Case for Sustained $100 Oil

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

In 2011, oil was one of the top performing commodities among those we track, with Brent rising more than 13 percent. Geopolitical risk and unexpected non-OPEC supply losses caused oil to rise significantly in early 2011. By October, we saw the black gold sink to a low of $80 per barrel before rising to its current level of nearly $108 a barrel.

This year’s unrest demonstrated how major oil-producing regions can significantly affect oil prices. As I’ve previously stated, according to PIRA, the Middle East accounts for over 70 percent of OPEC oil production and, along with North Africa, more than 95 percent of the cartel’s capacity growth.

A disruption of the supply chain can also influence oil prices. One of the largest chokepoints along the global oil supply chain is the Strait of Hormuz, which roughly 90 percent of all Persian Gulf oil tankers—some 18 million barrels per day—pass through, according to Barclays. With Iran controlling the entire northern border of the strait, there is a significant chance for disruptions should the country fall into conflict or war.

The story will likely continue into the new year, as “sanctions against Iran, including a possible European Union oil embargo, and fear of an Israeli attack on Iran’s nuclear facilities led 2011 to close on a bullish note” for oil, said PIRA Energy Group in its new report today. Additionally, there’s new political uncertainty in Iraq that may keep oil elevated.

The chart below sums it up: With more than 40 percent of the world’s oil controlled under autocratic rule, oil supply in democratic nations likely depends on the state of autocratic nations.

Read The Many Factors Fueling a Return to $100 Oil

China Rises to Top of Energy Pyramid

Another significant development in 2011 was that China surpassed the U.S. to become the world’s largest energy consumer. BP’s Statistical Review of World Energy report calculated that China’s energy consumption rate grew 11 percent over the previous year, with the country consuming 20 percent of global energy.

Read China is World’s Largest Energy Consumer

While coal accounts for a significant portion of China’s total energy use, the country’s need for oil should continue to rise. Its rising income levels, the government’s social housing plan, and an aggressive transportation effort to link 700 million people across more than 250 cities should continue to drive this growth. Bank of America-Merrill Lynch agrees, suggesting that “China’s oil dependency will rise as U.S. imports fall.”  In the chart below, it’s projected that China’s imports of crude oil and petroleum products will surpass the U.S. in 2014. BofA-ML thinks that on a volume basis, China oil imports “will grow quite rapidly on the back of rapid per capita income growth.”

China’s demand is what makes today’s oil situation different from the end of 2007. At that time, a lack of supply increased oil prices even though the U.S. was in a recession. What’s different is that “China is likely to re-accelerate” in 2012, according to Goldman Sachs.

China, along with other emerging markets, and the European Central Bank are in the early stages of a global easing cycle, primarily by cutting interest rates to spur growth. Also, the Federal Reserve should remain stimulative. These government actions set the stage for sustained, or perhaps higher, demand for oil. As stated earlier, geopolitical threats remain on the horizon, and could also be a positive catalyst for oil.

As always, our team will closely follow these events, as well as the monetary and fiscal policies, to find global investment opportunities in 2012.

We wish you and your family a very happy and prosperous new year!

John Derrick contributed to this commentary.

 

Index Summary

• The major market indices were lower this week. The Dow Jones Industrial Average lost 0.62 percent. The S&P 500 Stock Index decreased 0.61 percent, while the Nasdaq Composite was lower by 0.52 percent.
• Barra Growth outperformed Barra Value as Barra Value finished 0.87 percent lower while Barra Growth lost 0.40 percent. The Russell 2000 closed the week with a loss of 0.94 percent.
• The Hang Seng Composite finished lower by 1.25 percent, Taiwan fell 0.54 percent, and the Korean KOSPI declined 2.22 percent.
• The 10-year Treasury bond yield closed 15 basis points lower at 1.88 percent.

 

Domestic Equity Market

 

The domestic stock market as measured by the S&P 500 Index was lower this week by 0.61 percent. Two sectors of the index increased and eight decreased. The best-performing sector for the week was telecommunication services which gained 0.72 percent. Other top-three sectors were utilities and consumer staples. Financials was the worst performer, down 1.30 percent. Other bottom-three performers were materials and industrials.

