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July 11, 2005

Our Ignorance About Crude Oil
by Henry To

Dear Subscribers and Readers,

We switched from a 50% long position to a completely neutral position in our DJIA Timing System on the morning of June 13th at DJIA 10,485. Despite the perceived bullishness of the market recovery subsequent to the London terrorist attacks, this author still believes that the short-term trend for the foreseeable future remains down. Let's just say that probability is not on your side if you choose to initiate long positions here - due to the fact that most of our technical indicators are still too overbought to sustain an ongoing rally going forward. I am still looking for a "blow off" rally to occur later this year, but this can only occur after the market has experienced a significant correction. For now, nimble (retail) traders should stay in cash and use this "down time" to research potential long ideas instead of trying to outwit the very short-term movements of the stock market. Remember: Over the long-run and for the majority of investors, the big money is usually made on the long side.

Latest Market Poll: Please participate in our latest poll on crude oil. This week's question is: Where do you think crude oil is heading in the next 12 to 18 months? Like I said in our poll, please don't let my opinions sway you. Be objective - if anything, please gather your thoughts now and vote before you read our latest commentary. Note, however, that what I am about to articulate about the oil market isn't too far away to what we have been discussing over the last 12 months or so.

In a perfect world, all our cars will be fitted with hydrogen fuel cells as the primary storage of fuel. Our various energy sources will be limitless and they will be virtually free. All exhaust gases will be non-polluting - and the U.S. will finally be in compliance with the Kyoto Treaty. While we are very far away from this "perfect world scenario," most Americans have chosen or have been led to believe that we are close to such a scenario - that the current supply of crude oil and natural gas is inexhaustible and that sufficient supplies can be brought online to satisfy the world's increasing demand for at least the next 20 years (I am not going to bring up the other issue where most Americans are ignorant about - that a significant amount of energy reserves around the world are in countries where the majority of Americans know little of).

This may very well be the case. But as Mr. Matt Simmons - the founder of the very well-regarded energy investment bank, Simmons & Company International, located here in Houston, Texas - points out recently, the lack of production data being published by the OPEC countries (and in particular, the only swing producer - Saudi Arabia) is a great cause for concern. Throughout the 1970s until today, world oil demand has consistently been underestimated - at the same time, the capacity of the world to produce more oil has been consistently overestimated - which have historically resulted in unpredictable price spikes (similar to the events of the last 12 months). For example, in his new book "Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy," Mr. Simmons recalls "Oil prices had stayed so low for so long that by the end of the 1960s no respected energy analyst thought they would ever rise. The majority of oil experts assumed the price would steadily fall. This assumption was vividly illustrated in the last days of the low oil price era. The Shah or Iran, a strong U.S. ally, attended President Eisenhower's funeral in 1969. During this visit, he quietly offered the new President of the United States, Richard Nixon, a 10-year contract to supply the United States with oil for one dollar a barrel [emphasis mine]. According to Henry Kissinger's memoir's about the Nixon administration, the United States politely declined the Shah's offer because it was not clear to any senior government official that oil prices in a free market would stay as high as one dollar per barrel over this lengthy period of time [again, emphasis mine]."

