The Big Picture on Q2 2008, Part 1

June 20, 2008 at 8:11 am
Contributed by: Chris

Folks,

Happy summer solstice! Is it warm enough for ya? I don’t know about where you live, but here on the West Coast we’ve had August temperatures already…

In this week’s column for Energy and Capital, I revisit the big picture on energy and finance for the second quarter.

On Monday (June 23rd), I will be hosting an online discussion group about oil for the Washington Post from 10am – 11am PST. I don’t have any further information about it at this time, but look for it at washingtonpost.com, and feel free to jump in with questions!

Next weekend, my book will be featured at TheStreet.com in their “Open Books” section.

The Big Picture on Q2 2008, Part 1

How to Play Fossil Fuels in a Tough Economy

2008-06-18
By Chris Nelder

The second quarter of the year is almost over, so it seems like a good time to zoom out and look at the big picture again (especially after my last few articles, which were pretty technical).

The trends I indentified in my big picture update for the first quarter (Part 1, Part 2, Part 3) have only intensified. The events in Q2 continued to be negative for the economy, but excellent investment opportunities for those who took advantage of a few of my tips.

Let’s run the bases again…

Financials

The big story in Q1 was the implosion of Bear Stearns, and the beginning of the continuous mudslide of bad news for the financial sector this year. In the second quarter, the poster child for the credit market’s woes has been Lehman Brothers, down 62% for the year. And it looks like Morgan Stanley might be next on the block.

In both of these financial bear runs, I picked up a quick 10% here and a quick 10% there by playing the UltraShort Financials ProShares ETF (AMEX: SKF). It’s important to get the timing right with a play like this, but it’s not that hard if you pay attention. I watch the news carefully, looking for the early whispers of distress from the financial sector. I buy it when the market is up (which is when SKF is cheap), then after the bad news is plastered all over the front pages, I look for a particularly bearish day to get out.

For those inclined to play a little speculative money now and again, I think it’s a good hedge against the sickening jolts that have hit the markets with increasing frequency this year.

The fundamentals of a recession are firmly in place now. The whisper on the street is that the really bad news is yet to come, as broad swaths of the consumer credit markets buckle and break under the strains of steadily higher food and energy costs—the two things that the oft-quoted Consumer Price Index (CPI) explicitly leaves out—and a collapsing housing market.

If the whisper is right, and I think it is, then the markets are in for another downturn. So watch the news on the financials, and keep your powder dry for their next "good" day.

Oil

The volatility in the oil markets has increased quite dramatically in the second quarter, where a $5 to $11 swing in the price over a single day is now becoming more the norm than a rarity.

Crude_prices_Jun10-Jun17_2008.jpg

 

As I discussed in my piece two weeks ago ("It Takes Two To Contango"), we should expect to see such volatility increase, as the reality of the supply and demand balance really sinks in, and the market seeks to find the new, proper value for oil.

A chorus of analysts have popped up in recent days to claim that oil prices are in a speculative bubble, and their fervor only increased when oil hit a new record just shy of a $140 on Monday.

My favorite piece was an article in Fortune last week titled "Why oil prices will tank," which speculated, "It’s even possible that, a few years hence, we could see a sustained period of plentiful oil supplies and low prices, meaning $50 or below." All I could do was shake my head in wonder as the author carried on about how a "new abundance" would come from shale, tar sands, coal, and "an OPEC desperate to regain market share."

If that last bit didn’t make you laugh out loud, read it again.

Investor’s Business Daily, another venerable financial publication, went just as badly awry in its article three weeks ago, "Peak Oil: An Idea Whose Time Is Up." I was aghast at the parade of wrong information and blatant ignorance in that one. I intend to debunk it formally, but it’s going to take a whole ‘nother article to do that job.

So if you thought everybody was already on the same side of the trade in this seemingly endless bull run for oil, think again. Some of the most-read financial journalists in the country still don’t understand what "peak oil" means, don’t comprehend the numbers, don’t understand the crucial differences between oil shale, tar sands and crude, and apparently, some even think oil is overvalued by nearly 3x!