Within the telecom services sector the best-performing stock was MetroPCS Communications, up 6.24 percent. Other top-three performers were Sprint Nextel. and AT&T.

Strengths

• Health care facilities was the best-performing group for the week, up 3 percent, led by the group’s single member Tenet Healthcare. The Centers for Medicare & Medicaid Services (CMS) announced that it was going to delay the Recovery Audit Prepayment Review demonstration that was scheduled to begin on January 1, 2012.
• The building products group outperformed by gaining 3 percent, led by the group’s single member, Masco. November pending home sales rose 7.3 percent from October compared to the consensus expectation of a 1.5 percent rise.
• The homebuilding group outperformed, rising 2 percent, also spurred by the November pending home sales report. Also, as reported on Friday of the prior week, sales of new U.S. homes rose in November to a seven-month high. All three members of the group (Pulte, D.R. Horton, and Lennar) increased.
• The casinos & gaming group gained 2 percent, led by group member International Game Technology, with Wynn Resorts also gaining. The U.S. Department of Justice eased its stance toward online gambling restrictions.

Weaknesses

• The household appliances group was the worst-performing group, led down 7 percent by its single member, Whirlpool Corp.  The appliances manufacturer sold off after Sears reported that it will close up to 120 stores and that holiday same-store-sales were down 5.2 percent year-over-year. Whirlpool appliances are sold in Sears’ stores.

 

• The diversified metals & mining group lost 4 percent on weakness in Freeport- McMoRan Copper & Gold Inc. The firm settled a strike at its large Grasberg mine. The labor contract was extended for two years with a 24 percent base wage hike in year 1 followed by a 13 percent base wage increase in year 2.

 

• The office electronics group fell 4 percent as its single member Xerox declined.

Opportunities

• There may be an opportunity for gain in merger & acquisition (M&A) transactions in 2012.  Corporate liquidity is high, thereby providing the means to pursue acquisitions.

Threats

• A mid-cycle slowdown in the domestic economy would be negative for stocks.
• An escalation in concerns over sovereign debt obligations in Europe would be negative for stocks.

 

The Economy and Bond Market

 

Long-term treasuries rallied this week sending yields lower as the schizophrenic market gyrates up one week and down the next, which is what we have experienced in December.

The rally in treasuries this week could be attributed to continued concerns surrounding the European banking system and European banks’ continued reliance on the European Central Bank (ECB) for funding, even after the three-year lending program the ECB initiated last week made for a nervous market. This induced a “risk on” trade this week. The opposite is occurring in Europe as the chart below shows 10-year Italian bond yields back above 7 percent and near the highs of the recent crisis, indicating investors remain uncomfortable with European sovereign debt.

 

Strengths

• The Consumer Confidence Index hit an 8-month high even as there remain many global worries.
• The ISM Chicago manufacturing index remained in solid expansion territory in December and bodes well for next week’s national ISM release.
• Pending home sales rose 7.3 percent in November amid signs that the housing market may finally be coming back to life.

Weaknesses

• Negative economic data out of Japan this week included November household spending falling 3.2 percent and November industrial production sliding 2.6 percent.
• Fiscal austerity accelerated in Spain this week as the government cut $11.5 billion to reduce a budget deficit.
• Greek retail sales in October fell 8.1 percent as the country deals with its debt crisis.

Opportunities

• Economic news picks up next week after a holiday lull as the ISM Manufacturing index and unemployment are both reported next week.

Threats

• The situation in Europe remains extremely fluid and negative news is almost expected at this point; unfortunately it is politically driven and difficult to predict outcomes and ramifications.

 

Gold Market

 

For the week, spot gold closed at $1,563.70 down $42.65 per ounce, or 2.7 percent.  Gold stocks, as measured by the NYSE Arca Golds BUGS Index, fell 2.4 percent. The U.S. Trade-Weighted Dollar Index rose 0.4 percent for the week.

