The Real Rationale Behind Current Supply and Demand for Oil and Other Commodities

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 |  Includes: ACIIQ, ANRZQ, BTUUQ, CL, CNX, CTX, DHI, DRYS, DSX, EGLE, EXM, FCL, FDG, GM, GNK, JRCCQ, KO, LEN, NILSY, OMG, PAL, PEP, PG, RYL, SWC, USO
by: Mark Anthony

The market irrationality has reached a new record. Spot price for crude oil free falls to $31.41 a barrel (WTI Cushing Spot) two days after OPEC cut production by 2.2MB per day and made clear that they wanted to see $75 oil and will continue to cut if necessary. As OPEC vowed to keep cutting until they see $75 oil, oil should go up, but it actually went down. What gives?

In search for an answer, people blame it on "the oil demand has collapsed". Global oil demand did NOT suddenly collapse in the two days after the OPEC announcement. Look in a mirror for the answer. Yes that says you! Every one bet on raising oil after OPEC cut. The market ALWAYS fools most of the people most of the time, logical or not. Fundamentals work in long terms, not in short term moves. If you bet on short term moves, try to bet against most people, instead of betting on fundamentals.

Has the global oil demand collapsed? US oil imports in October actually surged. Read the EIA provided weekly US oil import data. In the week ending Dec. 19, total US oil imports were 12.780M/day, versus 12.907M/day in the same week a year ago. That's only a 1.0% drop. Consider the surging oil demand in China, Russia, India, the global oil demand probably sees a slight increase or at least remains flat.

Do not forget Peak Oil. The world's top ten oil fields are all in steep production declines. Mexico's Cantarell Oil Field is declining more than 33% a year! According to Matt Simmons, Mexico, our 2nd largest oil supplier, will CEASE to export oil by the end of 2009.

The free fall of oil completely defied logic. I did purchase some USO (NYSEARCA:USO) a bit too early after the OPEC decision. Judging from what happened to other commodities, oil price may continue to drop to such low levels that most oil producers can no longer make a profit. At that point people may finally be convinced that oil producers will cut production for real, instead of cheating on the OPEC production quota.

The fundamentals of commodities supply and demand can not change in just a few months. As I discussed before, the global credit crunch resulted in forced liquidation of global supply chains, as every one liquidated their inventory to raise cash in order to survive. The inventory sales flood the market to create a false over-supply situation while supply destruction is playing out at break-neck pace as unprofitable mines are shut down.

Due to the credit crisis, global commercial activities are brought to a grinding halt due to lack of credit. The global shipping industry is hit hardest. Read my analysis on what happened in the shipping industry and why I bought shipping stocks like DryShips (NASDAQ:DRYS) near the low. If you followed my past articles, you know I have followed DRYS for a long time but never bought before. I believe DRYS could be like the coal stock James River Coal Company (JRCC), which I picked up around $4 last year, gaining some 15+ fold from the low in a matter of a few months!

BTW I continue to call for people to sell JRCC and other coal stocks [Arch Coal (ACI), Alpha Natural Resources (ANR), Peabody Energy (BTU), CONSOL Energy (NYSE:CNX), Foundation Coal Holdings (NYSE:FCL) and Fording Canadian Coal Trust (FDG)] at any good rally. The US coal market is now a bear market. Coal is long term bullish but short term bearish. Obama's Global Warming team doesn't help coal either. I knew Steve Chu when I attended his seminar on his laser atom trapping research, two years before he was awarded the Nobel Prize in Physics. I am sad a brilliant physicist was tricked by the Global Warming Hoax. He was too occupied to spend 10 minutes scrutinizing the global warming claims using his basic physics training. But in any case, the coal sector is not going to be a happy sector for a while. Mr. Secretary Steve Chu, please spare a few dimes to the Cold Fusion research scientists, you know, as an experimental physicist, no one could continue to do the same experiments for 19 years, unless there really IS something in it. Cold fusion is real science and humanity's best hope of overcoming the energy crisis due to fossil fuel depletion.)

We need to make a distinction between the aberration caused by the credit freeze up, and the real fundamentals of supply and demand. The credit freeze up only has a temporary effect in halting global goods movements and suppressing or delaying demand. It can not last long. Governments around the world are printing fiat money like crazy and injecting huge liquidities to get the credit moving again. There are clear signs it's starting to work. Banks are NOT in the business to hoard cash. They are in the business of taking in deposits and then lending money out to earn the spread of interest rates. If banks do not resume regular business soon, the whole banking industry will disappear from our society. That is not going to happen.