For smart investors like you who do understand these things, though, all the confusion out there simply makes for a good trading environment. When the noise is all wrong, you buy, and when everybody comes around to the way you see it, you sell.

If you took my suggestion in my article two weeks ago, subtitled "Pullback in Oil is a Buying Opportunity," and bought the United States Oil Fund LP (AMEX:USO) that day, at the bottom if oil’s most recent dip, you’d be up about 10% on that position now. Not bad for a two-week gain!

Oil prices continue to have an inflationary effect on everything, from food to gasoline to everyday products (thanks to transportation costs). We’ll get into the food aspects in the next part of this series.

The next major cue on oil will come from a Saudi-hosted summit meeting of oil producers and consumers this coming Sunday. The kingdom is worried that instability in the markets and high prices will undermine the oil market and encourage alternative energy. King Abdullah has reportedly instructed his ministers to pursue any solution to skyrocketing oil prices.

It is expected that the Saudis will announce a 200,000 barrel per day increase in production starting in July. My bet is that even if they do announce it, it won’t affect prices much, or for very long.

They may also decide to raise their discount on crude. That might actually assuage the markets for a while, because it would help restore the profitability of refiners, and should eventually bring down the price of gasoline and diesel.

But in a few weeks or months, even such measures would lose their impact as the markets realize that the world really has no ability to increase production from here. Saudi Arabia has announced that they only intend to add about 1 million barrels per day (mbpd) of production capacity through the end of 2009. That increase still seems highly unlikely to me, but just taking them at their word, they are currently producing about 9.45 mbpd out of a claimed capacity of 11.4 mbpd, with expectations to raise it to 12.5 mbpd, and after that, nada mas.

So while the world waits for the next Saudi announcement, just remember: it’s just more short-term noise along the long-term signal of ever-higher oil prices.

The Dollar

The influence of the dollar on commodity prices, particularly oil, continues to be underestimated. I’ll dispense with the charts this time, but my observation in the Q1 update, that oil prices moved opposite to the dollar, continues to hold. According to calculations by Bloomberg, the dollar as valued against the euro has moved in the opposite direction from oil 93% of the time this year.

That’s a very strong correlation, and should not be overlooked when we hear the latest from Mr. Bernanke. He seems to have successfully jawboned the dollar into a stabler pattern since it crashed to the late-April low, but the recent rally now appears to be losing steam as the expectations of a rate hike in August start to look overblown.

Without a strong rebound in the dollar, which seems extremely unlikely given the Fed’s current position somewhere between the rock of inflation and the hard place of recession, oil will have to remain at or above its current heights. So don’t go running for the exits the next time you hear some "expert" saying that oil prices are going to crash—instead, buy on any weakness.

Gasoline and Diesel

Gasoline and diesel both shattered all previous records (even the inflation-adjusted ones) in Q2. The national average price of gasoline is now over $4 for the first time, and diesel is trading at the highest premium to gasoline in 15 years, 16% more than gasoline at $4.69.

Diesel is the world’s most popular transportation fuel, and refiners simply haven’t been able to make enough of it. Not only is it by far the preferred fuel in Europe, most of the rest of the world is currently experiencing shortages of it due to enormous demand and limited supply. China, for example, imported 34 times as much diesel in May as it did last year, partly in preparation for the Olympic Games. Across the Third World, diesel is increasingly being used to run generators as their grid power fails, due to shortages of natural gas and reduced hydropower.

By comparison, 43% of the world’s gasoline is consumed in the U.S., where demand is falling as prices rise. Although the sticker shock of gas over $4 has been hard on Americans accustomed to cheap gasoline, we’re still paying very low fuel prices compared to Europe and elsewhere in the industrialized world, where gasoline in the $8-12 range is the norm. As I have said before, we should really be grateful to the rest of the world for keeping our gas prices so low by not competing with us for it!

