Will Oil Be the Last Asset Standing?

Stocks and commodities gained last week while the dollar – as is often the case these days – fell.

As you recall from last week's update, the correlation between these three assets has unusually close. The see-saw today has stocks and commodities on one side and the dollar on the other.

Investors must ask themselves how long this party can continue, and which of these assets they should be left holding when it ends.

To be perfectly honest, when the party ends it will probably end for all three assets, with stocks, commodities, and the dollar all losing value. However, while all three will go down, only some will be down for the count...

THE RESILIENCE OF OIL

Leaving aside the dollar for the moment, let's focus on stocks and one key commodity, oil.

Our feeling is that oil prices have greater staying power over the long-term than stock prices. Unless you just walked in the door, you won't be surprised to hear us say that. But let's look at two of our most important reasons.

Right now, increased demand for oil stems from the part of the world where economic growth is highest – the emerging economies and especially China.

(Recently someone argued that Chinese growth is not really sustainable because the Chinese consumer accounts for only a small part of China's economy. We disagree that this situation constrains the economy. Chinese consumers are starting to step up their purchasing. We've seen a huge jump in Chinese auto sales for instance, to the level where they surpassed the car sales in the U.S. And retail figures suggest that the Chinese consumer is becoming more of a leader than a follower.)

Overall, Chinese industrialization, infrastructure building, and the rise of its consumer should prevent any collapse in oil demand.

On the other side of the equation, oil production is unlikely to overtake demand unless oil prices rise dramatically. Right now, producers need a minimum oil price of $70 a barrel to justify investing in new production.

And a temporary spike above $70 (like we have now) won't cut it. If anything, producers need to feel confident that $70 will be the bottom of oil's price range for the foreseeable future.

Given oil's huge spike and subsequent plunge in 2008, oil will need to get a lot more expensive and stay expensive for quite a while before producers get brave enough to start bringing new supplies online.

If oil prices fall back to under $70, oil supplies will remain at a level where they cannot keep up with even lackluster economic growth. Eventually, the world would not have enough oil available to increase production of other commodities or manufactured goods. With a fixed or even declining oil supply, Americans and other Westerners would have to consume less – gallon per gallon – in order for China and the emerging world to consume more.

And that's not a scenario anyone wants to see (especially since the developing world would win the contest).

Bottom line: we need oil prices to remain above $70 to sustain any growth whatsoever.

Meanwhile, U.S. consumers have problems of their own. They have sustained a serious blow, in the form of a $13 trillion drop in their collective net worth, which has them focused on saving more and spending less for the first time in decades. Under these conditions, higher commodity prices will act as a tax, giving consumers even more reason to stop spending. Eventually, it will hold back U.S. economic growth too.

How high can oil prices go before they start to impact economic growth? Actually, it's a question of both price and time. If oil prices remain in the mid-$70s between now and the end of December 2009, that would do it. It would mean we had a year-over-year increase of more than 80% - the level at which our Long Term Master Key would issue a “sell” signal on the overall stock market.

We are betting that oil (and commodities in general) will have more staying power as this scenario unfolds than stocks. Oil is in a cyclical uptrend whereas stocks are trapped in a trading range. However, you should know that both groups will decline in the short-term if that signal is reached.

By now, you may be wondering, “What do we do in the meantime?”...

FOLLOWING THE IRRATIONAL HERD

All we can say for now is that today's market is irrational to be following a path in which both stocks and commodities rise together. It's also irrational to see the most speculative, high risk stocks such as AIG or Fannie Mae accounting for the lion's share of market volume. Yet this has been the case on many recent trading days.

However, markets can stay irrational for some time. All we can expect, while we're waiting for the correction, is that the market leaders will continue to lead. Despite the incredible risks in today's economy the “high beta” (high risk) stocks may continue to outperform.

So if you are impatient and want to make some gains while waiting for the music to stop here's what to do...

First, hold on to gold and zero coupon bonds as a hedge for when the correction comes. Same with the conservative defensive/offensive stocks we mentioned last week.

