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The Curious Case of Crude Oil



Last week’s production cuts and further weakening of the dollar were not able to offset the expectations for slump in demand and crude oil fall to four year lows. OPEC claims that the severe decline is not based on fundamentals and it is pure overreaction. If they truly believe that the current price of crude is unfairly cheap, let step up and start buying oil futures as every self-respected company would buy its shares in a similar situation. Such behavior might seem extreme, but it will have better appreciation impact on oil futures than production cut.

During the last three weeks we experienced a small rally in many commodity related industries. All, except oil. The demand was highest for Gold. If smart money is truly expecting an economic recovery in 2009, it would be buying crude, not gold. Bidding up gold and treasuries is a sign of fear and uncertainty. It reflects a perception of higher risk. It is a desperate move aiming to save some of the purchasing power of the current wealth, which is devastated by FED’s favorite sport – dollars printing.

In the end of last year I wrote a post about crude oil, trying to explain that too high price of the black gold will be devastating for oil producing countries in long-term perspective. First, an extreme price of oil gives people an incentive to invest in alternative, more energy efficient technology. If a human being is motivated to achieve something, sooner or later, it succeeds. Second, high oil price changes people’s habits. They find a way to consume less and tend to stick to this newly found behavior even when the economy starts to recover. At the brink of extremes, people change.

It is fair to point out that OPEC didn’t and doesn’t have a major impact on crude futures. It is well known fact that they were bid up by financial institutions. Disregarding that, oil producers liked the thickness of their wallets and said that they can’t impact the price of oil. Why do they think that they will be able to do it today? They became complacent and didn’t think about the long-term ramifications of high oil price for their economies. Oil was found about 100 years ago and it was adopted as energy source, because it was cheap and efficient. Once those variables change the whole equation changes. People go and find a better alternative.

Earlier this year Bank of Kuwait came up with a report, revealing the break-even price of crude for the different oil producers. It claims it is $17 per barrel for Kuwait, $30 for Saudi Arabia, $33 for Canada and much higher (in the lower 40s) for many others. All small numbers that should suggest that at the current level of crude, many countries should stop producing. I don’t believe these numbers. Oil producing nations have sold profitably its products at even lower prices during the last several decades, even when inflation is taken into account. I would like to see a similar report for break-even prices from an unbiased entity.

What strikes me the most is not the break-even prices, but the claims that many oil producing nations have based their 2009 budgets on $70, $80 and even $95 per barrel. If for a moment we assume that this is true, countries like Venezuela, Iran and Russia are in big trouble. Not only many projects will be postponed (scratched), but their cash reserves will evaporate faster than a glass of water in a dessert. Extreme budget deficits will affect substantially the living standards of their citizens and it won’t be surprising to witness cases of massive civil disobedience. Ironically, political destabilization in any of the major oil producers will lead to far more efficient appreciating shock on oil futures than any coordinated cuts. An extremely low price of oil will lay a solid foundation down for its fast appreciation in a 3-5 years horizon, as an extremely high oil price caused what we are currently witnessing. Remember that for the next 20 years oil will most likely remain the cheapest and most efficient source of energy.

Assuming that the current short-term trend of weakness in crude oil continues, which industries would be the biggest benefactors? The fist groups that come to mind are Airplane carriers and trucking companies, which bottom line should get a boost from cheaper oil. So far there is no sign of that happening. Oil is only one variable in their EPS equation. The current decline in their input cost is more than offset by a decline in their output – people travel less often, companies sell less; less packages need to be transported.

The only industry that currently should thrive in an environment of low oil price is Gold mining. Not only crude accounts for substantial part of its expenses, but gold has been outperforming everything else this year. If this trend continues, and there are no signs that it will end any time soon, gold mining companies’ EPS should get a nice boost. Higher EPS growth often leads to higher stock prices. Certainly EPS is not the only factor that affects price. It is actually of secondary importance when put next to investors’ confidence. A simple way to measure confidence is through P/E ratio. It is self-evident that recession hits investors’ confidence big time. Often a rise in bottom lines of solid companies is offset by general lack of confidence.

9 Comments:

john said...

nice post Ivan

John said...

Ivan nice to know there are other gold bulls out there. I really liked your post. There is much talk now about the descending trend line in gold with the recent high at 880 forming a 3rd lower high. Any thoughts? I hope we can break this! Maybe we will then get some more bears running at that point!

ivanhoff said...

John,
I am bullish on gold in long-term perspective (6 months to an year). Still have no exposure to Gold. Within the next 2-8 weeks, I expect a normal correction in gold and gold miners that will offer good buying opportunity.

Market Speculator said...

There are too many gold bulls out there. The chart is in a clear downtrend...Gold will retest 700 and if it holds I would turn bullish.

We are going to start another wave of deflation as credit card issuers as well as commercial real estate loans will see massive write downs.

I can see gold retest 450 if 700 can not hold.

ivanhoff said...

Market Speculator,
The 1 year chart of gold is in clear down trend and there is high probability for gold to retrace to 700-750. This is why I am not a buyer at these levels.
On the other hand, the 5 year chart of gold is extremely bullish. There is strong physical demand for gold around the world due to the fact that every country is trying to inflate its currency. As I point out in the post, oil accounts for substantial % of gold miners expenses. Both factors should help the EPS numbers of gold mining companies. In the end of the day, money goes to companies that are able to make money.

Anonymous said...

I'd like to talk about Iron Mountain,it could acquire the European ledear data backup Risc Group, the rumor is it based?

Market Speculator said...

I get the fundamental case for gold and why so many are on the band wagon. I look at a 5 year chart of the generic gold futures contract and its telling me it wants to go back to 2005 levels...

I would steer you towards the industry groups that will be leaders (thanks to the New Deal III Obama is pushing):

Medical Information
Water
Heavey Construction

BUY "MADE IN AMERICA"

John said...

Guys:

I have seen many more bearish articles on gold than bullish ones. Most make a case like Market Speculator. I agree that some of the areas that Market Speculator has commented on will see some upside. Take steel for instance. It has broken its downtrend, but you want to see a chart that has REALLY broken its downtrend look at the xau! Also if the XAU to gold ratio returns to historic norms of about 0.2 then even at 700 gold the xau should trade at about 140 or about 24% higher than it is right now. Also have you looked at gold in any other currency then the USD? Some look uber bullish.

If you really believe in the new deal then why not buy energy? They should use a lot of it on these government make work projects!

Also HOW can you print several trillion dollars and still have a strong currency even if a bunch of people default on their credit?

Ultimately though thanks for the comments and I will watch this correction VERY carefully and get out of the way if Market Speculator is correct!

Market Speculator said...

The issue with the dollar is that all other nations are destroying their currency along with US. The debasing at the same time causes quite the issue with dollar bears. The dollar index is benchmarked against a basket of currencies and if they are debasing their currency along with us how does the dollar fall?

At some point, a pivotal point you will see this break...I think it will work to our favor. We are the only nation that can borrow. It gives us the advantage above all others.

The issue with buying energy is that most is known regarding the spending projects. All markets are forward looking and they are telling us that economic conditions are worsening, not getting better.

What happened to China's massive growth? Why would crude fall from $150 to $39? It falls because it is signaling a massive contraction in the world economies. Those who are net exporters are the ones who are going to be hurt the worse (India and China).

Ultimately, the markets will prevail and time will tell.

America will come out on top.

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