Crude Oil Is Not A Metal, But It Trades Like One
Summary
- Crude oil seems to be vulnerable to the vagaries of a cartel.
- Metals are driven by the business cycle.
- Crude oil seems more sensitive to what drives metals and less by the cartel.
Reading the books of giant scholars of the business cycle such as Geoffrey Moore and Arthur Burns is an adventure. They are the pioneers who laid the groundwork to understand the mechanism of the business cycle and what are the main forces driving it.
One particular thought resonated with me. In a rising economic environment the majority of commodity prices tend to rise. They tend to decline when the economy slows down.
Of course, there are exceptions, but investors are more likely to be on the right side of the trade by following their general movement. Their price sensitivity to changes in economic growth are a useful and timely indicator of market and economic conditions.
Two classic examples are copper and lumber. The trend of the price of copper is a reliable indicator of the trend of other metals and overall industrial sector. Lumber, of course, is closely related to housing activity. Strength or weakness in this commodity is reflects the trend of the construction business.
As I discussed in previous articles ("Yields, Economic Growth, And Stock Prices - A New World For Investors", "Commodities And Stock prices - It's All About The Business Cycle", and "The Inventory Cycle - Boring But Important Market Setter") the reason for their sensitivity is the need for manufacturers to buy raw materials when inventories are falling short of sales.
The weakness in commodities is mostly experienced when business has excessive inventory as sales slow down. The reduction in production to reduce inventories in line with slower sales forces business to buy fewer raw materials. This is the time when commodities weaken. On the other hand, commodities rise when business must increase production to restock inventories due to faster sales.
The strength or weakness of these two commodities - copper and lumber - reflects the growth of two major sectors of the economy.
However, there is a third commodity which is a crucial input to industrial activity as copper and lumber - crude oil. Any discussion on crude oil unequivocally centers on OPEC's meetings in Vienna and what the cartel might or might not do.
The above chart sheds some light on the main force acting on crude oil. Crude oil is very sensitive to business activity and it always corrects during a recession (shaded areas in the above chart).
However, the price of oil, as for most commodities, does not need a recession to decline. Oil prices fell during a recession in 1990, 2001, and 2009. However, there is no need for a recession for prices to decline as in 1996, 2014, and 2018.
Crude oil rises or declines depending on the growth of the manufacturing sector. The graphs in the above chart show several business cycles as represented by the growth of employment in manufacturing (red line). Such growth tells us about the strength of manufacturing activity. The price of crude oil is represented by the blue line.
The chart shows how changes in crude oil prices are closely related to the trends in the growth of manufacturing employment.
Relating crude oil prices to copper prices shows this relationship even more clearly. The above chart shows copper prices and crude oil prices from 2008 to January 2021. The price action of the two commodities is eerily similar. There is no doubt the two commodities are related to each other and both are driven by a common force. The strength of the business cycle is such a driving force, reflecting mainly the demand from the manufacturing sector as it attempts to control inventory levels.
The above graph shows the relation between the business cycle, as reported and updated in each issue of The Peter Dag Portfolio Strategy and Management,which I edit.
There are two important features in this chart. The first one is commodity prices are so sensitive that they react to changes in economic growth not just expansion or contraction. In other words, they rise when growth improves. They decline not necessarily because of a recession. They decline because growth is slowing down.
The bottom line, as Geoffrey Moore and Arthur Burns pointed out many years ago, most commodities move in the same direction. Crude oil or other industrial commodities are mostly influenced by trends in the business cycle. They rise when the business cycle shows growth is improving. They decline when the business cycle shows the economy is slowing down.
The role of cartels seems to be one of damage control rather than price setting. The cartel reacts, not pro-act, to business cycle developments.
Disclosure: I
have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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