Oil Shortages this Hurricane Season - Last Thing to Worry About
(June 11, 2006)
Dear Subscribers and Readers,
In last weekend's commentary (Will We Ever See a World Awash With Oil Again?), I stated that while the prices of most commodities (including gold and copper) have topped out for this cycle (even though they are still in a secular bull trend) given continuing tightening liquidity from the world's central banks and a U.S. economic slowdown this remains a different story with the price of crude oil. Since 2003, the world price of crude oil has more or less determined by the amount of (or lack thereof) spare capacity in the world's oil-producing countries and most recently, by the amount of political and terrorist jitters in countries such as Iran, Iraq, Nigeria, and Saudi Arabia. As of today, the Energy Information Administration (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 June 1st). Even assuming a relatively dull hurricane season this year, it will take several more months for Gulf of Mexico production to return to its pre-Katrina and Rita levels of last year. Therefore, for the rest of 2006, the oil markets should remain very tight but from 2007 and onwards, both the EIA and this author believes that new capacity coming online will significantly alleviate the current tight supply situation (again, please see last weekend's commentary for more details). In fact, the EIA estimates that: 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.
Please note, however, that the above projection of the EIA does not take into account a potential economic slowdown in the U.S. or in Asia/Europe later this year. As this author has pointed out since the beginning of this year, we're in for at least a mid-cycle slowdown for this year, and recent statistics, including the much-anticipated housing slowdown (along with the insistence of the world's central banks to keep on tightening) are signaling that U.S. GDP growth will significantly slow in the upcoming quarters. In the event that the U.S. experiences a recession (but which this author is not looking for), then world capacity could dramatically increase over the next few years and in such a scenario, this author would not be surprised to see a crude oil price of $50 a barrel or even lower.
Okay Henry, you just said that crude oil supply should remain tight for the rest of 2006. Is there a possibility of an oil supply shortage later this year especially during the most active part (August 1st to October 31st) of the Hurricane Season?
Of course, anything is possible. As a Houstonian, who would've thought that so many thousands would have to flee Hurricane Rita last year? Without the convenience of our radios, cell phones, and the internet, society could have quickly broken down in the midst of all the chaos. That being said, I am a numbers person and am very fond of probability at heart and if I was to bet, I would have to bet that another evacuation by Houstonians would not be necessarily this year (or for the matter, for the next five years). Using the same probability argument, one would definitely bet that there would be no significant crude oil or natural gas disruptions during this Hurricane Season based on the current NOAA (National Oceanic and Atmospheric Administration) forecasts and the accompanying analysis from the EIA. As history has shown, it has nearly always been better/profitable to not bet on a disaster or end of the world scenario.
Before I dive deeper into the subject, let me give you a little bit of a background. Per the EIA, the Gulf of Mexico is a very important source of both crude oil and natural gas for the United States. During 2004, crude oil production accounted for 27% while natural gas production from the region accounted for 20% of total U.S. production. That is why so many commentators and analysts are concerned about any adverse impact that severe weather may cause in the region during the 2006 Hurricane Season. Based on (both long-term and recent) history and current forecasts, however, the chances of similar disruptions this year is next-to-impossible (but again, this is subject to revision), as I will now outline.
As discussed in the latest This Week in Petroleum publication from the EIA: In May of each year, the National Oceanic and Atmospheric Administration (NOAA) produces an outlook for the upcoming hurricane season in the Atlantic basin, which includes the Caribbean Sea and the Gulf of Mexico. As the season progresses, NOAA fine-tunes its projections. Those projections are driven primarily by their forecasts of the seasonal Accumulated Cyclone Energy (ACE) index, which measures the collective intensity and duration of all tropical named storms and hurricanes in the Atlantic. For 2006, NOAA currently expects the seasonal Atlantic ACE index to range from 118 to 179 (135 percent to 205 percent of the normal level), corresponding to an 80 percent chance of an above-normal hurricane season in 2006. Although that forecast predicts a very active hurricane season, it is considerably lower than the Atlantic activity observed last year, which had an ACE index about 280 percent of the normal level. In addition to the ACE projections, for the 2006 north Atlantic hurricane season, NOAA predicts 13 to16 named tropical cyclones, with 8 to10 becoming hurricanes, of which 4 to 6 could become major hurricanes (Category 3 or higher).
