AI
Monday, July 04, 2005 11:11:45 AM
*** Don Coxe Conference call (6-30-05) ***
With thanks to TheSlowLane from SI's "The Woodshed" board for the transcript. (Link below)
(Link to audio version of CC [incl. Q&A] located below text)
Latest from Coxe...
Nesbitt Burns Institutional Client Conference Call for June 30, 2005
Don Coxe
Chicago, IL
“Has The Pain of Oil Prices Now Started Affecting The World?”
http://stockcharts.com/def/servlet/SC.web?c=$WTIC,uu[w,a]daclyyay[pc50!c100][vc60][iUb14!La12,26,9]&....
Chart: Crude Oil
Thank you all for tuning in to the call, which comes to you from Chicago. The chart that we faxed out was crude oil and we’re asking the question Has the pain of oil prices now started affecting the world?” And the real issue for us here is the question of whether we’re developing an inverse correlation. Not just an inverse correlation between the price of oil and the stock market - we’ve had that as sort of a factor on many, many trading days this year – but whether there’s an inverse correlation developing between oil and the metals and commodity prices generally.
What I’d like to do first though is bring you up to date with a few things which are tied in to the fact that today is the second most important trading day of the year for institutional investors, because at the close tonight we’re going to have the mid-year percentage rates of return and my experience is that although there’s quarter ends at the end of March and September that in terms of marketing institutional products the two numbers that matter are year-end and mid-year. So there’s a lot of organizations – ourselves included – who are watching anxiously on the ticks during the day to see where we’re going to come out because the difference between being first quartile or second quartile can be just a few ticks and sometimes you get some rather suspicious moves in some stocks that occur in the last couple of hours of trading on a day like this.
For years there were people who discovered that by checking these things that stocks that were held in a few of the Fidelity funds seemed to do extraordinarily well in the last day of trading in June and December, but that was one of those bits of demonology that no scientific researcher was able to document. But…it adds to the interest that institutional investors have in being at work today. Canadians get the day off tomorrow for Canada Day and Americans get the day off Monday for Independence Day, so this will be a long weekend no matter where you’re situated with lots to talk about because of closing the records on returns year to date.
Now, we look at the stock market year-to-date, the S&P is down one percent. Well, if you take dividend yield, basically it’s flat. The Dow is down 3.7%, NASDAQ’s down just under 5%. So all that fuss and fury and all those computer programs and all those intelligent minds put together have achieved very little considering that US GDP growth is about 3 ¼ percent in the first quarter, ummm…this isn’t much.
However, we start looking at some sub-indices, and the pattern is a little different. The Canadian Energy Index, the sub-index of the TSX is up 32%. That sounds very good except crude oil’s up 34% this year. As a matter of fact, if we look at sort of longer rates of return, the XOI, which is the American oil index, year over year is a full three percentage points under the price of oil, year over year returns.
I’ve commented on this from time to time, but it reflects the fact that there’s still disbelief out there in the investment community, notwithstanding…and I realize in Canada, having spent a week in Calgary and Banff, which is not a good place to go if you don’t want to believe in strong energy prices.
But even apart from being in that sector of the country, just talking to Canadians and reading the local media you see there’s still all this talk of a commodities bubble and that the oil stocks have gotten ahead of themselves. A very prominent Canadian investor whom I know well, institutional investor, has gone to a zero exposure in the oil & gas group in his fund. Very courageous move indeed, but it illustrates, I think, that we haven’t gotten the kind of performance out of the oil stocks that we should have, based on the move in the commodity. And in particular, we haven’t gotten the kind of move out of them that we got from the switch from backwardation to contango that we got in the first six months of this year.
I’ve spoken of that before and I’d like to come back to it again because it illustrates…I have a feeling that the contango is having more of an effect on the economy than it’s having on the stock market. So let me explain.
When we were in backwardation, then it was only the spot oil price that was being factored in to the cost structure of businesses. There was always this hope that things were going to get better because as you looked out the curve, every month was cheaper than the month before it. And this was reinforced by all the anodyne assurances from Wall Street that this was a bubble, a creation of massive speculation and that it was about to collapse.
Well…now if you look at the December crude contract, it’s 59.80 as against the spot price of 57.15. That means you’re being paid very substantially for holding oil. If we go out to December next year, December of 06, it’s 59 dollar crude. And if we go all the way out the curve to the last contract of this decade, it’s still a hearty 56 dollars and sixty cents.
So, my own guess is, that it’s the change in the curve from backwardation to contango which is starting to lead to a lot of the pessimism that you’re seeing out there. Because what this tells people, what it tells business people is…there’s going to be no let-up. And therefore they’ve got to learn to live with high energy costs. This was confirmed this week in Banff at the Investors Dealers Association Convention that I spoke at, by Spencer Abraham who was the Secretary of Energy in the first Bush administration. Pretty good guy. Arab-American from Michigan. Very smart fellow indeed. And in his presentation, he said that from his perspective, everything that he read and saw said that we were going to have high oil prices for as far ahead as the eye could see.
I don’t doubt for him, one of the big things he’s using is the curve itself. And that what this was saying is that the false signals we got from the curve when it was in backwardation because so many of the oil companies were hedging – that’s the term they use - by selling vast amounts of oil forward, since they gave up this series of self-inflicted wounds, what we’ve got is a strong forward curve and that reinforces therefore one side of the argument as to whether we’re going to be in surplus or in deficit in oil going forward.
The prestigious Cambridge Energy Research Institute published a report in the end of May, but it just went public last week, predicting massive oversupply of oil for years and years to come. Maybe a short-term shortage but then there’s going to be massive excess capacity and massive excess production and that oil prices could really plummet.
In other words, what has been the sustained wisdom of Wall Street and of Big Oil, is reflected in this. And one doesn’t dismiss Daniel Yergin’s organization lightly, one can dismiss Wall Street’s oil analysts lightly because of their record of demonstrated incompetence for years…collectively that is. Obviously some exceptions are there, but Daniel Yergin you had to take more seriously. And when you go through this report, what you see is that it shows that if everything works right and if all the OPEC reserve assumptions are accurate and if we don’t have any political troubles in Russia, Venezuela and Nigeria, then we’re going to have too much oil.
