Monday, September 29, 2008

Here is What is Wrong with our Economy

Rep. John Culberson came on Fast Money today and showed us why we are in an economic disaster. Watch and listen to this guy. He doesn't understand what he is saying and shows he is incapable of even listening to the experts on the show. We have no chance if this is who we have running our country.

http://www.cnbc.com/id/15840232?video=872233203&play=1

The Deal is Done

Monday morning, Sept 29, and the Deal is Done. We are going to get our $700B "bailout" of the American, if not world, financial system. But is this too little, too late to save the economy. This is what we have yet to find out.

There is no doubt in my mind, that if a deal hadn't been done by last night, we would have had an immediate devastation of the world stock markets. The backstop of the financial system will just allow the air to be let out of the balloon more gradually and less catastrophically. But the market is headed lower, maybe much lower, as the full effect of financial deleveraging and consumer angst is felt.

Another theme is developing: we will have many fewer banks in the next year, than we have had in the recent past. There is a deliberate effort by the Treasury and FDIC to consolidate banking assets to a few strong, or less weak, banks so that the crisis can be better managed. The "chosen ones" are apparently: USBank, Wells Fargo, JP Morgan, CITI and Bank of America. Goldman Sachs can also be added to the list as the only major investment banker left standing. I am somewhat vindicated in that I have long said (since last August) that I thought BAC and C would be considered "too big to fail" and would be protected by the Feds. I have to admit, though, that I have lost some money on this bet as even when I am right about their solvency, I have been wrong about the stock price.

All other banks are at risk. We know this because of the pattern that is developing. The FDIC just can't afford any more IndyMacs, which went bust in an uncontrolled way, leaving FDIC on the hook for $14B (or so) of insured deposits. FDIC only has around $45B of assets, so it can't afford to have all the banks go bust without some pre-emptive efforts. In the past week, it has overseen the dissolution of WaMu (assets only assumed by JP Morgan) and now, today, Wachovia (assets and liabilities assumed by Citi). Both banks were heavily exposed to the residential mortgage market.

On the investment banking side, Bear Stearns and Lehman have already been taken out with the help of Federal agencies. Morgan Stanley took itself out by selling itself off to Mitsubishi Bank.

What is next? The wave of banking failures is spreading around the world. Fortis and another less well know British bank were also dissolved over the weekend with assets transferred by European banking authorities. There is plenty of toxic exposure in China and other major Asian economies. The total effect of all this banking damage will be very negative for the world economy for many quarters to come. The markets must take a hit to reflect this reality.

Advice: it is too late to run for the exits, IMO. But, a little short side protection on existing positions is called for. I will buy SDS, the inverse and doubled short on the S&P500 index, in the next couple days. There may be an additional benefit of this action as I think when the Short Sale prohibition on many Financials comes off next week, that short positions may pop as a result of pent up demand into such a weak market.

Tuesday, September 23, 2008

A Look Back to Help Find the Way Forward

I have spent some time during recent days in remorse. "How did I not see all of this coming and get into cash?", I ask myself. But I am being unfair to myself, because I did see all of this coming, but could not bring myself to believe that it would actually happen or pull the trigger to sell out and get 100% into cash.

I looked to see what I was saying in January 2004, and low and behold, I thought all of this was a possibility, though in early 2004 I did not yet fully appreciate how much the real estate bubble would affect the future. By the end of 2005, I understood that was the true danger. But if our financial system was not so inherently weak prior to that bubble, it would not have brought the system down. Looking back on this advice, it sounds as relevant today, as it did almost five years ago.

Here is what I said in my annual letter, January 2004:

REAL ASSETS

This category was not mentioned in previous reports, but is an area of great interest. The base materials (natural resources) markets have outperformed many equities and all bonds in 2003. Gold, like oil and other natural resources, has reversed a 25 year downtrend. This is very significant. It was only two years ago that many central banks decided to liquidate gold reserves, pressuring prices with the anticipation of increased supplies. Now, gold has gone from $250, to well over $400/oz. in 18 months. What does this mean? Is it a portent of things to come? Gold has been the “Anti-dollar” since 1971, when the USA (and by extension, any central bank with currency linked to the dollar) went off the gold standard and onto a paper based standard (the USD). Gold prices went from $35 in 1971 and eventually to $850 in 1980, during the height of inflation. Then as now, gold strengthens when the dollar (and other paper currency) weakens, as gold is the alternate form of world financial exchange.

Gold and other commodity prices are considered by many economists to be predictors of future inflation. Inflation is created by excess debt leading to declining currency valuation. If government and consumer debt and money supply is again in excess, then inflation and declining purchase power of the USD is on the way (Boy, sure got this one right!!). The deficit spending of the past 3 years rivals the late 60s, during Johnson’s “Guns and Butter” program, as a percent of GNP. But the story is really worse this time. Unlike the 60s, when the USA was still the world’s creditor nation coming out of World War 2, with positive balance of trade, now, the USA has severely negative balance of trade. Continued build up of national and personal debt is doubly troublesome. Unlike the 1970s, now have nothing to offset our debt, except more paper.