While both NOAA and the EIA will revise their predictions later this August, the above forecast is encouraging, since even if the ACE index turned out to be at the high-end of its range (179), it is still lower than the ACE index exhibited during the 1995 (227.2), 1998 (181.6) and 2004 (224.6) hurricane seasons. As a matter of fact, an ACE index of 179 is still comparable to the ACE index exhibited during the 1999 (176.1) and 2003 (174.5) hurricane seasons two hurricane seasons which were not accompanied by any crude oil or natural gas disruptions in the Gulf of Mexico. Following is a chart from the most recent EIA publication (The Impact of Tropical Cyclones on Gulf of Mexico Crude Oil and Natural Gas Production) showing the North Atlantic ACE Index vs. the number of tropical cyclones for each hurricane season from 1950 to 2005:
Looking at the above chart, it is obvious even to the untrained eye that 2005, with an ACE Index of 247.8, was an outliner. Compared to the current high-end (an ACE Index of 179) of NOAA's estimates, the upcoming Hurricane Season should be relatively muted and should not cause any significant disruptions to Gulf oil or natural gas supplies. More importantly, however, even an ACE Index of 220 or over has only historically resulted in temporary disruptions as near-normal production usually returned the following month after the hurricane. From the EIA: [The following] Figure 4 shows the production of oil and natural gas in the Gulf OCS for 1995-2005 with the effects of various Gulf of Mexico tropical storms and hurricanes highlighted. There have been 6 major hurricanes during the past decade that have caused significant disruption in oil and natural gas production: Opal (1995), Georges (1998), Lili (2002), Ivan (2004) and Katrina/Rita (2005). However, with the exception of Ivan (which shut in about 25 percent of monthly production) and Katrina/Rita (which shut in about 70 percent of monthly production), most disruptions have been temporary with near-normal production returning the following month. In fact, most Gulf tropical cyclones only shut in production for a few days. For example, in 1997 Hurricane Danny passed within 50 miles of the center of OCS production, yet it registered a barely perceptible drop in daily production rates, shutting in about 2 percent of that month's oil and natural gas production. Hurricane Bret (1999) with 125 mile per hour winds slightly impacted crude oil production but had almost no effect on the trend in natural gas production.
As I mentioned above, Hurricanes Katrina and Rita were definitely outliers not simply because of their intensities but because of the paths they have taken, the long-term effects of the subsequent destruction, and the fact they occurred only a month apart from each other. The following chart shows the paths taken by Hurricanes Katrina and Rita last year. Note that more than 70% of all oil and gas platforms in the Gulf of Mexico were affected by the paths of these two destructive hurricanes:
Again, based on current forecasts as well as history, the chances of similar disruptions in oil and natural gas production in the Gulf of Mexico this year is next to impossible. In fact, based on current forecasts, this author would be surprised if we get ANY significant disruptions this year. All this is not lost on the folks at the EIA, as they are currently forecasting a cumulative production loss in the range of only 0 to 35 million barrels of oil and 0 to 206 billion cubic feet due to this year's hurricane season. For comparison purposes, a cumulative 162 million barrels of oil production and 784 cubic feet of natural gas production have been lost since the 2005 hurricane season began nine months ago.
Of course, no one can predict weather-related events with accuracy especially weather-related events that are more than two weeks out. But over the last few years, the forecasting tools that have become available have gotten much better in terms of prediction accuracy. Moreover precisely because of last year's freak events many oil and natural gas drillers have rebuilt their platforms and pipelines with stronger infrastructure, which should make them better able to withstand any upcoming hurricanes and storm-related events. When it comes to investing, the old adage is that you can't hedge what you can't predict and usually, the most profitable scenario is to not do so. Given the current evidence and historical experience, the message of this author is to not bet on another hurricane-related spike in either crude oil or natural gas this year.