 

Strengths

• With the end of tax loss selling on December 23 for Canadians, the pressure to lock in losses for the year was abated and there were some significant rebounds over the last five trading days of the year.  Gran Colombia Gold surged 16 percent while both Romarco Minerals and San Gold gained 6 percent.
• Although we have been seeing some profit-taking towards year-end, gold has advanced 10 percent, heading for the eleventh straight annual gain. Gold returns are largely uncorrelated with the market and this has boosted its demand as an alternative investment for portfolio diversification amid slumping equities.  Gold’s high for the year was a record $1,923.70, reached on September 6. 
• Holdings in exchange-traded products backed by physical bullion are increasing for the first time in three weeks, rising 0.3 percent this week after falling in the previous two weeks 1.5 percent.  Buyers are coming back as the market looks oversold at current levels. 

Weaknesses

• The United States Mint reported this week that sales of the U.S. gold and silver bullion coins slowed in the fourth quarter as precious metal prices fell from their highs, signaling that investor interest in physical metal purchases may be waning.
• Generally, news flow in the gold space was negative for the week.  Seasonally slow jewelry demand in India (the world’s largest gold buying nation) and a ban from the People’s Bank of China (PBOC) on all non-official gold trading exchanges in the world’s number two gold consuming company, all contributed to weaker sentiment.  The Bombay Bullion Association said on Tuesday that December’s imports of gold bullion to India will likely stand 50 percent below December 2010 levels.  The PBOC ordered the closure of all gold trading platforms and services outside the Shanghai Gold Exchange and Shanghai Futures Exchange. 
• Due to surging gold prices in rupee terms, to lift sales, Indian jewelers have reduced the gold content to make up for the loss.  A steep jump in the price of gold in the first half of the year impacted demand for gold, while the volatility over the remaining months ensured that gold traders and jewelry retailers destocked.  Jewelers in some cases were replacing the weight of gold with diamonds to keep investors’ interest. 

Opportunities

• The Head of Research at China’s Central Bank was quoted saying that the country should buy gold as the only safe place for risk-averse investors when other assets are losing value.  Zhang Jianhua, the head of the research department at PBOC, wrote in the Financial News that, “the Chinese government needs to further optimize China’s foreign exchange asset portfolio and to seek relatively low entry points to buy gold assets.”
• We would expect there to be renewed interest in picking up many of the beaten down gold stocks with the start of the New Year as the sell off was exacerbated by tax loss selling in both the U.S. and Canada in the fourth quarter.  Seasonally, the January Effect is in play and gold prices typically see seasonal strength up until the April/May window.
• Securities and Exchange Commission data shows John Paulson, Paul Touradji and Eric Mindich, all hedge fund managers, sold bullion this year.  While there have been reports of high profile investors cutting their gold exposure it cannot be conceded that this conclusively ends the run in gold bullion.  Certainly some of the bullion selling reflected investor redemption requests, and fund manager preference to sell bullion instead of stocks, which on a relative basis have underperformed.  Turmoil in Europe has also been a factor in pushing the euro lower to the benefit of the dollar and detriment of gold.  Keep the economic fundamentals in mind as the debt and unemployment problems are far from being solved and the politicians will be more likely to stimulate growth and print money to extinguish debt as they seek to get reelected in 2012. 

Threats

• Zimbabwe announced that it is considering setting up a ban on raw platinum exports, in an effort to force miners to set up refineries in the country.  Zimbabwe has the second-largest known platinum reserves in the world. 
• Peru’s government may declare a state of emergency in the northern Andes should protests resume against Newmont’s Minas Conga gold project valued at $4.8billion.  It has been speculated that those protesting against the project have planned a march in the highland region for January 2-3.  The government has said it will take legal action against the protest leader, Gregorio Santos, for barring all industrial activity in the area around Newmont’s project. 
• Beginning January 20, 2012, workers of Freeport McMoRan’s Grasberg mine, who have been on strike since September 15, will gradually return to work.  More than 8,000 workers went on strike demanding higher wages, and the union has agreed to a 37 percent pay rise over the next two years. Copper prices may see some slackness in the near term.

