Magic Carpet Ride

There is no doubt we are in an environment of risk premium price discovery which should continue foster increased volatility as the market seeks its comfort zone. Energy is arguably one of the most sensitive asset classes to risk appetite and while investors and the financial media are currently fixated on whether or not a Fed rate cut is warranted, we decided to take a look at the potential pattern in crude oil as we think it will have important implications for all markets as we trade into Q4, year end and beyond.

Crude and consequently the wealth of crude exporters has greatly benefited from a higher risk premium due to the weak dollar and Iraq conflict. Since the 2003 invasion, the price for a barrel is up 200%, driving a massive increase of international capital flows and petrodollars to oil exporting nations. According to a NY Fed study, oil export revenues jumped from $535b in 2002 to $1.5t in 2006. That number represents approximately 10% of the US stock market capitalization and over 10% of US GDP. Roughly half of that $981b increase in revenues has gone into the purchase of foreign financial assets. Lever that up a bit in hedge funds, private equity or structured products and voila, an asset bubble. This can explain the positive correlation crude has with carry trade pairs, credit spreads and equity prices implying the price of crude could affect the future course of markets around the world.

Recently we have heard Sen. Warner (ranking Republican, Armed Services Committee) call for troop withdrawal to begin in September with an eye on major draw downs by the holidays. According to press reports, the Government Accountability Office (GAO - the investigative branch of Congress), has reported that Iraq has only met 3 out of 18 goals set by the United States and is scheduled to deliver the “strikingly negative” assessment on September 11, just a few days before General Patraeus’ highly anticipated report on the troop surge is due. With the presidential election heating up its likely pressure to withdraw will only intensify.

Chart of Crude

With that said, let’s take a look at this long term chart of front month crude to determine what the market might be saying about the re-pricing of risk premium and volatility surrounding a potential US withdrawal from Iraq. In discussing with Dom, he believes crude could be setting up a large triangle pattern with this year’s January low being A, the recent July high around $78 B, putting us in a potentially ensuing C wave that would be expected to repeat last year’s post-July seasonal weakness. While we aren’t suggesting crude will be trading based on Washington rhetoric, we do believe it is susceptible to the wild swings of a triangle as the market comes to grips with the implication of a troop withdrawal coupled with the re-pricing of risk premiums. As we enter the last months of 2007, look for crude to trade lower in a 3 wave move finding support in the $55 area. If the triangle pattern unfolds as we are labeling it, the E wave should bottom and thrust higher some time late next summer or early fall, just in time for hurricane season and the elections.

Chart of EURJPY and SPX from same time frame as Crude

The Justice Department has reportedly stepped up investigations into large European banks for facilitating money laundering out of some oil exporting countries. This gives a new meaning to the idea of petrodollar recycling and supports our view that the EURJPY pair is one of the best indicators for “global” risk appetite. The future direction of equity and credit markets could be in the hands of a few sheiks and the liquidity in their trading accounts.