With that protection in place, and only to the extent of your risk tolerance, you can pursue gains among our high beta choices. Our recommendations here are long-term keepers. Even though they could come down hard in a correction, they are also likely to lead the market in the meantime. They include:

1. Potash (POT) and Mosaic (MOS), the world's two leading fertilizer producers.
2. Fluor (FLR), the world's leading engineering and construction company, which will benefit from any drive to raise energy supplies.
3. Intel (INTC) and Apple (AAPL) as Information Technology plays.
4. Oil service companies, such as Transocean (RIG), Nabors (NBR), Schlumberger (SLB), and National Oilwell Varco (NOV).

While these stocks will surely decline when the overall market tanks, they are still good stocks to own for the long haul, as they are set to dramatically outperform the market that’s destined to be erratic in the foreseeable future. And with our recommended hedges in place, you should get through the decline, when it comes, in much better than average shape.

Disclosure: Leeb Group, its officers, directors, shareholders, employees and affiliated entities and/or clients of such affiliated entities may currently maintain direct or indirect ownership positions in financial instruments (i.e., stocks, bonds, options, warrants, etc.) of companies or entities whose underlying exposure is in the companies mentioned in this article.

Comments

[kmi:]

Yank -

As a user I can tell you in no uncertain terms that oil at $100+ not only destroyed my ability to reinvest into the economy - till precisely this summer - I can also tell you that I myself as well as many of my acquaintances are following precisely the path I describe above.

You can look at your charts and assume that 'growth' continued through $100 barrel oil but my perception of the real economy paints a completely different picture.

Btw I will highlight just for the sake of argument the most recent example of energy diversification taking place - NYC's Empire State Building is now undergoing a complete energy rehab which will put it - can't remember either at 40% of it's energy use or reduce it's energy use by 40%. This is not an anomaly, this is the new normal.

Oil at $147 was an anomaly - created by geopolitics (Iran nuclear reactor, Nigeria, etc), weather (hurricanes), earthquakes (in China), and yes, a rapidly growing emerging world too. I'm not saying we couldn't face 147 again, what I'm saying is that people need to check their numbers, since CARS, new NG capacity, a weak global economy, energy diversification, the list goes on and on... going to chip away at the ability of oil to continue its recent (let's say 10 year) run.

And just for argument's sake, I remember reading we surpassed the inflation adjusted maximum oil price when we hit 100/barrel, if I remember correctly, making 147 the highest inflation adjusted number ever.

Aug 25 12:01 PM

[Dr. Stephen...:]

Kimi, I think you have to realize that alternative energies are not free - they require energy to realize. For example, wind requires steel, which requires iron ore, which, of course, requires energy. Understanding the interrelationships among commodities is no easy task and one that is utterly critical and unfortunately one to which we are paying no attention. Energy conservation is still another example of something that cannot be isolatated. Consider that the more successful we are at conservation, the less oil costs of oil, etc. relative to what it would have been without conservation, and hence the greater the demand. You are right that China is consuming less energy per unit growth but that is a characteristic of every economy as it develops. Just one factoid to consider, however, is that China is now the largest car market on the planet. Another is the number of people with under $2 a day to live on - over 2 billion. Finding the path to grow in a this commodity constrained world, whille perhaps not impossible, is going to be very difficult and require a lot more than replacing energy inefficient lights, etc.

Aug 25 12:45 PM

[toobad41:]

People generally don't know why oil should be in the $70 per barrel range. Let me explain why oil should be $70 and as an independent oil operator. Drilling a well 4,800 feet, running casing and putting it on production (assuming it is not a dry hole) costs me about $1,000,000. Let's say the well is pretty good and produces at a daily rate of 250 barrels per day. And it continues to produce for 60 days at that rate. Conventional thinking is you just multiply $70 x 60 days x 250 barrels and you get $1,050,000. Thus you have $50,000 profit, right. Wrong. You forgot to deduct royalties(as much as 25%!), lease operating costs, employee salaries, production taxes, general and adminstrative costs, transportation costs, tangible and intangible costs, rentals of equipment, etc. The list is very long and the amount of time needed to payout the $1,000,000 well usually runs into 2 to 3 years. Not only that the well is declining in production and may only be making a few barrels a day after 3 years. Lease operating costs can run as much as $3000 a month. So now you have a well that produces say 2 barrels per day and you get $70 (again assuming it stays at $70) that would be $140 per day or $4200 per month. But you have to deduct the $3000 lease operating expense and you are left with $1200. But that is not correct either because 25% royalty is taken off the top. You are left with $52.50 not $70. So $52.50 x 2 barrels x 30 days is now $3,150 not $4200. So you are left with $150 to pay employees, pay taxes, transportation costs, etc. Now do you see where this is going? The well is no longer profitable. Maybe I should spend $250,000 to re-stimulate the well to get production back up to 35 barrels per day. The killer, of course, is the overhead expenses that eat you alive. In order to be in the oil business you have to have a lot of production and a lot of nerve to stay afloat. And you have to have oil above $70 per barrel to make it worth the trouble of getting it out of the ground and into the market.