Moreover, based on our outlook of world spare capacity in last weekend's commentary, my guess is that oil will top out sometime in the next four months and will embark on a self-reinforcing decline starting later this year or early next year as both hedge funds and pension funds bail. This outlook is still being confirmed by our MarketThoughts Global Diffusion Index (MGDI). For newer subscribers, I will begin with a direct quote from our May 30, 2005 commentary outlining how we constructed this index and how useful this has been as a leading indicator. Quote: "Using the "Leading Indicators" data for the 23 countries in the Organization for Economic Co-operation and Development (OECD), we have constructed a "Global Diffusion Index" which have historically led or tracked the U.S. stock market and the CRB Index [and CRB Energy Index] pretty well ever since the fall of the Berlin Wall. This "Global Diffusion Index" is basically an advance/decline line of the OECD leading indicators - smoothed using their three-month moving averages." Following is the monthly chart showing the YoY% change in the MGDI and the rate of change in the MGDI vs. the YoY% change in the Dow Jones Industrial Average and the YoY% change in the CRB Energy Index from March 1990 to April 2006. Please note that the data for the Dow Jones Industrials and the CRB Index are updated to May 31st (the May OECD leading indicators won't be released until early July). In addition, all four of these indicators have been smoothed using their three-month moving averages:
Historically, the rate of change (second derivative) in the MGDI has lead or tracked the year-over-year change in the CRB Energy Index (and to a lesser extent, the Dow Jones Industrial Average) very closely. While the second derivative (rate of change) in the MGDI has been strong since November of last year, readers should note that ever since March 2004, the MGDI and the year-over-year change in the CRB Energy Index have embarked on a historical divergence most probably due to the lack of world spare capacity in crude oil production and the spike in last year's natural gas prices. Given that the supply outlook is more favorable going into 2007, this author expects the CRB Energy Index to correct in due time and thus taking down crude oil prices with it as well. While crude oil is still in a secular bull trend and remains a secular story, there is no question that it can and will correct in a big way in the short-term most probably starting later this year and continuing into 2007 and beyond.
As an aside, this author believes that any relief in gasoline prices will come too late for GM. The final insult came last week when Yanase (a Japanese chain that sells imported autos) announced that it will be slashing the number of dealerships that will be selling GM cars in Japan, while Suzuki has confirmed that it will be stopping all GM sales in Japan. Moreover, since GM has also bet most of its turnaround on its 2007 SUV lineup, further signs of GM's ultimate demise are now evident as SUV sales in general have dramatically slowed down with the popularity of SUV arson being now reported by the mainstream media. As I have mentioned before, the secular rise in oil prices will claim many casualties along the way including the legacy airliners, SUVs, and now most probably GM and the American consumer.
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. 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 three Fridays ago 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. 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).
As implied in our last weekend's commentary, we exited our final 25% short position in our DJIA Timing System on Monday morning, June 5th at a DJIA print of 11,190. The timing of this exit was rather unfortunate, as the Dow Industrials subsequently closed nearly 150 points lower at 11,048.72. Moreover, this was covered at a loss, as our average entry for this 50% short position was a print of 10,870. Finally, this author entered a 50% long position in our DJIA Timing System on Thursday morning, June 8th at a DJIA print of 10,810. Going forward in our commentaries, I will only give our readers a running account of our most recent long position as this is getting very long already. Readers who are interested in our historical signals can see more (and learn about our rationale behind those signals) at our MarketThoughts DJIA Timing System page.