Here in California, a 20-gallon fillup now costs me about $90, and I have no doubt that my first $100 fillup is just around the corner. Believe me, I’m not looking forward to it, but also believe that investing wisely in oil is your best defense against those ever-increasing prices.

While some destruction of diesel demand will take place eventually as vehicles are switched over to run on natural gas, electricity, and other alternative fuels, those transitions will take years to complete. I expect the current imbalances between gasoline and diesel to remain firmly in place for quite some time.

Natural Gas

The trend in natural gas is unchanged from Q1: prices have beat a straight line upward all year, rising from $8.30 on January 10 to $12.95 today. This trend also shows no sign of slacking, for there is very little net excess capacity for gas production.

Consequently, 2008 has been a sweet year for natural gas producers, with some of my favorites delivering better than 60% returns so far:

SWN-CHK-ECA_YTD.jpg

Coal

Coal has was full of surprises in the second quarter. My Q1 observation that coal didn’t have the signs you would expect from a growth industry was based in reality, but no sooner had I published that article than a massive spike in coal prices began.

In Q2, prices for domestic coal went through the roof:

 

Average Weekly Coal Commodity Spot Prices
Business Week Ended June 13, 2008

coal_prices_2005-2008.jpg

Source: EIA, Coal News and Markets

 

The explosion in prices was reflected in some of the industry’s better coal stocks:

20080618-acibtumee.gif

Despite this performance, the EIA expects domestic coal consumption to be lackluster, posting less than 1% growth this year after only 2% growth last year, and a lousy 0.6% growth next year.

On the production side, EIA expects a 2.9% growth in production this year, and increasing inventories with coal consumers.

So if it wasn’t domestic consumption, what drove prices up?

You guessed it: exports.

Exports of coal posted a sharp jump at the end of last year, and they are continuing to drive demand:

US_Coal_Exports_2001-2007.jpg

Source: EIA, Quarterly Coal Report, Oct – Dec 2007

The primary region consuming all that exported coal is Europe, where a very limited and uncertain supply of natural gas has been driving up grid prices. The outlook for electricity in Europe is increasingly dim, and they’re trying to make up the difference with coal. Flagging Australian coal exports to Europe, along with competition for supply with the emerging nations of the FSU, have really stretched the supply-demand equation.

Exports of coal from the U.S. to Europe jumped 19% from the third to the fourth quarters of last year, and were 52% higher at the end of 2007 than a year earlier.

Again, I do not see anything resolving the tension in this very tight market any time soon. It looks to me like another major bull run has begun for coal. The three stocks in the above chart should continue to do very nicely.

Electricity

The price spikes for natural gas and coal have translated directly to increasing prices for grid power. According to the 2008 Short Term Energy Outlook, June 2008, the Energy Information Administration (EIA) expects average U.S. residential electricity prices to increase by about 3.7% in 2008, and 3.6% in 2009.

 

US_Electricity_prices_1997-2009.jpg

The average rate of those historical price increases from 1997-2007 is 2.26%.

In other words, the EIA has just predicted that for the next two years, your bill is going to rise at a rate 63% higher than it has in the past!

For the communities who haven’t been aggressively seeking to deploy as much wind and solar and geothermal generation as possible, it spells a long march to ever-higher prices.

But for solar and wind generators, this is great news, because it means that the breakeven point on their projects just got bumped up a couple of years. It’s also great news for those who make solar and wind equipment, like the many companies we have recommended in the pages of Green Chip Stocks.

Don’t Panic, Profit

As the fallout from rising energy costs, particularly fuel shortages in the Third World, starts to settle around us, it’s causing a great deal of pain and unrest and confusion. People are starting to panic.

We understand their fear, but panic isn’t helpful. What’s important is to be able to understand the trends, play them wisely, and put yourself in the best position you can to weather the even harder days ahead.

That’s why we created the $20 Trillion Report—to spot the plays that will bring you profits while everybody else panics.

Next week, I’ll update you on the outlook for renewables, food and fertilizer.

Until next time,

Chris

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