Potential “Doomsday” scenarios come out of this ominous situation. At best, as hoped for by me, the large national debt will result in a price inflation, a stagnant economy, flat stock market, and declining bond prices in concert with increasing interest rates. See the 1970s for an example. I believe this is what the Fed is now trying to engineer: dollar devaluation and price inflation. The dollar devaluation makes exports more attractive and imports less attractive, helping our trade balance. Price inflation reduces the impact of long-term debt for both government and consumer at the expense of the creditors: mortgage holders in the case of consumer debt and foreigners in the case of government Treasury bonds.

In the worst case scenario, the dollar’s value will disintegrate taking the USA and many other dollar-denominated economies with, leading to a global financial crisis and depression that could last for 10 or more years. From this depression will emerge a new global financial power, China, which would de-link its currency from the USD, and make the China Yuan as the new global currency standard. As the new creditor power, replacing the USA role from the 50s and 60s, China will dictate world policy.

The end result of these concerns is the need to own either commodities in the form of mining, energy or other natural resource companies, and rare metals: gold, silver, platinum, etc, in certificate or in fact.

Energy stocks are another commodity that would do well in an international financial crisis. Asia (China) continues to increase consumption of energy products, like oil and coal. Supply is limited and requires years of effort to expand. Commodities will also do well during a period of global inflation, or deflation, as during the 30s. Raw material values may not increase in absolute terms during periods of deflation, but they do not decrease much, either. So, if currencies increase in value, as they do during a period of deflation, then commodities appreciate in relative terms.

Thursday, September 18, 2008

Hold on for a Ride Up

Looking at the market before the open this morning, of course I wish I had a lot more Financial stocks than I do. The UYG and XLF will explode higher this morning. I had been short financials by selling the puts of SKF, a short fund. But I closed out my position yesterday because I hoped the actions that took place would happen. I closed it with SKF running very high on fear at $140. Today, SKF may open below $90. Boy, that was close. That would have been expenisve if I had not gotten out yesterday.

Meanwhile, the very large Goldman Sachs position I hold is looking a lot better. It was trading as low as $85 midday yesterday. I own it at $172 (actually, the options, but the loss would be the same). Today, it looks like it will open above $140 and could go to $160 during the day, getting me back close to even.

So, though I won't have a chance to get back into my long UYG position (the opposite of SKF), because it is soaring in the pre-market, I am happy for what I have. Hopefully you will also have a very nice market day with the action in front of us.

Be glad you are not a professional short seller with big short positions in Financials (hedge funds, Al Queda?) They will be wiped out if naked (not covered by equal long positions)

Short selling in crosshairs of world market regulators (recapped)

It didn't take long for the government and large financial institutions to respond as I thought they might, to the biggest financial crisis of our lifetime (at least for those of us under 75). There were a lot of actions taken today from the list I posted yesterday, which itself was culled from a number of sources and common sense. I thought this article on short selling was important enough to recap given the current market situation. It sheds a lot of light on the problems of weakened companies that are targeted and attacked by groups of short sellers, punished in spite of strong financials.

Late breaking news, today, has the Congress, Treasury and Fed working together on a plan to implement a modern day RTC, another of the actions I thought were necessary, and likely in the works. I will post more on this once the details are known.


SAN FRANCISCO (MarketWatch) -- Gathering anger over short selling of vulnerable financial stocks exploded into the open Thursday as top market regulators and industry giants took steps to limit the practice and begin investigation into possible abuses. Britain's stock market regulator on Thursday banned short selling in financial companies and said it might extend the ban to other sectors.

The move followed the Securities and Exchange Commission's curbs on the practice that went into effect Thursday morning. Read full story.In other steps aimed squarely at the bearish practice, the country's largest pension fund, the California Public Employees' Retirement System, said it was taking steps to limit the practice on three financial stocks and the New York attorney general called for a wide-ranging investigation of the short selling of some prominent financial companies, including Goldman Sachs (GS) and Morgan Stanley (MS).

The concerted reaction followed two days of sharp declines in global stock markets, triggered by mounting fears that the credit crunch would spin out of control and deepen the financial crisis. As stock declines have deepened, the role of short sellers has come under fire. "The moves should help restrain the abusive short-selling practices lately rampant in the stock market," said analyst Thomas Brown of Bankstocks.com. "Short sellers can no longer deceive their brokers about their intention or ability to deliver shares. "The SEC on Thursday put a ban on so-called "naked" short selling, while Calpers said it won't allow lending of shares of Goldman Sachs, Morgan Stanley, and Wachovia (WB).

