Options Trader: Friday Outlook

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 |  Includes: DBO, OIL, USO
by: Philip Davis

Click to enlargeIt is ALL about oil.

Now the goons on CNBC are trying to tell you that declining oil prices signal some sort of problem in the global economy and that is true - for their parent company GE (NYSE:GE), which makes Billions of dollars building energy infrastructure projects and lending money for infrastructure projects and has grown revenues 15% as oil doubled the past two years while profits are up 33% since 2005.  It seems selling $2Bn worth of windmills for TBoone to tilt at is a VERY profitable business!

While I love GE the stock, I hate GE the oil-pimping, media-controlling conglomerate that is willing to bankrupt the United States of America in order to improve its bottom line.  The nonstop pump-fest that goes on daily at CNBC is a bit of a joke, but what these people are doing to the country certainly is not.  At this point they are blowing what little shreds of credibility that network has left by attempting to convince investors that declining oil prices are somehow bad for the economy.

The economy is 70% driven by consumer spending, and consumer spending is only 20% discretionary.  The average US HOUSEHOLD spends just over $40,000 a year, and less than $10,000 of that money in 2003 fell under discretionary categories.  In Q1 of this year, gasoline spending alone hit 5.2%, up 26% from the previous March, and that was back when oil was averaging $95.  The US consumed 21M barrels of oil a day in 2006 at an average of $64 per barrel, that works out to $490Bn or about $5,000 per family.  For simplicity’s sake we won’t discuss refining mark-ups or the inflationary effect on food and other consumables that are made using oil …

Click to enlargeSo $5,000 is a full 12.5% of a family’s total spending on energy alone.  We already know that wages are declining and jobs are scarce and the poor are getting much poorer (more on that this weekend) so what do you think the impact on spending is when the average price of oil goes from $64 in 2006 to $74 in 2007?  It’s not terrible, up 15% - that’s why we didn’t measure a big slip in consumer spending last year, it was "just" 15% overall, another $750 out of the family budget that had to be diverted away from dinners out or Levis or hair products.  Most of the gains in oil came in Q4 so the impact wasn’t really felt until this year.

Now 2008 is a very different story indeed.  We opened the year at $90 and ran up to $110 by the end of March.  Q2 saw the price of oil go from $110 to $145, averaging a whopping $129 for the second quarter and THAT is the quarter all this data is coming from!  $129 is a 100% INCREASE in fuel costs over and above what a family had to pay in 2006.  $5,000 MORE spent just on fuel in a crippling tax that disproportionately hit the bottom half of this country like a ton of bricks.  And what was the Fed’s response? Lower rates for the banks who were foreclosing on the people who couldn’t make ends meet, which drove oil AND food to record levels, completely destroying the spending power of the people of the United States.

Those are the numbers you are seeing reflected in the data, these are the effects that are showing up as slowing retail spending (there’s nothing left for people to spend).  On a global scale, the $129 average oil price in Q2 represented $5.6Bn PER DAY that was taken out of the hands of global consumers (86Mbd) ABOVE the $64 they spent per barrel in 2006.  That works out to $504Bn that went to oil companies and not retail, not entertainment, not financials, not invested, not saved, not enjoyed - no wonder people are depressed!  Through the Fed’s efforts, skyrocketing food costs ate another $300Bn of consumer dollars, amounting to a whopping 1.5% of the global economy driven down the tubes in a single quarter. 

When you take $69 and buy an IPod, you give it to the store (1), who sends money to Apple (2), who sends money to suppliers (3), who send money to material makers (4) who buy commodities (5).  When you spend $69 on a tank of gas you give it to the store (1), who sends money to the refiners (2) who send the money out of this country (oops).  Not only is that transaction terrible for the GDP but, when you spend $69 for an IPod you have - an IPod!  When you spend $69 on a tank of gas you are literally burning the money and that $69 tank of gas gets you no further down the road than a $19 tank of gas did just 5 years ago.

