Expensive Commodities and the Stock Market

On the first day of the second half of a thus-far difficult 2008 – and the second half is supposed to be the stronger half – we sat down with Director of Zacks Equity Research Dirk van Dijk, CFA for his take on what can be expected in the days, weeks and months ahead.

What is your latest thinking on the astronomical prices of oil these days?

There is a debate raging over the cause of the rise in oil prices: is it due to fundamentals or speculation, or due to a combination of both, and what is the relative importance of each? I come down squarely on the side of fundamentals being the predominant cause, although the sharp day-to-day moves clearly show that there is some speculation involved.

While it is true that the volume of oil futures contracts swamps the amount of physical oil, the fact remains that at the end of each month, the futures are settled and someone gets the physical commodity. If the price of the futures were way out of line with the fundamental price of the physical commodity that day before the futures expired, there would be a huge arbitrage opportunity.

For speculation to really drive the price of a commodity over the intermediate to long term, there has to be some evidence of hoarding of the actual physical commodity. Aside from some indications that the Chinese have been building up their stockpiles both ahead of the Olympics and as well as a result of the earthquake, there is little evidence of hoarding of the physical commodity. In the U.S. oil inventories are below historical averages for this time of year.

Are all speculators long?

One must keep in mind some very real differences between the commodity markets and the stock market. One could easily have a stock market where short selling was not allowed. Indeed, there is many a CEO and long investor who might prefer it that way. In the stock market, short sellers do provide a useful function, though not one essential to the running of the market, with the possible exception of shorting by the floor specialists. Futures markets are different, and short sellers are needed every bit as much as are long investors. Indeed, for every contract of every futures market, there will be, by definition, exactly as many short positions as there are long positions.

Theoretically, one could have a futures market where there were no speculators, just people with legitimate needs to hedge. The classic textbook example would be the farmer who wants to know with certainty what price his corn will bring after harvest would sell futures (i.e. short the market) for the amount of corn he expected to grow that year.

At the same time, the soft drink maker might want to know with certainty how much its corn syrup was going to cost at the same time and would buy those futures from the farmer (go long). That might be a fairly illiquid market, so speculators step in to provide liquidity. Speculators can just as easily be net short as they can be net long.

In your view, what do you think needs to happen?

While I don’t think that speculation is a primary cause of the rise in oil prices, I am in favor of greater transparency in trading. Large amounts of speculation can cause day-to-day volatility, but without hoarding it is unlikely to have an impact that lasts more than a day or two. A great deal (approximately 30%) of trading in oil futures is done offshore where players do not have to reveal the size of their positions.

Requiring U.S. investors to report their total positions, not just the ones in U.S.-based markets, would be useful, but I doubt it would make a significant impact on the price of oil. As things stand now, the CFTC cannot, by law, track or regulate electronic trading of energy futures.

Raising the margin requirements would be useful in reducing leverage in the system. While unlikely to significantly change the price of oil (since it would have to apply to both long and short positions), we have seen what excessive leverage has done to the mortgage market. We don’t need a repeat in the commodity markets.

While the rise in the price of oil has been getting most of the attention, oil is far from the only commodity to have soared in value over the last several years. Of the 27 largest commodity markets, all are up over the last five years, 20 of them by more than 100%, and 8 by more than 200%.

So could it be that the speculators are doing this on all the commodity futures markets at once? That doesn’t seem likely, and would still not explain why commodities which are not traded on futures markets are seeing similar price increases. The prices of both iron ore and coal have both roughly doubled over the last year, and those are sold via bilateral deals, with no futures contracts available for them.

Which industries look strongest to you in the current environment?

Even if oil prices remain stable or decline slightly from current levels, oil service firms and drillers like Transocean (RIG), Diamond Offshore (DO) and National Oilwell Varco (NOV) should have strong earnings growth baked in the cake through 2008. Cash flows at the oil companies (the clients of the industry) will remain strong. It will still be very worthwhile to explore for and develop oil fields, resulting in strong demand for the group.

Then we have aerospace and defense. On the Commercial side, the weaker dollar makes Boeing (BA) more competitive and that aids all the firms that supply it. The order book is bulging as the airline industry expands in emerging markets.

