Playing Cat and Mouse with Global Oil

By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors

 

Oil markets took another dose of global geopolitics this week when the International Energy Agency (IEA) unexpectedly announced that it would be releasing 60 million barrels of oil from strategic petroleum reserves (SPR) around the globe. Thursday’s surprise announcement gave oil prices a 4.5 percent hair cut and oil prices closed Friday at $91.25, down 20 percent from their April 29 peak.

 

The IEA, a Paris-based agency comprised of developed countries around the world, said the release would take place in increments of 2 million barrels per day over 30 days beginning July 1, and is intended to make up for lost crude oil production due to the Libya crisis. The IEA estimates that the fall of Ghaddafi’s regime and civil strife that’s followed has cost global crude supplies 123 million barrels of oil.

 

Sixty-million barrels of oil is a large number but represents only a small amount of the 1.6 billion barrels worth of reserves held in SPRs around the globe that are for “emergency use only,” according to Barclays. The U.S. holds a little more than half of these reserves (56 percent) while Japan (24 percent), Europe (14 percent) and Korea (6 percent) hold the rest.

 

 

While the short-term effect of the SPR release manifested quickly, it’s difficult to gauge where the market goes from here. For starters, emergency SPR releases are rare and have only been initiated twice in history (Iraq’s invasion of Kuwait in 1990 and following Hurricanes Katrina & Rita in 2005). Then, the releases covered for a little less than 7 percent of global demand, according to Barclays. The current program would only cover a little greater than 2 percent of global oil demand.

 

This chart from Barclays shows the immediate downward effect the release has on West Texas Intermediate (WTI) prices, but prices returned to pre-Katrina levels relatively quickly.

 

 

It should also be noted that the U.S. only sold about half of its first lot and didn’t even offer a second amount of its reserves during the Katrina SPR release, according to J.P. Morgan.

 

 

One cannot ignore the politics in play. Prior to OPEC’s June 8 meeting earlier this month, the IEA called for an OPEC production increase and tipped their hand that they were prepared to tap the SPR. The IEA said “we are prepared to consider using all tools that are at the disposal of IEA member countries,” as reported by Barclays. When the highly contentious OPEC meeting broke without an increase, the IEA was all but forced to act on its threat.

 

Essentially, the IEA is trying to buy time for Saudi Arabia to increase its production. Saudi oil production has increased in June and that’s expected to continue in July. Despite the increase, Saudi production remains below peak 2008 levels despite global demand reaching new highs.

 

As long-term investors, we’re less concerned with the game of “cat and mouse” the IEA, OPEC and global politicians are playing with short-term supply and we’re focused on the positive long-term structural supply/demand dynamics. BCA Research forecasts that “further downside is limited” and says that “one-time stock release should have little impact on cyclical or medium-term horizons, as the flow demand for oil from emerging countries keeps steadily growing year after year.”

 

Barclays argues that the IEA decision to implement the SPR “sends the wrong signal” to the market and will likely result in lower Saudi oil production over the long term, perhaps even by the end of 2011. “The use of SPR, particularly when Saudi Arabia has restated its commitment to supply customers with the crude they need, send the

incorrect signal,” says Barclays.

 

 

This is partly due to the fact that Saudi oil production doesn’t have much room to grow before it is maxed out. You can see from the chart that Saudi Arabia’s spare capacity is down roughly 25 percent from its peak around this time last year. Forcing additional Saudi production to market means this spare capacity could dry up even further.

 

Deutsche Bank (DB) says medium-term supply/demand fundamentals signal relatively tight markets going forward, which could easily return prices to $100 per barrel or higher. In fact, DB thinks the temporary drop in oil prices could relieve pressure on emerging market governments to reduce or eliminate fuel subsidies. Eventually, the IEA and consumers around will have to “surrender” to higher oil prices, says DB.

 

“The ultimate effect of the IEA’s decision may not just be a few months delay in market tightening, it could exacerbate that tightness, given the need for the SPR to be refilled at some stage,” says Barclays.

 

Broadly speaking, energy stocks were down 1 percent this week but the long-term appeal remains attractive. BCA cautions to not view the announcement as a reason to sell the S&P energy sector, but as a catalyst to remain bullish, especially given current “attractive” valuations.

 

We think one of the best opportunities in the market is in the oil services sector and we’ve adjusted our Global Resources Fund (PSPFX) portfolio accordingly. We see sustained higher energy prices as the catalyst for producers and the large, integrated oil companies to spend large amounts of capital on additional rigs, facilities and infrastructure.

