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Crude Oil Supply and Demand Update

(March 15, 2007)

Dear Subscribers and Readers,

Before we get on with our commentary, I want to remind subscribers that David Korn of will be writing a guest commentary for us this weekend – as I will be flying to Chicago, IL on Sunday for a quick two-day business trip.  In his guest commentary, David will chronicle the 1929 to 1949 secular bear market – and discuss the cyclical bull and bear markets within the context of the 1929 to 1949 secular bear market in detail.  Look for a copy of David's newsletter in your email inbox next weekend.

Volatility continues to be the name of the game, as the Dow Industrials declined as much as 136 points yesterday before rallying over 57 points to close at 12,133.40.  The bears would say that just when everything was looking grim (the Dow Industrials plunged to an intraday low of 11,939.61), the PPT (a.k.a. the Plunge Protection Team) came in and saved the day.  What they neglect to say, however, is the fact that the market was hugely oversold immediately before the intraday rally.  The NYSE ARMS Index closed at a level of 3.49 on Tuesday – which, if you ignore the 15.77 reading on February 27, 2007, was the highest reading since the 3.70 reading on March 4, 2003.  At its most oversold level yesterday, the NYSE ARMS Index touched a level of 2.  Combined with oversold readings of 2.31 and 2.26 on March 2nd and March 5th, respectively, readers should not have been surprised to see an oversold bounce during the New York lunch hour.

In terms of sentiment, the CBOE total put/call ratio is also now at its most oversold level since at least consistent records were kept.  Following is a long-term weekly chart of the 10-day moving average of the CBOE total put/call ratio, courtesy of

10-day moving average of the CBOE total put/call ratio 1989-present

As can be seen from the above chart, the 10-day MA of the total CBOE put/call ratio recently declined below its late May 2006 lows – which was in itself a record low.  More importantly, the shape of the CBOE put/call ratio has somewhat resembled the shape of the S&P 500 Index over the last 18 years – peaking when the stock market made a significant peak in July 1990 and bottoming during the October 1990 and January 1991 period.  The CBOE put/call ratio also spiked lower in the bond and stock market correction in 1994, as well as during the Russian, Brazilian, and LTCM crises in late 1998.  Finally, the CBOE put/call ratio also made a significant peak in early 2000 at a level below 0.50 – again spiking lower during September 2001, September/October 2002, March 2003, late May 2006, and most recently, over the last three weeks.  Based on historical patterns of the CBOE put/call ratio and major indices such as the S&P 500 and the S&P 100 – there is a good chance that not only are we currently hammering in a major intermediate term bottom, but potentially a longer-run bottom as well.

Given the above put/call ratio readings, and given all the things that we have been discussing over the last couple of weeks, I believe that for investors who have either an intermediate term or a long-term horizon should continue to hold on to their long positions, should you be holding any in the stock market.  For those that are currently not in the stock market, I would recommend waiting for the AAII and the Investors Intelligence surveys to confirm the bearish sentiment in the CBOE put/call ratio before buying any individual stocks or mutual funds.  Fortunately for the bulls, however, the bearish sentiment in the CBOE put/call ratio is also being confirmed by the pessimism implied in the latest ISE sentiment readings, as shown by the following chart:

ISE Sentiment vs. S&P 500 (October 28, 2002 to Present) - Over the last three trading days, the 20 DMA of the ISE Sentiment declined another 3.7 points to 102.2 - representing the lowest reading since the 101.5 reading on September 29, 2006, and prior to that a 101.8 reading on November 7, 2002. The continued decline in the ISE Sentiment index reflects pervasive pessimism among retail investors - especially given the heavy retail put buying on the major subprime lenders over the last couple of weeks.

Over the last three trading days, the 20-day moving average of the ISE Sentiment readings declined another 3.7 points to hit a reading of 102.2 – representing the most oversold reading since September 29, 2006 – and prior to that, November 7, 2002.

Moreover, given the fact that every asset class has been tanking recently with the exception of government bonds, this author would not be surprised to see the Fed REMOVING their tightening bias after the conclusion of their two-day meeting next Wednesday, March 21st.  For subscribers who have been keeping track, the Eurodollar futures market has already discounted a 25 basis point cut in the Fed Funds rate to 5.00% during the August 7th meeting.  Given that mortgage applications have just risen to a 3-month high, and given that the subprime fears have most probably been overblown (for the record, I think the fact that investment banks are cutting the lifelines of the subprime lenders so quickly – as opposed to staying in the space and throwing good money after bad – is a bullish development, although in the short-term it is having an opposite effect on sentiment), I would not be surprised to see a rip-roaring rally emerge should the Fed remove their tightening bias come the conclusion of the latest Fed meeting on March 21st.

But Henry, what about commodity prices?  Isn't the Fed concerned about that?

Yes, the Fed is definitely concerned about commodity prices.  However, the bond market has essentially been making rate cut decisions for the Federal Reserve over the last few years – and there is no reason to expect anything different this time around.  More importantly, the Fed has the option of “testing out the market” by removing the tightening bias in their statement and to see how the various markets react to it before choosing to actually ease later this year.  Sure, gold prices are currently about 20% higher than where they were at this time last year, but keep in mind that if the gold price stays stagnant for the next two months, this 20% year-over-year rise will actually turn to a 10% year-over-year decline – as the spot price of gold rose from just under $550 an ounce on March 14, 2006 to $725 an ounce by May 12, 2006.  Should gold prices remain weak over the next two months, I would not be surprised to see the Fed cutting 25 basis points later this year.

In the meantime, the West Texas Intermediate crude oil price is sitting 8% below than its level at this time last year.  Moreover, not only is oil supply expected to continue to grow over the next two years, world surplus capacity is expected to grow as well, as shown by the following chart from the Energy Information Administration:

World oil spare production capacity

Interestingly, world oil spare production capacity is expected to rise this year to a level not seen since 2003 – when crude oil prices were half of what it is now.  Obviously, oil prices won't decline back to its 2003 levels anytime soon (if it does, there would be no spare production capacity left since a significant amount of the supply would no longer be economically feasible) – but the fact that spare capacity is now higher than what it was in 2005 and 2006 should go a long way towards tampering any potential price rallies going forward.  For the rest of this year, I expect the price of crude oil to stay in the range of $50 to $65 a barrel.

For those commentators who keep harping on the drastic declines in oil production in the North Sea (essentially Norwegian and UK production), it is important to keep in mind that while oil production is no doubt declining in the North Sea, this decline is being offset by supply growth from other markets, namely Angola, Brazil, the United States, Russia, Azerbaijan (a country just east of the oil-rich Caspian Sea and the fastest growing country in the world last year, with a GDP growth of over 33%), and Canadian oil sands, as shown by the following chart courtesy of the EIA:

World oil supply growth (change from previous year)

Finally, given that oil demand in China and India is only expected to rise 400,000 barrels a day and 100,000 barrels a day, respectively, this year and in 2008, there is no reason to believe we will experience any oil crunch over the next two years – terrorist and active hurricane season notwithstanding.  Following is a chart (again, courtesy of the EIA) showing both the historical growth in world oil consumption and its forecast over the next two years:

World oil consumption growth

Signing off,

Henry To, CFA

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