Well, ah, that was subject to challenge from other quarters. And at our conference, Jim Gray, one of the great figures in the Canadian oil & gas industry, best know for his deep gas company that he created, Canadian Hunter, which was bought for a song by Burlington Resources despite my vigorous demands and phone calls in 2000 and 2001 to Canadian investors to bid up the stock price because I knew that one of the US gas companys with reserve life index of 7 years or so was going to be desparate to buy that cheap gas.
Anyway, he gave a terrific presentation, built around Matt Simmons new book, Twilight In The Desert, which talked about the Ghawar field. Now you’ve heard me talk about this before, but updating it to what Jim Gray had to say…we’re talking of a field and he noted something that I hadn’t realized was that it came onstream at the same time as LeDuc came onstream in Alberta, which is the beginning of the modern oil industry in Alberta.
This [Ghawar] is the oil field that supplies 6 - 7% of total oil consumption in the world. It’s five times bigger than the second biggest oil field in the world, which is Cantarelle in offshore Mexico. And this is a mature and not to say old oil field with all sorts of problems. And it’s quite obvious that we’re not going to get any new Saudi light out of this field and we don’t even know how much we’re going to get going forward of the heavy oil.
Well, all of this, when you start looking at the background to the assumptions underlying the forward curve, one has to say that businesses that are relying on energy heavily in their cost structure and economies that have been able to get by in the past…the Eurozone in particular. The Eurozone, the move in oil from 25 up to about 38 bucks cost them nothing because the Euro outpaced it.
But this year, with the fall in the Euro, and with crude oil having made the powerful move that it has made, this has been really bad news for the Eurozone. What we’ve got then is a situation when in the Eurozone the cost of oil is up 37%. Whereas in the United States it’s up 32%. And what that means to me is that this is the extra thing that in the Eurozone where they don’t need much new bad news to make them feel really gloomy about the outlook. I think this is a sense that things can only get worse.
Now the current issue of Basic Points deals with Euroangst, but I didn’t deal with this issue here of the change in the curve and then of course the big move in the spot price. But the Europeans may take a better look at the forward curve than Wall Street does. And what it’s telling them…they’re going to have these high costs going forward and meanwhile they’ve got economic growth that is within the E and OE range of zero. For their three big economies combined: France, Germany and Italy.
Now, if we take that situation and then we take the fact that the US economy is being driven at the margin by homebuilding and by home repairs and upgrading and tarting up houses for sale; what we can see is that there’s a certain fragility about the forward forecasts for the advanced economies.
And China, which is able to, apparently, keep roaring ahead no matter what energy costs are, it’s obvious that even there that there are some cracks. And I say it’s obvious because of what we get on data on shipping in to China. The Baltic Index shows that. And there’s some softness occurring in some of the base metals, not yet in copper.
And when you look at the base metal stocks on the year to date, you wouldn’t know that anything much good was happening to them because we’ve got…Inco’s up 5% year to date, but the rest of them…well Alcan has been a disaster, it’s down 37%. Freeport McMoran is flat on the year and Phelps Dodge is down 4%.
So, the question then that I’m raising is whether we’ve really reached the stage that we’ve got an inverse correlation and therefore for those investors out there who look at the commodity component of their equity fund and say “Yeah well I realize we’ve got a division between the golds and the others, because gold isn’t really correlated positively to anything. It’s correlated positively to serious inflation but that’s a pretty remote prospect at the moment.”
But it may well be that whereas we did have, coming off the low, where the CRB index was back at a multi-year low and the rally that we had then, we had the situation in 2003 when we had the greatest overall positive year for commodities since, something like 1978 or 79, in other words, the diffusion index of commodities was that everything was going up.
That was the timing of Jim Rogers book, able to demonstrate that everything from the grains on through the cotton and metals and oil, they were all going up. Well the economic recovery is now longer in the tooth and we’re getting a sorting process out there between those that can go forward with oil trading near sixty bucks and those that are struggling. And some of you may say “Well are you recommending then that we take money off the table in the mining group?”
So let me simply say that…I believe that the wise course of action is to be diversified within the commodities group - diversification being always a mantra for me - but recognizing that at any given time, you may get one group or the other outperforming. Now the golds underperformed terribly and the only one that’s positive on my screen year to date is Barrick and that’s the special case of the change in their forward hedge position.
But some of the others have gotten hit pretty hard year to date. But gold, the metal, after having a really rough time, now seems to be moving up and it seems to have decoupled from the Dollar, which is something that if it lasts, is definitely going to be the subject of one or two calls.
Those of you who have been following my work for years know that one of the key indicators that I use for making an overall stock market forecast is whether gold starts going up on its own without its tie to the Dollar. If that happens, it means that risks are rising within the global financial system.
So I guess that although is a very quiet move that’s been occurring in gold and none of the other indicators out there are showing much, this is something that is a bit of a source of concern. Now it may well be that simply we had too much of a sell-off in gold, related to all the talk of the IMF was going to be selling gold and that sort of thing, but it does mean you can actually say you’ve got a diversified exposure to the global economy and the global financial system if you own only commodity stocks…depending on your weightings within the group.
So, although I’m still of the view that the group that has the most to gain from the story of China and India going forward over the next ten years is the base metals group, because it’s simply too difficult to duplicate what resources they have. There’s more hope of finding the needed oil and gas in the world than there is of finding the needed copper, nickel, lead and zinc, when we get 300 million more middle class. Having said that, it may be that the powerful move in oil and the change in the forward oil curve have combined with the other problems that are out there in the global financial system, will produce a global slowdown and that that will be at least in the near term, negative not only for the price of base metals and mining stocks, but for the price of the metals themselves.