 

Energy and Natural Resources Market

 

Strengths

• The Global Resources Fund beat its benchmark this week primarily due to stock selection across various industries.  Also, the fund was aided by better relative performance of junior exploration stocks versus senior resources stocks.  
• Oil climbed 8.7 percent this year, set for a third annual gain, on speculation that escalating tension in the Middle East may disrupt supplies as a recovery in the U.S. economy bolters demand. (Bloomberg)
• First Quantum’s workers at their Mauritania mine ended a week-long strike after receiving water and electricity allowances and yearly bonuses.  Water and electricity allowances are now the equivalent of $171 and $257, while annual bonuses will be as much as six months’ salary. 
• Macquarie noted that iron ore is having a slight rally into year end, boosted by interest from Chinese traders ahead of an expected steel production push into Chinese New Year. The Steel Index 62%Fe reference price CFR China is now $138.4 per ton, over 5 percent above its mid-December lows. The annual average 2011 spot iron ore price is set to come in around $168 per ton for 62 percent material, up 14 percent from 2010’s record.

Weaknesses

• Copper finished down 3 cents per pound for the week to close the year at $3.43 per pound (COMEX).  Copper fell $1 per pound down 23 percent from its starting point of $4.45 per pound last year.  
• The LMEX index of six industrial metals contracted 23 percent this year, led by declines in tin, nickel and zinc.  Spot silver is 9.3 percent lower in 2011, set for its first annual decline in three years.  Palladium is poised to fall 21 percent, and platinum has lost 22 percent. 
• Natural gas futures dropped below $3 per British thermal units for the first time in more than two years as mild weather and rising production contribute to a growing U.S. stockpile surplus.
• Bloomberg reported that Brazil’s oil regulator fined Chevron for the third time for not properly managing an offshore oil field that leaked last month.  The Agencia Nacional do Petroleo said on its website today that Chevron didn’t comply with the development plan for the Frade oil field off the coast of Brazil.  The amount of the fine has yet to be finalized, but the first two fines may be as much as the equivalent of $26 million. 

Opportunities

• Bloomberg reported that Goldman Sachs said in a December 1 report that the world is likely to avoid a recession and maintained its overweight allocation to commodities, predicting a 15 percent return in the next 12 months.
• Chinese coal stocks at IPPs continue to drop in terms of days of use according to data from China Coal Resource.  A Vietnam state-owned coal exporter, Vinacomin, has said it will also cut its coal exports from the following year to 13.3 million tons from 16.8 million tons this year, as domestic demand increases. This just points to an opportunity for coal imports into China to pick up.
• The Baker Hughes U.S. rig count, a key indicator of activity in the oil and gas sector, hit a 27-year seasonal high last week. At 2008 rigs, this is up 17.5 percent year-over-year and indicates ongoing strong demand from the U.S. energy sector for high performance commodity materials.

Threats

• Bloomberg highlighted that the weakest growth in demand in at least a decade for shipments of iron ore, the second-biggest commodity cargo after crude oil, means rates for the largest vessels will plunge to the lowest level since 2002.  It has been estimated that capsizes, each hauling about 160,000 metric tons of ore, will earn an average of $15,000 a day next year, about a 4 percent decrease than in 2011, implying losses for ship owners and investors in their companies.
• Hitachi Construction Machinery said Chinese demand for excavators will decline in the fist half of 2012 as monetary tightening slows construction projects. The sales downturn in China will continue after the Lunar New Year next month, CEO Michijiro Kikawa said, adding that he had expected Chinese demand to come back sooner. Kikawa expects industry-wide sales of excavators in China to decrease by 30 percent in the year to March 31, compared with a forecast of a 20 percent decline two months ago. China will probably see no growth until June or July, Kikawa said.