On the Defense side demand is driven by the need to rebuild an arsenal worn out by the wars in Iraq and Afghanistan. A slowdown by the consumer is not going to have any effect on demand. Recently the entire fleet of F-15’s had to be grounded due to structural problems and it is hard to see how the country can put off replacing them indefinitely, regardless of who wins the White House. We are still bullish on Lockheed Martin (LMT) and General Dynamics (GD).

Finally, due to the twin looming problems of global warming and the potential of peak oil occurring within a few years, there is going to be a scramble to find clean renewable sources of energy. Within the group we favor the solar and wind oriented firms, over the ethanol producers since the ethanol firms face a headwind from higher feedstock costs. Our top Buys in this space are Energy Conversion Devices (ENER), Evergreen Solar (ESLR) and First Solar (FSLR).

Dirk van Dijk, CFA is the Director of Zacks Equity Research.

Comments

[DamonRich:]

It makes no sense why Boeing (BA) is beaten down to the mid 60's. They have over $350 billion in back orders to last them well into 2010-11.

2008 Jul 01 09:38 AM

[buyforeclos...:]

ener? nice call....lofl! probably goes to 50 or less

2008 Jul 01 01:10 PM

[Stockguy456:]

Wind, Solar and Fuel Cells.

2008 Jul 01 06:28 PM

[Walt17:]

Companies with long lead time contracts (such as BA) are going to be hurt by rising commodity prices. Their cost goes up, but their price is fixed. Just a thought.

2008 Jul 02 08:29 AM

[richjoy:]

Seems like a useful article to me...the only investment I here I'm not participating in is defense--my assumption being that in a few months (February) BO will stop all wars, bringing a new era of peace to the world (consequently no need for new weapons). The idea we may have to replace weapons used in Iraq and Afghanistan is interesting, but would be short term.

If OTOH, BM does not stop all wars...

2008 Jul 02 09:49 AM

[richjoy:]

Sorry, that was an honest mistake...

If OTOH, BO does not stop all wars...

2008 Jul 02 10:04 AM

[dsrtwriter:]

Sure, BO will probably underfund rebuilding the military in favor of more school lunch type programs. Meanwhile the Chinese build the world's largest navy,the N.Koreans public relations team does "we blew up our nuclear plant" stunts, and Iran recently asks the Japanese to "imagine a world without the United States". S'all good, brotha Barack.

2008 Jul 02 01:35 PM

[Osama b:]

Dear Mom

My job at the Inter Continental Exchange here in Atlanta is going great. I have made a lot of money here for uncle Abdullah. I have learned a lot from
these commodity speculators here in America. They have shown me how to make lot’s of money for myself as well. You see these people here in
America wants to buy all of Uncle Abdullah’s oil. They only want to pay 35 dollars for a barrel of it though. You know it cost uncle Abdullah 10 dollars
to get it to them and he wanted that new home in Dubai so I will do all I can to help out. I found out that I can buy 30 barrels for 5% or less than 2 dollars a barrel on the
Commodities exchange and he doesn’t even have to pump it out of the ground or even ship it. They buy it with there guaranteed pension and insurance
funds so uncle Abdullah’s money is real safe. And when I purchase it is so easy to hide you see they don’t have transparency. That means I can buy and
sell it raising the price each time and know body knows it’s me. It even gets better you see these purchases are called contracts and I get paid for each
contract. This is such a great country.. Sometimes I buy and sell a barrel as many as 30 times before Uncle Abdullah’s ever gives one barrel to the oil
company. My supervisor said there are no rules beyond the ones that we make here in Atlanta. He said they have a watch dog group called the CFTC
that has some silly rules, that makes it wrong for me to corner the market, but there leader is Mr Lukken said we don’t have to abide them. He said we
were a foreign exchange and for that reason those rules don’t apply. I don’t think he knows where Atlanta is though. LOL He is great it takes him 3
months just to generate a report. Maybe he should run for there president. But know matter by then I will have made so much money that I can start up
my own exchange when I get home. I am going to call it the Dubai Exchange. I miss you and will write you later.

Osamah

2008 Jul 02 07:00 PM