Now again, this is very early to make that call because inventories have been declining for just about everything except aluminum and aluminum is such a special case because it’s a manufactured product. Steel has been giving us negative signals for months, but then steel is not a pure commodity. It’s hundreds of different kinds of manufactured goods, different kinds of metallic content, different kinds of alloys and of course different kinds of shapes. Still, one ignores the message from steel at ones peril if you’re an investor in the copper or nickel or lead and zinc stocks.
So, my best guess is, you should probably assume that this is the typical summer slowdown for the group, which is based on a holiday cycle for the big manufacturing operations in continental Europe and that unless oil goes to $65 in the meantime or something else goes wrong in the global system that these prices should come back in the fall.
But it does mean in terms of any new money investment in the commodities, it looks like, on a near-term basis at least, the oil stocks are the best place to be. Because they have failed to discount the move that’s taken place in oil and gas this year, fully. and of course, given that the profit margins…it’s all flowing to the bottom line. When you move oil from 45 to 55.
Whereas the price action within the base metals other than copper, you could say to some extent has been anticipated by the failure of these stocks to move upwards along with the oil stocks when we had this phase at which commodities were a front page story as an asset class by themselves and was actually being discussed elsewhere in the world than in Canada.
Finally, I think that the other theme of Basic Points, which is the shape of the yield curve, that story is very much intact. We’re awaiting the Feds action today, but if they do anything other than raise the Fed funds rate a quarter of a point, there would be some kind of financial earthquake.
But there will be big debate about how much time thereafter the Fed can continue tightening, given the signs of softening in the global economy and given the fact that looking within the US economy, that the strength is not well defused through the economy, it’s too much tied in to the housing bubble.
On the other hand, what a dilemma to be in for the Fed. Because if they stop tightening, then what that means is there’s even cheaper money available for housing speculators to load up with interest-only mortgages and option ARMs and things like this. So the genie is out of the bottle and it’s not clear what’s going to come along that’s peaceful and benign to burst that particular bubble.
So we come back to it, that’s the real risk that finally is out there, that the Feds policy of inflating the system – which was the right one for getting us out of 9/11 – they stayed with it a long time and then the other forces we’ve discussed in Basic Points have created new kinds of synthetic liquidity which have the result that the Fed can tighten now and the European Central Bank can stay modestly tight, at least, and yet the world is awash in liquidity.
I’m going to be returning to that theme in the next issue of Basic Points which we start working on next week. But all we can say is, equity investors on the call, it’s pretty hard to make a case that you should be selling stock, notwithstanding the concerns I’ve raised here at a time that overall global liquidity seems to be so strong. There’s no doubt that the flip side – and I’ll end the conversation with this – the flip side of $58 oil is that the petrodollars have to be recirculated somewhere and a lot of them are coming back in to the Eurodollar market which means that the money is there. And that means that one way or the other it circulates back.
So, the party can keep going…at least for the next few months.
That’s it. Any questions?
Thomas Fitzgerald: Don, you’d mentioned some relationship between the Alberta field and Ghawar, I don’t remember you following up on exactly what the significance of that comment was.
Don Coxe: Well, the point is that Canadians are used to the fact that LeDuc long since peaked and went into decline. And that Canadian conventional crude production has been falling. The Ghawar field, the Saudis have always maintained that it was just going to keep going on for decades and decades and decades.
But we’ve written about it in Basic Points, we’re extremely skeptical about the Saudis data and we particularly focused on a statement of theirs that they were going to have a decline of 2 ½ million barrels of oil a day between 2005 and 2012 from existing fields, but they declined to identify where the decline was coming from. Well this was at a time that Ghawar was absolutely dominating Saudi output. We put that in Basic Points, that it looked like Ghawar was in decline and Al Jazeera took it all the way to the head of Saudi Aramco who basically couldn’t deny it.
Well, if Ghawar is in fact in decline then in the light of what Jim Gray had to say at our conference, that decline could become something big enough and fast enough to really influence world oil prices. We’re talking…you may say “just focusing on one oil field?” We’re talking of six to seven percent of total consumption in the world, this is a big story. And the Saudis have been so secretive about it. So, I think that those of you on the call who are interested in this should certainly read Matt Simmons book.
But, we’ll be following it up from many sources we have because it takes…the kind of production you’ve got to bring on from ordinary oilfields elsewhere that are out there to offset any significant decline rate in Ghawar is so enormous…this is not just the granddaddy of them all, it’s much more than that.
So, long answer to a short question, but that’s why I focused on it, it;’s the fact that this is now a major element of debate and Matt Simmons has helped to focus the debate on it, but without knowing it in effect, the Saudis did it themselves when they were incautious enough to reveal that they were bringing on five million barrels a day in new production but it wouldn’t be net that because of 2 ½ million barrels of decline.
So…to take 2 ½ million barrels out in a couple of years, there’s only a few places it could have come from. And if it’s Ghawar and then you start projecting this forward thereafter, we’re talking of something where they’ve just got to be finding new oil around the…look, the entire oil sands of Alberta by the year 2030 are supposed to be five million barrels a day. Ha! Well, that’s on the current decline rate forecast for Ghawar, all that will do is offset Ghawar. And we’ve still got all the other sources of demand for oil in the world, so, it is a big story all by itself.
Thomas Fitzgerald: And then, the other side, Don, would be, Cantarell. And there’s been some debate there as to whether they’ve been increasing or decreasing or stable in their production, we’ve heard both decreasing and stable but we haven’t heard much about increasing at Cantarell. What have you heard?
Don Coxe: Well, what Pemex has said is that they’re currently in decline but they’ve asked for money, authorization from the Mexican government to bring in partners from the big, bad US oil companies to offset the rates of decline and of course that’s like getting rid of all the Saints holidays in Mexico in terms of what you can do. So what we have on the evidence, is that Cantarell is in decline based on natural causes but that Pemex says that they could arrest this process if they got help.
All we can say is that the biggest in the world and the second biggest in the world are in decline and will stay that way until something amazing happens.
Collin Henry: You briefly mentioned the separation between the metals and steel. And you alluded to the fact that there might be some signals going on in the steel side of things, can you elaborate on that?