 

One way to measure demand for new equipment is to look at the backlog of orders at construction & engineering firms. BCA said in a May 31 report that “backlog growth is still accelerating…while global leading economic indicators have declined and warn of a global soft patch.” As of the beginning of June, the project backlog for C&E companies was up over 20 percent from the year before—the highest rate since late 2007.

 

Additionally, this group has strong earnings growth potential because they haven’t yet seen their margins expand to match energy’s current price levels. BCA says “this group is likely to demonstrate significant earnings outperformance, especially as margins in the broad corporate sector begin to narrow.” In addition, higher commodity prices will encourage additional production and give these companies pricing power.

 

BCA has looked back at the previous 30 years of performance for oil service stocks during rising, falling and flat markets. They found that the S&P Energy Equipment & Services Index handily outperformed the S&P 500 Index during market moves upward. Performance dipped significantly when the credit crisis hit but returned when the market started to rise again.

 

Although we expect volatility to continue, we believe that an active hurricane season, strong seasonal demand or an additional uprising in the Middle East region all have the ability to further constrain supply and keep prices at historically elevated levels. That doesn’t even include some of the reasons we’ve outlined for you in the past—Read: Three Reasons to Believe in $100 Oil.

 

This and the factors laid out by BCA make a strong investment case for the oil services group.

 

Many people are also concerned with the recent performance of gold mining equities. I addressed these concerns in last week’s alert and the positive feedback this week from our highly-engaged readers has been fantastic. In case you missed my special message last week (I know we’re right in the middle of summer vacation season), here is a link—Read: Will Gold Equity Investors Strike Gold?

 

Director of Research John Derrick contributed to this commentary.

 

 

Index Summary

 

• The major market indices were mixed this week. The Dow Jones Industrial Average lost 0.58 percent. The S&P 500 Stock Index declined 0.24 percent, while the Nasdaq Composite gained 1.39 percent.
• Barra Growth outperformed Barra Value as Barra Value finished 0.70 percent lower while Barra Growth increased 0.20 percent. The Russell 2000 Index closed the week with a gain of 2.05 percent.
• The Hang Seng Composite Index finished higher by 2.60 percent, Taiwan declined 1.20 percent, and the KOSPI gained 2.90 percent.
• The 10-year Treasury bond yield closed 8 basis points lower at 2.87 percent.

 

Domestic Equity Market

 

The figure below shows the performance of each sector in the S&P 500 Index for the week. Four sectors gained and six declined. The best-performing sector for the week was materials which increased 2.35 percent. Other top-three sectors were consumer discretionary and technology. Consumer staples was the worst performer, down 1.74 percent. Other bottom-three performers were energy and financials.

 

Within the materials sector the best-performing stock was International Paper, which rose 8.32 percent. Other top-five performers were Cliffs Natural Resources, FMC, Titanium Metals, and DuPont.

 

Strengths

• The home furnishings retail group was the best performer for the week, up 9 percent, led by Bed Bath & Beyond. The retailer reported fiscal first quarter earnings and revenue above the consensus estimates.
• The paper products group outperformed, gaining 7 percent on the strength of its largest member, International Paper. Earlier this month the firm made a hostile bid for Temple-Inland, which rejected the bid.
• The electronic manufacturing services group outperformed, rising 4 percent on the strength of its member, Jabil Circuits. Jabil shares gained after the electronics manufacturer posted fiscal third quarter adjusted earnings that were better than expectations, and it also announced a $200 million stock repurchase plan over the next 12 months.

Weaknesses

• The healthcare facilities group was the worst performer, down 7 percent, led by Tenet Healthcare.
• The drug retail group underperformed, losing 5 percent, led down by member Walgreens. The retail drug chain announced that it plans to stop filling prescriptions for customers covered by drug benefits manager Express Scripts, beginning January 1, 2012.
• The tobacco group lost 3 percent. By October 2012, cigarette packages and cigarette ads must display graphic warning labels showing diseased lungs and other unpleasant images.

Opportunities

• There may be an opportunity for gain in merger & acquisition transactions in 2011. Corporate liquidity is high, thereby providing the means to pursue acquisitions.

Threats

• The end of quantitative easing, currently scheduled by the Federal Reserve for the end of June might result in a weaker economy.
• The nuclear disaster in Japan creates uncertainty, which is not good for stock prices.

