Agora Financial’s Rude Awakening

Jump to Comments

Laguna Beach, California

• Commodities mount yet another rally as stocks flail,
• Crude: The other inflation hedge (and with room on the upside!),
• Plus, Rude moves house next Monday…Are you joining us?

Eric Fry, reporting from Laguna Beach, California…

For the second day running, commodities made some noise in the trading pits. Gold jumped to another all-time high of $1,064 an ounce; oil surged to a one-year high near $75 a barrel and most of the agricultural commodities bounced to new multi-month highs. By contrast, for the second day running, the stock market did a whole lotta nuthin’.

Two days’ trading action doesn’t make a trend, of course, but it does make a nifty topic of discussion for an online financial column! The specific “nifty topic” that interests us here at the Rude Awakening is whether commodities like oil, corn and wheat might now be much more compelling investments than the S&P 500 Index.

After all, if the economy is genuinely and truly recovering, demand for commodities will also recover. And yet, broadly speaking, the stock market has done a heck of a lot more “recovering” than the commodity markets. The S&P 500 trades for a lofty 19 times expected earnings – earnings, which, by the way, might not materialize as expected. Most commodities, meanwhile, change hands at price well below their highs of the last two years. And so we wonder, “Why not sell stocks and buy commodities?” Specifically, why not buy crude oil and/or the grains?

The nearby chart displays the recent price trends of both crude oil and the S&P 500 Index, since the end of 2007. As fate would have it, their respective zigs and zags have landed these two asset classes in approximately the same spot. Similarly, crude oil and the S&P 500 have both bounced about 60% off their March lows. But here’s where our story takes an interesting turn…

Historically speaking, stocks are very richly priced. On the other hand, crude oil seems very lowly priced, at least in relation to probably supply-demand trends and to the ever-rising cost of new production. Net-net, at the current quotes, the S&P 500 seems like a riskier bet than crude oil…and a MUCH riskier bet than the grains.

As an added plus for the would-be buyers of commodities, the U.S. dollar is looking a little shaky these days. Every time it stumbles, bids show up for the stuff that powers and feeds the world. Every time the dollar trips over itself, the world’s dollar-holders look around for ways to hold fewer of them – like exchanging them for gold, grains or crude oil.

For more on the whys and wherefores of the crude oil trade, please check out the insights below from Chris Mayer, editor of Mayer’s Special Situations. But a quick head’s up…Chris doesn’t get to the stuff about crude oil until about half way down the column. The first half contains what he calls “timeless investment wisdom”…

—- Options Hotline Limited Time Offer —-

Get the Next 24 Recommendations – Free!

Don’t miss this limited time opportunity to add up to $18,800 a month to your bank account!

You can get the next 24 trade recommendations from one of our most profitable services… Absolutely FREE (a $495 value)!

Here’s the best part… In 2008, this service averaged a 94% return per recommendation. Don’t miss out…Read On Here.

—————————————-

Why Oil? Why Now?
By Chris Mayer

Forecasting is a troublesome art even in less confusing times than these. As Edward R. Murrow once said, “Anyone who isn’t confused really doesn’t understand the situation.” We are in uncharted waters in many respects. Nonetheless, we must try to make sense of it all. Herein, a few quick observations on where we are with some timeless investment wisdom and some kind words for crude oil, which looks like something an investor can bank on in uncertain times.

We’ll start with Howard Marks, the chairman of Oaktree, which oversees some $60 billion in assets. At the recent Grant’s Fall Investment Conference, he offered an interesting summary of what happened during the financial collapse of 2008. The story was, essentially, one of too much debt.

A willingness to take risks, easy credit and optimism fueled the boom. The ratio of credit to GDP, which has tended to hover around 140–160% here in the U.S., shot up to 300% pre-2007 crisis. In the years immediately following the Great Depression, this ratio shot up to 265%. So we are well into “ugly” territory.

As Marks points out, much of the apparent improvement in the economy today has had to do with the financial sector, and not the “real” economy. “Business is still terrible,” he says. “Our industrial base is shrinking, perhaps permanently.” Many of the boom’s problems remain unresolved. The potential for more defaults and more bankruptcies is still substantial, he says.

But what is an investor to do? As Marks says, “You can’t always prepare for a 2008. You’d never do anything.”

