Will We Ever See a World Awash With Oil Again?
(June 4, 2006)
Dear Subscribers and Readers,
In last weekend's commentary, I discussed the oversold conditions of the U.S. “mega-caps” – paying special attention to mega-caps in the retail sector, such as WMT and HD. I essentially played “Devil's advocate” and asked the question: “Given the stock market is the ultimate leading indicator, could many of the large-cap retail shares have already bottomed (such as WMT at $42.50 and HD at $35), even as the U.S. economy slows down later this year due to the bursting of the housing bubble?” There are many other supporting factors to this argument, such as the hugely oversold condition of these stocks, their relative undervaluations (such as relative to themselves historically as well as relative to the S&P 500), as well as the fact that the consumer credit growth has been growing at a rate below nominal GDP for the last three years. The latter is especially important, as this means that consumers are not totally tapped out and still has a source of credit to tap once their housing ATM is shut down later this year. Finally, investing guru Bill Miller of Legg Mason has over 30% of his assets in the consumer discretionary group in both his Opportunity and Value Trust funds. As a semi-aside, the undervaluation of the U.S. mega-caps can also be witnessed in the following “market valuation graph” showing Morningstar's valuation of the companies with “below average” business risk (usually, the bigger the company is, the less the accompanying business risk). Note that Morningstar's valuation of these stocks is now near levels which we have not seen since early 2003. The following chart is, of course, courtesy of Morningstar.com:
Ultimately, whether one wants to buy the consumer discretionary stocks will come down to this: Do you think that the current stock prices of retailers have already discounted the upcoming consumer slowdown due to a housing slowdown? Do you believe this housing slowdown will merely cause a slow down in the growth of consumer spending or do you believe it will cause a consumer-driven recession – a consumer-driven recession which we haven't experienced since 1990 to 1991? This author will admit something: I don't know, and neither does anyone else including Ben Bernanke or Goldman Sachs. That is why the Federal Reserve is always assessing and re-assessing – and that is why the Fed has remarked that any further rate hikes going forward will be dependent on upcoming data.
However, this author has always been willing to add his own thoughts, and this time will be no different. In our many commentaries over the last 12 months, I have constantly said that the Fed was not done yet – even in the midst of the destruction wrecked by Hurricanes Katrina and Rita. Earlier this year, I continued to harp on this theme, saying that the Fed will not stop until the commodity markets have taken a pause or if the stock market suffers a correction or if the current account deficit righted itself. Over the last few weeks, however, it has become clear that many of the general commodity indices and emerging markets have now popped – and combined with the ongoing housing slowdown, the Fed has most probably nearly finished its job. This has also been the message coming from Ben Bernanke – when he stated that both the CPI-U and the PCE deflator inherently overstate consumer inflation (I know many of our subscribers will take issue with this comment, but please do keep in mind that sometimes, perception is more important than reality). Moreover, the ECRI Future Inflation Gauge has been giving us benign readings for the last three consecutive months – and I have no doubt that the Fed is also watching this indicator as well. Again, the important theme for our readers is this: It does not really matter whether we have inflation or not, but whether the Fed thinks so going forward, and what they intend to do with regards to monetary policy. For now, it looks like that the June 29th rate hike will be the final rate hike for this cycle – with the next one most probably a rate cut instead.
The only remaining question for this author is whether the last rate hike will be a 25 basis or a 50 basis point hike. With the exception of the 1997 cycle, the Greenspan Fed has always ended his series of rate hikes with either a 50 basis or a 75 basis point hike. Given Bernanke is supposed to be more hawkish than the Greenspan Fed, and given that he needs to establish a reputation for being a strictly "inflation-targeting” Fed Chairman, there is a real chance he will hike by 50 basis points in the June 29th meeting but signal to the markets that the Fed is done. This will also send a message to the commodity markets that the Fed is serious about clamping on speculation in the metals and in gold - but at the same time, give the speculators "a chance" to "correct their ways" on their own (since they will be pausing). Finally, what the Fed doesn't finish in the commodity markets will be finished by the ECB and the Bank of Japan. The U.S. economy will most likely have a slowdown, but it doesn't make sense for us to go any further risk a recession just because both the ECB and the Bank of Japan have been too loose with their policies.