Mr. Simmons also notes that from 1950 to 1982, the countries that later made up OPEC published detailed field-by-field oil production data - at least on an annual basis and sometimes even semi-annual basis. However, this practice came to a halt in 1982. From that time on to the present, the OPEC countries rarely reported production data or reserves data on a field-by-field basis. This lack of transparency has lead to great volatility in oil prices since that time - on the downside as well but mostly on the upside.  As an aside, this "data vacuum" has led to the proliferation of a new class of energy consultants, that of the "Tanker Traffic Counters" - whose jobs were to estimate production volumes based on the observation of tanker traffic at the world's major loading docs. As Mr. Simmons contends, this story would sound unbelievable to industry outsiders but this is a great example of how opaque OPEC (and particularly Saudi Arabia) data is and the kind of information that respected publications such as Oil & Gas Journal and institutions such as the Energy Information Administration are relying upon. I will quote: "Emerging as the leader in this new field [that of the "Tanker Traffic Counters"] was a Geneva-based firm called Petrologistics, which still claims to have harbor spies at all major loading ports watching tanker liftings and guessing at the tankers' destinations. Reports from Petrologistics estimating export volumes became a first source of OPEC production volumes. As strange as this may sound to people outside the international oil industry, Petrologistics, as far as anyone has been able to discover, has one key employee, Conrad Gerber; he heads the firm, counts the tanker traffic, and feeds the data to various media sources. Mr. Gerber conducts his business from the global headquarters of the firm above a small grocery store in Geneva. He claims that Petrologistics has upwards of 20 to 30 "harbor spies" in its secret employ. But the names of these spies have never been disclosed. Since there is no way for anyone to independently verify even the existence of these secret collectors of tanker data, the possibility must be granted that Mr. Gerber simply glances at the estimates of many other OPEC production guessers and either uses the consensus views or randomly pulls some numbers out of thin air. Nevertheless, Gerber's OPEC oil export data have become the "original" source for most media estimates of monthly OPEC production, including the extremely important and highly regarded IEA's Oil Monthly Report." For a further discussion on Mr. Gerber, please go to the following link at Peak Oil.

I picked up "Twilight in the Desert" this past weekend and found it a fascinating read, although the gist of the message is not very far away from the research that Mr. Simmons and his associates had been posting on their company website for the past few years. For a good introduction to Mr. Simmons' research - you can find most of them on his company's website. As for a good introduction to this book, the following MSNBC article is a must-read - but I would definitely recommend picking up the latest copy of his book if one is a serious practitioner of stock market and commodities investing.

As I outlined in our August 29, 2004 Special Report: "Economic Survival in the 21st Century - the Three Key Questions to Ask," the era of cheap energy (1990s-style cheap, that is) is effectively over - concluding that "There are currently three factors at work which should contribute to a continued increase in the world oil price - the maturing of supply, growing demand, and the lack of a cushion in refining capacity and low inventories" and "...crude oil prices could rise to $80 or even $100 a barrel. I sure hope that my readers would not be taken by surprise if gas prices at the pump soars to $4.00 a gallon five to six years from now." More recently, British Petroleum released a fresh report noting that North Sea output fell 10% in 2004 - with a 230,000 barrel per day reduction that were greater than the production declines in every other individual producing countries. A more alarming fact is that the UK, for the first time since 1991, became a net importer of oil for two months during Fall of last year. Such is also the case with Indonesia (which is a member of OPEC) - where for the first time last year, it also became a net importer of oil. One has to wonder: If most oil producing countries are seeing declines in production, can Saudi Arabia ramp up their production from the current 10.5 to 11 million barrels per day to 12.5 million barrels per day within the next several years, as they have claimed to be able to do? Finally, the idea of extracting more oil from the Canadian Oil Sands seems to be a very attractive proposition, but is this enough to offset dwindling supplies from other countries and to satisfy increasing world demand for oil in the next five to ten years? My guess is "no" - and since shutting out China or India is not an option, we will just need to develop more alternative energy sources or embrace the idea of energy conservation (or both) going forward.

In the next 12 to 18 months, however, I believe crude oil prices have most likely topped in the $60 to $62.50 a barrel range. In a world of opaque production data and with the proliferation of hedge funds seeking outsized returns in all kinds of markets, I would not be surprised if a significant amount of speculators and hedge funds piled into crude oil over the last 12 to 18 months. As the following chart from the Energy Information Administration suggests, U.S. inventory levels - at 325 million barrels - are still very much greater than the high-end of its previous five-year range - suggesting that there is ample crude oil to supply the domestic U.S. energy infrastructure.

Ironically, the build-up of these inventories may have further contributed to the recent spike in crude oil prices - as U.S. refiners continue to be worried about the lack of excess surplus production capacity both in the OPEC countries and around the world. The following chart from a March 2005 presentation by the EIA illustrates the lack of surplus oil production capacity perfectly:

Another interesting point is that since April, the short-term contract for crude oil has been cheaper than the longer-dated ones - further encouraging the build-up of inventories and further driving up crude oil prices. This is another bearish development for the price of crude oil during the next 12 to 18 months.

