Tough Sledding in the Markets and Economy

The jobs report came out this AM and it is not good, even very bad news. Job cuts of 533K were announced for November and October was revised up (down) to 320K from 240K; September was revised up to 403K from 284K. That is a lot of job loss the past 3 months, the worst since Q2 of 1980 when Paul Volcker shocked the economy into submission with 20% interest rates.

But those of us who follow the market daily are not too surprised by this bad employment "print". The stock market has been crashing anticipating very bad economic news, serving its function as oracle of the economy. And some of us (me) have seen job cuts at our own place of employment based on painful forecasts for 2009. So there is a very good chance the lousy numbers are already "baked in the cake" of the stock market. Today's (Friday's) early stock market action certainly suggests that, as the DJI is only off by 90 as I write now, but still well above the lows from mid November.

All of the economic slowness, global recession and the resultant strength of the dollar is just hammering energy, much to the displeasure of my portfolio. But at the same time, the government policy makers around the world appear prepared to "throw the kitchen sink" at the economy to get it going again. This will mean a recovery in 2009, maybe beginning as early as Q2. As soon as the world economies recover, the demand for energy will return and drive oil prices back up, though maybe not to $150 since the hedge funds have been hit hard and leveraged speculation in the near future is unlikely. But I think we could all live with $75-80 oil which more accurately reflected the rising demand and tight supply of early 2007. Prices in that range are economically sustainable and would create a stable environment for the Canroys.

I am swallowing hard and holding on to my energy shares, knowing that there will someday be an economic recovery and when it comes, there will also be some inflation to pay for all the money pumped into the economy. Higher economic demand accompanied by mild inflation will be a good environment for commodities and energy.

Here is more on oil:


$25 Oil Could Happen Before a Return to $100
December 05, 2008
By Matthew Hougan

http://seekingalpha.com/article/109393-25-oil-could-happen-before-a-return-to-100?source=article_lb_articles


Jim Wiandt says that oil will go to $100/barrel before it hits $25/barrel. I'm not so sure.

The reason I'm confident that the Dow Jones industrial average will top 10,000 before it hits 6,000 is that stocks are a leading indicator. They anticipate recoveries, typically turning upward 6-9 months before the economy as a whole. We are already one year into the recession, so I'm guessing we are getting close to the point where stocks will turn the corner. When you add in the fact that valuations and yields are the most attractive I've seen in my adult investing life, the outlook for equities is quite good.

Oil, on the other hand, reflects mostly immediate, near-term supply and demand. If the economy gets worse before it gets better, stocks might see the light at the end of the tunnel, but oil won't. It can't. Prices will keep falling as demand deteriorates in real time and the current supply glut gets worse.
Remember, oil is expensive to store. For the most part, it won't just sit around waiting to be used if there is a lack of demand. (Some can be stored, but not that much). It must be sold and used at whatever the current clearing price is.
And we have yet to see the magnitude of supply cutbacks in the oil market that we've seen in aluminum, copper and other commodities. The world is continuing to pump out millions and millions of barrels of oil.

Here are a few facts to consider:

• Oil has averaged a nominal price above $50/barrel in just three years in the history of the world: 2005 ($50.04/barrel), 2006 ($58.30/barrel) and 2007 ($64.20/barrel).
• On an inflation-adjusted basis, oil has averaged an annual price above $50/barrel for just 12 of the 62 years of the post-war era.
• The average inflation-adjusted price of oil in the post-war era is $33.65/barrel.
• Oil traded below $25/barrel as recently as 2002.
  

As the saying goes, "This time it's different" are the four most-expensive words in investing. So why not $25/barrel oil?

I was amazed during the recent oil price retreat how quick people were to say that $100/barrel was the "right" price for oil. $100/barrel is off the charts historically, and completely neglects both the supply and demand impacts that high oil prices have.

To put it another way, stock prices are now trading where they were in 1997. What's to say oil shouldn't be trading where it was in 2002?
The truth is, I have no idea where oil prices are headed. But I don't think it's a gimme that they're going back to $100/barrel. In fact, if you gave me 2-1 odds, I'd bet they hit $25/barrel first.

