All About Oil
(August 25, 2005)
Dear Subscribers and Readers,
We switched from a neutral position to a 25% short position in our DJIA Timing System on the morning of July 14th at DJIA 10,616. As of yesterday at the close, the Dow Industrials stood at 10,434.87 - giving us a gain of approximately 181 points. While a number of our indicators are now at the neutral level (such as the number of new highs vs. new lows) or at even at the oversold level (such as the ARMS Index and the Rydex Cash Flow Ratio) - not many of them are in agreement with each other. If one has to bet on the future direction of the market, one would have to bet that the current downtrend would continue until at least the major market indices reach a more oversold condition. A tightening Fed and a continuing uptrend in both crude oil and natural gas prices are creating severe headwinds for the market - despite continued stock buybacks and cash acquisitions from many domestic corporations.
Some of our readers are probably getting tired of all the current discussion surrounding crude oil already - but this author would argue that it is a very important commodity to keep track of going forward - one that requires more in-depth analysis and discussion than what you normally see or read in the popular media. I will begin by showing our readers the inflation-adjusted crude oil price from 1970 to the present, courtesy of www.chartoftheday.com:
The $90 record high oil price that you read about in the popular media is clearly illustrated in the above chart - coming at the heels of the Iranian Hostage Crisis, when all oil imports from Iran were halted. With the possible exception of the period during the 1973 to 1974 Oil Embargo (the only reason it is a possible exception is that domestic oil production peaked at around that time), all of these "price spikes" were the result of temporary supply constraints. That is, spare capacity at any point in time during the last 35 years on this chart was actually very plentiful. The problem was that some of the oil-producing countries just shut off their production or chose to significantly curtail the exportation of crude oil.
Such is not the case today - as we first illustrated in our "Three Important Questions" article about 12 months ago. Today, there is credible evidence that all OPEC countries (with the exception of Saudi Arabia) are already producing oil at full capacity. At the same time, any potential new discoveries in the region are not expected to materially impact the oil supply or spare capacity for the foreseeable future (I would recommend every subscriber of mine to read the book "Twilight in the Desert" by Mr. Matt Simmons). Please also note that recent production numbers from other non-OPEC countries have also been disappointing - including the UK, Norway, and even Russia. Finally, as I mentioned in our "Three Important Questions" article, "the "last frontier" for the production of oil (namely the North Sea, Siberia, and Alaska) is now aging. Most companies are now struggling in order to even maintain their current production levels." Twelve months later, this is still the case.
Today, most investors, speculators, and consumers in the oil markets are focusing on the concept of "spare capacity" i.e. how much of a cushion the world has in terms of oil production should we experience an unforeseen shortage somewhere in the world, such as a halt in Gulf production due to a hurricane, etc. The following chart courtesy of the Energy Information Administration (taken from an early July 2005 presentation) illustrates this concept (a concept which everyone has been discussing lately) perfectly:
By all accounts, all OPEC countries with the exception of Saudi Arabia are pumping and exporting oil at full capacity. Moreover, as Matt Simmons claims, Saudi Arabia's current production is not sustainable in the long run and the country may actually be jeopardizing its future ability to produce oil by pumping at the current 9.5 to 10.5 million barrels a day. The 20 million number that Saudi Arabia has contented it can reach has been its goal for the last 30 years is now all but a pipe dream. Unless Saudi Arabia can crank production capacity up to 12 million barrels a day by 2007 (a number which they have strived for during the last 30 years but has never been able to achieve), there is no doubt world oil prices will remain high - our view has always been that oil prices will reach $80 to $100 sometime in the next few years - barring a worldwide economic recession.
But Henry, what about oil inventories? Aren't they at ample levels right now? To which, we will answer: Yes, U.S. inventories are at historically high levels, but the "forward cover" (i.e. days of supply) are actually lower than historical averages, as demand growth has outpaced inventory growth over the last couple of years. Moreover, it is not sufficient to only look at U.S. inventories when one is looking at a worldwide and transparent commodity such as oil. Instead, one should be focusing on global inventories (or effectively, OECD inventories) as illustrated by the following chart courtesy of the Energy Information Administration:
Please note that the above chart was created in early July and thus contains somewhat outdated data - but OECD inventories are not easily available so we will just need to take what we can get (if anyone has a source for the latest OECD inventories numbers, please let me know at email@example.com). As the above EIA chart illustrates, while global inventories are within the normal range (which in itself is more bullish than the U.S. data suggests), the forward cover is actually low given demand growth over the last couple of years. The wildcard, of course, is China. Did some of the surge in Chinese demand over the last couple of years go to inventory building? Or does China currently have inventory to speak of? We will find out at some point in time. For now, the long-term trend of oil prices is definitely up.