Our MarketThoughts Global Diffusion Index (GDI) is also calling for a significant correction in commodity prices going forward. For a more detailed discussion of how we developed our GDI, please refer to our May 30th commentary. To put it briefly, the MarketThoughts GDI is still trending down and showing significant weakness - as outlined by the continuing negative readings in the rate of change in the GDI and the fact that the year-over-year change in the GDI is about to hit the zero line. Please note that historically, the rate of change in the GDI and the year-over-year change of the CRB Index has tracked the movement of each other in a pretty established way. Barring a colder-than-expected winter in five to six months, I expect the CRB Index to fall at least 10% - which will also result in a significant correction of oil prices (please note that our MarketThoughts GDI is updated to May, while both CRB and DJIA data are updated to June):

As an aside, if the equity markets (as per the Dow Industrials as outlined in the above chart) is to track the movements of late 1994 to early 1995 (which is a very credible scenario given that the rate of change in the MarketThoughts GDI was also very negative at that time), then the equity markets may take off anytime now. This is just one potential scenario that has been bothering me and my "one more correction before a blowoff top" scenario - but for now, probability still suggests that my scenario is still the preferred scenario.

But now, you may ask: Well, that is all and fine, but what about the historical correlation of oil or energy prices vs. the rate of change in our MarketThoughts GDI (as an aside, the CRB Index will be revised on July 12th - this revision will give a heavier weight to energy prices and to crude oil, in particular)? Following is a chart showing the performance and the rate of change in our MarketThoughts GDI vs. the year-over-year change in the CRB Energy Index, whose components include WTI crude oil, natural gas, and heating oil (again, our MarketThoughts GDI is updated to May while everything else is updated to June 2005):

It is interesting to also the historical correlation between the performance of the MarketThoughts GDI and the year-over-year change in the CRB Energy Index. If this historical correlation holds true, then the yellow line should at least hit 0% at some point within the next three to six months. A 0% year-over-year increase in crude oil prices would translate to a range of $42 to $56 a barrel from now until December - suggesting that oil is definitely now very overvalued. Perhaps a valid comparison can be made with the natural gas spike during the Winter of 2000 and 2001 - where the NYMEX natural gas contract (priced the Henry Hub in Louisiana) spiked from a level of $2.50 per MMBtu to over $10 per MMBtu in a matter of months due to fears of a natural gas shortage in the midst of a colder-than-expected winter. Of course, there were shortages in various areas of California (where natural gas spiked to $50 per MMBtu) and New York, but definitely not in Louisiana! Nine months later, the spot price of natural gas at the Henry Hub subsequently declined to $2 per MMBtu. While I am definitely not predicting such a short-term decline in crude oil prices, I believe that a crude oil price of $40 a barrel is definitely very possible within the next 12 to 18 months - given the global economic slowdown (in fact, China has just reported a slight year-over-year decline in crude oil imports for the month of June), the hugely bullish sentiment, the fear of the lack of excess supply, and the subsequent rush to build inventories.

Of course, the price of natural gas at the Henry Hub is now about $7 per MMBtu - suggesting that the 2000/2001 spike was the precursor of permanently high natural gas prices. I expect the same scenario to occur for oil prices. While I believe there will be a short-term decline in oil prices within the next 12 to 18 months, I am very bullish on longer-term oil prices. My position is that oil prices could very well hit $80 to $100 a barrel within the next four to seven years - if not higher. If we are to experience some kind of supply disruption during that timeframe, (for example, a shut down of oil facilities in Venezuela), then oil prices could very well spike to over $200 a barrel.

Please note that the above is not some kind of doomsday scenario. Higher energy prices will hurt, but as a percentage of consumer spending, prices paid for energy is still very much below than what were spent during the early 1980s. Let's assume you possess a SUV with a fuel "efficiency" of 15 miles per gallon. Let's also assume you live here in Texas and you drive 15,000 miles a year. Each year, you will need to fuel your tank with 1,000 gallons of gas/petrol. A $2 increase in fuel would only increase your spending by an extra $2,000 a year - hardly a cause for concern for the family who could afford such an SUV in the first place anyway. For families or individuals that do not want to spend any more money on gas/petrol going forward, I would recommend driving a smaller car going forward. A sustainable oil price of $80 to $100 a barrel would also encourage the further development of alternative or renewable energy resources.

