The market's pullback this week was a thing of beauty, and only increases our confidence that the bull market in commodities is alive and well. Bull markets in commodities and equities always have violent pullbacks on the way up. These corrections allow investors to add to positions or start new ones in equities they've been researching and monitoring. It also shakes out the weak hands in the market, which pays dividends later on when they rush back in. The bull market for commodities is intact. Don't let anyone tell you otherwise. In this report we will evaluate the reasons why we believe this and why oil equities will be showing huge returns to investors in the coming years.
Bull Market Within A Bear Market
The main indices in the United States have been in a secular bear market since the turn of the century (we are currently in a secondary bull market within this secular bear market). At Pinnacle we believe more of an investor's portfolio should be allocated to commodity and precious metal based equities over the coming years. Our two reasons for this are to avoid the bearish secular trend in stocks (longer-term trend) and to protect oneself against inflation and the riskiest asset out there - the U.S. dollar. Although the last two years have felt like a massive bull market, keep in mind, the markets are still way down from their inflation adjusted high of 2000. Much of the gains have come at the behest of rising inflation and a falling U.S. currency.
Stocks have performed terribly over the past decade and are clearly in a secular bear market. This is good news for commodity investors as commodities have historically outperformed stocks during secular bear markets (just look at the performance of all major commodities in comparison to the S&P over the last 24 months). Although the markets have been rallying over the past 24 months, this is a classic cyclical move within a secular bear market. A pullback in the major U.S. markets is coming and investors need to be exposed to commodity and inflation protected assets.
Here is an inflation adjusted chart of the DJIA. The first red peak was in early 2000 in the midst of the tech boom. The red line extends to early March 2011 and as you can see, it hasn't come close to its inflation adjusted highs of 2000.
(Click to enlarge)
The point of the above chart is to highlight the fact that the bull market for stocks ended in 2000. Secular bear markets last between 5 and 25 years with most averaging between 15 and 20 years in length. Secular bear markets, by definition, consist of smaller bull markets and of course, larger bear markets. If a secular bear market for stocks began in 2000, history would suggest we have another 5 to 10 years to work through this bear market (before a true bull market emerges for stocks). This makes clear sense when you consider the global debt load and restructuring that will have to occur before the US can actually enter a period of sustained, real economic growth.
The Federal Reserve's undying will to create inflation and devalue the U.S. Dollar has fuelled the commodity boom to this point. The Fed's ability to keep interest rates low is the only thing holding back a run on the U.S. dollar and an explosion in all commodity prices. We are already seeing record highs, but what lies ahead for commodity related equities could truly be a once in a lifetime investment environment.
Again, there are only two things that can happen. Foreign central banks can demand higher interest on U.S. Treasury bonds, which they've already begun doing, thus driving up interest rates and forcing the Fed to ramp up the printing press; or secondly, foreign central banks simply stop buying U.S. Treasury bonds at the auctions and the Fed has to step up and start buying even more than it already has! This again results in more money printing, more inflation and record high commodity prices.
The Hedge: Black Gold
Oil is one of the main commodities to own when protecting oneself against inflation. It impacts our daily life more than any other commodity. It is our strong belief that commodities (and related equities) will provide the greatest gains over the next 5 years. So why not own the king of all commodities and one of the most direct hedges against a falling U.S. dollar?
Our angle on oil is simple. We are focusing on domestic (North American) oil producers at the start of their growth curve. Speculation is our game, but we have no interest in speculating on foreign (particularly middle east) oil plays. There are just way too many variables with foreign oil plays and because of this, domestic plays will receive favourable valuations for their politically safe component.
We are looking for junior oil producers with attractive land positions, pipeline infrastructure in place and cost efficient, expandable resources. Domestic oil producers, specifically in Canada, have our long-term interest.
Looking back at our predictions: Below is an excerpt taken from a Weekly Volume in early October, 2010:
"The Fed and the US government have one and only one way out of debt. Inflation. Bernanke and the Fed will fight off deflation like the plague because if prices are allowed to drop, all debt, public and private, have no chance of ever being paid off. This is what you need to know. Inflation is coming.