The California State Teachers' Retirement System made a similar move and it called on 60 other funds to follow suit. "We don't want to inadvertently contribute to the instability of these companies or the market," Clark McKinley, a Calpers spokesman, told The Wall Street Journal. Calpers has one of the largest securities lending programs in the country, at $38 billion.

Much of the concern in the U.S. focuses on naked short selling. Naked shorting can allow market manipulators to force prices down much lower than would be possible in a legitimate short sale. In an abusive naked short sale, according to the SEC, the seller doesn't borrow a stock, as would happen in an ordinary short sale. The seller also fails to deliver the stock to the buyer.

Bill Stone, chief investment strategist at PNC Wealth Management, supported the SEC ban on naked shorting. "They don't let me go out and buy stocks without paying for them, so they shouldn't be able to do that selling them. Fair is fair," said Stone. Brown and others want the SEC to take its authority even further. They argue the SEC should re-impose the so-called "uptick rule" that prevented traders from selling short unless there was a higher bid price in the stock. "They shouldn't outlaw shorting but putting more controls on it is necessary," said John Langston, analyst at Hodges Capital Management. The SEC repealed that the uptick rule in July 2007.

They also want the SEC to dig into the option and credit default swaps strategies used by short sellers. Short selling itself isn't illegal. Some investors contend short sellers are a reality check for the market, in some cases, shining light on possible accounting shenanigans at corporations. "Short selling provides market liquidity and keeps management honest," said money-manager Russell Glass at RDG Capital.

In a regular short sale, the seller borrows a stock and sells it, with the understanding that the loan has to be repaid by buying the stock. New York Attorney General Andrew Cuomo plans to investigate rumor mongering and illegal conduct. "The markets need to be stabilized," Cuomo said. "One way is to root out short sellers who spread false information."

In further moves that should rattle short sellers, the SEC is expanding its push into the trading records of hedge funds, which are less-regulated than mutual funds. The agency said it is sending subpoenas to at least 50 big hedge funds, seeking trading records and communications about trading in specific companies.

The SEC is considering a rule that would force hedge fund managers with more than $100 million invested in stocks to report their daily short positions. This is drawing the ire of famous short-seller Jim Chanos, who helped expose the accounting gimmicks at Enron. "For investment managers such a requirement is akin to the government suddenly requiring Coca-Cola to disclose their secret formula for free to all their competitors," Chanos said.

SEC Chairman Christopher Cox has been under scrutiny for his handling of the financial crisis sending shockwaves through the market. On Thursday, Republican Presidential candidate John McCain said SEC Chairman Christopher Cox should be fired. McCain said Cox "serves at the appointment of the president and, in my view, has betrayed the public's trust. If I were President today, I would fire him."

Is this Market Wreck an Attack by Al Queda?

This is just my speculation, but I wonder if this chaos is being initiated by Islamic extremists. There is enough money from oil sales in the hands of Iran or other anti-American oil nations to precipitate this crash.

Think about it: the entire goal of hitting the WTC on 9/11 was to collapse the Western world's financial system. Knocking down buildings didn't work, so I am sure Al Queda and other extremists went to work on a new plan to do the same.

There was evidence of short selling by Islamists against the American market on the days leading up to 9/11. They know how to use that tool. To make the case more compelling was the attack on the US Embassy in Yemen yesterday. Al Queda likes to conduct attacks on multiple fronts to undermine confidence in the Western economic system.

Today, I just heard that there is a short selling campaign against State Street Bank, which is a major clearing house for Wall Street, based in Boston.
If this is the case, it can be stopped by a concerted effort of the Central Banks and regulators. The terrorists know that we are very reluctant in a free economy to employ controls. They are counting on us allowing our free markets to solve the problem. But they are manipulating short selling against major banks, one at a time, first the weak, and then the strong. We should be suspending all short sales, period, against money center banks and major financial institutions. That will freeze the market, but at least it will get rid of the speculation.

Then, there should be an intense effort to trace every significant short sale against banks on record to trace back the transaction to its source. If those sources are foreign, the accounts that transacted the business should be frozen. If we find it is terrorists, we should do everything possible to eliminate those people. If the transactions are domestic, the FBI should be sent to question the transactors to find out their intentions. If the intentions are found to be manipulative rather than speculation, the transactors should be prosecuted on federal racketeering charges.

This is what I hope is happening today behind the scenes.

Wednesday, September 17, 2008

Back to Reality

I was at my annual boys golf tournament the past 3 days. We call it "Party At The Pines" at a resort in northern Minnesota. This is the 14th year we have gone north with 16 or 20 guys and played non-stop golf for 3 days. It is a great way to get away from it all. You can't think stocks or trouble at work, when you are focused on hitting that little white ball about 400 times over those 3 days.

Now that I have missed all the stock market fun this week, I have a little chance to consider what has happened and where we go from here. One thing is for sure, the market has left its moorings. It has entered the irrational phase when anything can happen. The one thing I know from all the reading I have done, is that at times like this, it is best to just stand still and do nothing.