The real supply and demand is nowhere near a catastrophe. World Bank predicted a 2% drop in international trade next year. MasterCard (NYSE:MA) reported a 3% y-o-y drop in US gasoline purchases. The US Census Bureau reports a 4.4% increase of goods exports and 3.9% increase of goods imports in October, compared with last year. The scariest number? The Japanese government reported a 26% drop in exports to the USA in a recent month. Well dah?! Japanese count numbers in Japanese yen, the same US$ amount is now 23% lower in yen compared with a year ago. So Japanese export in US$ terms probably dropped a mere 3%. Everyone is shouting "demand destruction" but how many actually dig into the data and scrutinized the facts?

As I discussed, the modernization of China, India etc. is the fundamental driving force behind the global commodities bull cycle. This transition has been going on for some 30 years and can go on for decades more, as the per capital consumption of many raw materials and goods in China is still far below even the global averages. Read "China Eats the World". China's current highway mileage is worth about ONE INCH of highway per person. There is a gigantic demand for steel and cement if China provides its citizens at least one finger or one foot of highway.

The basic demands come from basic human needs. During bad economic times, people cut spending on luxuries but continue to demand things that are essential. So let's examine what is a luxury and what is a necessity in people's lives. First let's not confuse luxury with expensive items. Something expensive doesn't necessarily make it a luxury, and something cheap doesn't mean it is a necessity. This is important to keep in mind.

Drinking Coca-Cola (NYSE:KO) is a luxury; driving a car to work is NOT; Brushing your teeth with tooth paste, rinsing your mouth with mouthwash, or using shaving cream while shaving is a luxury; but visiting a dentist for a cleaning or a dental crown is a necessity. Watching big screen TV is a luxury, but owning a computer to surf the internet is essential. Living in a 5-star hotel is a luxury, but living in a place with aroof over your head is absolutely essential.

Companies that produce "luxury" items should be considered good short targets now, particularly those big blue chips stocks few thought about shorting. In early August, 08 I called for shorting soft drink companies like Coca Cola and Pepsico (NYSE:PEP) as I believe soft drinks will become non-essential luxury items. These two stocks have moved down a bit but they are still good long term shorts.

Now come to think about it, do people really need to use an ever growing amount of toothpaste, mouth wash or shaving cream? Even Albert Einstein did not use shaving cream. He just used warm water. I am thinking about shorting related stocks like Colgate-Palmolive Co. (NYSE:CL).

With a saturated market and shrinking profit margin, it's ridiculous that CL is priced at more than twice its annual sales and 15 times its book value. The short ratio seems to be low so CL may be a good long term short. On similar consideration maybe one should also consider Procter & Gamble Co. (NYSE:PG) as a possible short. The difference is PG's is at a more reasonable 2.83 times book value, and it is well diversified into a lot of different products. So I will be cautious and want to do more DD before shorting PG.

Three things in life are absolutely essential: eating, living and moving. Eating is of course the most important. However there is a lot of room in cutting eating costs, without cutting nutrition. People will cut on non-essential and unhealthy processed food, and rely more on cheaper fresh food. One example is potato chips and pop corn. Why would any one eat these junk foods? Frito Lay came to mind but it's part of Pepsico. Can anyone recommend a good snack food producer to short?

There is much less to be compromised in living. For 99.99% of Americans not living under a roof is unthinkable. You either own a home or rent a home, one way or another. Surprisingly, the majority of the home builders, like DR Horton (NYSE:DHI), Centex (CTX), Lennar (NYSE:LEN) and the Ryland Group (NYSE:RYL), are still around today. People either own a home, or have to rent one. So if people are not buying houses, then there must be a booming rental market and a booming business building rental units. Is it time to buy home builders as many of them seem to have gone up from their lows? I am skeptical. We need to see at least half of home builders go out of business to remove enough excessive capacity, before the remaining ones can return to profitability. There are so many good things to buy now. It's not time to go into home builders yet.

I see even less room to compromise on moving. Mobility is an essential human need more important than eating and living. In the Great Depression movie "The Grapes of Wrath", the family lost everything and they had little to eat. But they kept their family truck, which allowed them to move to California, find a job and find a place to live. Without four wheels you are reduced to just two legs. Without two legs you are reduced to two wheels. That's how important mobility is.

Car ownership is an essential part of the American lifestyle. You need a car to go to work or go shopping. Even if you do not have a job, you still need a car to move around looking for jobs, or go get some help, or to move to a better place. Has the global auto demand collapsed? Not by a long stretch! Just look at global oil consumption. The Big Three US auto makers, particularly General Motors (NYSE:GM), are at the mercy of government help now. But it is a problem that the Big Three are unable to compete with foreign auto makers, not a problem with fundamentals of the global auto industry.