 

The Economy and Bond Market

 

Bond yields continued to fall this week as concerns surrounding the global economy continue to mount. Three key events unfolded late in the week that appear to be a coordinated global effort to jump start the economy. The EU and Greece have apparently come to an agreement to continue to provide funding to Greece in exchange for additional austerity steps by Greece. The International Energy Agency (IEA) announced the release of 60 million barrels of oil from strategic reserves; it was a surprise move and on the surface is oddly timed as oil peaked in early May. Finally, Chinese Premier Wen Jiabao stated that China’s efforts to curb inflation has worked and inflation is expected to slow, which implies China’s tightening measures are over for the time being. The chart below highlights initial jobless claims, which indicates economic growth and job creation has stalled. Economic data has generally deteriorated in recent months and pressure is on governments to implement additional policies to spur the global economy

 

 

Strengths

• Existing home prices in China moderated in May, one of the key factors allowing the government to possibly end its tightening program.
• The IEA announced it will release 60 million barrels of oil, immediately impacting oil prices, which should provide a lift to the consumer.
• Durable goods orders for May rose 1.9 percent, beating expectations and bouncing back from a decline in April.

Weaknesses

• Initial jobless claims rose from 15,000 to 429,000 in the week ended June 18, indicating no improvement in the labor market.
• New home sales fell 2.1 percent in May and existing home sales fell 3.8 percent, hitting a six-month low.
• The Fed revised down their economic growth forecast for 2011 as the economy has been surprisingly slow.

Opportunities

• The Fed may be forced into another round of quantitative easing if employment and the economy do not improve soon. This is not consensus and the market is applying low odds of this occurring, but if it were to come to pass the fixed income markets would likely rally from here.

Threats

• Another Greek bailout appears inevitable and others are likely to follow, which increases the eventual risk of default and is a potential threat to the global banking system.

 

Gold Market

 

Spot gold closed at $1,503.20, down $31.85 per ounce, or 2.07 percent for the week. Yet gold equities, as measured by the Philadelphia Gold & Silver Index, delivered a modest gain of 0.93 percent. The U.S. Trade-Weighted Dollar Index rose 0.85 percent for the week.

 

Strengths

• The import of gold and silver by India has risen 222 percent between April and May 2011, as compared to a year ago. In the month of May alone, imports were a staggering $9 billion, a growth of 500 percent compared to the month a year ago. To put this into perspective, the yearly average of gold imports by India is $22 billion, indicating in May alone they already reached 40 percent of the average.
• Peoples Bank of China (PBOC) has announced that in view of the rising demand for their Panda coins, the output number of gold Pandas will be raised from the previously announced 300,000 units to 500,000 this year. The smaller coins in the series will have their maximum circulation numbers increased from 200,000 coins to 600,000 for each series. Also, the PBOC says that it is doubling the maximum issuance of silver Panda coins from 3 million to 6 million. To emphasize this growth in demand, issuance in 2010 was just 1.5 million.
• The big rises in the maximum issuance for the smaller gold coins and the series of silver Pandas is yet another indication that not only is demand exploding for precious metals among the Chinese growing middle class, but also confirmation that the government is encouraging its citizens to buy precious metals.

Weaknesses

• The gold price closed the week lower as the U.S. dollar spiked higher. The price of gold faced heavy selling pressure, as did stock and commodity prices, after European Central Bank President Jean-Claude Trichet warned that the sovereign debt crisis poses a “serious threat” to the financial stability of the European Union. In addition, President Obama announced oil would be released from the Strategic Petroleum Reserve in a concerted effort with other nations to help bring down energy prices.
• The Purchasing Managers Index in China sank to 50.1, its lowest level in 11 months. A reading of less than 50 would signal contraction in the country’s economy. Premier Win Jaiaboa wrote a column in the Financial Times on Friday, stating his belief that the policies have firmly brought price rises in China under control.
• The Obama administration extended its emergency ban on new mining claims around the Grand Canyon until December 20, 2011, enhancing the probability of the ban becoming permanent. The two-year moratorium on new mining claims in the Grand Canyon was set to expire on July 20.

Opportunities

• Representative Ron Paul has not abandoned his quest for an independent audit of U.S. gold reserves. The Gold Reserve Transparency Act of 2011 would not only request an independent audit of the 5,000-plus tons of gold bullion stored in Fort Knox, but also audit U.S. gold reserves held in Denver, West Point, and the New York Federal Reserve Bank. Rep. Paul wants some of the bullion to be tested by an independent laboratory to prove that the bars are investment grade gold bullion.
• Eric Thorson, inspector general of the Department of Treasury, last September became the first outsider in 37 years to be granted full access to Fort Knox. Additionally, only one member each of the Senate and House has been allowed to tour Fort Knox since the 1970s. In testimony before the House, Rep. Paul also questioned whether gold that is pledged to the International Monetary Fund (IMF) by the U.S. should be considered as part of the U.S. reserve base.
• According to Mexico’s Chamber of Mines, revenue from mining was expected to surpass $13 billion in 2010, making mining the third-largest generator of revenue in its economy. There are a number of world-class deposits being developed in the country and around 740 active exploration projects.