Aug 25 01:13 PM

[kmi:]

Thank you for taking the time to respond Dr. Leeb;

The point I am mostly attempting to get across is that 147/barrel is more anomaly and aberration than a rational price, and that its mere existence has caused a far more accelerated diversification away from oil than the charts and graphs traders are looking at. Am I the only one who remembers watching every single bullish phenomenon the world has to offer driving oil prices? Earthquakes, geopolitics, hurricanes, wars...

The result of current real world activity will be not a rapid return to $100+ but more likely a return to a more normal trading range.

The value therefore lies in the companies who will benefit from the FUD people are creating around oil. For example I like certain NG based utilities since I can see them profiting from locked in prices with a weak underlying commodity.

So if someone is trying to game how to play the approaching market I would suggest similar strategies, as you do - in the later half of your article.

BTW - The current administration offers 30% - that's a FLAT 30% - of costs to install geothermal HVAC (which trend to reduce energy costs up to 60%). In the real economy, we aren't talking about energy efficient lightbulbs, we are talking about real reductions in actual energy consumption. (See also initiatives such as CARS and gov't investments in domestic companies promoting renewables).

And as for China... they are bringing in new coal fired plants for energy and pushing EVs far harder (they can being a centralized state) than the US can (see BYD). They -were- burning diesel for energy. They still might, but not as much. I haven't heard a word about bombing Iran in a while, and Iraq expects to increase production - if they can secure contracts...

I just don't get why people keep crying oil at $150 it just doesn't make any sense.

Aug 25 01:33 PM

[kmi:]

Doh didn't see your post toobad41 -

Great comment but I should point out that if you want to sell me oil at $100/barrel don't be surprised if I am installing renewables and alternatives relatively rapidly...

No offense but frankly I can't make a business case for paying that much for oil for any protracted period of time.

Aug 25 01:48 PM

[The Greates...:]

Letter from a refinery worker.
I am a 22-year refinery worker. I have seen a lot of changes over
the years in unit production. Make no mistake about it folks
they are in the business of making money. Just 6 years ago they were profiting 40 billion a quarter on us. Now the oil CEO’s have put wage a wage and hire freeze on the 4 major plants where i live and work at. These oil giants are getting the message we are sending out, we just simply wont buy at a high price.
The government needs to open the patent office take back the patents that the Oil Company owns for the cars that get 100 mpg.
Then Americans would buy them, jobs would come back to the manufacturer, the banks would make money on the loans and people wont mind paying over 2 or 3 bucks a gallon.
It still costs refiner’s on average about 20 to 30 cents per gallon
to produce gas, oh and buy the way diesel fuel is a by product from making gas, yes a waste product so why is that so expensive?
Just a few thing to think about from the inside.
Thanks and best of luck to all, because we need it

Aug 25 02:31 PM

[The Greates...:]

Did you ever notice that when oil goes up, gas jumps immediately, but when it comes down, it goes down slowly. That was brought up here awhile back so I asked the guy taking my money for the gas I just bought. He told me that his supplier, made him raise it, if he did not do it right then, he would not be getting any more gas delivered.
Here are a few fun facts:
By 2008, a barrel of oil was traded 27 times, on average, before it was actually delivered and consumed.
To see how your Representative is doing in relation to Oil and gas lobbyist in 2009, go to
www.opensecrets.org/in...

Aug 25 02:32 PM

[The Greates...:]

Just a little FYI:
The last 20 years have been characterized by rising U.S. oil consumption, but now
"www.eia.doe.gov/oiaf/a..."
the U.S. Energy Information Agency, incorporating the most-recent changes in U.S. consumer behavior, says there will be no appreciable growth in U.S. oil consumption between now and 2030, with biofuels accounting for all of the growth in liquid fuels.