Don Coxe: Yeah, the steel story is one…those of you who’ve followed my work may have noticed that I have managed to almost never mention steel when I’ve been talking about the base metals and when I’ve been talking about the commodity story. One of the reasons is, in terms of what stocks you can buy in North America, there’s only a few really good companies, because so many of them have gone through bankruptcies because of pension problems and old integrated facility.
But also, it was to me apparent that this was one thing where the Chinese were eventually going to become pretty much self-sufficient in it. I could tell you all on the call, four years ago I was told by a client that operated a steel service center in the Midwest. He had just come back from a trip to China where they had offered to buy huge amounts for the next five years of a particular grade of steel at a price above what’s paid for it in the Midwest, to guarantee a spread. So he was thrilled with that.
But they said, we should tell you something. By the end of five years, we will be at surplus capacity within China and then we’re going to have to start exporting to the US to pay for these plants and we’ll probably be able to put you out of business. Are you willing to enter a long-term contract on that basis? And he said, I did. Well it looks like they may be a year ahead of schedule because they’re net export of an increasing range of steel products.
You can build new steel plants easily but you cannot open new copper mines or nickel mines easily. You’ve got to have the orebody there. So, to me. It’s always been too easy just to use what was happening in steel as an indication of the attractiveness of the base metals group. Yeah, it’s very important if you’re pricing iron ore, but there’s only a few iron ore stocks. There’s Cleveland Cliffs and there’s CVRD and of course it’s a big source of income for BHP. But my emphasis has been on those that produce the metals that are required for developing middle class homes in China and India. And then the cars, because of the importance in the engines of these other metals.
So steel is a much more complicated story and Metal has managed to put together the biggest steel company in the world by buying up all sorts of companies that were in bankruptcy or on the edge of bankruptcy all around the world. To me, this has the look of, in effect a conglomerate that may be a bubble and could implode. For example, the fact that he’s paid the highest price for a house in London that anybody has ever paid, has all the looks of a Nouveau Riche bubble situation. And it was never clear to me that putting together all of these underachieving and unprofitable steel companies would work. The only reason it would work is because steel companies were just levitating.
Well, the Chinese will certainly be able to blow away that kind of competition because they’ve just expanded their production so much, so, pardon me for the length of this reply but it’s because I’ve stayed away from commenting on steel. The Nucor’s of this world and the Ipsco’s of this world are a very different category. Brilliantly run companies and they remain profitable under the most adverse conditions.
But I’m still worried when you have the biggest steel company in the world in a position where he may be overextended – we don’t know that – he came up too fast and he’s spending money on himself too fast. So, I hope I’m wrong on this because I’d like that to be another Indian success story, but my concern is that what we could have is, if we have a deflationary global recession, if that occurs in the next year, and with leading indicators all over the world turning down you’ve got to be concerned about that possibility, that could be a bubble situation, which would falsely convince people that the whole commodities story was a bubble.
That was never part of my argument for investing in commodity stocks in the first place because I always saw this as a very different kind of thing. It just happened that it was a major raw materials item. And there are raw materials that aren’t, in effect, pure commodities.
David Boyd: Quick question from Windsor, Ontario. For those of us who got in on the oil advice you’d given us in Basic Points a couple of years ago, now looking at it, reading through Bill Gross’ article yesterday and talking about the potential for interest rates moving on the US side, talking to Mike Herring on our side about interest rates moving, wanted to get your thoughts a little bit about the strategy of using long-term coupons, potentially, to offset the oil and gas profit we have in some of the equity positions
Don Coxe: As you notice in the most recent Basic Points, I’ve recommended for US institutional investors a totally new asset class, which is very long duration bonds and I’ve recommended 5% and I’ve said if you can do it, go to a 20-year duration. Now the only way you can possibly get the 20-year duration is having an overwhelming percentage of zeroes or coupons.
So, I believe that this makes sense for individual investors as well and in fact this is going to be developed in much more detail in the forthcoming Basic Points, as to you how you look at a proper kind of hedge against a new kind of recession, which we’ve never had to face since the Great Depression, which is a deflationary recession. And in a deflationary recession, the asset class of choice is long zeroes.
Yes, I agree with you and I hope to document this in much greater detail in the publication that you will read in mid-July.
Thomas Fitzgerald: Don, do you have any comments on the possibility or probability of a Chinese currency re-valuation?
Don Coxe: Well, I guess I’ll start taking it seriously when it stops being on the front page. There’s just too much discussion of it and the Chinese would never do it under duress. They would have to be independent. To me, frankly, the only big effect of this would be on the US Dollar index, it would need an adjustment. It would also focus more on the value of gold. But ten or fifteen percent revaluation of the Yuan isn’t going to get rid of China’s trade surplus with the US.
I also believe that when it happens, I won’t say if it happens, when it happens, the Japanese will also move up the Yen, because I believe that the events of October 1998, which I’ve discussed in Basic Points, when Japan revalued the Yen from 142 to 115 in twelve hours of trading. And that was in effect a sword right at their throat from China because China had already made clear through an international banking syndicate that they were prepared to devalue the Yuan, unless Japan upwardly revalued the Yen.
That was the time, in effect, where world currency leadership shifted to China and it hasn’t moved away from there. So, long answer to your question, but I think that when the revaluation comes, you will find that rather than China losing its preferred position, in effect within Asia, that the other Asians will move along except the very minor countries. That’s why it will be such a big event, because the Yen will move as well. One of the reasons I’m doubtful we’re going to do anything about it now, this year, whereas I thought we would, because of the breakdown and the fast developing enmity between China and Japan. With all the public humiliations and shouting, it may well be that any chance of monetary cooperation has been put on hold.
So, I regard this as a story that’s on Page One that should be largely ignored, thank you.
Thank you all for tuning in. Have great long weekends, wherever you are, and we’ll talk to you next week.
http://www.siliconinvestor.com/readmsg.aspx?msgid=21473607
==============================================================
To listen to the audio presentation of the above CC (incl. Q&A session):
http://www.bmoharrisprivatebanking.com/webcast.asp
With thanks to TheSlowLane from SI's "The Woodshed" board for the transcript. (Link below)
(Link to audio version of CC [incl. Q&A] located below text)
Latest from Coxe...
