Will Oil Be the Last Asset Standing?

Stocks and commodities gained last week while the dollar – as is often the case these days – fell.

As you recall from last week's update, the correlation between these three assets has unusually close. The see-saw today has stocks and commodities on one side and the dollar on the other.

Investors must ask themselves how long this party can continue, and which of these assets they should be left holding when it ends.

To be perfectly honest, when the party ends it will probably end for all three assets, with stocks, commodities, and the dollar all losing value. However, while all three will go down, only some will be down for the count...

THE RESILIENCE OF OIL
Leaving aside the dollar for the moment, let's focus on stocks and one key commodity, oil.

Our feeling is that oil prices have greater staying power over the long-term than stock prices. Unless you just walked in the door, you won't be surprised to hear us say that. But let's look at two of our most important reasons.

Right now, increased demand for oil stems from the part of the world where economic growth is highest – the emerging economies and especially China.

(Recently someone argued that Chinese growth is not really sustainable because the Chinese consumer accounts for only a small part of China's economy. We disagree that this situation constrains the economy. Chinese consumers are starting to step up their purchasing. We've seen a huge jump in Chinese auto sales for instance, to the level where they surpassed the car sales in the U.S. And retail figures suggest that the Chinese consumer is becoming more of a leader than a follower.)

Overall, Chinese industrialization, infrastructure building, and the rise of its consumer should prevent any collapse in oil demand.

On the other side of the equation, oil production is unlikely to overtake demand unless oil prices rise dramatically. Right now, producers need a minimum oil price of $70 a barrel to justify investing in new production.

And a temporary spike above $70 (like we have now) won't cut it. If anything, producers need to feel confident that $70 will be the bottom of oil's price range for the foreseeable future.

Given oil's huge spike and subsequent plunge in 2008, oil will need to get a lot more expensive and stay expensive for quite a while before producers get brave enough to start bringing new supplies online.

If oil prices fall back to under $70, oil supplies will remain at a level where they cannot keep up with even lackluster economic growth. Eventually, the world would not have enough oil available to increase production of other commodities or manufactured goods. With a fixed or even declining oil supply, Americans and other Westerners would have to consume less – gallon per gallon – in order for China and the emerging world to consume more.

And that's not a scenario anyone wants to see (especially since the developing world would win the contest).

Bottom line: we need oil prices to remain above $70 to sustain any growth whatsoever.

Meanwhile, U.S. consumers have problems of their own. They have sustained a serious blow, in the form of a $13 trillion drop in their collective net worth, which has them focused on saving more and spending less for the first time in decades. Under these conditions, higher commodity prices will act as a tax, giving consumers even more reason to stop spending. Eventually, it will hold back U.S. economic growth too.

How high can oil prices go before they start to impact economic growth? Actually, it's a question of both price and time. If oil prices remain in the mid-$70s between now and the end of December 2009, that would do it. It would mean we had a year-over-year increase of more than 80% - the level at which our Long Term Master Key would issue a “sell” signal on the overall stock market.

We are betting that oil (and commodities in general) will have more staying power as this scenario unfolds than stocks. Oil is in a cyclical uptrend whereas stocks are trapped in a trading range. However, you should know that both groups will decline in the short-term if that signal is reached.

By now, you may be wondering, “What do we do in the meantime?”...

FOLLOWING THE IRRATIONAL HERD
All we can say for now is that today's market is irrational to be following a path in which both stocks and commodities rise together. It's also irrational to see the most speculative, high risk stocks such as AIG or Fannie Mae accounting for the lion's share of market volume. Yet this has been the case on many recent trading days.

However, markets can stay irrational for some time. All we can expect, while we're waiting for the correction, is that the market leaders will continue to lead. Despite the incredible risks in today's economy the “high beta” (high risk) stocks may continue to outperform.

So if you are impatient and want to make some gains while waiting for the music to stop here's what to do...

First, hold on to gold and zero coupon bonds as a hedge for when the correction comes. Same with the conservative defensive/offensive stocks we mentioned last week.

With that protection in place, and only to the extent of your risk tolerance, you can pursue gains among our high beta choices. Our recommendations here are long-term keepers. Even though they could come down hard in a correction, they are also likely to lead the market in the meantime. They include:

Potash (POT) and Mosaic (MOS), the world's two leading fertilizer producers.
Fluor (FLR), the world's leading engineering and construction company, which will benefit from any drive to raise energy supplies.
Intel (INTC) and Apple (AAPL) as Information Technology plays.
Oil service companies, such as Transocean (RIG), Nabors (NBR), Schlumberger (SLB), and National Oilwell Varco (NOV).
While these stocks will surely decline when the overall market tanks, they are still good stocks to own for the long haul, as they are set to dramatically outperform the market that’s destined to be erratic in the foreseeable future. And with our recommended hedges in place, you should get through the decline, when it comes, in much better than average shape.

