Dilemma of Commodity

The price of commodity is dropping against dollar. I have been shorting oil by going long on airlines. I decided to review my position after US government officially took over Fannie and Freddie. The dilemma of commodity lies between worsening supply/demand and high inflation pressure.

There are many forces that will drive commodity price down, at least over the near term. Demand destruction is obvious. In the US, total petroleum and other liquids consumption is projected to decline by 610,000 bbl/d. The sale of gas-guzzler is plummeting. The change of consumer behavior will likely to effect long term demand. Internationally, Asian equity markets are among the worst performers this year. Chinese market is down more than 60%. The weak equity market reflects a gloomy outlook of the region's economy. I also use the chart of Euro-Yen exchange as an indicator for oil supply/demand picture. As Europe is a big oil producer and Asia is a big consumer, when oil demand decreases, Yen will appreciate against Euro. (see the chart)

On the supply side, oil producing countries are increasingly addictive to high oil price.Their expansive fiscal policy depends on exporting oil. Iran's nuclear power project and Chavez's nationalization plan come to mind. If oil price drops further, they might be forced to increase their output to maintain the capital inflow. Thus the downward move is reinforced.

However we can not ignore dollar when analyzing commodity-dollar relationship. After taking over Fannie and Freddie, US government is officially on the hook with the 5.2 trillion mortgage debt. According to some reports, it will likely to cost US government 200 Billion or more. The question is how this bill is going to be paid. With the dismal economy, tax revenue will be down. I doubt that US government will be able to fund this 200+ billion entirely by issuing treasury. Mostly likely big Ben's money printer is running at full speed. Hence I think the recent strength in dollar might be short lived. The inflation pressure will remain high, which will support commodity price.

Wage might become the unexpected force to further drive inflation up. Labor unions are been gaining strength recently. Boeing, GM, Ford just to name a few. In the last 20 years of low inflation and high growth economy, workers do not need to defend their share of cake. During last high inflation era (early 80s), 20% of private sector workers are union members. Today this number is 7%. It will be naive to believe the real way will keep falling. When the real wage is falling at record pace (article), workers will more rely on union to negotiate higher wage. Higher labor cost will further push the inflation higher.

How do I trade this? I have kept my long position in airlines expecting further drop in oil price. The price increase implemented during the days of 150 dollar oil will not go away. Airlines will be the major beneficiary of falling oil. I went long with a small position in Peabody Energy (BTU)yesterday to hedge my oil bear bet. Coal demand is more stable, as the majority of production goes to electricity production.