Nesbitt Burns Institutional Client Conference Call for June 30, 2005
Don Coxe
Chicago, IL
“Has The Pain of Oil Prices Now Started Affecting The World?”
http://stockcharts.com/def/servlet/SC.web?c=$WTIC,uu[w,a]daclyyay[pc50!c100][vc60][iUb14!La12,26,9]&....
Chart: Crude Oil
Thank you all for tuning in to the call, which comes to you from Chicago. The chart that we faxed out was crude oil and we’re asking the question Has the pain of oil prices now started affecting the world?” And the real issue for us here is the question of whether we’re developing an inverse correlation. Not just an inverse correlation between the price of oil and the stock market - we’ve had that as sort of a factor on many, many trading days this year – but whether there’s an inverse correlation developing between oil and the metals and commodity prices generally.
What I’d like to do first though is bring you up to date with a few things which are tied in to the fact that today is the second most important trading day of the year for institutional investors, because at the close tonight we’re going to have the mid-year percentage rates of return and my experience is that although there’s quarter ends at the end of March and September that in terms of marketing institutional products the two numbers that matter are year-end and mid-year. So there’s a lot of organizations – ourselves included – who are watching anxiously on the ticks during the day to see where we’re going to come out because the difference between being first quartile or second quartile can be just a few ticks and sometimes you get some rather suspicious moves in some stocks that occur in the last couple of hours of trading on a day like this.
For years there were people who discovered that by checking these things that stocks that were held in a few of the Fidelity funds seemed to do extraordinarily well in the last day of trading in June and December, but that was one of those bits of demonology that no scientific researcher was able to document. But…it adds to the interest that institutional investors have in being at work today. Canadians get the day off tomorrow for Canada Day and Americans get the day off Monday for Independence Day, so this will be a long weekend no matter where you’re situated with lots to talk about because of closing the records on returns year to date.
Now, we look at the stock market year-to-date, the S&P is down one percent. Well, if you take dividend yield, basically it’s flat. The Dow is down 3.7%, NASDAQ’s down just under 5%. So all that fuss and fury and all those computer programs and all those intelligent minds put together have achieved very little considering that US GDP growth is about 3 ¼ percent in the first quarter, ummm…this isn’t much.
However, we start looking at some sub-indices, and the pattern is a little different. The Canadian Energy Index, the sub-index of the TSX is up 32%. That sounds very good except crude oil’s up 34% this year. As a matter of fact, if we look at sort of longer rates of return, the XOI, which is the American oil index, year over year is a full three percentage points under the price of oil, year over year returns.
I’ve commented on this from time to time, but it reflects the fact that there’s still disbelief out there in the investment community, notwithstanding…and I realize in Canada, having spent a week in Calgary and Banff, which is not a good place to go if you don’t want to believe in strong energy prices.
But even apart from being in that sector of the country, just talking to Canadians and reading the local media you see there’s still all this talk of a commodities bubble and that the oil stocks have gotten ahead of themselves. A very prominent Canadian investor whom I know well, institutional investor, has gone to a zero exposure in the oil & gas group in his fund. Very courageous move indeed, but it illustrates, I think, that we haven’t gotten the kind of performance out of the oil stocks that we should have, based on the move in the commodity. And in particular, we haven’t gotten the kind of move out of them that we got from the switch from backwardation to contango that we got in the first six months of this year.
I’ve spoken of that before and I’d like to come back to it again because it illustrates…I have a feeling that the contango is having more of an effect on the economy than it’s having on the stock market. So let me explain.
When we were in backwardation, then it was only the spot oil price that was being factored in to the cost structure of businesses. There was always this hope that things were going to get better because as you looked out the curve, every month was cheaper than the month before it. And this was reinforced by all the anodyne assurances from Wall Street that this was a bubble, a creation of massive speculation and that it was about to collapse.
Well…now if you look at the December crude contract, it’s 59.80 as against the spot price of 57.15. That means you’re being paid very substantially for holding oil. If we go out to December next year, December of 06, it’s 59 dollar crude. And if we go all the way out the curve to the last contract of this decade, it’s still a hearty 56 dollars and sixty cents.
So, my own guess is, that it’s the change in the curve from backwardation to contango which is starting to lead to a lot of the pessimism that you’re seeing out there. Because what this tells people, what it tells business people is…there’s going to be no let-up. And therefore they’ve got to learn to live with high energy costs. This was confirmed this week in Banff at the Investors Dealers Association Convention that I spoke at, by Spencer Abraham who was the Secretary of Energy in the first Bush administration. Pretty good guy. Arab-American from Michigan. Very smart fellow indeed. And in his presentation, he said that from his perspective, everything that he read and saw said that we were going to have high oil prices for as far ahead as the eye could see.
I don’t doubt for him, one of the big things he’s using is the curve itself. And that what this was saying is that the false signals we got from the curve when it was in backwardation because so many of the oil companies were hedging – that’s the term they use - by selling vast amounts of oil forward, since they gave up this series of self-inflicted wounds, what we’ve got is a strong forward curve and that reinforces therefore one side of the argument as to whether we’re going to be in surplus or in deficit in oil going forward.
The prestigious Cambridge Energy Research Institute published a report in the end of May, but it just went public last week, predicting massive oversupply of oil for years and years to come. Maybe a short-term shortage but then there’s going to be massive excess capacity and massive excess production and that oil prices could really plummet.
In other words, what has been the sustained wisdom of Wall Street and of Big Oil, is reflected in this. And one doesn’t dismiss Daniel Yergin’s organization lightly, one can dismiss Wall Street’s oil analysts lightly because of their record of demonstrated incompetence for years…collectively that is. Obviously some exceptions are there, but Daniel Yergin you had to take more seriously. And when you go through this report, what you see is that it shows that if everything works right and if all the OPEC reserve assumptions are accurate and if we don’t have any political troubles in Russia, Venezuela and Nigeria, then we’re going to have too much oil.
