Stephen’s Posterous

Commodities Throw a Curveball by Liam Denning, WSJ.com

Despite big swings this week, oil prices have been stable, bobbing around the $50-a-barrel mark, plus or minus 10%. This is remarkable when you consider that fundamental supply and demand data have been bearish.

This month, the International Energy Agency raised the specter of early 1980s-style demand destruction. In terms of days of supply, commercial-oil inventories in the industrialized world are higher than in 1998, when crude crashed to $10.

Some take hope from the upward slope of the oil-futures curve, known as contango, interpreting it as indicating higher prices ahead. This view is misguided. Indeed, the extreme steepness of the current contango, with oil a year out trading 20% above the May 2009 contract, points to a more complex situation.

Energy economist Phil Verleger makes a robust case for the market impact of speculators, although not in the way you might think. Contrary to the widely held viewpoint that speculators were to blame for the spike in oil prices last year, movements in the price of oil and many other raw materials display virtually zero direct correlation with flows into and out of commodity funds.

This money, much of it passive, does, however, affect the shape of the forward curve. An upward-sloping curve is indicative of there being a surplus of oil relative to real demand. Funds buying oil futures push up forward prices, steepening the curve's upward slope.

For the traders selling the contracts to them, this presents an incentive to buy cheaper physical barrels and put them in storage for delivery at higher prices down the road, hence high inventories. This removes some oil from the market, putting a floor under spot prices. Supply cuts by the Organization of Petroleum Exporting Countries help in this regard, too.

Relying on investor optimism and cartel cohesion to maintain stable prices even as global economic forecasts worsen, however, requires nerves of steel. If faith in peak oil crumbles further, or financing tightens again, lower demand for futures would reduce the steepness of the forward curve. That, in turn, would erode profits on the oil-carry trade, leading speculators to liquidate inventories, likely hammering prices.

Optimism regarding industrial metals rests on similarly fragile foundations. Bellwether copper is up 43% since late February 2009. This head fake comes courtesy of China cannily stockpiling inventories of raw materials like copper and iron ore even as demand contracts virtually everywhere else.

Stockpiling, however, isn't consumption. The surge in Chinese imports hasn't been matched by increases in industrial production, suggesting metals are going into warehouses, not factories. Oddly, despite the country's apparently insatiable demand for iron ore, big price cuts are expected this year. Like the oil overhang, when those inventories get "mined," prices will likely suffer, transforming the head fake into a major headache.

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Jim Rogers Isn't Buying a U.S. Stock Rocovery by John Kimelman, Barron's Online

Bank executives and investors can breathe a sigh of relief: Jim Rogers has covered the short positions on financial stocks he put in place ahead of last year's massive meltdown.

But just because this influential investor isn't betting that big banks will fall much further doesn't mean he's confident they will stage a lasting rally either. He feels similarly about U.S. stocks in general.

"I am skeptical about the rally, and the world economy for the next year or two or three," he says. "But if stocks go down, I can make money with commodities."

Rogers, now 66, gained fame as George Soros' hedge-fund partner in the 1970s and 1980s. After retiring from professional money manager in his late 30s, the Alabama native tooled around Europe, Asia, Africa, and Latin America visiting emerging markets, one by one. His resulting book, Investment Biker, helped to popularize emerging market investing at the outset of a bull market for the sector.

He also helped to popularize commodity investing, which for decades was the province of niche investors. In the 1990s, he developed commodity indexes based on futures contracts that in recent years have been turned into exchange-traded funds available to all investors. His 2004 book, Hot Commodities, came ahead of a surge prices for energy, metals, and agriculture.

Since its inception in July 1998, the Rogers International Commodities Index has gained 158%, while the S&P 500 has fallen 23%. And that gain for the commodities index comes despite the fact that it's lost more than half of its value since last July. At these levels, Rogers has been a buyer.

These days, Rogers, now 66, is sticking close to home in Singapore with his wife, Paige Parker, and two small daughters. He's about to release his latest book, A Gift to My Children: A Father's Lessons for Life and Investing in which he encourages other people's children to travel widely and learn Mandarin so they can reap the rewards of China's economic boom.

Recently, Rogers talked to Barrons.com by phone from his Singapore home.

When you last did a lengthy interview with Barron's magazine a year ago you were lightening up on emerging markets investments. Well, you called that one right. But now that many of those markets have fallen from their highs of recent years, are you more optimistic?

No. I've sold all emerging markets stock except the ones in China. I bought more Chinese shares in October and November during the panic, but I have not bought China or any other stock markets including the U.S. since then. I'm not buying anything in China right now because the Chinese market ran up maybe 50% since last November.

It's been the strongest market in the world in the past six months and I don't like jumping into something that has been that run up. Still, I'm not thinking of selling these stocks either. I think if it goes down I'll buy more. I think you will find that it's the single strongest market in the world since last fall.

In your latest book, you talk of China as the great investment opportunity of the 21st century, just as the U.S. was in the 20th century. What percentage of a typical American investor's portfolio should be in China?

If they can't even find China on a map, I don't think they should have anything in China. They should know something about China before they invest there. If they have the same convictions that I do then they should probably have a lot. If you asked me that question in 1909 about the U.S. stock market, I would have said to put 100% of your money in the U.S.

Might it make sense to have a greater weighting in a diversified mix of Chinese stocks than in U.S. stocks?

Well yes. Just as in 1909, if you were German or Chinese, you should have had the largest percentage of your money in the United States. The idea of investing is to make money, not to have some sort of political agenda.

That being said, you currently think Chinese stocks are bid-up now, so you're not buying at these levels. So what have you been buying lately?

