Oil Politics and Cattle Conundrums

Dave Nadig, HardAssetsInvestor.com (Nadig): This is Dave Nadig, associate editor with HardAssetsInvestor.com. Once again, I’m here with Kevin Kerr, for the Hard Assets Investor Weekly Trading Update. Kevin is the editor of the Global Commodities Alert, available at KerrAlert.com, and Kevin’s going to help us this week make some sense of the commodities markets from a trader’s perspective. If you have any questions, you can drop us emails at [e-mail] e-mail address is being protected from spambots, you need JavaScript enabled to view it . Kevin, how are you this morning?

 
Kevin Kerr, Global Commodities Alert (Kerr): Well, I’m fantastic. After another volatile week, it’s good to get some rest. 

Nadig: I have a hard time imagining next week is going to be a lot better. We’ve got a little bit of an event coming next week. What do you think?

Kerr: It’s such an exciting time, of course, as we head into the election. A lot of people are leaning toward, it seems, to the Obama presidency, but nobody knows until the election happens who we’re going to actually have in the White House, so there’s a lot of people wondering what’s going to happen next.

Nadig: In previous years, even after Election Day, we haven’t quite known who’s going to be in the White House. Assuming that doesn’t happen, and we do have an idea on Wednesday morning when we wake up, what do you think traders should be looking for on that Wednesday morning based on whichever president comes in? What do you think the plays are?

Kerr: Let’s face it, everybody is talking about change, and obviously with the economic debacle, the housing debacle, change could be very motivating at first. Now, Wall Street is clearly scared of a Democratic presidency and a Democratic Congress together, and regulatory problems, so initially, I think you could see an overall euphoria in the market, kind of a relief rally. My fear is that going forward, especially with a Democratic presidency, that Wall Street may be very concerned and we’ll see more pressure on the market.

It’s going to be a very interesting time to see how the next president handles it coming in, and that’s going to be the big key. How is the government going to stabilize these markets whichever candidate wins, and convince people that these markets are solid, that there is going to be a plan of action to get them up and running again, and to find some kind of bottom here if that’s possible?

Nadig: Well, there’s got to be a bottom somewhere underneath all this.

Kerr: There’s always a bottom, yes.

Nadig: One of the plays that gets talked up is obviously the oil play, with Governor Palin talking about “drill baby drill.” Do you think that there really is an oil play here to one side or the other, or is the issue of offshore drilling really not enough of a supply factor that it’s really going to matter?

Kerr: You know, when we were at $126 a barrel, certainly at $147 a barrel, alternative energy plays and drilling offshore and the drill, drill, drill argument and all was being blasted everywhere. But now we’re back down here around $65, $66, we’re seeing driving patterns pick right back up to what they were before.

AAA came out with some statistics (Lundberg). We’re seeing statistics already that people are driving more again. So what happens is, when we get this, it’s a double-edged sword. We get these prices pulled back, and it helps consumers.

Hopefully –we didn’t see it this week though – they will start going out and spending more money on other things, but the problem is, it takes away that money from research and development, and development of alternatives, and the motivation to go out and drill. So it is a double-edged sword with this oil price. I do not see oil staying down here around the $60, $70 level; my level is more around $85 to $110, and I think that’s the nominal level for oil, and I think we will see that within six months.

Nadig: Yeah, we had T. Boone Pickens coming out this week saying that he’s actually out right now, he’s not bought back in, but that he sees something similar, that there’s sort of a baseline price for oil in 2009 of around 100 bucks, and really, the issue is, when do you catch that rally? Is it too early to be buying that rally, or do you wait until after the election? Well, at this point, anybody who’s listening will be waiting until after the election. But do wait until next year before you say, OK, I believe that oil has reached a temporary bottom where it’s safe to buy?

Kerr: The old thing on the floor is, you sell popcorn when the circus is in town. What that means is that this is the time to buy, because right now prices are cheaper. Now certainly crude could go lower, so I will tell you that our strategy here at GCA and my overall trading strategy is, I’m very conservative in a market like this. So with this kind of volatility, the best way for us to play it is to use option spreads.

Now that sounds scary to a lot of people that have never traded options in the first place, but actually what it does is it helps the options to be more affordable, and it protects you because, of course if it does drop to $50, I can always cover one of my options, and then I’m still long anyway, and I also have plenty of time.

So if I buy crude oil options all the way out until next December, I’m pretty confident that we’re going to see a higher oil price by then, and so that is the way to play it. Now, you’re not going to make as much money as you would if you were trading outright futures, and I would be conservative buying shares.

Nadig: And if you’ve got it right.

Kerr: Exactly, but you have to protect yourself. In this type of market, you must be using serious risk management, there’s no doubt about it.

Nadig: Let’s stay on oil for a minute and talk a little bit about some of the companies underneath this. We had Exxon reporting its biggest earning ever. We had Royal Dutch Shell saying that there was a 22% increase in Q3 profits even though production was substantially lower. We had Pickens saying he’s out of the market. Do you think that with all of this cash sitting in the oil industry, are we looking at a potential consolidation takeover market over the next year or two? Traditionally when we’ve seen companies just get these huge windfall piles of cash, we’ve either seen that cash revert back to shareholders or we’ve seen consolidation.

Kerr: Yeah, we’ve seen Exxon (XOM)  buying back millions and millions of shares as well of their own stock. I think you will see some consolidation; the smaller companies will get gobbled up, or the ones that are light on cash. This just makes the market more efficient in many ways, and we always see this, we see this in every industry.