Producing Fuel from Algae

Last year I wrote that I felt Oil from Algae was the technology to watch.

Well Exxon is now investing $300 Million into research (Via SGI) in this technology. I consider Exxon to be "smart money".

SGI is harnessing photosynthetic microbes (i.e., algae) to produce a range of liquid fuels and chemicals directly from sunlight and carbon dioxide. Algae produce significantly higher amounts of biomass and oil as compared to terrestrial crops, can be grown on land that is not suitable for agriculture, can thrive in sewage or other types of waste water, and are efficient at capturing and recycling carbon dioxide, a major greenhouse gas.

Current methods to produce fuel from algae include processes that resemble farming. Algal cells are grown, harvested, and then bioprocessed to recover the lipids from within the cells. In contrast, in one of our solutions, SGI has engineered algal cells to secrete oil in a continuous manner through their cell walls, thus facilitating the production of algal fuels and chemicals in large-scale industrial operations. Our first product in this area is a biocrude to be used as a feedstock in refineries

How They Took Down the Price of Oil

I figured out how they took down oil.....it went like this.....

1) They wanted to desperately take down the price of light sweet crude because its a bench mark for all pricing

2) There was (is) a shortage of light oil but a glut of heavy

3) so they pump light sweet to cushing from the SPR and replace it with heavy sour

4) The EIA week reports no change in SPR levels but Cushing is full of light sweet

5) Market concludes there is a glut of light sweet and they are right but for the wrong reasons

6) Don Coxe was right about the deliberate take down in oil

7) I just figured out how they did it

see

http://news.goldseek.com/GoldSeek/1234386901.php


I am a genius (but a broke one)

Semgroup LP's bankruptcy is one of the Main Factors Behind the Recent Decline in Oil

I strongly believe that Semgroup LP's bankruptcy is one of the main contributing factors behind the recent decline in the price of oil. In the short term, speculators clearly determine the price of oil. Semgroup had a large short position in oil which had to be covered. This drove the price of oil to $147 per barrell. Once all the short covering was complete the price of oil has stabilised.

I still believe that the longer-term fundamental factors reign supreme. The current high price of oil is in my opinion clearly justified by fundamental factors and while short term factors such as the Semgroup blow up are important they should not detract from the story behind the oil run up.

I am still invested 90% in oil and gas income producing assets.

Natural Gas and Oil Prices Showing Unexpected Strength

Crude Oil

After 4 days of losses, crude roared back to move into positive territory. Backs were even stronger up $1.70+ in most terms. Products were also up sharply. There was not a lot of bullish news to prompt the move though the USD was marginally weaker. Rather, this appears more technical in nature: the market tested but held support just under $79.00 which has encouraged funds to jump back in for a move higher again.

Natural Gas

Today's 57 BCF injection was bullish vs. expectations that were largely around 65 BCF. Beyond that, the trend of injections has been supportive: since 2000 the average injection for the past six weeks has been 73 BCF, this year we have average 56 BCF. We remain near all time records but have been losing ground. Meanwhile, with the weekend looming and a (weak) storm in the Gulf some more strength may be in order. Liquefied Natural Gas imports have slowed to under 1 BCF per day. if this keeps up natural gas prices should continue to strengthen.

Goldman Sachs on the Marginal Price of Oil Being Over $70 Per Barrell

Last night I picked up comments on the Investors Village CWEI board comments on the latest Goldman Sachs report on oil. I felt I should share this report with you. If Goldman Sachs is right then our income investing philosophy will be rewarded because some of the largest dividend paying investments are related to the oil and gas industry.

However, I caution readers on Canadian Oil and Gas Trusts because they are more sensitive to Natural gas prices (except Canadian Oil Sands Trust) and unless the oil:gas ratio improves along with the rising price of oil then the Canroys will continue to struggle.

The Goldman Sachs report talks about a lot of the issues we've discussed. Most interestingly, they believe that the long-term price of oil is determined by the marginal cost of oil production. Marginal cost is defined as the average of the highest cost (or bottom quartile) producers. Their study concludes that marginal costs are now close to $70/bbl. Furthermore, there are no more than 4 million b/d of current production that have a cost greater than $70/bbl, meaning 4 million b/d of extra capacity costing under $70/bbl to bring the long-date price down.

