest in the U.S.

What a week and it has been and it's great to be back! We have had a fantastic response to join The Energy Report Community! Welcome to all the new readers it is great to have you aboard! If you are not aboard yet it is not too late just call me at 800-935-6487 or email me at pflynn@alaron.com to open your account!