Since the latest monthly foreign reserves data are not available from the Federal Reserve just yet, I am going to skip the commentary about foreign reserves (this commentary is getting too long already) and go directly to a discussion of the stock market - starting off with our usual daily chart of the Dow Industrials vs. the Dow Transports:

The action of last week has severely disrupted my short-term correction/downtrend scenario, with the Dow Industrials gaining 145 points and the Dow Transports gaining 81 points for the week. The most important development, by far, is the fact that the Dow Transports is now closing in on its June 2nd closing high at 3,649.96. If this high is taken out, then this will mark the first time I have been wrong in awhile - made all the more likely given that we are now only 60 points away. However, please note that this week will mark the beginning of earnings season - and anything can happen in earnings seasons, especially since this is the first quarter in the last three years where S&P 500 earnings growth is expected to be below double-digits. For now, the fact that this market is now overextended suggests that this is not a good time to initiate long positions.

Let's now turn to our weekly sentiment indicators - starting off with the Bulls-Bears% differential readings in the American Association of Individual Investors (AAII) Survey:

As we mentioned in the above chart, the AAII Bulls-Bears% Differential enjoyed a slight bounce in sentiment in the latest week - bouncing from 16% to 23%. Moreover, this indicator is definitely no long oversold (but not extremely overbought either) so under normal circumstances, the market should be good for at least a scalp here. Keep in mind the qualifier "under normal circumstances" - since with an impending economic slowdown and the earnings season in full swing (not to mention overbought conditions in many of our technical indicators), we are definitely not experiencing "normal circumstances." I believe we should at least wait for an oversold condition in the above indicator before we even think about initiating any long positions.

The same message applies to the Bulls-Bears% Differential in the Investors Intelligence Survey:

The readings coming out of the Investors Intelligence Survey is now pretty overbought - although not as overbought as they were back in December 2004. Again, probability does not favor the long side over the next several months. Let's now turn to the "most correct" indicator of all - that of the Market Vane's Bullish Consensus:

Why do I say "most correct," you may ask? As I have been saying over the last several months, the Market Vane's Bullish Consensus is the one sentiment indicator that has been bothering me - in that it never really got that oversold during the various corrections over the last 18 months. In retrospect, this indicator was telling us that the ensuing rallies would be relatively dismal - and it was correct. For the foreseeable future, I believe both our subscribers and us should continue to heed the readings of this indicator. And what is this indicator saying now? Well, the latest Market Vane's Bullish Consensus reading remained steady at 67% - an overbought indicator any way you look at it - but especially overbought when one looks at it in the context of the ten-week moving average. The ten-week moving average is now at 65.9% - the most overbought since mid-April 2004. Please also note that the Market Vane's Bullish Consensus readings were also high during the Madrid bombings of March 2004 (as a side note, the stock market quickly recovered after the Madrid bombings, but declined quickly afterwards).

Conclusion: While we are ST (next 12 to 18 months) bearish on crude oil prices, we are structurally bullish - with a price target of $80 to $100 barrel within the next four to seven years - barring no supply disruptions within that time frame. A key producer to watch (even though we only import 1.5 million barrels a day from that country) is Saudi Arabia - the only swing producer left in the world. Time and again (that is, over the last 30 years), the Saudis have hit a wall at 10.5 to 11 million barrels a day - could they really increase production to 12.5 million barrels a day over the next several years, as they have claimed? We will find out soon enough - for now, I believe that any substantial correction in oil prices should be bought (barring a worldwide economic recession). For the serious stock market and commodity investor, I would highly recommend picking up a copy of "Twilight in the Desert."

As for the equity markets, the message remains the same from last week: The Summer/Fall correction that I have been looking for is still in play. Only a Dow Transport close 60 points above the current reading would make me THINK ABOUT re-establishing my position. Again, my sense is that the upcoming earnings reports could be the trigger for a more significant correction, but we will see. For now, we will remain neutral - in cash, and waiting for a more oversold condition before initiating long positions.

Signing off,

Henry K. To, CFA
MarketThoughts.com

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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