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There are two separate subjects to talk about today, one is oil and the other copper.  Oil has been cut by more than half in just six months.  As I speculated last week, I believe someone, somewhere “is already dead”.  For all intents and purposes, the shale businesses across the globe have been rendered upside down.  Along with the business models of course is all of the debt taken on to create the businesses.  The debt is estimated in North America alone to be greater than $500 billion and has provided much of what little growth GDP has recorded the past few years.

Regarding “who may have won” with collapsing oil prices, Ann Barnhardt wrote “How could trillions of dollars be laundered from the Wash DC regime to Saudi Arabia? Why, through Citigroup, of course.”  This is a very interesting and timely speculation on her part.  After pondering this for quite a while I have several questions but no real hard answers.  We do however have some hard data to work from.  We know the largest shareholder in Citi is Prince Alaweed of Saudi Arabia.  We also know Citi has increased the size of their derivatives book by nearly $20 billion over the last two quarters but we don’t know “what” derivatives these are.  Another fact in the know is Saudi Arabia “wants” lower oil prices as judged by their actions.  Whether this was to blow up the shale business and put other competitors out of business, or a deal cut between them and Washington or even possibly China, we do not know.

Another piece to this puzzle came amazingly from the Republican held House of Representatives.  If you recall, the banks (and even Mr. Obama himself) lobbied Congress to attach a rider to this year’s spending bill.  The rider allows the banks to include their derivatives exposure under FDIC coverage should the bank fail.  In effect, the American taxpayer now has $303 trillion worth of derivatives exposure via the FDIC (which has direct borrowing privileges from the Treasury).  The American taxpayer in my opinion had a knife stuck squarely in their back, yet few even have the slightest clue this has happened and written into law.

The questions we do not have answers to are as follows:  has Saudi Arabia actually been short the oil market and either fully hedged or even more than fully hedged and actually making money on the drop in oil price?  What derivatives have Citi been taking on to expand their book so much…and why?  Are any of these derivatives oil or energy related?  A peculiar thought would be this, is Citi actually the “long” to a Saudi “short”?  The question raised by Ms. Barnhardt is a good one, is Saudi Arabia “hedged” and being paid by “their bank”, Citi?

The drop in oil prices has now been confirmed by copper.  Copper has broken below a 5 year wedge and broken down with other “commodities”.  You will or have already heard this breakdown described as a “collapse of the copper roof”.  This concept has gone back well over 100 years.  Whenever copper prices collapsed, it was a sure sign the real economy itself was slowing.  The current world’s economy is a global one, no longer is the U.S. the big player when it comes to commodities like copper, steel or even cement (China has used more cement in the last 3 years than the U.S. did in the entire 20th Century!).  Clearly, China and the rest of the world is slowing down.  You can see this not only in the prices of commodities but also in the credit markets.

If you recall, just before year end, China made a move within the financial system to only accept AA and AAA rated corporate bonds as collateral, this was very significant as it shrunk the collateral pool greatly.  While speaking of collateral, we have yet to see the fallout from the Chinese warehouses with either missing collateral or multiple pledged collateral (copper, nickel, zinc), this will be very interesting to see!  Fast forward just a couple of weeks and the PBOC blinked, they performed a mini QE of their own.  In order to keep their economy moving, they are stuck in the same mud the Federal Reserve is in, it is either inflate or die.  For now, commodities are saying the “die” part is overwhelming the “inflate” part.

I see this as very significant, you should too!  Why?  Because there is one more piece to the puzzle, gold and silver have bottomed and are not going down during this commodity meltdown.  Gold (and silver to a different degree) are money, NOT commodities.  China has accumulated massive quantities of gold as they understand its monetary qualities in a debt ridden world.  They also understand the dollar will not survive a credit collapse as the dollar is credit itself.  They are avid students of history.  Think back to the last credit collapse in the 1930’s, what exactly happened and what policy was used in an effort to “reflate”?  Yes, you are correct, gold was revalued overnight 69.33%!  Some will say “but that was in a world where gold was money” …  I will tell you, gold has ALWAYS been money, we have simply lived through an era where governments did not “want” it to be money and did not want people to “believe” it was money.  They tried as hard as they could to “de monetize” gold, it worked for many years until 2001 …on the American psyche …(not so much on foreigners though).

The credit markets lately have done a Dr. Jekyll and Mr. Hyde performance.  Many sovereign credits have moved to all time high levels and low yields.  This has been seen as a “no” vote on the reflation efforts and capital has moved in to this space for “safety”.  Lesser rated credits (including anything to do with commodities) have been trashed and yields have exploded out of fear.  I ask you this, how “safe” do you believe Italian or Spanish or even Japanese government bonds are?  The markets are labeling them as “pristine” with incredibly low yields, but are they really?  Just two years ago, several of these lower rated sovereigns were discussed in the same sentence with the words “default, bankruptcy and insolvency”, now they are considered “safe havens”?

Clearly, the “reflation” effort is not working and the carry trades all over the world are blowing up.  You are also seeing this with the wild gyrations in stock markets which look ready for a trap door moment at any time.  But why?  Why now?  This is simple, QE 3 was ended.  The morphine drip of Fed monetization was shut off and the baton pass to Japan was not enough of a substitute.  The credit bubble is losing air from several different directions, the Fed will be required to announce another round of QE in very short order.  The only question I have is what the reaction will be.  I am sure the first 24-48 hours after an announcement will be “happy days are here again”, but what happens after that?  Do we slog through another 12 months or more of markets “recovering” or does the market just outright panic?

I obviously don’t have the answer to this but I cannot believe investors have not figured out after four episodes that QE plain does not nor can ever work.  Any future QE announcement from the Fed which is met by markets not “obliging” them will be the obvious sign of an empty gun.  I personally believe the damage in oil, copper and other commodities is too far along for another QE to repair.  In other words, the derivatives losses are already too great and the losses have been embedded…plus, sovereign treasuries are now too levered to try another reflation.  The fact that gold is increasing versus dollars and exploding versus other currencies I believe is giving us a heads up to this thought process because it is money.  We are watching a deflation unfold versus gold and dollars, soon to only be versus gold.  We are entering a credit implosion or seizure on top of a banking system and sovereign/central bank impairment.  Never forget, dollars are 100% based upon credit which is based upon confidence and nothing else. The ability to relate always existed in the past, now this ability is again being tested while debt to GDP levels have never in history been worse.  I guess the next and only big question is this, will the next QE bullet be a blank?

Regards,  Bill Holter.