I am not a disinterested bystander, by the way. I thought I was fairly well protected from this eruption (which I suggested was a possibility as early as 2005, based on the housing bubble bursting), but I have been more or less fully invested since I believe it is impossible to pick a bottom. And honestly, this market situation is at the extreme end of what I thought was possible. There has always been a doomsday scenario suggested by some analysts, that would be triggered by this type of loss of confidence in the financial system. But I never really thought it would go as far as it has.

You know that I have been buying high dividend stocks and funds and reinvesting the large dividends in the same stocks to average down my cost if the price goes lower. I am very diverse in my holdings so that the risk is spread. But still I am getting hurt badly in this market because even the babies are now getting thrown out. Even cash is no longer safe, as some big money market funds are now "breaking the buck" and unable to return $1 of principal.

But this has all the look of capitulation. VIX peaked at near 40 today, which is its highest level since the 2000-03. Generally any spike over 30 signals fear in the market and a buying opportunity, though note how long high market volatility went on in the Tech Bust:



What needs to happen to change the direction of the market? There are a few basic actions to look for. The basic need is to break the vicious feedback loop in which the market is now engaged. The actions need to come from the government as they are regulatory in nature and in most instances, the government initiated the rules or regulations that have precipitated this crisis.

1. Suspend the "Mark-to-Market" rule: It came out of Sarbanes-Oxley legislation and was implented by the accounting board, FASB. Mark to Market is the primary culprit for circular market action, since the action of marking down assets weakens the capital structure of a bank and causes it to decline in value. As assets decline in value based on the weakness in the institutions backing the financial assets, the market price declines requiring another round of markdowns. This has gone on until some banks have broken their statutory capital requirement level and become insolvent in the process. This must stop to repair the market, so look for a loosening here and the option of "Marking to Model"

2. Clamp down on short selling: Although I have been doing some short selling to provide protection, and believe in it from a free market perspective, but it can really exacerbate the snowball effect of a downward spiraling market. Because financial institutions use the equity on their balance sheet as capital against their book of bank financing, they are exposed to damage by short selling more than other businesses which don't leverage their equity to do business. The "uptick" rule should be reinstated and I see that there are further restrictions on Market Makers put into effect by the SEC today so that shorts have to have claim to the physical stock in order to short it (that is, no naked shorts).

3. Continue infusing liquidity into the market: The Feds need to continue flooding the market with capital so that the financial engine does not seize up. Money is like a lubricant to financial institutions and business in general. If it ever stops flowing, then business freezes. The Feds have many ways to put money back into the financial markets.

4. Back more institutions with capital as needed: AIG and Fannie/Freddie were both bailed out with large US government loans. But these are not necessarily bailouts that will cost the taxpayer over the long term. This is the modern equivalent of the Resolution Trust Corp (RTC). The Feds are giving capital loans at a high percent interest ($85B at 12% in the case of AIG). This paper can later be sold on the open market at a big profit once the market panic passes and the company's balance sheet is repaired, just as any bond can be sold.

Goldman Sachs (GS) and Morgan Stanley now look like the two that need the most help, though they were thought to be top of the heap a few weeks ago. GS just beat expectations with its earnings report on Tuesday. Apparently their CDSs (credit default swaps which are like loan insurance) sold to other banks to hedge risk in loan portfolios, are jumping in cost. The Fed can help them here by buying the CDSs onto the Fed's balance sheet and later reselling to the market at a profit, to the taxpayer's benefit.

Even though they have so far avoided attack by the short sellers, USB and Wells Fargo are not out of the woods. In this market, the shorts can ruin any bank.

5. Coordinate Central Banks globally to take a similar approach with their own national banking companies. There is so much linkage in the financial system this is not an exclusively American problem, though it may have started here. The Central Bankers should be talking to each other (I am sure they are) to coordinate actions for the maximum positive effect. The Euro can be used to prop up European banks and the Chinese and Japanese central banks are flush and should do the same for their home banks.

6. The Central Bank should not worry about inflation right now. Everything happening right now (not 6 months ago) is Deflationary, not Inflationary. Financial contraction, in terms of deleveraging of financial institutions and dropping real estate prices, is inherently deflationary. The Fed can pump as much money into the banking system as it wants without adverse effects today. Once there is recovery, the Fed then would need to take money back out of the financial system by calling its loans, or selling them off.

7. Shut down the ratings agencies: Moody's, S&P, and other ratings agencies are doing more harm than good. They were big contributors in blowing up the real estate bubble by rating sub-prime securities as AAA, thereby attracting cheap money from abroad into our housing market. And now they are over-reacting the other direction and are dropping ratings on good companies because their stock price is declining and it is decreasing capital ratio coverage (see points 3 and 4). The function of agencies is to provide constructive guidance to investors based on their research departments. But the agencies have not lived up to that promise for more than a decade. They missed the Tech Bust as well.