So I do expect some of that, and I expect these companies to continue to have incredible earnings. They are happy with oil at $80 or $90, and of course, they’ve had a huge windfall. So what they do with all that cash … I hope they invest it in some infrastructure. I hope they invest it into some more refineries and other things, things that we should be doing now that were all being talked about at $126 and now at $66 that are not even being discussed.

My biggest fear, though, if we do have a Democratic presidency and a Democratic Congress, we’re going to start to see windfall profits taxes and a lot of this money taken from these companies, rather than reinvested into infrastructure and put into programs instead that never really come to fruition; that’s my biggest fear. I guess you can tell which way I’m voting.

Nadig: This isn’t a political show, that’s not the point; and besides, by the time those people listen to it, they will have already voted, or I hope they will already have voted. You talked a little bit about the refinery issue, which is an interesting one. We have seen gas prices come down almost a buck fifty in some places from the highs this summer, and we have seen some pickup in driving patterns, but the counter to that is, we’ve seen these pretty negative sentiment numbers and an actual 0.3% one-month drop in consumer spending. Where does that play out? They sort of seem like they’re in conflict with each other.

Kerr: Yeah, it’s great that the gasoline – at least in my station nearby – is around $2.79 a gallon, which is incredible. It was close to $5 even just several months ago.

The bottom line is jobs. Here in this area, the Eastern U.S. where I am, so many people have lost their jobs. In the Midwest so many people have lost their jobs. Employment is the key here. People don’t care about if prices are $3 a gallon if they have a job. If they don’t have a job, they can’t go to Walmart, they can’t go to the supermarket, they can’t fill their car up with gas no matter what it costs.

I think the biggest problem here is all these job losses that we’re seeing, and I think that’s unfortunately going to get worse. That is the biggest part of this equation, and that is putting a lot of pressure on the consumer. We’re seeing it: They’re not spending as much, they’re fearful and I think that’s going to continue until we can get these job numbers back up.

Nadig: Is that setting us up for deflation? Because clearly in the commodities market, we’ve had tremendous deflation; almost everything is down – with the possible notable exception of cattle – but all of these inputs to consumer goods, eventually … all of them are down.

Kerr: That’s good, because I’m long cattle. You know, look, the dollar strength has been a big issue of this too; stronger dollar, weaker commodities – that has put pressure on these commodities. You had a lot of these hedge funds redeeming their money, taking it out of these funds. I think a lot of that money could come back in quickly, so there’s a lot of factors at work here.

Deflation, yeah, I think we’re in a deflationary mode for many of these commodities, but I think we have to look at how far and how fast they ran to the upside. My real belief is it’s like a pendulum: This thing swung so far to the right with crude oil going as high as $146, and now it’s back down to $62 or $65 or wherever it is here, that somewhere in the middle, as T. Boone said, somewhere in the middle, we have a nominal price for many of these commodities – the grains, the softs, the cattle even – and we just have to find that level. The fun money will come back though.

Nadig: Tell me about your long cattle play.

Kerr: Well, my long cattle play, again, is all sort of spread. This is an options spread market for me right now, and that is because I want to be able to take the most advantage of the volatility. We’re long cattle out to February of ’09, and the play there was it was just undervalued. There’s strong buying coming in now, the options are doing very well, we covered the short side of our options spread when it was at its bottom, and so now we can take advantage of this upside run.

But I am cautious; it’s very dependent on the grain price, and grains have been, well, mediocre at best lately, although I do think that the crops are very poor and harvest is showing that. I got a report yesterday from one of my farmers. The corn crop is horrific where he is, and it’s been a cold, snowy harvest so far. So I just don’t think it’s as rosy as the government paints the picture for the grain markets.

Nadig: One of the interesting things, looking at cattle over the course of the last year, has been this dichotomy, where it is this peg to grain most of the time, but now we’re in this interesting position where we’ve seen the grains come way down, but we’re still living with the results, because cattle … it takes a while to make a cow. It’s not something that you get; you don’t all of sudden breed a lot more cows. As corn got so expensive, we heard reports of farmers sending their cattle to the feed lot much sooner, slaughtering younger cows, bring those to market. So we almost had an anticyclical action here where we had cattle quite low during this boom in corn prices, and it seems like we’re on the other side of that. Is that something that you see happening over and over again, or was this sort of an anomaly?

Kerr: Well, I think it was, in a way, an anomaly. My fear is that a lot of these hog producers have gone out of business. I visit a farm in Minnesota every year, the Singlestead farm. They’re good friends of mine. They have a big hog operation, they do farrow to finish; in other words, from beginning to end, and he said, “I just can’t do it anymore; it’s just not cost-effective.” The prices had gone up so much to raise one of these hogs that he just couldn’t do it anymore and he shut down the whole operation just to focus on his soybeans.

Now, that’s not an isolated incident. There’s a lot of farmers and a lot of meat producers that have done that; they have just shut down their hog operations. This is going to affect the price longer term.

When this economy gets ratcheted back up and people want their steak at Ruth Chris and they want all that, they’re going to find it’s going to be much more expensive, because the cattle and hogs … these operations … many have just been forced out of business. A lot of farmers have been forced out of business. They was renting their acres for a phenomenal price. The cost of fertilizer and feed and everything else has gone up to the point that now it’s in the system.

Now we’re starting to see the effects, as you said, in cattle, while we’re seeing the grains pull back a little bit. I don’t think that’s going to continue for very long. I think they will continue to rise.

Nadig: Well great. Kevin, that’s all the time we have this week. I look forward to talking to you next week when we’ll have a little bit more news; we’ll actually hopefully know who the new president is going to be.

Kerr: Excellent; great talking to you.