That is true. Marks shared a few of his favorite investment mantras, which are useful to keep in mind. The first is that “improbable things happen; and probable things fail to happen.” Anybody who lived through 2008 needs no reminder of this. It would’ve seemed improbable that oil prices could fall from $143 to $30 in six months, but it happened. It would’ve seemed probable that inflation would be high by now, but it isn’t.

Second, “It is not enough to survive on average; you have to be able to survive the worst day.” Marks used the example of a 6-foot man drowning in a river only 5 feet deep on average. The lesson: Buy companies that can survive the worst days.

Third: “Being too far ahead of your time is indistinguishable from being wrong.” Anyone who was bearish on oil at $100 a barrel — on its way to $143 — was pretty much wrong, even though they were ultimately right. Timing, sometimes, is everything.

And finally, on forecasting, Marks was brutally honest. He doesn’t believe forecasts, even his own. (“In fact, I don’t believe half of what I just told you,” he said as the crowd laughed. To which Jim Grant, ever ready with a rejoinder, quickly asked: “Which half?”)

With that, we’ll take a stab at the oil market, which seems to exhibit the wisdom of all the above.

The story of oil is one of an increasingly costly supply base and a stubbornly high demand for oil. Andrew Hall told the story. He is chairman of Phibro, a large commodity trading firm. His presentation highlighted all the pitfalls of our precarious oil supply. The U.K., Norway and Mexico are all in decline, and each was a major producer of crude oil not long ago. Indonesia, one of the founding members of OPEC, is now a net oil importer.

True, we’ve had several new discoveries. As Hall points out, though, these are all costly sources of oil. And all the new discoveries will barely offset the existing declines elsewhere. Add in the potential downside risk of delays and cost overruns and Hall believes there is little chance of upside surprises.

The key to his whole argument rests on the current replacement cost curve for world oil. The average marginal cost to produce 84 million barrels of oil per day – the current demand – is $70 a barrel. In other words, if the oil price falls below that level and stays there for a while, marginal production becomes uneconomic…which means that production would be certain to fall.

Furthermore, the cost of production continues to rise. Less than a decade ago, the marginal cost was only $25 a barrel. So the whole curve has been shifting upward over time.

There is also a kind of feedback loop here. The biggest cost to produce oil is the price of steel and the price of oil itself. So as oil prices go higher, it means extraction costs also go up. The return we get on energy invested, or EROEI, is another element in decline. In 1930s, the return was greater than 100:1. By the 1970s, it slipped to 30:1. Today, the “energy return on energy invested” is in the mid-teens. It seems clear we’ll spend even more energy on to get energy in the future.

The great backdrop of demand remains those emerging markets. They are still early in the growth curve for oil demand. As Hall says, the emerging markets are at a per capita level at which oil demand begins to grow rapidly.

That, plus the supply issues, paints a powerful bullish backdrop for oil. It’s why Hall concluded his presentation by saying, “Oil price upside is virtually guaranteed.”

We will see. But how to play it? Hall recommended owning oil in the U.S. or Canada. Also oil field service stocks remain attractive as the picks and shovels of the oil industry. He recommends avoiding the refineries, which should be a terrible business for years to come. He is also not a fan of the midstream assets (i.e., the pipeline stocks), as they won’t participate as much in a rising oil price.

The other thing about oil is that, like gold, it is an inflation hedge. Asked about oil as an inflation hedge, Hall said, “All hard assets are going to perform well in nominal terms. Oil prices quadrupled in the ’70s and then quadrupled again.”

So if we circle back round to Marks’ wisdom, “Improbable things happen.” How about a rising oil price in the face of a weak economy? Improbable, most would say. Inevitable is what Hall’s presentation promises.

Joel’s Note: Speaking of oil investments, right now Chris is spending some time over in the Middle East, checking out opportunities for his readers. After that, he’s off to India to get some “boots-on-ground” exposure there. In fact, Chris and Addison, our executive publisher, are amassing an international network of financial minds to help people get a better handle on the many investment ideas abroad. If you’re in any way “bearish on the Empire,” you might want to look at what Addison and Chris are building. You can check out their first briefing right here.

—————————————–

[Rude Endnote: Please don’t forget, dear reader, that The Rude Awakening is closing at the end of this week. From next Monday onwards, your editors will publish their thoughts, hunches, speculations and guesses from The Daily Reckoning. If you haven’t done so already, you can sign up for free here.

That’s all for another day.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com