So Henry, what are you saying? What you just said opposes the views of the many commentators who have been complaining of an out-of-control Fed printing money left and right.
Yes, what I just said with regards to the Fed is at odds with many commentators out there, especially the doom-and-gloomers who have been predicting the imminent collapse of the U.S. economy for the last five years. To illustrate my views, let me give you an update on what our MarketThoughts “Excess M” (MEM) indicator is saying. Readers can refresh their memories on our MEM indicator by reading our October 23, 2005 commentary (this commentary is available for free), but basically, here is the gist of it: Our MEM indicator is calculated by taking the difference of the 52-week growth rate of the St. Louis Adjusted Monetary Base and the 52-week growth rate of M-3 (both indicators smoothed using their ten-week moving averages). The rationale for using this is two-fold:
- The St. Louis Adjusted Monetary Base (currency plus bank reserves) is the only monetary aggregate that is directly controlled by the Federal Reserve. One can see whether the Fed intends to tighten or loosen monetary growth by directly observing the change in the adjusted monetary base. By knowing what the Fed intends to do, we will know whether investors and speculators are "fighting the Fed" so to speak, and generally, fighting the Fed usually ends in tears more often than not.
- The St. Louis Adjusted Monetary Base inherently has very little turnover (i.e. low velocity). On the contrary, the components of M-3 (outside of M-1) has higher turnover and is more risk-seeking. If M-3 is growing at a faster rate than the adjusted monetary base, than it is very logical to assume that velocity of money is increasing. Readers should note from their macro 101 class that the Federal Reserve has no direct control on M-3. Instead, M-3 is directly affected by the ability and willingness of commercials banks to lend and by the willingness of the general population to take on risks or to speculate.
Since the Fed has just stopped publishing M-3 statistics, this author has now revised our MEM indicator accordingly. Instead of using M-3, we are now choosing to use a monetary indicator that most closely resembles the usefulness of M-3 – that is, a measurement which tries to capture the monetary indicators which inherently have the highest turnover/velocity in our economy. We went back and found one measurement which is very close – that of M-2 outside of M-1 plus Institutional Money Funds (the latter is a component of M-3 outside of M-2 which the Fed is still publishing on a weekly basis). That is, we have replaced M-3 with M-2 outside of M-1 plus Institutional Money Funds in our new MEM indicator. Following is a new weekly chart showing our new MEM indicator vs. the St. Louis Adjusted Monetary Base vs. M-3 vs. M-2 minus M-1 plus Institutional Money Funds from April 1985 to the present:
As can be seen in the above chart, our MEM indicator is still significantly in negative territory – meaning that the Fed has continued to more or less tighten (lack of growth in the St. Louis adjusted monetary base) even as speculators and investors alike continue to take on risks (increasing pseudo M-3). That is, the Fed has not been loose at all. Most of the recent monetary growth has come from commercial banks and the private financial sector, but even the monetary growth coming out of those sectors is low relative to what is occurring in the Euro Zone. Following is a monthly chart showing the year-over-year growth in M-3 for the 12 countries in the Euro Zone from January 1980 to April 2006:
As evident on the above chart, the Europeans have been even more “loose” with their monetary policies than Americans, as the most recent year-over-year growth of M-3 in the Euro Zone hit a high of 8.9% - a high not seen since early 1990 when East Germany were being integrated with the democratic world. For comparison purposes, the most recent year-over-year growth of M2 less M1 plus institutional money funds is approximately 6.5% - a number which is actually lower than nominal GDP growth. As for Japan, readers should go back to our April 30, 2006 commentary (“Divergences and the Dash to Trash”) for an idea on how much liquidity the Bank of Japan has created in recent years – starting with its zero interest rate policy and then moving to its “quantitative easing” policy starting in March 2001. Most recently, however, Japan has ended its quantitative easing policy, and the Japanese monetary base has plunged in response. Following is the year-over-year growth in the Japanese monetary base vs. the Nikkei from January 1991 to May 2006:
Readers who follow our discussion forum postings should know that the Bank of Japan injected 500 billion yen and 1.5 trillion yen in liquidity in two separate instances, once on May 26 and the latter on May 29, respectively. The opinion of this author is that those two liquidity injections were mostly to keep Japanese short-term rates at near zero and provide some support to the bond market and the rest of Asia. Make no mistake: The Bank of Japan is still willing to mop up excess liquidity and to officially end its quantitative easing policy sometime this summer. The year-over-year decrease of 15.35% of the Japanese monetary base represents the lowest reading EVER (at least since records were kept from the early 1970s) – while the second derivative (the rate of growth of the Japanese monetary base) is now at its lowest reading since April 2003. Given the huge rise in the Nikkei in the last 12 months and given its huge divergence from the growth of the Japanese monetary base, the rest of 2006 should be tough for Japanese equities. More importantly for U.S. and European investors, however, it increasingly looks like the Japanese carry trade is almost over – with gold and copper having already topped out for this cycle (I still believe we are in a long-term secular bull market for gold and silver, however).