Aug 25 02:33 PM

[The Greates...:]

Oil in our government:
Combined with its $6.8 million outlay in the first quarter, Chevron spent about $12.8 million on lobbying in the first half of 2009, the fourth-highest tab for companies and organizations that file disclosure reports, according to data from the Center for Responsive Politics.
Chevron, the second-largest U.S. oil company behind Exxon Mobil Corp., spent $3.2 million on lobbying in the second quarter of 2008.
In the most-recent period, Chevron lobbied on a variety of issues, including legislation dealing with market speculation and manipulation and Federal Trade Commission rulemaking. It also weighed in on environmental matters and industry-specific issues such as hydraulic fracturing, according to the disclosure form filed July 17 with the House clerk's office.
Besides Congress, Chevron lobbied the departments of Energy, State, Commerce, Treasury as well as the Environmental Protection Agency and the Executive Office of the President.
Among those lobbying for Chevron were Lisa Barry, the former principal deputy assistant secretary at the Commerce Department, and Judy Blanchard, former deputy staff director for the House Committee on Oversight and Government Reform.
www.opensecrets.org/
Congress needs term limits.

Aug 25 02:35 PM

[The Greates...:]

Some families in America are placing school supplies on lay-away.

Aug 25 03:04 PM

[Donald Ingram:]

Canada is the major oil supplier to the USA. A good portion of that oil comes from the oil sands, where costs of production are $50 - $60 per barrel. Now that leaves a pretty thin margin. The amount of oil reserves contained in the oil sands is prodigious. If the US continues it's energy use at present levels of consumption then oil prices will remain above $70 per bbl. Actually when you factor in demand (which is escalating) from the rest of the world, you begin to see oil above $100 per bbl in the near future, as the USD continues it's slide in purchasing power.

Aug 25 03:51 PM

[aja8888:]

My next door neighbor just came home with a new GMC Yukon SUV (15 MPG). He traded a Ford Expedition on it which got 12 MPG. He feels good. I drive a VW diesel and get 40 MPG. I am in the oil business. He works for a bank.

Well, there is a lot of bellowing going on now about what happens if oil goes to 150/bbl or higher. Wait until you see and hear the bellowing when significant quantities of oil are "not available" to refine in the U.S. due to the Vens, Iranians, Russians, Nigerians, Saudies, Iraqies, etc selling it for higher prices than what our refiners will pay for in the U.S.

Oh, by the way, they are "Big Oil" these days (not Exxon, Shell, etc). We import crude from Mexico at the rate of about 1.4 MM bbl/day. That is drying up with the rapid decline in the Cantrell Oil Field, the largest field in Mexico. They have no replacement source. Good thing for Canada to have the oil sands and other crude sources.

Friends, the U.S. can easily be held hostage for crude pricing once the world economy picks up. Ethanol, bio-diesel, etc requires energy to make it and we cannot make enough of it to matter.

My clients (producers in Texas, etc) cannot make money on $70 or less per barrel. See the post a few above, his is the true story on costs.

The only resource that will help the energy situation here in the U.S. is our abundant supply of natural gas from shale reserves and additional vertical drilling. But our folks in Washington have no plan for it, which doesn't surprise me.

Aug 25 04:40 PM

[The Greates...:]

The last 20 years have been characterized by rising U.S. oil consumption, but now
"www.eia.doe.gov/oiaf/a..."
the U.S. Energy Information Agency, incorporating the most-recent changes in U.S. consumer behavior, says there will be no appreciable growth in U.S. oil consumption between now and 2030, with biofuels accounting for all of the growth in liquid fuels.

Aug 25 05:09 PM

[The Greates...:]