The report is the best I've read. It is the most technical, most numbers based. I've included a couple quotes below. I think oil is going down over the next few days as the dollar has a little bit of a rally here. If it goes down enough, I might add to my already significant positions in preparation for what could end up being a long, hard winter.

Excerpts from the report;

"In July, we argued that a significant increase in Saudi Arabian, Kuwaiti and UAE production by the end of the summer was critical to avoid prices spiking above $90/bbl this autumn. Last week, OPEC announced that it would increase production by only 500 thousand b/d by November 1. We believe that this will be too little, too late, baring an outright collapse in demand, and now expect inventories to draw to critical levels this winter."

"Despite only modest demand growth this past year, anaemic oil supply growth, due to disappointing non-OPEC supply increases and OPEC production cuts, has pushed the market into a significant deficit, which pushed the oil forward curves back into backwardation, creating the first cyclical bull market since 2003 that will likely carry into 2008."

"The current structural bull market, or investment phase, has entered its sixth year; however, the industry has added very little new, low-cost, production capacity as it has run into technological and political bottlenecks that will likely take years to resolve, supporting our view that the investment phase will likely last another five to 10 years. Further, costs have continued to rise, pushing marginal costs closer to $70/bbl, leading us to raise our 5-year forward WTI forecast to $70.00/bbl from $67.50/bbl... "

"Crude oil production during these summer months was nearly 1.0 million b/d below the level a year ago, while demand was averaging more than 1.0 million b/d higher than the level a year ago. This sharp imbalance prevented the normal seasonal build in inventories and has even set the stage for a third quarter draw on stocks, which is a rare event typically associated with significant winter spikes... "

"Net, we now expect inventories to decline by 1.5 million b/d during the fourth quarter versus a seasonal norm of 0.5 million b/d, which will likely cause prices to spike above $90/bbl this winter as inventories are drawn down near critical levels. It is important to emphasize that the current market deficit is being driven more by supply shortages than by excess demand, which is why upside price risks are so high despite significant economic growth concerns. We estimate that during the fourth quarter, demand growth would need to be 1.0 million b/d below our forecast, nearly 1.25%, to create a balanced market with a normal fourth quarter draw of 0.5 million b/d... "

"Given the inability of non-OPEC producers to significantly expand conventional production, we have argued for some time that oil at the margin is no longer pricing conventional oil but rather non-conventional oil such as synthetic crude oil, renewable fuels, and synthetic fuels... "

"1. The energy, water, and labour bottlenecks in the Canadian tar sands are severe and will likely prevent significant scaling up of the supplies at an oil price of $70/bbl, while a substantial change in Canadian policies in order to incentivise the use of nuclear power in tar sands production, and facilitate immigration of much needed foreign engineers appears unlikely in the near term;

"2. The nationalization of the Orinoco belt assets by Venezuela has led to a sharp decline in non-conventional output and no further foreign input of capital;

"3. Biofuel production has substantially driven up agriculture prices, pushing the subsidized cost of many of these fuels anywhere from $65/bbl to $150/bbl with a further scale-up likely to push agriculture prices even higher and hence raise biofuel production costs;

"4. ExxonMobil abandoned its gas-to-liquids (GTL) project due to high costs, the Sasol GTL plant in Qatar has run into technical problems in the ramp-up phase, and the Shell GTL project is significantly over budget, all of which suggest that GTL is off the table at an oil price of $70/bbl...

"If OPEC wishes to push the long-dated oil price down, it would need to offset almost all of the high cost production. However, as the group only has 2.0 to 3.0 b/d of spare capacity at most, it cannot displace the high cost production that supports the long-dated oil price. Instead, it can only control inventory levels, which ultimately controls curve shape..."

"Over the past five years, volumetric exports from the (Gulf Cooperation Council) region have been flat as demand growth has absorbed all of the supply growth..."

"If Saudi Arabia, UAW, and Kuwait ramp production up by 1.0 million b/d, the world would be left with very little spare capacity, which is politically dangerous for the GCC countries as they would have less of a negotiating position that the spare capacity provides, and would be economically dangerous for the consumer countries."

COT (Committment of Traders) BLOG

There is an excellent BLOG on the Committent of Traders Reports titled the "COT BLOG " that I suggest you follow.

The link is:

http://cotstimer.blogspot.com/2007/09/cots-loooove-nasdaq.html

The Time is now for Oil & Gas Trusts

I will be picking up oil and gas trusts over the next month because I think the lows are in for the year.

The gassy trusts are a real value at these levels because nobody wants them with Natural Gas storage full and prices in the low $5 area.

Remember, be fearful when everyone is greedy and be greedy when everyone is fearful.