As for crude oil, it remains a different story, given the current lack of spare capacity in every oil-producing in the world and given political and terrorist jitters in countries such as Iran (although as Stratfor implies, the chances of an Iranian disruption is definitely not very high), Iraq, Nigeria, and Saudi Arabia. The following chart from the Energy Information Administration shows the historical direct relationship between the West Texas Intermediate crude oil prices vs. OPEC spare capacity from April 1999 to March 2006:
For the month of May 2006, the EIA estimates that remaining OPEC surplus capacity is at a mere 900,000 barrels to 1.4 million barrels per day – and these are all very heavy crudes. And while there is still 325,000 barrels per day of shut-in production remaining from the Gulf of Mexico (caused by last year's Hurricanes Katrina and Rita), chances are that this potential production won't be ready in time for the Hurricane season (which officially started a few days ago). Even assuming a relatively “dull” hurricane season this year (which is highly unlikely although “experts” are forecasting it will be less active than last year), it will take several more months for Gulf of Mexico production to return to its pre-Katrina and Rita levels of last year. For the rest of 2006, the oil markets should remain very tight – and this author will not be surprised if we see another spike to all-time high levels due to another Gulf hurricane or continuing political instability somewhere in the world.
I will now show you a chart which may not be so obvious to stock market traders – given the historical inverse relationship between stock prices and oil prices. However, the following chart is a chart I have shown before, and it shows the action of the Dow Transports vs. the OIH vs. the WTI crude spot oil price from October 1, 2002 to June 2, 2006. Please note that since the current cyclical bull market began in October 2002, the Dow Transports, the OIH, as well as the WTI crude spot price has moved up in tandem ever since:
The above chart implies that crude oil prices will probably at least make one more new high sometime this year – given the continuing strength and uptrend in the Dow Transports (with the airlines being the most notable) and given the confirmation in the OIH (Oil Service HOLDRS). But after the end of the busiest time of the 2006 Hurricane Season (starting in October), anything goes – and given the slowdown I am looking for in the U.S. economy, and given continued tightening by the European Central Bank and the Bank of Japan, this author is looking for a top in oil prices sometime during the 2006 Hurricane Season.
Aside from a significant slowdown on the growth in demand, this author is also looking for a significant increase in supply coming online in 2007, 2008, and continuing into 2010. As projected by the EIA, much of the supply increases will come from Algeria, the UAE, Libya, the Caspian, Brazil, West Africa, Angola, Canada, along with recovering production coming from the Gulf of Mexico and the beginning of production from the Thunderhorse and Atlantis fields. This in turn will more than make up production losses (due to the maturity of these production fields) in the North Sea, Russia, the Middle East, and Mexico. Following is a direct quote outlining projected spare production capacity from a May 4, 2006 EIA testimony before the Committee on Energy and Finance from the U.S. House of Representatives:
In OPEC, surplus production capacity will remain tight in 2006, but EIA expects around 600 thousand barrels per day of surplus crude oil production capacity growth and 600 thousand barrels per day of non-crude production growth. Specifically, the UAE could add 200 thousand barrels per day from de-bottlenecking the Zakum and Umm Shaif fields. New crude oil production capacity at the Bonga and Erha fields in Nigeria has been offset by disruptions to Shell-owned, offshore oil production, and these recent disruptions could have longer-term implications for net supply growth from Nigeria. Algeria's production is expected to increase by 100 thousand barrels per day from increased oil and condensate production. Libya could also add 100 thousand barrels per day, primarily from enhanced recovery from existing fields. Iran and Indonesia are projected to lose capacity by 2007. This year, EIA expects non-OPEC total liquids supply growth of up to 800 thousand barrels per day, and we expect an additional 1.5 million barrels per day in 2007. One major portion of the increases in non-OPEC supply in 2006 is simply recovery from the Gulf of Mexico hurricanes. Improvements to oil supply recovery technology in the Gulf of Mexico, recovery of the Mars production platform, and the beginning of production from the Thunderhorse and Atlantis fields account for a large portion of growth from the United States. By the fourth quarter of 2007, oil production from these fields is expected to account for about 10 percent of the lower-48 oil production. Outside of the United States, major supply additions in the Caspian, Brazil, and West Africa stem the decline in mature field production in the North Sea, Russia, the Middle East, and Mexico.