Oil and the Seduction of the World
Lets try this from a different angle, if I have something that everyone in the world wants I am in a good position no doubt. Now lets start at the beginning, say around 1999, and close 26 refineries between 1999 and 2001 on the West Coast alone. At that time frame crude was relatively dirt-cheap, now lets do some merging over the next 5-6 years in which we end up with 5 major oil firms. Even today, oil is pumped out of the ground in Saudi Arabia for around .25 a barrel, so it was real cheap in 1999. Then in 1999-2001 Phil Graham re-writes the futures commodity legislation and opened the door for hedge funds and future buying in the speculated market in energy. Which led to the Enron mess, the Prime-Lending disaster, also traders do not answer to anyone here in the US and purchase fees are cheap enough that the can purchase large shares in the crude oil market with out any intention of using the oil, just sit on the contract until the three month period is up and then sell at a profit if possible. No one can deny the huge net profits of these companies over the last 6 years or the balance sheet they are caring today. Not to mention the fact that all 5 of the major oil companies are currently buying their stocks back at record levels today. It is reminisce of the Hunt brothers and the cornering of the silver market, ah, but they got caught. Energy companies are currently giving millions to the lobbyist in Congress right now to kill green energy programs. And they are giving so much that they will spend millions more this year then last year. (opensecrets.com)
A de-facto tax cut for American motorists. Each $1 per barrel drop in oil increases U.S. GDP by $100 billion per year and every 1 cent decline in gasoline increases U.S. consumer disposable income by $600 million per year.

Aug 25 05:12 PM

[whidbey:]

The Administration fears oil prices since it it rises for any reason over any period of time, the economy is hurt in ways you can not imagine.

This means the administration will quickly ration oil and gasoline and the right to drive. It is obvious they can not manage supply so use will get managed.

Aug 25 05:14 PM

[long_on_oil:]

We all love cheap oil and the cheap gasoline that goes with it but lets face it every person on the earth uses so much energy per year. As the population increases so does oil consumption. The increase in population does not care about recession or prosperity so oil consumption keeps increaseing irregardless of the economic times.
Now we cut production due to low oil prices and we all know what that leads to.
Balancing oil prices to world demand is like an elephant walking a tight rope. We can blame speculators for high prices but blame will not produce one single barrel of oil.
If we produce 85 million barrels a day and the demand is 86 million then who gets left out? This is what the future looks like a supply demand disparity that is only resolved by high prices.
Not drilling and increaseing oil supplies is not going to stop the population explosion and the future demand.

Aug 25 06:55 PM

[mna:]

Thanks for the great article. I agree with most of the points, except the following:
----------
It's also irrational to see the most speculative, high risk stocks such as AIG or Fannie Mae accounting for the lion's share of market volume.
---------
I've always advised friends and colleagues since October of last year that the innate value of these assets were being unfairly punished, and that liquidity concerns, rather than long term concerns have pushed the stocks to far below what they were worth. When liquidity returns to the market, provided that they didn't have to issue vast amounts of stock in the meantime, these stocks would eventually return to more normal valuations. That's what's been driving the "high beta" stocks. Remember, most of the high beta stocks was, and still are, punished by the market for liquidity issues. Since then, the market has moved on from liquidity to short term profitability issues. In any case, if you have a longer term outlook, these are of no consequence.
Otherwise, as far as oil is concerned, I agree with the long term demand picture for oil. I just recently read some columns that basically predicted the death of the Canterrell oil field by end of next year. This is huge, and I wonder why it didn't make more of a splash on the oil scene. 600k bbl/day is pretty a significant cut, especially since it's pretty much permanent without replacement sources.

Aug 25 07:55 PM

[schoolchildren:]

Wow, interesting comment on AIG, etc. I admittedly have been exceeding doubtful about the move in the stocks. You have not changed my mind but have reminded me that there are always two sides to the story and it never pays to get too wedded to any position. Many thanks

Aug 25 10:21 PM

[sethmcs:]

The lastest oil spike has nothing to do with China (last I checked China runs on coal) or cost of production or demand. Its manipulation caused by such few firms controlling a large market. Where do you thing the price oil would be if the government decided to break up the big oil companies on antitrust grounds or even theatened to? What if the government encouraged oil companies through tax code to avoid the spot market and buy long-term contracts? Where would the price of oil be? What if speculative positions had to front 100% of the purchase price of oil contracts up front where would oil prices be? What if banks GS C MS et al where prohibited from trading commodities where would the price of oil be? My conclusion is just like health care and higher education there are structural problems in the oil market preventing market forces from finding the true price of a barrel of oil which should be between $30.00 and $40.00 a barrel.

Aug 25 11:51 PM

[Chancer:]

Question for Mr. Leeb or anyone else:

Where can I find a list of mutual funds (for IRA) that focus on investments in oil services, like RIG and NBR.

The only one I found so far is FSESX.

Do you know of others or better performing funds?

Aug 26 02:15 PM