It seems that everywhere we look these days; we see some reference to the CIBC World markets estimate that oil will be at or over $200 a barrel by 2010 or so. It is as if that number is becoming a sort of reference point by which the current price of oil is judged, and the impact on whomever household or whatever industry is therefore measured by. So much so, that we are beginning to wonder whether this is starting to sound like some of those price “targets” used by high tech analysts back in 2000 – interesting and exciting, but unlikely.

A little while ago, we ourselves had ruminated that perhaps the price of oil was about to join some of the other commodities in having what we termed a ‘high-risk’ run. That is, we had been wondering whether the current supply/demand situation coupled with all of the speculative elements of the commodity funds, and the general conviction that energy prices may never be able to fall (by much) into the future, might well bring about one of the closing crescendos that commodity runs like to end on. This month, we ponder aloud, as it were, and ask, is it here?

According to a recent CFA Society Financial News Brief, “In Asia, oil reached a record high price of more than $135 a barrel and then retreated. Concerns about supply, increasing global demand and a declining dollar are keeping crude futures moving up. Analysts are starting to question what will stop oil prices from increasing as they continue to set new records almost daily. Although there are technical indications in the futures market that crude might drop, few analysts are ready to call an “end.”

Indeed, one might well inquire, once oil is north of $120-130, is there any price in particular that of necessity will be the peak price reached? To that, there can be no answer, save one of sane sensibility, and just what that may be is anyone’s guess. However, paralleling the gains in oil, there has been a huge run-up in the price of uranium based on the thesis that was – and still is, for that matter – a global ‘shortage’ of uranium. The price shot of uranium rose to $138 a pound because of the massive global demand as all sorts of new reactors come into operation. Since that time, however, the price then started a decline, which became almost a rout, and uranium has now “settled” back down to around the $60 level very recently. So could it happen to oil as well? We really can’t answer that question definitively at all. But we can take a look at the respective Charts of uranium and oil, courtesy of Bloomberg because they are quite interesting in our humble view (or perhaps, imagination).

Here we have the two price charts, the first of uranium, and the second of oil. Both are in “short supply” and “huge demand”. Lets us start with uranium as it has, if not peaked) fallen back from its recent high to less than half of its peak price in 2007. Uranium is/was in high demand as many countries, notably including China, are moved to a nuclear solution to generating electricity. It is less polluting than coal, oil, or gas (unless it is allowed to leak out as was feared in the Three Mile Island accident a few years ago, or as actually occurred in the Chernobyl disaster). In recent years, literally dozens of new projects were announced, driving the price of uranium from about $6.75 a pound in 2000 to a peak of $138 in June 2007, before falling back to $60 a pound today. What changed to knock down the price so severely? Not much, one would aver. There is still hot and heavy demand for yellowcake, no major projects have been abandoned as far as we are aware, and they certainly haven’t found great gobs of new supply, although everyone is looking for it. The speculation just sort of … ended, and the price fell back to something a lot more commercially reasonable than it was at $138. We should note that speculators still believe that uranium can still go much higher than at present, and the James Dines Investment Letter (among others, undoubtedly) is still rampantly frothing-at-the-mouth bullish.

And that brings us to oil. In April, 2007, oil was trading at $60 a barrel and today, it has just settled back a bit from its very recent high $133.70. What has driven oil so high, and can it stay here? Clearly, CIBC World Markets among others think so. Using inflation-adjusted pricing, they point out that oil is not really that high, and that demand and lack of new supply can only drive oil prices in one direction. However, Wayne Jett of Classical Capital reports that at a recent hearing of the Senate Committee on Homeland Security, hedge fund manager Michael W. Masters testifies that index speculators are driving up the world price of crude by increasing the capital devoted to commodities futures contracts, and are doing so regardless of the price. He used the term ”Speculators” here to mean institutional investors who buy and hold commodity futures solely for investment purposes as opposed to those who actually plan to take delivery for use at some time in the future. Apparently, the amount of investment capital diverted from more traditional investments has increased some 20-fold in the past 4-5 years, in the process driving up many commodity prices up sharply. And some of the sharp commodity price spikes have been in commodities which are in plentiful supply? Wheat and even corn would come to mind here.

Masters went on to observe that these commodity investors plan to buy and hold the futures contracts, simply rolling them over at expiry into the next forward contract, never having to sell effectively. Curiously, the size of some positions actually violates restrictions on position limits in some commodities. But the funds have found a technical loophole through buying a swap through a bank, in effect controlling the commodity. At issue for the regulators then, is – are commodities suitable investments for pension funds and should this loophole be closed or left open to allow further commodity buying by, in effect, non-users of the commodities in question and thereby creating a totally artificial demand, spiking prices higher and higher (until they collapse under their own weight?). Masters suggests that this loophole be firmly closed to stop an increasingly massive speculation in commodities by investment funds which will go on until prices reach that collapse point, at which time the funds will be bailing out in size into a market where there is no demand. In other words, the prices collapse.