Major projects in Angola include the Chevron-led Benguela Belize project, of 200 thousand barrels per day, and the ExxonMobil-led Kizomba B and C projects, of 250 thousand and 240 thousand barrels per day, respectively. By the time these projects are all producing at their maximum rates in 2007 and 2008, they will have added almost 700 thousand barrels per day to Angola's existing production. In the Caspian, the BP-led consortium that is developing the Azeri-Chirag-Guneshli (ACG) project will increase production by around 400 thousand barrels per day between 2005 and 2007. The project operators maintain that they will be able to double Azerbaijan's existing production to around 1 million barrels per day by 2010. Finally, in Canada, conventional oil production in the Western Canada Sedimentary Basin will continue to decline at around 3 percent per year. Taking into account nonconventional growth from oil sands, EIA still expects 400 thousand barrels per day of net growth from Canada between 2005 and 2007.
Based on projects that are already in the pipeline, there is a strong likelihood that additions in OPEC and non-OPEC capacity will exceed demand growth between 2008 and 2010. World surplus production capacity could grow to 3 to 5 million barrels per day by 2010, substantially thickening the surplus capacity cushion, if demand projections prove accurate.
Again, giving the anticipated slowdown in the U.S. economy, and given continued tightening by both the ECB and the Bank of Japan, there is a good chance that oil prices will top out sometime during the 2006 Hurricane Season – not to mention the result of an even larger surplus production capacity than the EIA has originally anticipated by 2010. Make no mistake: This author still believes we are in a secular bull market in commodity prices (especially gold, silver, crude oil, and natural gas), but in the meantime, I would not be surprised if oil prices plunge back to $50 a barrel or below over the next couple of years.
Let's now take a time out and discuss the broad stock market. Let's first recap our most recent signals in our DJIA Timing System:
We switched from a 25% short position to a neutral position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 – giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday, January 18th at DJIA 10,840. We then switched to a 50% short position on Thursday afternoon, January 19th at DJIA 10,900 – thus giving us an average entry of DJIA 10,870. As of the close on Friday (11,278.61), this position is 378.61 points in the red. We then added a further 25% short position the afternoon of February 27th at a DJIA print of 11,124 – thus bring our total short position in our DJIA Timing System at 75%. We subsequently decided to exit this last 25% short position on the morning of March 10th at a DJIA print of 11,035 – giving us a gain of 89 points. We subsequently entered an additional 25% short position in our DJIA Timing System on Monday morning (March 20th) at a DJIA print of 11,275 (which was exited the Friday morning before last at 11,260).
We then further added a final 25% short position at a DJIA print of 11,610 on the early afternoon of May 9th. A special alert email was sent to our subscribers in real time – and a message was posted in our discussion forum alerting our subscribers of this change. This position was subsequently exited on Wednesday morning, May 17th at a DJIA print of 11,255 – giving us a gain of 355 points of the final 25% short position that we at 10,610 (which shifted our DJIA Timing System from 100% short to 75% short). On Friday morning, May 26th, we further pared down our short position from 75% short to 50% short, and exited our March 20th position at a DJIA print of 11,260 (giving us a gain of 15 points in this position).