 

Emerging Markets

 

Strengths

• According to China Daily, China will invest RMB 200 billion for rural road construction. In fact, the populous rural area across the country needs huge infrastructure and home improvement to improve the quality of life and efficiency of the rural economy for the 600 million people, though many will continue to urbanize. In spite of tremendous accomplishments in the rural economy and living standards, the farming population lives in very third-world conditions, which means growth opportunities for China.
• The Chinese government reiterated this week that high speed rail (HSR) remains China’s transportation priority. China just released its investigation report on the Wenzhou HSR accident on July 23, which many regard as positive since it clearly revealed the irregularities behind the tragedy.
• With all the doomsayers predicting China’s immediate collapse, the November data showed some pretty good growth. Real estate floor space under construction was up 27.9 percent year to date on a year-over-year basis, and new starts rose 9.1 percent; power generation rose 8.5 percent; new coal production grew by 4.4 percent year-over-year, and coal imports reached a record monthly high up 59.5 percent, while exports were down 34.9 percent. November’s iron ore imports went up by 11.9 percent, but implied domestic production fell to 270 million tons per year. November’s refined copper production rose by 6 percent and consumption increased by 21.6 percent.
• In 2011, China surpassed Germany to become the second-largest luxury car buyer, with the U.S. still being at the number one position. China bought an estimated 94,000 luxury cars in 2011, up 39 percent from the previous year. Luxury cars are only 5 percent of the total car market in China, compared to 23 percent in the U.S. and 18 percent in Germany. This is why luxury car makers believe China has more room to grow. Eighty-one percent of the luxury cars are European brands.
• China’s National Development and Reform Commission (NDRC) announced this week China will first reform the natural gas price mechanism in Guangdong and Guangxi provinces. The reform will consider “market return,” in which PetroChina will reduce its loss by an estimated RMB 4 billion a year, according to China International Trust and Investment Corporation Securities (CITICS). PetroChina will benefit more once natural gas is priced by the market.
• After this week, China starts the Year of Dragon which is favored for babies to be born, because the dragon is a symbol of power and authority, and perhaps good luck as well. We saw the stock price of baby products makers relatively outperform the market in Hong Kong. We believe those stocks showed “growth at a reasonable price” (GARP) characteristics in an unappreciating market this year. 
• China’s Ministry of Commerce predicts secondhand car transactions will be more than 10 million units by 2015. It will also license secondhand car dealerships. As existing cars grow old, dealerships with post-sales services can benefit from such new business.
• The People’s Bank of China (PBOC) stopped issuing three-month bills this week, but instead injected net RMB 90 billion into to the system. The market interprets the act as an indicator that the central bank will cut the reserve requirement ratio (RRR) over the weekend.
• China’s Ministry of Housing and Urban-Rural Development mentioned in a recent interview that social housing new starts will be 7 million units in 2012, with total investment to support 18 million units of social housing construction. This will be positive for construction machinery and construction materials.
• Foreign direct investment to Indonesia surged this year to $9.1 billion as of September, up 41 percent year-over-year. In 2011, Indonesia’s GDP is expected to grow 6.5 percent, while inflation dropped to 4.15 percent in November from 7.02 percent when the year started.
• Macau’s gaming revenue from tables for the first 26 days in December was at MOP 19.2 billion. If adjusting this for the full month and adding back slots, gaming revenue is likely to be about MOP 23.8 billion, up 26 percent year-over-year, higher than brokers’ estimate.
• The world’s biggest major-currency decline is actually benefiting South Africa’s largest companies, as export earnings in dollars rise and commodity producers from AngloGold Ashanti to Sasol Ltd. beat peers in the stock market. Bloomberg data shows that the South African rand is the world’s third-worst performing currency year-to-date, ahead of only the Argentine peso and Indian rupee. 
• Roubini Global Economics revised its Colombia outlook, after third-quarter GDP growth was stronger than expected and will carry over onto following quarters.  Colombia surprised markets with a 7.7 percent year-over-year expansion for the third quarter of this year, the highest growth recorded since the fourth quarter in 2006, being mainly driven by a stronger-than-expected consumer sector expanding at 7.3 percent year-over-year and strong fixed capital formation accelerating to 20.14 percent from 14.7 percent in second quarter. 
• With the Argentinean government’s push to tighten foreign-exchange controls, peso forwards are posting their biggest monthly rally in almost three years as this promotes traders to pare bets the currency will tumble. 
• The National Statistics Institute said in a report this week that Chile’s industrial output rose 2 percent in November from last year. 
• As international oil prices decline, the Department of Energy of South Africa will lower the price of gasoline by 0.5 percent. 