Threats

• Brazil is considering a new tax on large mining projects as part of the government's overhaul of the mining code. The proposal would levy the tax on 25 percent of the existing mining concessions and include a potential increase in royalties that companies must pay to the government.
• The mining industry opposes tax increases, particularly the royalty increase, saying that it would reduce Brazil's competitiveness because mining companies already have a high overall tax burden. The government expects to send a draft bill to Congress in the second half of 2011, after more than a year of discussions with the industry.
• Rising reserve ratios instituted by the People’s Bank of China has led to cash hording and the inversion of the swap rate curve as China’s 7-day repo rate surged to a 3-year high of 8.79 percent. The last time the country’s swap curve inverted was during the failure of Lehman Brothers.

 

Energy and Natural Resources Market

 

Strengths

• Chinese oil demand is up 9 percent year-over-year in May despite stronger prices and various tightening measures, and is running 10.9 percent higher year to date, far exceeding initial consensus expectation.
• According to the World Steel Association, global crude steel production in May was 130 million tons, 4.2 percent higher year-over-year. The data also showed that China alone produced 46.4 percent of the world’s crude steel in May.
• U.S. preliminary steel imports rose to 2.44 million metric tons, up 2.8 percent month-over-month and 20.9 percent year-over-year on a day’s adjusted basis.
• Aluminum demand in the U.S. and Canada rose 6.6 percent year-over-year to an estimated 1.814 million pounds in April, the Aluminum Association said. In the first four months of the year, demand climbed 8.5 percent year-over-year to 7.127 million pounds, the group said.
• Indian power utilities increased coal imports by 43 percent during last month to 2.97 million tons. April imports stood at 2.34 million tons. India’s Central Electricity Authority has set a target of 35 million tons of imported thermal coal for fiscal year 2011-2012, according to Bloomberg news.

Weaknesses

• Crude Oil Futures (West Texas Intermediate) fell 2 this week percent after the International Energy Agency announced it would release 60 million barrels of oil from strategic petroleum reserves in the U.S., Europe, and Asia to ease high oil prices and offset supply disruptions from Libya.
• The Australian Bureau of Agricultural and Resource Economics and Sciences cut its met coal output and shipment estimates for the year ending June 2012 by 4.4 percent and 5.6 percent, respectively, as the country still tries to recover from historic flooding in the Queensland region. Met coal exports for the fiscal year are now estimated to be 164.2 million tons.
• The AIA Architecture Billings Index slipped to 47.2 May, suggesting that the positive momentum in confidence in non-residential activity in the U.S. has faded in recent months.
• According to the U.S. department of Transportation, U.S. highway travel fell 2.4 percent in April from a year earlier and fell 1.3 percent year-over-year in March.
• Japan’s steel output fell 7 percent year-over-year in May as demand remained weak following the earthquake.
• Japanese thermal coal imports were down by 21.6 percent to 13.1 million tons in the last month per a report from China Coal Resource.

Opportunities

• According to the chief engineer for the Ministry of Industry and Information Technology, China may need to eliminate 70 million tons of outdated iron-smelting capacity in the next five years.
• According to Eskom’s chief commercial officer, Dan Marokane, the South African power utility requires 15 new mining projects over the next 2 to 4 years in order to meet Eskom’s demand between 2011 and 2018. He also said that between 2011 and 2039, about 1200 megawatts of power was at risk due to potential project delays.
• According to Wall Street analysts, Rio Tinto and BHP Billiton are expected to generate significant free cash flow over the next three to five years due to robust commodity prices. In fact, both companies could generate $20 billion in cash this calendar year, which could be used to buy back further shares, make accretive acquisitions or be distributed via a special dividend.

 

Threats

• Germany’s ZEW survey of investor confidence fell to a two and a half year low in June. Both the current conditions and future expectations components of the survey fell, pointing to slower growth in the coming months.
• Japan’s rebuilding efforts are facing a major hurdle in the form of debris to the tune of 25 million tons of concrete, steel and wood etc. The Japanese government estimates an expense of $8.4 billion and a period of at least three years in clearing areas prior to rebuilding.