I will now be honest: As of Sunday evening, June 4, 2006, this author is getting somewhat uncomfortable with our 50% short position – given the very oversold conditions in some of technical indicators including the NYSE McClellan Summation Index (which is an intermediate term indicator), the Rydex Cash Flow Ratio, our popular sentiment indicators (which I will discuss later), and a one-day equity put/call ratio of 0.87 – which represents the most oversold one-day reading since October 2005. However, history suggests that we will still see at least more of a consolidation period before we see some more further gains in the major market indices – and thus this author will use any sell-offs this week or next week in order to shift to a completely neutral position in our DJIA Timing System. Again, please note that this author is not looking for a new bull market here. Rather, this author believes that many of the major market indices have now topped – but it increasingly looks like they will try to retest their all-time highs (or perhaps a blow-off) before correcting further later this year. Again, going forward, I will post more of my daily thoughts on the stock market such as updates on the ARMS Index, the Rydex Cash Flow Ratio, etc., on our MarketThoughts.com discussion forum. I urge every one of you to visit our forum at least once a week since the quality of our posters are exceptional and since many of the things I post on there are not mentioned in our regular twice-a-week commentaries.
Let's now take a look at the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 1, 2003 to the present:
As I mentioned on the above chart, given the severe oversold condition in many of our technical indicators and given the significant rise of the Dow Utilities in the latest week (the Dow Utilities rose more than 11 points to close at 415.90 – its highest level since February 26, 2006), probability suggests that the current bounce in the major market indices will gain some traction over the next six to eight weeks. Readers should continue to monitor the NYSE A/D line, the NYSE McClellan Oscillator and Summation Index, along with NYSE and NASDAQ volume for any signs of a stronger-than-expected recovery, but given the recent strength of both the NYSE and the NASDAQ McClellan Oscillators, it now looks like that many of the major market indices may go on to retest their most recent highs over the next six to eight weeks. Time will tell, but this author will now look for any weakness in the Dow Industrials to close out our 50% short position in our DJIA Timing System sometime this week (and possibly even tomorrow).
I will now end this commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators sank further below the 20% level – declining from 18.4% to 14.0% in the latest week – a low not seen since early November 2005. This reading is clearly now in territory that is consistent with short-term bottoms in the markets over the last few years. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
In last weekend's commentary, I stated: “Given that the four-week moving average is still not as oversold as where it has been during the market bottoms over the last few years, there is a good chance that we will need to wait a couple of more weeks before getting one. However, readers should keep in mind that our sentiment indicators can reach a similar oversold level simply with the markets consolidating or drifting lower. That is, the market does not have to plunge from here. Most likely, we will see the major market indices consolidating over the next week or so – with a subsequent retest of their May highs sometime in July or early August.” Since last weekend, what I anticipated has more or less come true – given the consolidation we experienced next week and given the increasingly oversold condition in our popular sentiment indicators. I expect more consolidation (with a possible retest of the 11,100 level) over the next week or so, and I expect to use any weakness to get rid of our 50% short position (at a loss) in our DJIA Timing System.
Conclusion: As of Sunday evening, June 4th, the chances of a Fed rate hike in the June 29th meeting has dropped back to 45% - but this author still believes that the Fed will hike one more time, and that will be it for this cycle. Whatever the Fed doesn't take care of will be taken care of both the European Central Bank and the Bank of Japan, given that they have been the primary creator of liquidity for the last few years. As for crude oil prices, this author believes that it will most probably make another all-time high sometime this hurricane season, but will top out for this cycle sometime this year – given a slowing down in the U.S. economy, continuing tightening by both the ECB and the BoJ, and new surplus capacity coming online in 2007 all the way through 2010. As with my commentary last weekend, I believe readers should continue to keep an eye on the U.S. mega-caps such as WMT and HD.
As for the current state of the markets, this week continues to look like more of a consolidation week, but this author will use any weakness during this upcoming week in order to shift to a completely neutral position in our DJIA Timing System (from a current 50% short position). The severely oversold condition in some of our technical indicators – combined with the strength of both the NYSE and the NASDAQ McClellan Oscillators last week – tells me that there is some strength in this rally, and that we may go on to retest the recent highs in many of the major market indices.
By the way, has everyone read George Gilder's chapter on John Mauldin's “Just One Thing” yet? After reading this chapter, you will never look at the current state of the stock market the same way again!
Henry K. To, CFA