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

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 (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 (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 (CNX), Foundation Coal Holdings (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 (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 (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 (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. (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. (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 (DHI), Centex (CTX), Lennar (LEN) and the Ryland Group (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 (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, (EXM). There are others, like Diana Shipping, (DSX), Eagle Bulk Shipping (EGLE) and Genco Shipping (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 (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 (PAL). I also own a significant stake in OM Group (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 (NILSY.PK) 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.

Comments

[bfras921]

I suggest you sell every share of drys as the company is headed by a guy that would make Madoff look like a cub scout

You really are clueless and i hope others do not follow your lame advice

2008 Dec 26 07:56 AM

[Ferdinand E. Banks]

This is an interesting and useful article, even if I disagree with certain claims by the author. Of course, his pointing out the situation with fossile fuels makes it worth reading for everybody.

About Stephen Chu. Regardless of his background in physics I see him at the present time as a member of the new president's environmental team, because environment rather than energy is likely to be emphasized by President Obama. But that's OK if the result is a focussing on nuclear, because something that Professor Chu can undoubtedly do - and might be interested in doing or having done - is to calculate the cost of electricity generated by nuclear as compared to gas and coal and renewables. Of course, if he gets what I think is the wrong answer, I'll have to wake the town and tell the people - assuming that I still have access to a forum, which isn't certain.

About global warming. I don't see any point at all in bad-mouthing global warming (AGW), even if it turns out that.... As for dry fusion, when the music starts at the new year's eve parties...in 2099, they probably will still be talking about getting that. The physicists working on dry fusion should be retrained to work on health issues.

2008 Dec 26 08:26 AM

[SubsidyEye]

Pop corn is not junk food -- unless you saturate it with butter (or oil) and salt.

2008 Dec 26 08:38 AM

[long_on_oil]

America is a junk food nation. Give an American food stamps and the first thing they buy is potato chips, popcorn, and pop; the essentials of life.He missed the mark there. I can not figure out what this guy brushes his teeth with if not some form of toothpaste. Mouthwash is not needed but I can't imagine toothpaste as a luxury.
The best part of the article was his oil and shipping analysis he is right on there. As far as power plants, natural gas is the only economically feasible way to go due to the limited amount of fuel for nuclear and the peak oil theory on oil.
When the dam breaks on all this liquidity the fed is putting into the economy we will all be flooded with massive inflation. Banks can borrow at zero percent interest and there is a credit crunch...BS. Credit card rates are going to collapse to get the economy going, you can bet on it.
If you remember all the predictions for 2008 made in 2007 you will see only a very few came close to the actual results. The results for 2009 will be the same, very few will get the bearish prediction right. Since I am an eternal optimist I am going out on a limb by predicting a 14000 Dow sometime in 2009...lol May you all have a prosperous 2009.

2008 Dec 26 09:13 AM

[j_remington]

Your bullish call on PAL was a disaster.

2008 Dec 26 09:36 AM

[bones33]

EXM still pays a .40cent dividend per quarter.This is the best of breed in my opinion(along with FRO).Forward PE of around 2.Even if they cut the divedend in half it will still be a bargain at these prices.

2008 Dec 26 09:37 AM

[Mongoose]

I usually find it very stimulating when there are valid pros and cons. Thanks for all the food for thought this year. When everyone agrees LOOK OUT. Happy 2009

2008 Dec 26 09:40 AM

[axelrod608]

Mark - thanks for a long, well reasoned analysis of what you're buying and why. Whether one agrees with either your numbers or conclusions, it is good food for thought.

I know no 100% accurate traders. So I like to listen to all sides of the discussion and sort out which makes sense. To me.

Ignore the critics. The only critic I pay attention to is my bottom line. I'm still ahead - barely - year-to-date. And I've ignored a LOT of advice from "experts".

2008 Dec 26 10:19 AM

[Gumby]

Futures on thermal underwears is soaring now...

2008 Dec 26 10:23 AM

[Reagan Fan]

You say a $2 tube of tooth paste is a luxury, but a $150 dental cleaning is not. I have news for you. Dentists are telling me that people are opting for the tooth paste. We will see how your other predictions play out.

2008 Dec 26 10:29 AM

[Gumby]

Carmakers will boost CAFE on new cars toward 35 mpg. Europe wll push even higher . The demand on oil will keep falling. This year's small drop can be tracked to so many SUVs and PickUps still in working conditoin and rolling on the road.. Many SUVs and PickUps plants are shuttered for good. There wll be return to sam old ways of guzzling gas. Major oil companies had been enhancing and extending existing depleting oil reserves with horiziontal drilling and other technologies used to gain access even to previously depleted oil reserves . There is talk of depleted oil reserves that are not actually depleted but still contain as much as two thirds left but in need of enhancement technologies that we had been using for past couple decades.. The only problem is tha we cannot pump faster than previously. The oil reserves are still there but slowly accessilbe. This is the reason we must start conserve oil with far more fuel efficient cars that delvier 35 mpg or better.There is still plenty of oiil reserves but it takes more cooking to get done ...

