Energy Report: Shanghai Surprise

October 20, 2010 10:23 AM

By Phil Flynn, energy analyst at Phil Flynn Group

A whole new ball game! Did China's surprise interest rate increase rebalance what seemed to be an out of balance global economy? Will this interest rate increase take the heat off the Chinese who are under increasing U.S. pressure to set their currency free?

China crushed the runaway commodity complex when it raised its benchmark deposit and lending rates by 0.25 percentage point yesterday for the first time since December 2007.
The move was to stem domestic inflation but it could be the first of a series of rate increases could also be seen as a move gesturing to the US for our restraint by not declaring them a currency manipulator.
In the real world a currency that is allowed to float would normally increase the value of its currency. The Chinese, by raising interest rates, it was almost like a de facto increase in the value of their currency. By doing that it raised worries that even a slight slowing in the Chinese economy could slow the growth of neighbors and the uncertainty surrounding their next move improved the value of our beaten down greenback.
It also reduced the price of commodities that threatened to derail the global economic recovery. We all know that the US is pressuring China to increase the value on their yuan and that commodities have soared since the Federal Reserve at their September, 23 meeting said that they promised to provide additional accommodation if needed to support the economic recovery and to return inflation over time.
Yet after China took steps to put the brakes on the economy we saw how fragile that artificially inspired oil and commodity rally really was. The price of oil and gold first and foremost has been a product of massive government intervention designed to take away the illusion of deflation. When oil surged and broke up into the mid eighties, we heard a slew of predictions touting the second coming of $100 barrel oil.
Analysts were seizing on short term data that seemed to suggest the global supplies were tightening. While many had designs on sharply higher oil prices we see how quickly global central banks can change the equation.
China's bustling, explosive economy was also helped along by massive government stimulus, a stimulus that had to be removed. As the Chinese economy rebounds the Chinese government is acutely aware of the fact that they have created a bit of a bubble. Maybe a massive bubble. If they do not slow down growth and manage their soaring inflation surge, they risk bursting that bubble. At the same time the possibility of a currency war or a trade war is the type of disruption that the Chinese government could make trying to manage this wild lion of an economy absolutely impossible.
More mundanely, if the Chinese continue to raise rates demand for commodities will fall. For oil that means that we are still in a range, the same range that we have been in for most of the year. We have said time and time again that oil, if based on fundamentals of supply and demand, should be substanlly lower but with all of the printing of money is keeping the market supported. While many long for the days when oil added to its price year after year, the truth is that once again there is a real chance that oil will end the year lower than where we started. Maybe supply might matter today.
The American Petroleum Institute reported that crude inventories rose by 2.315 million barrels. Gasoline inventories fell by 83,000 barrels, while distillate stocks dropped by 854,000 barrels. Refinery runs rose to 80.9% from a revised figure of 80.3% last week. 
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