P.S.: One more thought about oil. Even if you strongly disagree with me and think crude oil is a screaming buy, please be careful before you buy a crude oil futures ETF like the US Oil Fund (NYSEArca: USO). Oil is in a violent contango. A fund like USO faces a 3% monthly headwind from contango right now, meaning oil prices must rise about 3% each month just to offset the losses from rolling contracts forward. Until that situation is reversed, investing in crude oil futures could be challenging... even if I'm wrong about crude oil prices.

Investing in Canroys for Long Term Success

From Jake:
Brian I am still not fully invested in the oil group, with the commodity bubble expected to bust I have invested lightly in this area. Any suggestions? Maybe short term? I have CANROYS but wanted to invest more before the run up but did not want to be taken out in a couple of months. I know hard to answer but any thoughts.
Otherwise a great day for me positioned well in all areas! Thank you!


My Response:
I think the Canroys will do very well short term and long term. In the mid term (2 mths to 12 mths) I am expecting a commodities correction. I think there is a lot of hot money in commodities that is parked there while the recession worries play out. I think that hot money (traders and hedgies) will move back to U.S. equities once the all-clear is called for the market. I expect that to happen anytime from June this year to March next year, sooner more likely.

Short term (next 2 months) I think Canroys will benefit from the hotness of the energy market. The Canroys hedge some of the product forward, but not all of it. So, they are benefiting from the higher energy prices on a daily basis, as they sell some production into the spot market. Also, as futures contracts expire, they will write new futures contracts at the current higher prices to lock in this level. So, there cash flow will dramatically increase the next 12 months, way above their budget forecasts, which are mostly in the $60s for oil and around $7 for gas (this info is in their annual reports).

Regardless of market concerns over the Canadian tax consequences, eventually, the value of this cash on the books must be rewarded. There could be a large special dividend, an acquisition which would increase future revenue and cash flow per share, or a takeout, which would result in a large premium on the stock price. I expect a 50% increase in price in the stocks if not taken out. If one of the small Canroys, like Daylight or Baytex for example, are taken out, they could double in value over a couple of days.

So, I think this is a great entry point for the Canroys, though it would have been even better a month or two ago (Daylight has gone from $6 in mid-January to $10 today, for example)

Regarding the Long term, 12 months to 10 years or more in the future, oil and gas will get more and more expensive as demand increases and supply stays flat if we are lucky. After 10 years, I expect alternative technologies to began increasing energy supply in general, shifting demand. I think solar will become a much bigger factor as new technology improvements drive production costs down. Wind, geothermal and wave energy will also be increasingly important. As fuel cell and battery technology improves, more vehicles will operate on electricity which can be produced by solar sources (wind and wave energy is indirectly derived from the sun, as is hydro power from rainfall into reservoirs). I expect biofuels like ethanol to become less and less important. They are very inefficient to produce and compete with the food supply.

I think Solar will be the most immediate winner in alternative energy and I am working in this industry, so can keep an eye on it up close. Today I am buying a small tracking position ($1000) in a new ETF for solar energy called TAN. Solar has had a big run and might pull back quite a bit in the likely coming commodity correction. So, I will buy more gradually looking for a better point to add a big position.

Energy, Gold and BRICs

Here is more fodder for consideration:

Energy, as a percentage of the S&P500, peaked at over 20% in 1980. It then declined to near 6% in 2000. Now it is back at 10%. So, the price of energy stocks could double versus the rest of the market before they were historically overvalued / near a top.

Gold is a similar story. Gold relative to oil also peaked in 1980 at $800 versus oil at $40 per barrel. Normalized for inflation the past 20 years, the comparable price of oil would be $100, which means the comparable price of peak gold would be $2000. If the dollar continues to decline, then dollar inflation relative to 1980 (as a baseline) will increase this equation and $150 oil and $3000 gold at the next peak. If the pattern from the 70s repeats and we are at about 1972 right now (using the Bretton Woods II thesis), then we would see this scenario play out by 2015.

The above scenario is given a fixed world market for oil and gold. But it can be argued that the global supply of both gold and oil is tighter in 2007 and the demand is greater with the development of the BRIC economies (Brazil, Russia, India and China). So, lots of upside.