Well, ah, that was subject to challenge from other quarters. And at our conference, Jim Gray, one of the great figures in the Canadian oil & gas industry, best know for his deep gas company that he created, Canadian Hunter, which was bought for a song by Burlington Resources despite my vigorous demands and phone calls in 2000 and 2001 to Canadian investors to bid up the stock price because I knew that one of the US gas companys with reserve life index of 7 years or so was going to be desparate to buy that cheap gas.
Anyway, he gave a terrific presentation, built around Matt Simmons new book, Twilight In The Desert, which talked about the Ghawar field. Now you’ve heard me talk about this before, but updating it to what Jim Gray had to say…we’re talking of a field and he noted something that I hadn’t realized was that it came onstream at the same time as LeDuc came onstream in Alberta, which is the beginning of the modern oil industry in Alberta.
This [Ghawar] is the oil field that supplies 6 - 7% of total oil consumption in the world. It’s five times bigger than the second biggest oil field in the world, which is Cantarelle in offshore Mexico. And this is a mature and not to say old oil field with all sorts of problems. And it’s quite obvious that we’re not going to get any new Saudi light out of this field and we don’t even know how much we’re going to get going forward of the heavy oil.
Well, all of this, when you start looking at the background to the assumptions underlying the forward curve, one has to say that businesses that are relying on energy heavily in their cost structure and economies that have been able to get by in the past…the Eurozone in particular. The Eurozone, the move in oil from 25 up to about 38 bucks cost them nothing because the Euro outpaced it.
But this year, with the fall in the Euro, and with crude oil having made the powerful move that it has made, this has been really bad news for the Eurozone. What we’ve got then is a situation when in the Eurozone the cost of oil is up 37%. Whereas in the United States it’s up 32%. And what that means to me is that this is the extra thing that in the Eurozone where they don’t need much new bad news to make them feel really gloomy about the outlook. I think this is a sense that things can only get worse.
Now the current issue of Basic Points deals with Euroangst, but I didn’t deal with this issue here of the change in the curve and then of course the big move in the spot price. But the Europeans may take a better look at the forward curve than Wall Street does. And what it’s telling them…they’re going to have these high costs going forward and meanwhile they’ve got economic growth that is within the E and OE range of zero. For their three big economies combined: France, Germany and Italy.
Now, if we take that situation and then we take the fact that the US economy is being driven at the margin by homebuilding and by home repairs and upgrading and tarting up houses for sale; what we can see is that there’s a certain fragility about the forward forecasts for the advanced economies.
And China, which is able to, apparently, keep roaring ahead no matter what energy costs are, it’s obvious that even there that there are some cracks. And I say it’s obvious because of what we get on data on shipping in to China. The Baltic Index shows that. And there’s some softness occurring in some of the base metals, not yet in copper.
And when you look at the base metal stocks on the year to date, you wouldn’t know that anything much good was happening to them because we’ve got…Inco’s up 5% year to date, but the rest of them…well Alcan has been a disaster, it’s down 37%. Freeport McMoran is flat on the year and Phelps Dodge is down 4%.
So, the question then that I’m raising is whether we’ve really reached the stage that we’ve got an inverse correlation and therefore for those investors out there who look at the commodity component of their equity fund and say “Yeah well I realize we’ve got a division between the golds and the others, because gold isn’t really correlated positively to anything. It’s correlated positively to serious inflation but that’s a pretty remote prospect at the moment.”
But it may well be that whereas we did have, coming off the low, where the CRB index was back at a multi-year low and the rally that we had then, we had the situation in 2003 when we had the greatest overall positive year for commodities since, something like 1978 or 79, in other words, the diffusion index of commodities was that everything was going up.
That was the timing of Jim Rogers book, able to demonstrate that everything from the grains on through the cotton and metals and oil, they were all going up. Well the economic recovery is now longer in the tooth and we’re getting a sorting process out there between those that can go forward with oil trading near sixty bucks and those that are struggling. And some of you may say “Well are you recommending then that we take money off the table in the mining group?”
So let me simply say that…I believe that the wise course of action is to be diversified within the commodities group - diversification being always a mantra for me - but recognizing that at any given time, you may get one group or the other outperforming. Now the golds underperformed terribly and the only one that’s positive on my screen year to date is Barrick and that’s the special case of the change in their forward hedge position.
But some of the others have gotten hit pretty hard year to date. But gold, the metal, after having a really rough time, now seems to be moving up and it seems to have decoupled from the Dollar, which is something that if it lasts, is definitely going to be the subject of one or two calls.
Those of you who have been following my work for years know that one of the key indicators that I use for making an overall stock market forecast is whether gold starts going up on its own without its tie to the Dollar. If that happens, it means that risks are rising within the global financial system.
So I guess that although is a very quiet move that’s been occurring in gold and none of the other indicators out there are showing much, this is something that is a bit of a source of concern. Now it may well be that simply we had too much of a sell-off in gold, related to all the talk of the IMF was going to be selling gold and that sort of thing, but it does mean you can actually say you’ve got a diversified exposure to the global economy and the global financial system if you own only commodity stocks…depending on your weightings within the group.
So, although I’m still of the view that the group that has the most to gain from the story of China and India going forward over the next ten years is the base metals group, because it’s simply too difficult to duplicate what resources they have. There’s more hope of finding the needed oil and gas in the world than there is of finding the needed copper, nickel, lead and zinc, when we get 300 million more middle class. Having said that, it may be that the powerful move in oil and the change in the forward oil curve have combined with the other problems that are out there in the global financial system, will produce a global slowdown and that that will be at least in the near term, negative not only for the price of base metals and mining stocks, but for the price of the metals themselves.
Now again, this is very early to make that call because inventories have been declining for just about everything except aluminum and aluminum is such a special case because it’s a manufactured product. Steel has been giving us negative signals for months, but then steel is not a pure commodity. It’s hundreds of different kinds of manufactured goods, different kinds of metallic content, different kinds of alloys and of course different kinds of shapes. Still, one ignores the message from steel at ones peril if you’re an investor in the copper or nickel or lead and zinc stocks.