8. Finally, remember that when the market does get over its panic, the rebound will be substantial. It may not bounce back to 14,000 Dow anytime soon, but it could bounce back to 12,500. The Financials that are left standing can double or triple over a 6-12 month period as they regain the irrational / non-fundamental losses. So, financial index UYG, as one suggestion, will do very well at some point.

I hope Bernanke and Paulsen work quickly on the above, plus anything else they can think of that I have not. They need to do so to keep us from crashing into a Depression. I think we have the right people at the top to avoid a real crash with Bernanke an expert on deflations and Paulsen an expert on investment banking finance. Watch for any or all the above and when you see action taken, it should solve the problem.

Until I see what comes from the Fed, I am sitting on my hands trying to avoid doing any more damage to my accounts by selling low, but also not sure if we are at the bottom, so not willing to buy, other than through the methodical reinvestment of dividends that I have set up.

Thursday, September 11, 2008

Watch VIX Today

I think VIX will cross 30 today and on a bit of panic will set a new market low. This low will be in the same range as the market low on July 15 at around SP500 (1180-1200) and will set up a reasonable period of market recovery. This is a continuation of the bottoming process that started back in March, with the Bear Stearns takeover by JPM. Because of the severity of the financial crisis, and its continuing ripple effects around the world, this bottoming can take a long time.

If we remember back to the 2000-2003 market decline at the end of the Tech boom, there was ripple after ripple that unwound separate excesses, from the Teleom sector, to the Internet sector, to the Large Cap growth sector, to Enron and Tyco. One after the other of these segments came apart until all the previous excess was exhausted.

This is what we are seeing again. It started with the riskiest of the mortgage companies (those specializing in sub-prime) and has continued through home builders, banks, insurance companies and then spread overseas causing export declines in Asian and European economies, leading them to recession and market declines (check out China, FXI, which has declined by 70% from its peak last year). Now, the energy, metals and commodities sectors, which were overheated, are getting taken down because of the reversal of the Yen and Euro carry trades against the US dollar (with the strengthening dollar). The Hedgies are dumping their commodity positions and some of those hedge funds will crash.

But, we are getting closer to the end of the chaos. It is hard to think about any other sectors that were run way up that have not already come down. So, the bottom will likely hold (1200) and we will rebound once again. Eventually, I am saying after the election uncertainty is eased in November), the market will rebound and continue working its way higher. The Fed is now in a position to drop interest rates (with spreads stabilizing with the GSE rescue) and the Euro in trouble with recession in Europe. That should signal the turnaround. Expect the Fed to drop by at least 0.25% by year end.

Monday, September 08, 2008

Is Fannie / Freddie Takeover the Last Shoe?

On Friday, at the market close, and less than 6 hours after the Financial stocks tanked on the bad employment data from August, Treasury Chairman Hank Paulsen let leak that the Feds would be taking over Fannie and Freddie on Sunday.

My reaction was: DARN! or something close to that. I had been waiting for this to happen and knew it would create a trading opportunity on the financial indexes that I have been trading. But unlike the Bear Stearns bailout in March, where the rumor was on the net a couple days before the event, this one was very well guarded. Some people must have known as after the financials tanked Friday, they worked their way higher all day from about 10am on. Then, at the close, when the press release about the meeting on Sunday was announced, the UYG popped by 10% and I knew my goose was cooked, at least for a few days.

I would have loved to have been on the right side of this trade, but the financials had not dropped enough for me to cover my short position (SKF) and take a new long position (UYG). I was close, but about 5% away from pulling the trigger. And, as I have a day job, I did not have a chance to watch the financials move higher all day long into the close and the Fed press release. Had I been a full time trader, I would have looked into that counter trend movement (against the backdrop of the bad employment data in the morning) and might have found enough information to get me to switch direction.

But all is not lost! This is NOT the proverbial "other shoe dropping" signaling a change in direction for the financials, the stock market and the economy. In fact, I was stunned that the market reaction was so dramatic this morning. The fact that the Fed would have to intervene in Fannie and Freddie has been known for many weeks, really since the July 15 bottom when Paulson asked for and received authority to make this move. Most market followers expected this move sooner than this, so there should have been no "surprise factor" here.

In fact, the deal went down just about as expected. Fannie and Freddie common share is basically wiped out. This was necessary to eliminate concern of "moral hazard" where investors get taken off the hook by taxpayers. But Paulsen did not stop at common shares, he also took out the preferred shareholders. He did not actually bankrupt the company, but by giving warrants to the US government / taxpayers that give 80% of the equity to the government, with no dividends until Fannie and Freddie get profitable, for practical purposes, the stock is worth very near zero.