 

Emerging Markets

 

Strengths

• Chinese Premier Wen Jiabao said that China’s efforts to stem inflation have worked and that the pace of consumer price increase will slow. The market is interpreting his statement as a potential tightening pause.
• China’s National Development and Reform Commission (NDRC) wants to change or remove local government limits on the number of license plates issued, the National Business Daily reported.
• China’s A-share market valuation reached an 11-month low this week, and it is in a move to form a short-term technical rebound.
• Moody’s upgraded Brazil’s credit rating to BAA2 from BAA3. Large reserves, estimated at $335 billion, should permit Brazil to weather any contagion from the Greek crisis.
• Brazil’s unemployment in May declined to 6.4 percent from 7.5 percent last year, the lowest level on record. Growth in retail wages of 4 percent year-over-year has been supportive of growth in financial intermediation and retail activity.
• Retail sales in Mexico in April grew by 4.9 percent in April, ahead of estimates of 2.7 percent.
• The European Union’s 10 eastern states lead the 27-nation bloc in boosting productivity. This chart from Bloomberg plots the ratio of industrial production and industry labor indexes, a gauge of productivity changes. Industry in Romania produces 84 percent more per employee than it did in 2005, followed by Slovakia and the Baltic countries. By contrast, companies in Greece are less productive than they were six years ago.

Weaknesses

• China’s NDRC says the month of June will see inflation reach the highest level in the last 11 months, and then gradually slow down. Hog prices have reached their highest this week, up 80 percent year-over-year, and pork prices are up 63 percent year over year. Pork prices are expected to continue to rise for the rest of the month.
• China’s Purchasing Manager’s Index (PMI) is in a downward trend, at 50.1 percent for June versus 51.6 percent in May.
• China’s 7-day interbank rate reached 9 percent, reflecting extremely tight liquidity conditions, after recent RRR increases and the expectation for further interest rate increases. China’s monetary tightening this year has slowed the economy and prevented housing prices from dramatic change.
• The La Polar controversy in Chile, related to unauthorized credit activities at the retailer, does not show signs of abating. Following an 80 percent decline in the share price, the stock rebounded by 35 percent in the last two days, prompting an insider trading investigation by the authorities.
• The jobless recovery will make it harder for Central European countries to narrow budget deficits that have ballooned during the crisis, according to Raiffeisen analyst in Prague. Persistent unemployment will cause income-tax revenue to fall short of plan, while welfare spending won’t decline as projected.

Opportunities

• UBS investment research has pointed out that Korean stock market valuation is near a historical bottom. As shown in the chart, implied return on equity is 10.1 percent at the moment, after a market correction of 9 percent in the KOSPI. UBS believes the falling ISM Index and Greek debt crisis have mostly been priced in, and therefore this is a buying opportunity.

• GDP in Colombia in the first quarter grew by 5.1 percent with mining leading the way, up 9.4 percent. Agriculture followed, up 7.8 percent, and commerce, up 6.7 percent. The prospect of lower corporate taxes should be supportive of investment activity in the country.
• The Bogota Stock Exchange is likely to see six to seven IPOs by the end of this year, valued at $3.5 billion. We expect strong demand from investors in this vibrant economy.
• Yesterday, the newly elected president of Peru, Ollanta Humala, indicated he would like to have “strong government that will protect democratic gains of last 10 years and will support investment in Peru’s natural resources.” Mr. Humala will travel to Washington at the beginning of July at the invitation of President Barack Obama, where more clarity on his government program is likely to emerge.
• Global carry trade could finance the current account deficit in Turkey, according to J.P.Morgan. A slowing U.S. economy and the turmoil in Greece mean the rates will likely stay lower for longer, and global fixed-income investors will continue to hunt for yield. And the carry on the lira is one of the highest in the world.

Threats

• China’s industrial production may see a further slowdown. This is the result of credit tightening in China to control housing and consumer goods prices.
• It is still unclear if the merger between Perdigao and Sadia, forming Brasil Foods two years ago, will be allowed to proceed on competitive grounds. The final vote was postponed until mid-July to allow the company to come up with a disposal plan for some of its assets.
• Is the Chairman of ASUR, the airports operator in Mexico, likely to sell his 20 percent stake in the company? The rumor in the local paper has put the stock under pressure this week.
• In Turkey, newly elected Kurdish deputies threatened to boycott the Parliament, creating political tension ahead of the debate on a new constitution and the formation of the new government. The boycott has the potential to upset financial markets.

 

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