Our own (SAC) guess is that investing in commodities violates, if not actual pension law, the principle that all investments suitable for pension funds must carry with them the prospect of generating income for payout at some point. Commodities do not do this and their only potential return is higher prices. While in theory, there is nothing wrong with buying commodities in the hope that their prices will rise, in practice they cannot rise forever and at the turning point and beyond, there is absolutely zero probability that they can be held long enough to actually generate income as commodities do not generate income per se. That strongly suggests that those same institutions will be abandoning ship with their tails between their legs and unable to sell until the commercial clearing price is reached (and probably beyond, due to the pressure to sell at any price).

And finally, in light of Masters testimony, we would have to ask, what is the difference between oil at $60 a barrel a year ago, and oil at $130 a barrel 12 months later? The answer is …12 months. Not a single thing has changed since that time in terms of the knowledge that we had then and the knowledge that we have today. The same Hubbert’s Curve is still in operation, the same demand parameters are still there – the Chinese and Indians are still buying more cars than anyone else – the same fields are drying up, the same Americans are wasting more energy than all the world combined and doing less about it in any official capacity (except holding more hearings than anyone else), although as it turns out, they are driving less than they used to with a 4.3% decline in driving in March.

What has changed is that it is now emerging that fund speculators have taken the bit in their teeth and run up oil to levels which may or may not prove to be at extremes. The size of fund demand almost equals the growth in demand for China over the past 5 years, and with ‘success’ in investing in oil, more money is pouring in. Fund hotshots on a speculative tear are exactly the same formula that drove dotcom stocks to silly extremes only to see them collapse like the proverbial house of cards. The difference between the dotcoms and oil is that it actually costs something to produce oil. The marginal cost of new oil production is probably somewhere around the clearing price for oil if (as, and when?) those fund speculators are forced to sell.

And what will happen to the oil and gas stocks if Masters turns out to be right and oil prices decline? One of two things might happen to bring that about – the law is changed to prevent pension speculators from getting around the commodity position size loophole, or the market demand for oil, at the margin, falls far enough to bring about a self-perpetuating collapse in the price under the sheer weight of lack of demand (in the short term is all that it would take). We don’t know exactly, but when uranium collapsed, Cameco, one of the world’s premier uranium stocks roughly fell from $59.90 to $31.39, as our chart shows. The current price is still about 33% lower than the peak price. This despite the fact that the Fair market Value did not decline much, if at all! Whether that means that the uranium analysts have never dropped their high price expectations for yellowcake or whether there is such a growing demand for the metal that the earnings are expected to simply continue to be strong, we don’t know. We do note, however, that a year ago when oil was at $60, the Fair Market Value for the Oil and Gas Index was in excess of +75% and it has only gotten higher. As with Cameco, we suspect that that would not prevent the energy stocks from being pushed against the wall and thoroughly beaten up, however.

The final horror of it all is that (again ifMasters is correct and the current price is a figment of the imagination of a bunch of trigger happy fund managers, aided and abetted by CIBC World Markets not to mention Goldman Sachs who first mentioned $100+ oil pricing) there will be no telling when the price of oil may peak and therefore whether – or even if – that the energy stock prices themselves may decline. They have been so volatile anyway that an investor could lose 25-30% of one’s investment before it became remotely evident that anything more than the usual seasonal (or whatever) factors are cutting in, that oil is not heading to a new price peak, and that we should have gone “some time ago”.

It is always a clear possibility (probability?) that we are concerned for nothing and that Masters is just blowing smoke. Unlike a stock valuation, there is really nothing much to go on in the commodities markets save the marginal cost of production. No balance sheets present themselves for regular review and analysis, and what numbers we do get, such as inventories, changes from moment to moment. The big picture in oil production and demand favours high oil prices, although not necessarily higher oil prices. On the positive side, China and the Far East is industrializing and their citizens becoming consumers in the sense that we are consumers. On the negative side, the US is in recession, and the recession is deepening. Colour us ‘concerned’ and pondering lightening up on our energy positions a bit.

As a final consideration, should oil tumble, then there would be some clear beneficiaries of lower oil, including anything that is propelled by gasoline, diesel, or aviation fuels. Even the US consumer would probably lift up his head for a moment and smile. Inflationary fears would abate, especially if the decline in oil prices were accompanied by declines in other commodities as well. And that might well occur as energy costs have an impact virtually everywhere. The Canadian dollar would weaken, of course, not because it ought to because of any weakening of our national balance sheet, but because currency speculators like to think of the C$ as a sort of ‘petro-currency’. Stretching your credulity from the realistic to the micro-imaginative, we could even see an oil price rally in the midst of the oil price decline (should one ever occur) as the boost given to confidence due to oil price weakness spilled over into some rally strength in oil on the grounds that energy weakness was causing enough general strength to force oil prices back up again! (Don’t laugh. We’d cheerfully bet a bottle of scotch – or better yet, a gallon of gas – oops, 4 litres of gas, we meant to say – on that happening.)

 

Sector Updside Potentials

Comment

There is no doubt that as things move along, as the analysts become more and more bullish, and as the comfort that an economic recovery is just around the corner, the market is looking better and better from a Fair Market Value point of view!  Strip out the commodity inflation from the Canadian numbers, however, and see what happens.