So, my best guess is, you should probably assume that this is the typical summer slowdown for the group, which is based on a holiday cycle for the big manufacturing operations in continental Europe and that unless oil goes to $65 in the meantime or something else goes wrong in the global system that these prices should come back in the fall.
But it does mean in terms of any new money investment in the commodities, it looks like, on a near-term basis at least, the oil stocks are the best place to be. Because they have failed to discount the move that’s taken place in oil and gas this year, fully. and of course, given that the profit margins…it’s all flowing to the bottom line. When you move oil from 45 to 55.
Whereas the price action within the base metals other than copper, you could say to some extent has been anticipated by the failure of these stocks to move upwards along with the oil stocks when we had this phase at which commodities were a front page story as an asset class by themselves and was actually being discussed elsewhere in the world than in Canada.
Finally, I think that the other theme of Basic Points, which is the shape of the yield curve, that story is very much intact. We’re awaiting the Feds action today, but if they do anything other than raise the Fed funds rate a quarter of a point, there would be some kind of financial earthquake.
But there will be big debate about how much time thereafter the Fed can continue tightening, given the signs of softening in the global economy and given the fact that looking within the US economy, that the strength is not well defused through the economy, it’s too much tied in to the housing bubble.
On the other hand, what a dilemma to be in for the Fed. Because if they stop tightening, then what that means is there’s even cheaper money available for housing speculators to load up with interest-only mortgages and option ARMs and things like this. So the genie is out of the bottle and it’s not clear what’s going to come along that’s peaceful and benign to burst that particular bubble.
So we come back to it, that’s the real risk that finally is out there, that the Feds policy of inflating the system – which was the right one for getting us out of 9/11 – they stayed with it a long time and then the other forces we’ve discussed in Basic Points have created new kinds of synthetic liquidity which have the result that the Fed can tighten now and the European Central Bank can stay modestly tight, at least, and yet the world is awash in liquidity.
I’m going to be returning to that theme in the next issue of Basic Points which we start working on next week. But all we can say is, equity investors on the call, it’s pretty hard to make a case that you should be selling stock, notwithstanding the concerns I’ve raised here at a time that overall global liquidity seems to be so strong. There’s no doubt that the flip side – and I’ll end the conversation with this – the flip side of $58 oil is that the petrodollars have to be recirculated somewhere and a lot of them are coming back in to the Eurodollar market which means that the money is there. And that means that one way or the other it circulates back.
So, the party can keep going…at least for the next few months.
That’s it. Any questions?
Thomas Fitzgerald: Don, you’d mentioned some relationship between the Alberta field and Ghawar, I don’t remember you following up on exactly what the significance of that comment was.
Don Coxe: Well, the point is that Canadians are used to the fact that LeDuc long since peaked and went into decline. And that Canadian conventional crude production has been falling. The Ghawar field, the Saudis have always maintained that it was just going to keep going on for decades and decades and decades.
But we’ve written about it in Basic Points, we’re extremely skeptical about the Saudis data and we particularly focused on a statement of theirs that they were going to have a decline of 2 ½ million barrels of oil a day between 2005 and 2012 from existing fields, but they declined to identify where the decline was coming from. Well this was at a time that Ghawar was absolutely dominating Saudi output. We put that in Basic Points, that it looked like Ghawar was in decline and Al Jazeera took it all the way to the head of Saudi Aramco who basically couldn’t deny it.
Well, if Ghawar is in fact in decline then in the light of what Jim Gray had to say at our conference, that decline could become something big enough and fast enough to really influence world oil prices. We’re talking…you may say “just focusing on one oil field?” We’re talking of six to seven percent of total consumption in the world, this is a big story. And the Saudis have been so secretive about it. So, I think that those of you on the call who are interested in this should certainly read Matt Simmons book.
But, we’ll be following it up from many sources we have because it takes…the kind of production you’ve got to bring on from ordinary oilfields elsewhere that are out there to offset any significant decline rate in Ghawar is so enormous…this is not just the granddaddy of them all, it’s much more than that.
So, long answer to a short question, but that’s why I focused on it, it;’s the fact that this is now a major element of debate and Matt Simmons has helped to focus the debate on it, but without knowing it in effect, the Saudis did it themselves when they were incautious enough to reveal that they were bringing on five million barrels a day in new production but it wouldn’t be net that because of 2 ½ million barrels of decline.
So…to take 2 ½ million barrels out in a couple of years, there’s only a few places it could have come from. And if it’s Ghawar and then you start projecting this forward thereafter, we’re talking of something where they’ve just got to be finding new oil around the…look, the entire oil sands of Alberta by the year 2030 are supposed to be five million barrels a day. Ha! Well, that’s on the current decline rate forecast for Ghawar, all that will do is offset Ghawar. And we’ve still got all the other sources of demand for oil in the world, so, it is a big story all by itself.
Thomas Fitzgerald: And then, the other side, Don, would be, Cantarell. And there’s been some debate there as to whether they’ve been increasing or decreasing or stable in their production, we’ve heard both decreasing and stable but we haven’t heard much about increasing at Cantarell. What have you heard?
Don Coxe: Well, what Pemex has said is that they’re currently in decline but they’ve asked for money, authorization from the Mexican government to bring in partners from the big, bad US oil companies to offset the rates of decline and of course that’s like getting rid of all the Saints holidays in Mexico in terms of what you can do. So what we have on the evidence, is that Cantarell is in decline based on natural causes but that Pemex says that they could arrest this process if they got help.
All we can say is that the biggest in the world and the second biggest in the world are in decline and will stay that way until something amazing happens.
Collin Henry: You briefly mentioned the separation between the metals and steel. And you alluded to the fact that there might be some signals going on in the steel side of things, can you elaborate on that?
