Oil and the Commodity Complex

Thinking about some of the problems I’ve been trying to tackle in these recent posts over the weekend, I tried to formulate a more coherent way of structuring the issues, and at first I thought I had stumbled on something new, but after having looked at the little data I can get my hands on, it appears somewhat less promising than I first thought. Nevertheless, I have decided to make use of it as a way of keeping all the moving pieces together.

One thing I did find interesting is the rather close approximation between the oil/copper ratio (back again!) and the yield curve. Unfortunately and rather strangely, I cannot find an oil/copper or copper/oil chart anywhere on the web, apart from the ones I can piece together over the last ten years, but it would appear that there is some sort of relationship between oil/copper and bonds. There appears to be a vague correlation between oil/gold and the yield curve, and even better one with the oil/silver ratio.

oil/silver ratio

(I didn't add that conundrum bit)

The oil/copper ratio appears to work better, although I am not sure how close the correlation is, or if one ratio is leading the other. The oil/metal ratio spike from the Iraqi invasion of Kuwait, for example, appears to lead the spike upwards in spreads by a year or so, but it is really hard to tell.

If you recall, which you may not, because I can barely recall all the wild speculation I engage in, the oil/copper ratio appeared to bear some relation with the dollar index/10 year yield ratio. My suspicion is that when commodities rise and the Federal Reserve lowers short-term interests rates in an attempt to defy Gibson’s Paradox, this weakens the dollar and juices commodity prices further, although this will require a closer look at some later date. The way those prices roll out (in terms of the ratios I am trying to impose some order on) have laws of their own but commodities in general—most likely copper first—will rise as a general rule.

As a way of expressing the hypothesis I came up with over the weekend, I constructed a graphic. I already knew it was simplistic and incomplete and my dissatisfaction with it has only grown since then, but I’m going to put it up anyway to express the convoluted relationships I am trying to grapple with.

working (?) hypothesis

Now, over the course of the first decade of this century, this is more or less how things worked out commodity-wise. Copper led the way out of the NASDAQ bust, and the copper top was first ‘identified’ by the copper/oil and copper/silver ratios and was soon confirmed by the copper/gold ratio.

Over the course of this period from the NASDAQ bust until the financial crisis, there were a number of relationships that seemed to exist which I will try to formulate in terms of equations. Thus,

copper/gold = copper/silver

oil/gold = oil/silver

copper/oil = silver/gold

copper/gold = silver/oil

These equations move from most to least substantiated, as I recall. And since we entered a new phase of the market (using my bedrock system), the ‘equity phase’, these have broken down somewhat, but again, we will address that a later date.

The most frustrating of all these ratios at the moment is the oil/silver ratio. We have seen that for the last 40 years, although the oil/gold ratio is the most volatile of the commodity/gold ratios we have been exploring, it also works according to an apparently inscrutable logic. This has been confirmed by our system of market phases. There is apparently a rhyme of some kind to the oil/copper ratio, which we have seen in Klombies’s observation about the copper/oil ratio, as well as in the apparent relationship between oil/copper and the dollar/yield ratio and the yield curve. But, when I look at the oil/silver ratio, although I see the resemblance to the other ratios, it is nevertheless difficult to make out what is being said.

So, in my previous post I mentioned that I wanted to look at the oil/gold and oil/silver ratios over the course of the last decade, and now is as good a time as any for that.

I think it is not hard to see that there is a relationship of some kind between the two, and I suppose it is not utterly surprising, given that silver and gold are both precious metals.

oil/copper ratio

Here is the oil/copper chart yet again, and some similarities are again discernible, although there is something of a difference, too. The oil peaks in these ratios occur at different times. Oil/copper peaks in 2003; oil/silver and oil/gold both peak in 2005, although silver seemed to be putting greater pressure on oil than did gold until late 2008.

Silver seemed to be putting pressure on gold up until that point.

silver/gold ratio

You might see why we have posited a relationship between the silver/gold and copper/oil ratios, as well.

copper/oil ratio

But, let’s try not to get too lost here. We had promised that we were going to look at whether or not the oil/silver and oil/gold charts could help us figure out the oil trade in addition to the techniques we had previously attempted to utilize which brought us to the tentative conclusion that oil would hit $150 within the next 15 months.