The current credit crisis forced many people to delay buying new cars, but it also means a strong pent-up demand which might allow the sector to come back soon. Historically, due to skyrocketing oil prices and inflation, auto demand collapsed in early 1980s and GM's stock hit a low in mid 1982. But just a little over a year later, in 1983, US auto sales reached a new record high as consumers who delayed car purchases found they still needed a new car when the old car broke down.

I believe it is in America's best national interest, as well as in the interest of the country's consumers, to keep the Big Three alive and keep the competition alive, and keep vehicle prices low. But I do NOT advocate buying GM stocks as an investment. There is no reason to believe they can pay off their huge mountain of debt and pension obligations, and start to make a profit any time soon. So there is no reason to invest. Both the longs and shorts in GM stocks right now are just gambling against each other, trying to pick a few dollars from each other's pocket.

We should invest in companies that have been indiscriminately hit hardest, but are financially strong and have good future prospects of profitability. The best sectors to be in right now are mining companies and bulk shipping companies. The shipping sector should rebound sooner and stronger than anything else, due to the pent-up shipping demand from the goods stockpiled on harbors waiting for credit letters. That is why I started massively purchasing shipping stocks like DRYS and Excel Maritime Carriers, (NYSE:EXM). There are others, like Diana Shipping, (NYSE:DSX), Eagle Bulk Shipping (NASDAQ:EGLE) and Genco Shipping (NYSE:GNK).

But my favorites remain the by-product rare metals, palladium, and cobalt. Both metals are critical both during peace time and during war time. Stillwater mining (NYSE:SWC), America's only palladium mine, remains my biggest holding, although DRYS is now catching up and is my No. 2. Another palladium mining company to own is North American Palladium (NYSEMKT:PAL). I also own a significant stake in OM Group (NYSE:OMG), the world's dominant cobalt chemical company.

You've got to like palladium and cobalt because both metals are mostly by-product metals, and the supply of both could be interrupted by a single-point-of-failure, which is very real. I talked about a possible Russian Checkmate. Norilsk Nickel (OTCPK:NILSY) could suspend unprofitable production due to low nickel price, hence cut off 45% of the world's palladium supply.

Now it seems things at Norilsk are playing out more favorably for palladium than I thought! Norilsk resumed the US$2B stock buyback. That leaves them $2B less in cash and closer to a liquidity squeeze that will force them to shut down the unprofitable mine soon. Norilsk also announced a production cut. Nickel production in 2008 was cut to 298K tons from a planned 300K tons, and will be reduced to 290K to 305K tons next year. The cut in palladium is much more dramatic, from a planned 3.05M ounces to actual 2.764M ounces in 2008, and 2.61M to 2.62M ounces in production next year. Why is the production cut in palladium so much bigger than nickel?

Norilsk explained there are two reasons for lower palladium production:

Reason 1: they will reduce local mineral ore production and purchase third party intermediates (metal concentrates) to supplement nickel production. Nickel concentrates purchased from third parties will contain no palladium, only nickel.

Reason 2: much lower PGM content in the ores. Norilsk's mineral reserve statement shows that the nickel-rich part of ores actually contain less palladium (2.91% Ni and 7.41g/t Pd) while the nickel poor ores contain more palladium (1.19% Ni and 11.92g/t Pd) . If they seek to reduce capital expenditures, they will economize by producing ores rich in nickel and poor in palladium. Using the content ratio of the richest nickel ore, if Norilsk's polar region nickel production is 225K tons, then the palladium production will only be 1.922M ounces, versus the normal 3.05M ounce.

It's the end of December now and the annual Russian government stockpile palladium shipment has NOT showed up in Switzerland. Maybe the Russian palladium stockpile sale has finally ended for good. It's in Russia's strategic defense stockpile. There is no reason to sell at current low palladium prices. The Russian Government has taken effective control of Norilsk Nickel, and will support the mining company by buying up its metal products.

What better support can the Russian Government extend, than to simply buy up Norilsk's palladium production and re-stock the nation's defense stockpile? In doing so they can bid up the global price of palladium to over $2000 an ounce, which means a cool extra $6B per year for Norilsk, money they desperately need right now.

These numbers and facts continue to convince me that Stillwater Mining (SWC) is the best mining stock I can own for the next 5 years. That is the reason I continue to hold a dominant position in this mining stock, America's ONLY producer of the strategic PGM metals.

Full Disclosure: The author is heavily invested in SWC, DRYS, OMG and PAL. I currently have no position in GM, KO, PEP or CL.