Worse for the financial market, many banks hold Fannie and Freddie preferreds as part of their capital structure. This was an arrangement with the bank regulators where FNM and FRE stock was considered as safe as cash, so avaiable as collateral for capital. But, it was not so safe and has now been written down to nothing. In fact, the preferred was not convertible to common, so its only value is for the dividend, which has now been eliminated for the forseeable future.

This is a material surprise. And it has a materially negative impact on many banks. That information will get back into the stock price in the next few days. I still think the Financials will continue to go down, with bounces along the way. I would use this opportunity to get short on Financials, which I am doing by selling more puts on SKF.

Sunday, September 07, 2008

What $300 a Barrel Oil Means for us

Even though energy prices are down for the time being, and perhaps going lower, I have maintained that they will eventually go much higher. I say this because the marginal cost of extracting oil keeps increasing, and cost becomes the floor for price. So, as long as energy demand continues to increase through growth in Asia and other developing markets, the price of oil must continue to increase to encourage additional supplies.

The only thing that will stop the increase in petro energy is the growth of cheaper alternative energy sources, especially that can be used in transportation. With the advent of fuel cell or other electric powered vehicles, substitution of energy sources will eventually reduce demand. But the alteratives are many years away from practical and widespread use. So, for the next 10-20 years, petro energy will continue to be our most important source of energy. Here is an article from this week's Barrons. Read on:


What $300-a-Barrel Oil Will Mean for You
Charles Maxwell, Senior Energy Analyst, Weeden & Co.
By LAWRENCE C. STRAUSS

AN INTERVIEW WITH CHARLES MAXWELL: He correctly predicted the recent price spike -- and he sees an eventual move to around $300 a barrel.

CHARLES MAXWELL, WHO BEGAN HIS CAREER in the energy business in 1957 working for Mobil Oil, is no stranger to Barron's readers. In an article he penned nearly four years ago, Maxwell predicted that oil prices would move sharply higher by 2010, and then higher still. Maxwell, 76, got the timing and trend right, though his top price of $60 a barrel by 2010 proved far too low. "Oil is unique in that when it begins to disappear, there really aren't any good substitutes, which there are for so many other commodities," Maxwell says. "It's that lack of substitutes that forces the pricing mechanism to balance supply and demand." "Only price will slow the use of oil; the rising price tells us we don't have enough. So, we are now beginning a bitter, bitter competition for fuels that will see the price rise to ridiculous levels."

Maxwell has worked since 1999 as senior energy analyst at Weeden & Co., an institutional brokerage firm in Greenwich, Conn., having started as an energy securities analyst in 1968. Oil prices came down last week, trading at around $108 a barrel, but he predicts an eventual sharp move upward -- to around $300 a barrel -- owing to a lack of available supply. Barron's caught up with Maxwell recently for his latest assessment.

Barron's: What's your prediction for the price of oil over the long term?

Maxwell: I see it heading on an upward slope. Around that long-term line, there will be a lot of ups and downs. I thought the peak on this cycle might be somewhere around $100 a barrel, but it turned out to be a lot higher, more than $145 in early July. But like a child's blocks piled one upon another, you finally reach a point where at $145 they were beginning to sway. It had gone far beyond the fundamentals. So the questions are: 'What are the fundamentals and what should the price be?' The answers depend on where you are sitting and what you own.

Barron's: What's your view?

Maxwell: I would put the price of oil today at somewhere between $75 and $115. That implies quite a fast rise, given that we were averaging about $32 a barrel for West Texas Intermediate in 2003. However, it is perception that really is changing, not the true value of oil throughout the system. The perception change involves whether we are going to move into an era where oil supplies will be generous and easy to find and, therefore, relatively cheap -- or whether those supplies are going to be closed off for both political and geological reasons.

Barrons: Which scenario do you see?

Maxwell: We are not going to have enough oil, and we are going to have to start a huge switch in which we make do with a number of other fuels that are not so easy to convert to our immediate energy needs, mainly for transportation.
It sounds like this comes down to not having enough supply to meet demand.
We will have enough coal supply to meet demand, but the real question there is, 'Can we afford to substitute a great deal of coal given the emission problems?' The carbon footprint of coal is very high. We will be forced to use some more coal, but until we develop clean-burning coal technologies and underground gas fields to store carbon dioxide, we are going to be under very tight restrictions on its incremental use. That doesn't seem to be such a bad thing until you look at, say, nuclear power, which would be another big alternative, and you realize that it's being used effectively by the French, the Japanese and the Germans. But for various reasons, nuclear power has become a political football in the United States. If we committed to nuclear power today, we wouldn't have it up and running for another 10 years or longer.

Barron's: Does the tight oil supply, coupled with a lack of enough viable alternatives, make the U.S. vulnerable in terms of having enough energy supply?

Maxwell: It does, probably between about 2010 and 2025, thanks to a lack of sufficient power to drive our economy on an upward course. We haven't yet seen declining energy supply at a time of growing GDP. So for the moment, we will need more power to drive the world economy higher.