Oil has fallen $40 since the beginning of this quarter.  Our average price per barrel paid is already below $120 but we won’t see those numbers reflected until next month’s data and we still have a long way to go before we put that whole $5,000 back into 100M families’ pockets so they can spend that $500Bn on more important things like IPods and mortgage payments.  Declining oil prices will not kill the global markets - it will invigorate them to the tune of over $2Tn a year globally. - more money than has been earned TOTAL by all companies on the planet outside of the energy and financial sectors.  $500Bn taken out of US consumers pockets is enough to pay off $9Tn in mortgages - pretty much all of them!  There’s your housing crisis solved as well…

Not only is falling oil a blessing for the economy but, as we saw yesterday, both industry and consumers are quicly learning to make more efficient use of fuel.  Productivity was up 4.3% in Q2, a move of necessity in a quarter that began with oil at$147 a barrel.  Overall, US consumption of crude is off drastically, with monthly consumption down to 586,000 barrels in June from 621,000 barrels in June of ‘07 and 636,000 in June of ‘05.  So that’s a 7.8% decline in consumption on a doubling in the price of oil, especially when you consider that the EIA consumption data includes 45M barrels that we EXPORT, up from 37Mb last year and way up from just 30Mb per month in 2005.  That scam is already being investigated (see yesterday’s post) but, suffice to say both consumers and businesses are using less and, if the price heads back to a normal range, we may end up spending less money on fuel than we did in 2006 - very bad for oil companies, very good for America!

The energy sector has done this math, and those companies are pulling back fast as their expenses have gone through the roof the past few years as money has just been dumped on that sector.  We’re hearing about hedge funds who backed energy plays going belly up, and there will be more shocks to come, but it’s not surprising that the S&P and NYSE are down when the energy sector, which made up close to 20% of those indexes last year, is off 25% and looking much like housing did in 2005, just making its first leg down off a ridiculous spike.   The financials popped in a similar fashion last year and now it’s oil’s turn.  Frankly with Builders down 50% and Financials down 50% and the Energy sector halfway to 50% off (not to mention the Semiconductors, which are in their own private hell ,down 40% from last year - it’s amazing the market isn’t down much more. 

Clearly from this chart you can see how rising oil killed first housing, then the financials, and now declining oil can bring them back. But we’re still up 200% since 2003 and it’s a long, long way to normal. You can see the builders (using TOL as a benchmark) already responding to a dip in oil, and once the hyenas stop chewing the legs off the financials, that sector can get it back in gear as well, and that’s a rally we can get behind.  I’m not predicting all this will happen tomorrow, but I am saying that we are getting hit by a ton of backward looking data that took a snapshot of the worst possible quarter and that there are a lot more signs that things are getting better, not worse and much of that continuing depends on the continued decline in crude prices.  We need $85, not $105 and I have no doubt we’ll get there as oil is worth $70 at best, everything else is pure speculation.

I set our bottom targets in last night’s Big Chart Review and it looks like we might get them today, or near enough, as unemployment hits a 5-year high in August, with employment falling for the 8th straight month giving us a whopping 6.1% rate.  Payrolls declined 84,000 in August and June was revised higher, from 51,000 lost jobs to 100,000 - which shows you what a joke these market-moving numbers are.  Average hourly earnings were up 3.6% from last year, falling behind oil-driven inflation.  Overall the report was about in-line with expectations and better than yesterday’s doom and gloom sell-off would suggest, but there’s no stopping a market that’s determined to get to the bottom so we’ll have to play it by ear.

Asia was a mess, and Europe is down sharply this morning, but I’m out of time so just keep this in mind as a long-term outlook.  Are things really that awful or is this all about just one thing and is that one thing already getting better?  Like an infection that you kill off but still leaves you weak - oil prices are receding quickly but it will take the economy more than a month to recover and it will take a lot more time than that for the data to catch up with the improvements.

Have a good weekend.