We have been reporting on the trade-off between the producer price index of crude oil (domestic production) and the PPI of iron steel since 2009. During this time there has remained a linear and lagged link between them. Our previous update included PPI data through March 2012. Here we present an annual wrap-up.
We reported that the PPI of crude oil had been likely evolving in sync with that of iron and steel, but with a lag of two months, in September 2009. In order to present both indices in a comparable form, the difference between a given index, iPPI (i.e. iron&steel and crude), and the overall PPI was normalized to the PPI:
These normalized differences represent the evolution of the rate of deviation from the PPI over years.
Figure 1 depicts the corresponding time histories of the normalized deviations from the PPI, including the most recent period through August 2012. Even a simple visual inspection reveals the following feature: the (normalized deviation from the PPI of the) index of iron and steel lags by approximately two months behind the (normalized) index of crude oil.
Figure 1. The deviation of the iron and steel price index and the index of crude oil from the PPI, normalized to the PPI.
In order to reduce both deviations to the same scale we additionally normalized the curves in Figure 1 to their peak values between 2005 and 2012.
This scaling allows a direct comparison of corresponding shapes. In Figure 2, we display the normalized index of iron and steel shifted by two months ahead to synchronize its peak with that observed in the normalized index for crude petroleum. The scaled index of crude demonstrates just short-term deviations from the index of iron and steel in the overall shape and timing of the peak and trough. Simple smoothing with MA(3) makes the curve's resemblance even better. As an extra benefit of the resemblance, one can use the two-month lag to predict the future of the iron and steel price index.
Figure 2. Deviation of the iron and steel price index from the PPI, normalized to the PPI and the peak value after 2005 as compared to the deviations of the index for crude petroleum normalized in the same way. The normalized index for iron and steel is shifted two months ahead.
The link between oil and iron has been unbreakable. Between 2006 and 2012, the deviation of the price index of iron and steel from the PPI in the USA repeats the trajectory of the deviation of the index of crude petroleum (domestic production) with a two-month lag. Therefore, the prediction of iron and steel prices for this horizon is a straightforward one. Our model shows that oil prices will suffer a long term fall into the second half of the 2010s, likely down to $45 (+-$15). This fall will be accompanied by strong short-term fluctuations. In this situation, steel might be an object of short-term investment with oil signaling peaks and troughs.