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Marginal Growth in Global Crude Oil Production

(May 22, 2011)

Dear Subscribers and Readers,

Let us now begin our commentary with a review of our 13 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172;

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863;

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;

9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points;

10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.

11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points;

12th signal entered: 50% long position initiated on May 21, 2010 at 10,145;

13th signal entered: 50% long position SOLD on December 15, 2010 at 11,487, giving us a gain of 1,342 points; the DJIA Timing system is currently in a neutral position.

As shown in the following chart (courtesy of the US Energy Information Administration), global oil supply has steadily increased from just over 60 million b/d in 1990 to over 80 million b/d today.  According to the EIA, global oil production was 85.5 million b/d in 2008, declining to 84.4 million b/d in 2009, and rising to a record high of 86.7 million b/d last year.  Global oil production is projected to increase steadily to over 110 million b/d by 2035, with unconventional production making up 12% of total supply:

Interestingly, US oil consumption is projected to remain stable over the next 25 years.  In fact, both “conventional” oil consumption and oil imports are expected to decline, with growth in natural gas plant liquids and biofuels playing a more significant role:

The projected decline isn't surprising.  The last major peak in US oil consumption came in the 1970s, as the “center of power” in the global oil industry shifted from the Texas Railroad Commission to the OPEC countries.  This was demonstrated twice with the spike in prices during the Oil Embargo from October 1973 to March 1974 and the second oil crisis in 1979 that occurred in the wake of the Iranian Revolution.  As a result, automobile fuel economy increased; while natural gas and coal became the preferred fuel of power plants and other industrial customers.  US oil consumption would not surpass its late 1970s high again until the late 1990s.  Going forward, a further increase in automobile fuel economy standards, as well as the introduction of plug-in electric vehicles and the commercialization of second-generation biofuels, should alleviate any increased oil demand by US consumers.

Notwithstanding EIA's optimistic long-term projections, global crude oil supply growth is expected to increase only marginally over the next 18 months.  This is not surprising—as production in the North Sea and Mexico continues to decline—while recent deep-sea discoveries, such as Brazil's Libra oil field, would not be producing until several years from now.  As shown in the following two charts, non-OPEC production is projected to increase by 690,000 b/d this year and 420,000 b/d in 2012; while OPEC production is projected to fall by 450,000 b/d this year, and rebound by 640,000 b/d in 2012. 

Due to the unrelenting growth in global oil demand, however, OPEC surplus production capacity is expected to decline from 3.9 million b/d to 3.6 million b/d this year, followed by another decline to 3.1 million b/d next year.  As shown in the following chart, OECD commercial oil stocks is also expected to decline to the middle of its 5-year range by the end of this year—following by the elimination of all “floating storage” by the end of last year:

Despite the ongoing development of oil shale deposits and deep-sea projects in Brazil and other countries, it is difficult to see how the EIA's production goals could be met without a further rise in oil prices.  Producing nearly 100 million b/d of “conventional” oil by 2035 would also result in substantial environmental degradation.  Somewhat optimistically, I expect second-generation biofuels to be commercialized by the middle of this decade—and if that occurs, global oil production should start to decline, especially with the ongoing technological improvements in solar panels and battery storage.  If we fail to commercialize second-generation biofuels by the middle of this decade, then crude oil will likely spike to $200 a barrel before the decade is over.

Meanwhile, the primary uptrend in US equities remains intact.  However, both our liquidity and breadth indicators are deteriorating—a signal that the bull market is maturing.  Going forward, there would be more volatility in both the US stock market and individual securities.  However, given the momentum behind global equity prices, the rally in the Dow Industrials and the S&P 500 should continue in the short-run, although we are still looking for a larger-than-expected correction this summer.  Again, should the Dow Industrials continue to rally (preferably to over 13,250) on dismal upside breadth and/or volume, we will likely go 50% short in our DJIA Timing System.

Let us now discuss the most recent action in the U.S. stock market using the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown in the following chart from January 2008 to the present:

For the week ending May 20, 2011, the Dow Industrials declined 83.71 points, while the Dow Transports rose 64.85 points.  Both Dow indices remain close to their three-year highs, while the Dow Transports actually exhibited relative strength last week by not confirming the decline in the Dow Industrials.  The momentum behind this rally should propel the market further, especially since market valuations are still decent.  However, given the weakness in our technical indicators, we expect a market correction this summer.  We remain neutral in our DJIA Timing System, and may shift to a 50% short position should the Dow Industrials rally further on weak upside breadth/volume.

I will now continue our 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 four-week moving average of these sentiment indicators declined from a reading of 20.8% to 19.0% for the week ending May 20, 2011.  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 1998 to the present:

After peaking at 30.8% (its highest reading since late February 2007) in late January, the four-week MA declined to 19.0% last week.  While there is likely more upside for this indicator and the market in the short-run, the lack of a recent correction suggests the market is highly vulnerable to a larger-than-expected correction—likely sometime this summer.  We will retain our neutral position in our DJIA Timing System, and will likely shift to a 50% short position if the Dow Industrials rally to over 13,250.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

The 20 DMA declined from 110.6 to 107.4 last week—its most oversold level since September of last year.  Similarly, the 50 DMA is also at a semi-oversold level.  There is likely more upside in both this sentiment indicator and the market in the foreseeable future, especially since momentum and valuation levels remain decent.  However, should the Dow Industrials rally to above 13,250, we will likely go 50% short in our DJIA Timing System.

Conclusion: With global oil production expected to rise only marginally in the next 18 months, the chances of a crude oil spike remains high.  Moreover—unless second-generation biofuels are commercialized by the middle of this decade—crude oil prices should rise substantially over the next decade.  I would not be surprised if WTI crude oil hits $200 a barrel before the oil structural bull market is over.  Going forward, R&D spending in solar power, second-generation biofuels, battery storage, and smart grid technologies will need to increase.  In the meantime, the short-term momentum of the stock market remains to the upside.  We remain neutral in our DJIA Timing System and will likely go 50% short if the market rally further on weak upside breadth/volume.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA


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