Barron's: What's been constraining the supply of global energy, oil in particular?

Maxwell: There are several factors, one being resource nationalism. The Russians are the classic example. They are not against us, but they simply want to develop their own supplies in their own way, on their own timetable, with their own money and with their own methods. Another example is Iraq. I said once to a junior minister of that country that Iraq would be producing 9 million barrels a day with the full development of reserves that most of us think are here, as against the 2½ million barrels a day they were producing at the time. And he said to me, 'Could we do that? Yes. Would we do that? No.' He said, 'I predict you will never see more than 6 million barrels a day coming from Iraq, ever' [to preserve the supply].

Another constraint is political instability in various places, including Nigeria. There's also refining, which is probably one of the easier constraints to solve. The world is using a great deal more lighter crudes, and we are actually producing more of the heavier crudes. We have to continue to change the refining system to handle the heavier crudes in order to give us the lighter products.

Barron's: What other constraints exist?

Maxwell: Many countries, for political reasons, don't want to allow oil companies to come in and do business. They don't like us, the U.S. in particular. Venezuela is an example where they do allow you to come in, but under terms that are so harsh that companies don't. The remaining constraint relates to geology, although it's not the primary issue today. It is the geopolitical and the instability issues that are stopping the biggest part of the development.

Barron's: How would you sum up the geological issue?

Maxwell: The easy places to find the oil have been, in most cases, tested, proven and produced. This occurred in the continental U.S. in the 1920s and 1930s and, on a worldwide basis, in the 1960s and 1970s. Now we are looking for oil in places like the Arctic of Russia or the Arctic of Alaska, where costs are much higher. It is not only more difficult to operate in those places, but it is a long way to transport the oil. There may be a great deal of oil under Antarctica, but, because it is a land mass, unlike the North Pole, which is water, we can't see through the ice sheets that cover Antarctica. So we don't know where to drill there.

There's also the issue of existing fields that are diminishing. The classic example is that in 1985, the North Sea produced 2½ million barrels a day from nine fields, compared with about 1.7 million barrels today from nearly 100 fields. We are running desperately on a treadmill on which it is very difficult to stay up, because they are not finding as many new fields as old fields are being depleted.

Barron's: At some point, doesn't it come down to lowering consumption or tapping alternative sources of energy?

Maxwell: Right, and we will probably do both. Ten years ago, 40% of the world's energy was in oil, versus 39% in 2006. It should reach 38% in the next five years -- and 37% three years after that. So oil is slowing, and I expect it will stop its growth around 2015, at which point the supply begins a slow retreat.

Barron's: Then what?

Maxwell: We will either have to reduce our economic growth around the world, which has all kinds of political and social repercussions attached to it, or we will have to find a substitute for oil. But it turns out that oil is a remarkable type of energy, as it doesn't spoil when you keep it overnight in a warm dish. It transports easily. It stores easily. It is very fluid. You can pump it across long distances. Oil has been the basis on which we have made a remarkable economic expansion, and now we may be tested by something a lot more serious, which is a coming shortage of oil and a need to start using other forms of fuels, which are not naturally the ones that we have developed.

Barron's: Where does natural gas fit in?

Maxwell: Its supply should last another 40 or 50 years before it runs into the same problems of peaking that we have in oil. Natural gas has a very low carbon footprint, meaning it's a cleaner type of energy, and it has wonderful petrochemical adaptability. But it doesn't help at the moment to solve our principal problem, namely oil supply, particularly for transportation uses.

Barron's: The dependence of the U.S. on foreign oil has grown significantly. Where do you see that going?

Maxwell: Dr. M. King Hubbert, the great geophysicist for Shell who gave his name to the Hubbert's Peak, said that we would reach the limit of domestic production of oil in the continental United States in the early 1970s. That, he said, would touch off a major change in the way we lived, the way we drove, where we lived, and so forth. But when we actually got there -- and he was correct that it was the peak of American oil in November 1970 -- the transformation to the use of foreign imported oil was almost seamless. There was no great change in people's habits. He thought the American public would never be stupid enough to fall for the concept of foreigners continuing to give us all the oil that we wanted.

Barron's: Could you elaborate on why you see the price of oil going much higher?

Maxwell: The price is eventually the only thing that will slow down the use of oil; the rising price tells us that we don't have enough of it. So, we are now beginning a bitter, bitter competition for fuels that will see the price continue to rise to these ridiculous levels.

Barron's: How high do you think the price of oil will go from here?

Maxwell: We will see $300 a barrel -- or roughly $250 in today's dollars -- because oil supply will be so short. If you want that oil, that's what you will have to pay for it. That will be in 2015, after the peak of oil [supply]. But even earlier, around 2010, more than 50% of the non-OPEC world will have peaked in its production of oil so the dependence on OPEC will become extreme. That will give OPEC a chance, I'm afraid, to lift prices rather more quickly on us than they are doing today.