Our team at Pinnacle is playing this trade with commodities and more specifically, with companies producing commodities. If gold goes to $2000, investors aren't going to buy physical gold, they will buy $2 gold companies until those companies are worth $4 or $8 or $12 dollars per share. We use gold as an example because we are all very familiar with it and likely own it either directly or indirectly. With that stated, gold is just one commodity. While it's an important one to own in times of inflation, it's just as important you don't get tunnel vision and miss other homeruns.
All commodities have exploded in the past month and many are close to multi-year highs. This trend is going to continue as the world's reserve currency continues to be devalued and nations from around the world buy commodities. Oil is going back above $100 ... Way above."
Our prediction in October is playing out as if it were scripted and domestic oil companies are getting set to profit immensely from oil's recent rally. Just like gold, oil is an inflation play. You are betting the U.S. dollar is going to continue its slide by investing in oil and oil based companies. The beauty of oil companies with proven reserves is that as the value of the U.S. dollar plummets, the value of these reserves go up.
As tensions in foreign oil producing countries increase, the emphasis on domestic oil production will rise dramatically. It's not rocket science. How long will the U.S. be able to import oil from countries in the Middle East and Northern Africa? Eventually these violent countries, with no regard for human rights, will be forced into economic exile for their actions.
The World's Top 10 Oil Reserves (by country)
- Saudi Arabia
- Canada
- Iran
- Iraq
- Kuwait
- United Arab Emirates
- Venezuela
- Russia
- Libya
- Nigeria
Which of those countries would you trust to consistently provide you with energy?
The U.S. will continue to import more than 50% of its oil from Canada because it can trust Canada as a secure source. Other countries around the world will look to Canada to provide a stable source of oil as well. China, the world's largest energy consumer, is leading the pack to Canada's oil reserves. It is simply because most of the other countries, on the top 10 list above, immediately bring visions of violence, corruption, civil unrest and risk. This is why our next Featured Company operates in the low risk, politically stable region of Canada (and a new up and coming oil and gas region within the country).
Inflation aside, there are global demand forces at work that will impact the price of oil long after the US inflation crisis comes and goes. As living standards in emerging economies increase, the amount of oil consumption will grow in tandem. We have all heard different stories about how the emerging markets will impact the price and demand of oil. We urge you to really think about the implications of the below facts and projections.
Fact: For the first time ever in 2009, emerging markets purchased more automobiles than developed nations.
Fact: In 2010 the world consumed 86.7 million barrels of oil. This is an all time record. Oil demand and consumption reaches record levels in 2010.
The U.S. Energy Information Administration has estimated that worldwide consumption of oil is to increase to 125 million barrels per day by 2040.
Of the 86.7 million barrels of oil consumed (annually), the U.S. consumed more than 21 million of them. China consumed just over 10 million barrels in 2010 and is expected to be consuming 25 million barrels of oil per day by the year 2040. That is a 150% jump from their current consumption!
Fact: The medium price of finding a new barrel of oil has increased to roughly $70 per barrel.
Isn't it realistic to assume this cost will go up as oil reserves become more difficult to find and harder to tap?
Fact: China's 5 year economic plan includes a 33% increase in energy consumption.
The bottom line is that there simply isn't enough oil to go around without a significant increase in its value. Much like gold, there is an insufficient supply. However, unlike gold, oil is immediately used up and gone forever. Worldwide oil supply shrinks by the day. We are not fanatics at Pinnacle who think no new oil fields will be discovered and that we will be out of oil in 10 years. We will never fall into that group. However, the world is getting comfortable with $90 plus oil. There are too many people around the world clamouring and fighting over oil for its price to take a significant (and sustained) hit. Oil is being viewed more as a luxury nowadays.
Oil is an inflation trade, but also a no brainer, fundamental trade. To not have exposure to the most valuable and widely used energy source in the world, amidst a period of massive expansion from emerging markets (3 billion people), is foolish. Our team recognizes this and hopes you do to.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
