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Sunday, October 5, 2008

Black murky waters...

In this past week the overall feeling in the market has shown a sudden and abrupt volte-face and it finally appears that the market and investing community has realized that regardless of the “bail-out” the economy is still going through tough times and is unlikely to reverse direction any time in the near future. Internally I am torn about this sudden widespread realization. On the one hand the value investor in me is in fine fettle, on the other hand the altruistic global citizen in me is nervous about our near to medium term prospects (hence the title of the post). That being said there is always a way to profit in any market so let’s try to find out how.

The passage of the TARP plan will increase our federal deficit substantially. The current fiscal year 2009 deficit (which is the current FY) is estimated to be at $565bn and this was before the passage of the TARP. If you take this plus the estimated cost of TARP plus additional maturing coupons our federal deficit could reach a staggering $1.5 trillion (with a T!). With all this additional debt you have to wonder how our dollar is strengthening versus other currencies. The key to this is it is all relative. The EU and UK were viewed as relatively strong and as such had strengthened substantially against the dollar over the past couple of years. Now that everyone realizes that they are not immune from the financial malaise, their currencies have been dropping precipitously. This in turn has been quite negative for export heavy companies. While I believe we will continue to strengthen against the EUR, GBP, NZD, AUD, and YEN, I believe we will start to weaken against EM currencies which are heavy on natural resource exportation. This is the perfect segway in to what is turning out to be my weekly update on the energy markets.

Over the past several weeks, the oil market has been whipsawed between two opposing forces: (1) strong near-term fundamentals driven by continued supply problems and extremely low inventories; and (2) rising financial and forward demand concerns which have been accompanied by significant financial de-leveraging. As the market continues to be pulled in both directions by these opposing forces, price volatility has surged. This surge in price volatility represents a significant departure from the past five years, as the one variable in the market that remained relatively stable was volatility, trading in roughly a 30-40% range. The market simply trended up or down and inventories in the United States and the rest of the OECD remained above or near the five-year average, providing a cushion to any supply or demand disruption. However, beginning this summer and accelerating this past week that trend has been clearly reversed – implied volatility reached 55% this past week as inventories continued to plummet due to hurricane-related disruptions. Volatility has not been this high, nor have stocks been this low on a seasonally adjusted basis since the Gulf War II in 2003 (see below):

US inventories dropped a massive 18 million barrels, bringing the total inventory draw since August 28, 2008 to 50 million barrels. US total hydrocarbon stocks are now at record low levels for this time of year, and US gasoline inventories are now at levels not seen since 1967 when demand was nearly half the level as it is today. Further, the situation for gasoline on the other side of the Atlantic is no better, with Europe also at low inventory levels with ARA stocks dropping to the lowest levels since 2003. Further, this week saw crude oil stock draws in Japan that took stock levels back to record lows for this time of year. What is critical is that this is the period in which stocks should be built globally to prepare for the winter months, not drawn. This puts the market into a very precarious situation as we near the winter heating season. Many observers point to the fact that demand is weak, so this observation is not as worrying as it would otherwise be. In fact, the US Department of Energy (DOE) reported exceptionally weak product demand last week. Although this demand weakness generated downward price pressure post the data release, it is again important to emphasize that you can’t consume what you don’t have. Ongoing refinery outages have left US refinery utilization at critically low levels leading to a loss so far of almost 70 million barrels of petroleum products. As a result of the outages, Colonial Pipeline – the primary artery for USGC petroleum product distribution in the southern and eastern United States – has been operating at reduced rates, generating local shortages and reports of long lines at the pump (hence the news of gasoline shortages in the south). It is important to highlight that despite this extreme tightness in gasoline supplies, traded NYMEX gasoline margins have weakened substantially in the past two weeks.

Over the past several weeks, concerns over the sustainability of Chinese oil demand have been brought into question. Driving these concerns have been real events. Two weeks ago Sinopec announced it would reduce fourth-quarter crude oil imports by 8-10 percent from previous targets as end-use inventories inside China remain high. And then last week, Unipec announced it would not import diesel for a third straight month again due to high domestic inventory levels. At the same time, expectations for 2009 Chinese growth have been revised down.

First, in terms of the base levels, these slower growth expectations do not have a large impact in terms of barrels. At most it would slow end-use oil demand growth by 70 thousand b/d and in terms of crude oil imports for the fourth quarter relative to previously announced targets, and would slow imports from 14% yoy growth to 9% yoy growth, which is still relatively strong growth from a historical perspective.

Second, the Chinese government still has two very significant policy levers at its disposal, both fiscal and monetary policy. On the fiscal side, unlike previous time periods of slower growth, the Chinese government has at its disposal 2-3% of GDP for fiscal stimulus. On the monetary side, we saw the central bank aggressively raise rates to counter inflationary pressures. Now that those inflationary pressures, particularly from agriculture, have abated, they are likely to be equally aggressive in lowering rates. The bottom line is that the government is likely to act with policy in response to the current concerns, which will likely avert a more serious slowdown. This aversion should help keep their demand high which helps add to the bullish oil argument.

In the near future I will make a specific company recommendation, so until then keep reading.

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