Barron's: What concerns you the most about such high oil prices, assuming that turns out to be the case?

Maxwell: One thing is that people are going to be asked to change much faster than they are willing to.

Barron's: What's on the horizon over the next two years?

Maxwell: Supply and demand will be equal temporarily. There are three or four Saudi oil fields coming on stream, but there won't be any more low-sulfur crude fields coming on after the end of 2010. There's also the recession, which takes away some demand, but oil prices will remain high.

Barron's: Where do you see energy investment opportunities right now?

Maxwell: The tar sands, particularly those in western Canada, will be one area where the oil industry will continue. That includes companies like Suncor Energy (ticker: SU) and EnCana (ECA), both of which are on my buy list. They are integrated energy companies with big exposure to natural gas. EnCana has a deep asset base, huge North American land holdings and a disciplined management team. My target price, which is for the next 18 months to two years, is $112, compared with around $67 recently. My price target for Suncor is $90 (versus about $50 last week) but it might take three or four years to get to that level.

Barron's: Any other investment themes?

Maxwell: I see other types of opportunities developing in energy, although not in the traditional areas. It is going to be a lot easier in the next 10 years to reduce demand than it is going to be finding new supplies to substitute for oil. That's a very big principle. It will require increasing amounts of energy, particularly electricity, to run the new world.

Barron's: Can you be more specific on companies?

Maxwell: There are going to be so many new companies and so many new technologies that it boggles my mind at the thought of identifying all of them. There are going to be a lot of new industries coming in and wonderful opportunities in the stock market. But the old names in energy that I've covered for years won't be what they were. Most of the oil companies will be swallowed up by the larger ones. Then the larger ones will be broken up into trusts or new corporations. I don't think the oil industry can go on as it is now.

Barron's: What kind of world can we expect to live in with all of these changes?

Maxwell: It will be a little simpler. Your friends are going to be a little closer to you than they were before. Your vacations are going to be a little closer to home. You are going to have lower temperatures in the house. We will drive smaller cars with less horsepower, but they will get 60 to 80 miles to the gallon, enabling us to stretch gasoline supplies a lot further. There are going to be thousands of new adjustments leading to new investment opportunities. But the adjustment to that rising oil price, which could take as long as 20 years, will be a very harsh social experience -- not only for our society, but for every society.

Thanks very much, Charley.

Friday, September 05, 2008

Staying alive in this topsy-turvy market

It has been a week since I last posted, and what a week it has been. We witnessed Hurricane Gustav and its less than disatrous landfall, the postponement and then spectacular conclusion of the Republican convention where we were not disappointed by Gov. Palin (really, better than hoped for) and Sen. McCain. And we saw another week of violent whipsawing in the stock market.

What to do?

I have been successful playing the whipsaw. I don't see any other way to go, other than to hunker down in cash and take a long nap. In my trading account (my retirement accounts are full of conservative high dividend, buy-and-hold stocks and funds) I continue to play the trading range of the Financial index. UYG and SKF are the two bookends of the trade, SKF being short and UYG being long. They are both based on the XLF S&P index for Financials, but levered by 2X. The XLF range is oscillating between 20 and 23 since mid-July with a round trip every 10 days (which is very volatile).

In the latest cycle, I closed out my UYG Sept 25 sold puts contracts on Wednesday for around $3 (with the XLF around 22.00). Then I sold puts on the SKF October 125 for $20. On Thursday, at the open, the XLF moved to 22.50 and I could have sold more SKF puts at $23, but I held on as I was in the red. By Thursday close, the XLF had dropped 6% and was at 21.50. My SKF puts were in the black.

Today, on Friday, the XLF continues to drop and is now close to $20. The SKF which was at $110 on Thursday at the open, is now at $123. UYG has gone from $23.50 to $20 as of now. As mentioned, $19 or just a little less, is the low end of its 7 week range. I have a "buy to close" order on the SKF puts at $10.50 and a "sell to open" order on another round of UYG sold puts (Sept 25) for $7 (which will execute when UYG gets close to 19). I expect to close out the SKF today or Monday, depending on how quickly the market drops, and then get back in for the ride back up on the UYGs next week. I will continue playing this cycle until I can't.

Another trade on the horizon is selling more PWE canroy puts short. PWE is approaching its 24 month weekly low of $25. (it did hit 23.50 for one day on Jan. 24). It has corrected back to the level it was at when Nat Gas was $5.50 and oil was $70. But they are not at those low levels. PWE gets sold down hard by speculators even though it is not a speculative stock with its 15% dividend. It will always bounce back based on solid cash flow for the forseeable future.

The PWE Dec 30 put is at $5 as of today. I have orders in to sell puts at $5.50 and $6, giving me prices of $24.50 and $24 on the underlying stock if assigned. I will take that price on PWE any and every day.