2008 Dec 26 10:34 AM

[Gumby]

Also, there is no reason to heat/cool your entire 3000-6000 sq ft homes as HVAC technology will evolve into more intelligient delivery meaning that only rooms occupied will be heated or cooled . Often most part of homes are unoccupied by residents and will be reduced in heating and cooling.. What it will mean is that we wont need 2-5 ton AC system or 120,000 BTU gas furnaces... We will be suing much smaller ones that will deliver heat/ cool to wherever residents are in their homes.. The ductworks will be more intelligient with air flow control diverters. Thermostats will be in every room and able to sense presence.

2008 Dec 26 10:39 AM

[Gumby]

I have a simple solar concept that will eliminate most of my heating bills during winter . I am not marketing it yet.

2008 Dec 26 10:40 AM

[scammy]

He's dead WRONG on gasoline consumption here in the USA, I've been tracking the numbers because I've made a ton of money shorting oil and gas.. Gasoline consumption has DROPPED millions of bbls. EACH WEEK since November, each week is worse and worse than the one before, you add them up and since gasoline is 40% of the use of each bbl. of oil, it FAR outweighs ANY cuts OPECker can or have made.. Thats JUST the gasoline decrease in the USA, that DOESN'T include the REST OF THE WORLD..LOL..!!!! Oil is toast for years..

2008 Dec 26 10:50 AM

[GMiki1]

True on oil, but why a bear call on coal as a short term trade and not a short term bear call on palladium? And I do hold platinum and palladium stocks. The coal stocks move with the rest of the energy complex. If Pakistan and India go to war--God forbid--but if they do--something will be affected and it's probably energy and precious metals. See Jim Sinclair and today's headlines on troop movements within India.

2008 Dec 26 11:03 AM

[NOWHEREMAN]

Have new steel technologies emerged in the last year which do not involve Coal? If so, I would love to know what they are.

Otherwise, Obama's infrastruction stimulus plan is not viable without coal. IMO

2008 Dec 26 11:21 AM

[scotty1560]

Tend to think people will procrastinate on medical and dental visits during
a downturn... these are luxuries for the working class...ask your dentist.

Like a lot of the authors opinions though.

My thinking on oil consumption is similar to alcoholic's addiction. If an alcoholic has a bottle of wine or beer sitting around a house, then there is a good chance they will eventually have to have it. So, if gas prices stay down as they are, then I expect most will take the bait and increase driving- they may avoid vacations, but they will drive more miles. I myself think less about filling the tank than six months ago. So while gas/oil used in industries like construction may stay down, I see drivers going back to old habits at these prices, myself included. Oil prices should sneak up towards Memorial Day.
OPEC and oil is the champ...never count out the champ. A little action from
Russia, maybe a little terrorism threat, maybe a hurricane. Thinks seem
awfully calm at the moment.

The big question is inflation..deflation..... My vote is stagflation via years of flat real economic and asset growth but inflationary cost of living growth effecting human's core needs: fresh water, "real" food, energy. More people will rent and owners will put off home improvements, so Home Depot and real estate related services are probably dead for years.

How about bringing in Bill Parcell's for bringing in real vehicles of growth?
For 10+ years "our" football team has had nothing but gimmick's from the coaches: Al Greenspan's low rates, tax codes to favor second homes and home purchases, de-regulation leading to gimmick after gimmick from the lending and financial worlds, hedge funds, swaps....every trick in the coach's playbook. Now that the playbook is exposed the coach looks at his team and says: we stink. No resources, no manufacturing, or true engines of growth on this team....better get Parcell's, he can turn it around.

2008 Dec 26 11:55 AM

[long_on_oil]

Low gas prices will bring the country out of its funk just as high gas prices put us into the funk. More money in consumers pockets, no matter how it gets there is good for the economy, that is the simple bottom line.

2008 Dec 26 12:13 PM

[woodsey]

When assessing demand for non-essentials such things as addictions (e.g. caffeine and salt) should be considered.

2008 Dec 26 12:18 PM

[Jake2]

As usual Trader Mark is shooting from the hip. He thinks he has all of the answers but unfortunately he is not even asking the right questions. Hey, Mark: the poles are melting, the poles are melting! Wake up! There is no reason for anyone to read one word of this post. Reader, pass by!

2008 Dec 26 12:36 PM