Don Coxe: Yeah, the steel story is one…those of you who’ve followed my work may have noticed that I have managed to almost never mention steel when I’ve been talking about the base metals and when I’ve been talking about the commodity story. One of the reasons is, in terms of what stocks you can buy in North America, there’s only a few really good companies, because so many of them have gone through bankruptcies because of pension problems and old integrated facility.
But also, it was to me apparent that this was one thing where the Chinese were eventually going to become pretty much self-sufficient in it. I could tell you all on the call, four years ago I was told by a client that operated a steel service center in the Midwest. He had just come back from a trip to China where they had offered to buy huge amounts for the next five years of a particular grade of steel at a price above what’s paid for it in the Midwest, to guarantee a spread. So he was thrilled with that.
But they said, we should tell you something. By the end of five years, we will be at surplus capacity within China and then we’re going to have to start exporting to the US to pay for these plants and we’ll probably be able to put you out of business. Are you willing to enter a long-term contract on that basis? And he said, I did. Well it looks like they may be a year ahead of schedule because they’re net export of an increasing range of steel products.
You can build new steel plants easily but you cannot open new copper mines or nickel mines easily. You’ve got to have the orebody there. So, to me. It’s always been too easy just to use what was happening in steel as an indication of the attractiveness of the base metals group. Yeah, it’s very important if you’re pricing iron ore, but there’s only a few iron ore stocks. There’s Cleveland Cliffs and there’s CVRD and of course it’s a big source of income for BHP. But my emphasis has been on those that produce the metals that are required for developing middle class homes in China and India. And then the cars, because of the importance in the engines of these other metals.
So steel is a much more complicated story and Metal has managed to put together the biggest steel company in the world by buying up all sorts of companies that were in bankruptcy or on the edge of bankruptcy all around the world. To me, this has the look of, in effect a conglomerate that may be a bubble and could implode. For example, the fact that he’s paid the highest price for a house in London that anybody has ever paid, has all the looks of a Nouveau Riche bubble situation. And it was never clear to me that putting together all of these underachieving and unprofitable steel companies would work. The only reason it would work is because steel companies were just levitating.
Well, the Chinese will certainly be able to blow away that kind of competition because they’ve just expanded their production so much, so, pardon me for the length of this reply but it’s because I’ve stayed away from commenting on steel. The Nucor’s of this world and the Ipsco’s of this world are a very different category. Brilliantly run companies and they remain profitable under the most adverse conditions.
But I’m still worried when you have the biggest steel company in the world in a position where he may be overextended – we don’t know that – he came up too fast and he’s spending money on himself too fast. So, I hope I’m wrong on this because I’d like that to be another Indian success story, but my concern is that what we could have is, if we have a deflationary global recession, if that occurs in the next year, and with leading indicators all over the world turning down you’ve got to be concerned about that possibility, that could be a bubble situation, which would falsely convince people that the whole commodities story was a bubble.
That was never part of my argument for investing in commodity stocks in the first place because I always saw this as a very different kind of thing. It just happened that it was a major raw materials item. And there are raw materials that aren’t, in effect, pure commodities.
David Boyd: Quick question from Windsor, Ontario. For those of us who got in on the oil advice you’d given us in Basic Points a couple of years ago, now looking at it, reading through Bill Gross’ article yesterday and talking about the potential for interest rates moving on the US side, talking to Mike Herring on our side about interest rates moving, wanted to get your thoughts a little bit about the strategy of using long-term coupons, potentially, to offset the oil and gas profit we have in some of the equity positions
Don Coxe: As you notice in the most recent Basic Points, I’ve recommended for US institutional investors a totally new asset class, which is very long duration bonds and I’ve recommended 5% and I’ve said if you can do it, go to a 20-year duration. Now the only way you can possibly get the 20-year duration is having an overwhelming percentage of zeroes or coupons.
So, I believe that this makes sense for individual investors as well and in fact this is going to be developed in much more detail in the forthcoming Basic Points, as to you how you look at a proper kind of hedge against a new kind of recession, which we’ve never had to face since the Great Depression, which is a deflationary recession. And in a deflationary recession, the asset class of choice is long zeroes.
Yes, I agree with you and I hope to document this in much greater detail in the publication that you will read in mid-July.
Thomas Fitzgerald: Don, do you have any comments on the possibility or probability of a Chinese currency re-valuation?
Don Coxe: Well, I guess I’ll start taking it seriously when it stops being on the front page. There’s just too much discussion of it and the Chinese would never do it under duress. They would have to be independent. To me, frankly, the only big effect of this would be on the US Dollar index, it would need an adjustment. It would also focus more on the value of gold. But ten or fifteen percent revaluation of the Yuan isn’t going to get rid of China’s trade surplus with the US.
I also believe that when it happens, I won’t say if it happens, when it happens, the Japanese will also move up the Yen, because I believe that the events of October 1998, which I’ve discussed in Basic Points, when Japan revalued the Yen from 142 to 115 in twelve hours of trading. And that was in effect a sword right at their throat from China because China had already made clear through an international banking syndicate that they were prepared to devalue the Yuan, unless Japan upwardly revalued the Yen.
That was the time, in effect, where world currency leadership shifted to China and it hasn’t moved away from there. So, long answer to your question, but I think that when the revaluation comes, you will find that rather than China losing its preferred position, in effect within Asia, that the other Asians will move along except the very minor countries. That’s why it will be such a big event, because the Yen will move as well. One of the reasons I’m doubtful we’re going to do anything about it now, this year, whereas I thought we would, because of the breakdown and the fast developing enmity between China and Japan. With all the public humiliations and shouting, it may well be that any chance of monetary cooperation has been put on hold.
So, I regard this as a story that’s on Page One that should be largely ignored, thank you.
Thank you all for tuning in. Have great long weekends, wherever you are, and we’ll talk to you next week.
http://www.siliconinvestor.com/readmsg.aspx?msgid=21473607
==============================================================
To listen to the audio presentation of the above CC (incl. Q&A session):
http://www.bmoharrisprivatebanking.com/webcast.asp
Dan 
Discover What Traders Are Watching
Explore small cap ideas before they hit the headlines.