By using Klombies’s technique in the mid-2000s, we would have had to have taken notice of the fact that the copper/oil ratio was dancing around the 5:1 level from the spring of 2006 to the summer of 2007. The big push in oil would only come at that point, but the big oil push of 2007-2008, although definitely noticeable, did not achieve new highs in the other ratios. Those peaks had come in 2003 and 2005.

One would like to have been able to take advantage of that 2007-2008 oil spike, which the copper/oil ratio had been promising since 2006, but prior to that, it is not clear what markers we could have used to make sense of oil moves, particularly as they relate to commodity rotations. The 2001-2003 rally was reflected in each of the oil/metal ratios. After the 2003 top and correction, oil began to move upwards again, quite sharply in 2004 and then evenly from early 2005 until the summer of 2006, but the oil/precious metals tops had already occurred by the summer of 2005.

At the moment, there is nothing I can see here that suggests an especially relevant technique that can add much to what we have found so far. The only other possible correlation I see is that the silver/oil ratio had achieved a relatively new high in early 2007, which may have been indicative of the imminent rise of oil, but it is hard to argue that there is any particular rule in operation here.

Well, okay, there’s one more. The strange similarity between the silver/gold ratio and the copper/oil ratio. Although I don’t see how anyone could use this kind of P&F chart to trade the silver/gold ratio for example, it did seem to indicate that it was rising fairly steadily until it’s top in 2006. Prior to that, both the silver/gold and copper/oil ratios bottomed in the spring of 2003. They bottomed again in late 2008, although copper/oil was sooner to bottom and rise. After that, they both moved more or less in sync, with the collapse in the copper/oil ratio in the winter of this year apparently presaging the fall of the silver/gold ratio in the spring.

I would have said that this was one of the unlikeliest correlations to exist a few months ago, but this one holds up perhaps better than any of the four correlations I posited above. The copper correlations have broken down since we entered the ‘equity phase’. The oil correlations hold up fairly well, but are tough to make sense of. We are still left to consider the silver/oil=copper/gold equation, but before we get to that, it would appear that this copper/oil=silver/gold holds a great deal of promise.

A way to try to confirm that on a longer-term basis is to consider that if oil/copper=gold/silver and our observations regarding the oil/copper ratio’s relationships with the yield curve and the dollar/yield ratio hold true, then gold/silver should look something like the yield curve we displayed at the top of this post.

gold/silver ratio vs recessions

From this eagle’s eye perspective, it looks to me as if there is a relationship, but I simply may be looking too hard. The mid-’80s, for example, don’t look like an especially good fit. And, what about today? Both the oil/copper and the gold/silver ratios, after having jumped sharply upwards after bottoming in 2006, have been pushing their way lower, sharply lower since the ‘equity phase’ began in May of last year. Since last year, the yield curve has appeared to flatten, although not as severely (yet) as one might predict if relying on our commodity ratios for guidance. If these ratios are telling us that yield spreads are going to move down, the only way to imagine that is if bonds move up, since the Fed doesn’t seem like it’s going to be raising rates any time soon. But, what could drive bonds up in this environment other than an economic slowdown?

But, we are bullish on both the stock market and commodities, so how would that fit? There is the possibility that the Fed would raise rates, of course, but it would only take that kind of action if a shockingly strong recovery and/or inflation were to make itself felt. Even if that were to turn out to be the case, wouldn’t it at least seem more likely that between now and that point that bonds would fall first? Bonds must remain for another day, but it is something (for me, at least) to keep in mind.

I would like to wrap all of this up with a nice big bow, but I am afraid I only have time to consider that fourth equation that I mentioned at the top, and see if it has anything to say for itself. Again, it was copper/gold=silver/oil. Below, I am comparing oil/silver and gold/copper.

oil/silver ratio

If there is any relationship, however, it appears to be an inverted correlation.

Here are the charts from the last decade. Copper/gold versus silver/oil.

silver/oil ratio

copper/gold ratio

Again, this appears inverted to me. So, let’s look at oil/silver again instead.

It is frankly hard to know quite what to make of this. This seems to be an even more unlikely combination than the third equation (except of course that oil and copper are industrial commodities and silver and gold are precious metals), but there does seem to be some such relationship, although it would be almost impossible to see if you weren’t really looking for it, and it is especially doubtful because I cannot yet imagine any useful information contained in this comparison. I suppose this is what happens when the most volatile industrial commodity and precious metal are combined with the most stable industrial commodity and precious metal. But, is there anything more to this story?

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