Weaknesses

• China’s December PMI is 48.7, slightly higher than 47.7 in November composed by HSBC and Markit. PMI below 50 indicates the economic activities are in contraction. The December number shows the economy is predicted to be sluggish for the second month after November. Many in the market forecast official PMI will be 49, again a contraction mode but not crashing slowdown.
• For the first 11 months, Chinese corporate profits increased 24.4 percent on a year-over-year basis, compared to a 28.2 percent increase in the same period last year. In November alone, corporate profits were up 17.7 percent, 0.9 percent lower than in October this year, according to the National Bureau of Statistics. The market is in the process of digesting a slower GDP and corporate profit growth in China this year and next year.
• Property sales and price changes in China are watched tensely by bulls and bears alike in the market. Year to date, sales volume fell 13 percent on average on a year-over-year basis, according to China International Capital Corp (CICC).   The average price at the end of November for the first time reduced 0.53 percent on a year-over-year basis, but dropped 5.8 percent from the high level in May this year.  On a week-over-week basis, the average price across the country dropped 6 percent. You can see property price drop accelerated in the second half of the year. The trend will likely continue into next year until the Chinese government feels it is enough, at a point predicted to last several months into 2012 with 15 percent price reduction similar to what happened in 2008. Even by then, the market doesn’t expect the government to change its heart completely, other than some cautious policy lifting. 
• Hong Kong exports rose 2 percent year-over-year in November, missing expectation for a 3.9 percent gain.
• Korea’s consumer confidence fell to a three-month low of 99 in December on political concerns after Kim Jong Il’s passing. On the corporate front, Korean manufacturing confidence dropped to 79 for January from 83 the previous month. In separate news, Hong Kong home prices fell to the lowest level in 37 months, Centaline Property Agency Ltd. said in a statement today. The Centa-City Leading Index dropped 0.1 percent from a week earlier to 96.68 in the week ended December 25. 
• For the first three weeks of December, China’s passenger vehicle sales were 725,800 units, falling 3 percent year-over-year, but increasing 7 percent month-over-month after working days adjusted. The slowdown mainly comes from high base in last year and destocking of auto dealers. Some believe December passenger vehicle sales may still grow 5 percent.

Opportunities

• The chart below shows increasing demand for cement in Indonesia as the country builds its infrastructure. In a recent visit to Jakarta, we learned there is vast demand for roads, railways, ports, airports, and power plants, but they cannot be built due to difficulties in obtaining lands owned by private citizens. The recently passed land bill has the power to buy lands, and the process is final if a price is endorsed by district court or Supreme Court if necessary. The land bill is very positive for the economy, not just construction materials such as cement.

• The HSBC Russia Manufacturing PMI survey for December indicates that Russian manufacturing business sentiment improved, albeit at a slower rate. The seasonally adjusted headline index fell from November’s eight-month peak of 52.6 to 51.6 in December, resuming its divergence from the pre-crisis (2002-2007) business activity average level of 52.7.

Threats

• With slowing infrastructure investment and manufacturing activities, and possibly not-so-fast consumer consumption growth, China’s GDP growth may soon come down to near 8 percent (with consensus 8.3 percent). Many fear the housing market will collapse, though it is a big bet against the Chinese government.
• Argentina, South America’s second-biggest economy, published its 2012 monetary program this week, aiming to expand the M2 money supply by 26.4 percent.  This year, it had targeted 28 percent monetary growth.  The news that the Argentinean central bank plans to keep injecting cash into the economy at the current pace is a move that may further increase inflation, which is already among the fastest in the world.

 

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