As of Sunday evening, June 11, 2006, this author is getting ready to shift our 50% long position in our DJIA Timing System to a fully-invested 100% long position. Since our last weekend's commentary, many of the technical indicators I have discussed have gotten more oversold. More importantly, we are now getting signs that a bottom is starting to come together, such as:
1) The fact that the Dow Utilities bottomed as early as the beginning of April and the fact that it has significantly outperformed the other major market indices over the last three weeks. More importantly, the Dow Utilities managed to rise 0.63% in a general down market last Friday resulting in a non-confirmation of the down day in both the Dow Industrials and the Dow Transports. Given that the Dow Utilities has historically led the Dow Industrials and many major market indices, this uncanny strength in the Dow Utilities should not be ignored by the bears:
2) The relative strength of the Retail HOLDRS (RTH) vs. the S&P 500 bottomed eight weeks ago. Since the relative strength of the RTH vs. the S&P 500 has typically led and bottomed two to eight weeks prior to a bottom in the major market indices, one can say that the current decline in the S&P 500 is getting long in the tooth. If anything, we should at least witness a short-term bottom sometime this week. This argument is all the more powerful given that the RTH relative strength low of eight weeks ago was at a level not seen since March 2003. Following is the weekly chart of the RTH vs. the S&P 500 from May 2001 to the present:
3) One of the industries that have led the current decline has been the U.S. homebuilders having actually topped out in early April vs. the top of the S&P 500 on May 9th. From early April, the U.S. homebuilders literally crashed over the next couple of months, as the U.S. homebuilder ETF (shown in the below chart) declined from a top of 46.52 to a bottom of 32.97 last Thursday morning. This 30% decline in the U.S. homebuilders over the last two months has been even more dramatic than the decline in Indian, Russian, and Turkish stock markets during that time. By the end of last week, however, it has become quite obvious that selling has been exhausted in the U.S. homebuilders, as the XHB (the homebuilders ETF) fell dramatically in the early parts of last week only to reverse starting Thursday morning and extending into Friday. This reversal was also confirmed by the accompanying high volume in the XHB, as shown below:
Again, please note that this author is only currently looking for a tradeable bottom, and not for a new bull market here. Rather, this author believes that many of the major market indices have now topped out 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 strength in the Dow Utilities over the last few weeks, probability suggests that a short-term market bottom will develop sometime this week followed by a tradeable rally that should play out over the next couple of months. 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 non-confirmation of the NYSE A/D line and the McClellan Oscillator on the downside last week, it now looks like that breadth should continue to hold up in the coming weeks. Time will tell, but this author will now look for any weakness in the Dow Industrials to shift to a 100% long 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 nearly touched the 0% level last week declining from 7.7% to 4.0% in the latest week a low not seen since April 2003! This reading has now even surpassed the oversold levels that are 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 had expected more of a consolidation phase, with a possible retest of the 11,100 level as the market gets ready for its next move up. Needless to say, I was a little bit surprised by the 90% downside day on the NYSE last Monday having just gotten rid of our 50% short position in our DJIA Timing System that morning. Luckily, we didn't go long in our DJIA Timing System that morning!
We got some redemption later last week, however, as we initiated a 50% long position in our DJIA Timing System on Thursday morning at a DJIA print of 10,810. The market proceeded to go lower in the next 15 minutes after we made that decision, but it would subsequently reverse and close positively for the day (at 10,938.82). While the market could very well decline below the 10,810 level this week (you never know what Chairman Bernanke will say nowadays although we are still betting on a final-and-that's-it rate hike on June 29th), it is our assertion that any declines this week should be bought and held for at least the next couple of months.
Conclusion: As of Sunday evening, June 11th, my views don't really change that much from last week's. No matter what Bernanke says this week, we believe that the Fed will hike one more time on June 29th, 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 slowdown 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. Even another high during this hurricane season is not a slam dunk, however, as the chances of a significant disruption in crude oil and natural gas production is very unlikely. As with our commentaries over the last few weeks, I believe readers should continue to keep an eye on the U.S. mega-caps such as WMT and HD. Readers should now also add MSFT, INTC, and EBAY to the list.
As for the stock market, this author is now looking for at least a short-term bottom sometime this week and will try to utilize any weakness in the market to shift from a 50% to a 100% long position in our DJIA Timing System.
Henry K. To, CFA