That being said, there may be some short-term relief coming soon, as bullish sentiment in oil prices is now close to the peak in bullish sentiment prevalent during the three short-term peaks in oil prices back in 2004. Following is the daily chart showing the WTI Crude Oil Spot Price vs. the 21-day and the 55-day moving averages of the Market Vane's Bullish sentiment from January 2003 to the close on August 23, 2005:
As one can, bullish sentiment is now getting relatively extreme - suggesting that we are now very close to at least a short-term top in oil prices. That being said, a top in oil prices (or any commodity or financial index for that matter) is usually preceded or accompanied by an upside spike. Traders and investors alike should definitely be careful here. I would not recommend touching oil at its prices - but at the same time, I would not hesitate shorting the commodity should the price of oil jumps another 10% in an upside spike during the next couple of days and the week before Labor Day Weekend.
The relative strength of the American Exchange Oil Index (which we have illustrated several times before in this commentary) vs. the S&P 500 is now also at a level coincident with at least a short-term top. Following is a weekly chart showing the relative strength of the XOI vs. the S&P 500 from August 1983 to the present:
Please note that the relative strength of the XOI broke through resistance (a resistance that dates back to 1991) about a year ago and has been on a relentless uptrend since - are we at a blowoff stage or is this just a sign of sustainable high prices going forward? My guess is the latter - but for now, the relative strength of the XOI (which is now at its highest level since October 1990) is suggesting at least a short-term top here. Unless the S&P 500 can continue to rise, then traders and investors should hold off on buying oil stocks.
In trying to time a top in oil prices, traders should ask themselves: Who are the marginal consumers of oil? Is it the airlines? Countries with subsidized fuel prices like Indonesia? Hedge funds or companies (similar to the China Aviation Oil case) that are currently short crude oil contracts? How about Chinese factories or the Chinese consumer? Let's also not forget the European consumer - given the fact that economic growth is still relatively dismal in the Euro Zone and given that gasoline (petrol) prices in Western Europe are more than twice what they are here in the United States. As I have illustrated time and time again, the current rise in oil prices is different in nature than all the ones we have seen over the last 35 years - in that this rise is mostly attributed to oversized demand as opposed to a temporary constraint in oil production capacity. That is, a top in oil prices would not be obvious until we have seen significant demand destruction.
Following is just a conjecture - but could the companies within the Dow Transports be regarded as marginal users of oil? At the very least, any signs that the economy will not be able to withstand high oil prices will be reflected in the Dow Transports - as these companies have been passing most if not all of their fuel costs to their customers. Once they lose the ability to do that, it will be reflected in the performance of the Dow Transports. Following is a chart showing the relative performance of the Dow Transports vs. the OIH (Oil Service HOLDRS) vs. crude oil from October 1, 2002 to August 24, 2005:
Please note the extremely positive correlation of all three indices/prices from October 1, 2002 and onwards. This relationship, however, broke down earlier in March this year - as the Dow Transports has been significantly underperforming while both the OIH and the price of crude oil continued their ascent into the stratosphere. Is the underperformance of the Dow Transports signaling an imminent topping out of crude oil prices? Time will tell.
Conclusion: While we are longer-term bullish on oil prices due to the lack of spare capacity (due to continuing demand growth) and recent oil discoveries, there may be signs that the oil rally is in the midst of topping out. This is reflected in the extremely bullish sentiment of oil traders, the historically high relative strength of the XOI vs. the S&P 500, and the underperformance of the Dow Transports since March earlier this year. In monitoring this situation, investors and traders alike should continue to ask: "Who are the marginal users of oil?" Only when those marginal users are "taken out" would see a sustainable (although probably only intermediate term) downtrend in oil prices. Be careful, however, as most if not all significant tops are preceded or accompanied by huge upside spikes in prices. That is, this author would not be surprised if oil goes up another $5 to $10 a barrel before topping out.
We are also reevaluating our 25% short position in our DJIA Timing System. We are continually monitoring our overbought/oversold indicators, and some of our indicators are getting in the oversold area - so don't be surprised if we switch to a completely neutral position at some point in the next few weeks. We will talk more in this weekend's commentary.
Henry K. To, CFA