I have been buying commodities through the Rogers commodity indexes I developed because my lawyer won't let me buy individual commodities. I recently bought the all four Rogers indexes, the Elements Rogers International Commodities Index (ticker:RJI) as well as the three specialty indexes, the International Metals (RJZ), the International Energy (RJN), and the International Agriculture (RJA.)

That's how I invest in commodities and that's what I bought last week. I have been buying these shares since last fall and up to last week.

Though you got out of emerging markets last year before they fell hard, you seemed be caught by surprise by the fall-off in commodity prices last year. Is that right?

Yes, I was surprised. I did not expect commodities to go down that much and in retrospect it was a period of forced liquidation for many (professional) investors. You know AIG went bankrupt, which was huge in commodities. Lehman Brothers was big in commodities.

But at least I was shorting the investment banks at the time and other financials such as Citigroup and Fannie Mae. So I was hedged by being long commodities and short the other things such as financials and as you know most of them were down from 80% to 100%, so I more than made up on my shorts than I lost on my longs.

So thank God for (the stock decline in) Citigroup and thank God (for the decline) in Fannie Mae.

Now despite the recent stock-market rally that started in March, many U.S. stocks are trading well off their 2007 highs. How come you see no value to this market?

I am not buying U.S. companies mainly because I think we may have seen a bottom but I don't think we have seen the bottom. I am skeptical about the rally, the world economy for the next year or two or three. But if stocks go down, I can make money with commodities. In the 1970s, commodities went through the roof even though stocks were a disaster. In the 1930s, commodities rallied first and went up the most long before stocks pulled it together.

Can you summarize the reasons for your bullishness about commodities?

It depends on the supply and demand. And we have had a dearth of supply. Nobody has invested in productive capacity for 25 or 30 years now. The inventories of food are the lowest they have been in 50 years and you have a shortage of farmers even right now because most farmers are old men because it has been such a horrible business for 30 years.

And as for metals, nobody can get a loan to open a mine as you know. Who is going to give you money to open a zinc mine? It takes at least 10 years to open a mine so it's going to be 15 or 20 years before we see new mines come on. Nobody has been opening mines for 30 years and they are not going to.

And in the meantime reserves are declining. As for oil, the International Energy Agency came out recently with a study showing that oil reserves worldwide were declining at the rate of 6% or 7% a year.

That does not mean that if suddenly the U.S. goes bankrupt that everything won't collapse in price. But I would rather be in commodities because it's the only thing I know where the fundamentals are improving.

They are not improving for Citibank or General Motors but the supply situation in commodities is such that when demand comes back, then commodities are going to be the best place to be in my view.

What do you think of bonds?

I am anticipating shorting bonds, the U.S. long bond. It's about the only real bubble around that I can see right now -- other than the U.S. dollar. I am not shorting bonds at this moment because I've shorted plenty of bubbles in my day, and I have learned that you better wait because they go up higher than any rational person can anticipate. But my plan is to short the long bond in the U.S. sometime in the foreseeable future.

I've read that you think the penchant of the last two presidential administrations for bailing out failing U.S. companies is a big mistake and will contribute to prolonging this recession. You argue that it's best to let these companies all go bankrupt. How bad can the economy get?

Yes, politicians are making mistakes. In Japan, the problem has lasted for 19 years. I hope that it doesn't last 19 years in the U.S. The approach that works is to let them (U.S. banks and automakers) collapse and clean out the system.

The idea that phony accounting is the solution (through changes in mark-to-market rules) is ludicrous. And the idea that a debt problem and an excessive spending problem can be cured with more debt and more spending is ludicrous.

It's laughable on its face, but politicians think they've got to do something. Unfortunately, they are doing the wrong things and they are going to make it worse.

Thanks for your time.

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The slowdown in investment in oil and gas production could lop off nearly eight million barrels a day of future oil supply growth, setting the stage for another big crude price surge in years to come, according to a new study.

The global credit crisis and falling oil prices have squeezed oil companies' finances and forced many to cut capital spending and postpone projects. That could have big implications for supply when the global recession ends and demand for energy recovers, the report by Cambridge Energy Research Associates (CERA)  says.

CERA projected last summer, before the economic crisis set in, that world oil production capacity would rise to 109 million barrels a day by 2014 from the current 94.5 million barrels a day. It now says 7.6 million barrels a day, or slightly more than half of that increase, is "at risk" due to project deferrals or cancellations.

The report says that reduction in capacity is a "potentially powerful and long-lasting aftershock" following the oil-price slide of 2008, when within a few months crude fell from a record high of $147 a barrel. Crude-oil futures rose $1.57, or 3%, to settle at $54.34 a barrel Thursday.

"A price collapse of this magnitude really registers on the Richter scale, and its impact on levels of future investment will be felt for years," CERA Chairman Daniel Yergin said in an interview. The report comes amid ample evidence companies are scaling back on investment in costly projects that require a high oil price to be profitable, such as the oil sands of Canada or the ultra-deep waters off west Africa.

Middle East oil producers, hit by falling export revenue, have reined in spending plans. The Organization of Petroleum Exporting Countries says as many as 35 new projects in OPEC countries could now be delayed past 2013. Most Western oil companies say they are sticking to their investment plans but are slowing down some developments.

The slowdown is troubling the International Energy Agency, the Paris-based adviser to oil-consuming countries, which also has trimmed its forecast for supply growth. The agency's deputy executive director, Richard Jones, told a conference in London this week that more than two million barrels a day of expected new oil production capacity looks likely to have been deferred for now.

"Unless sufficient companies have the will and financial ability to invest through the downcycle, there is a real risk that supply growth may lag the eventual rebound of demand, leading to substantial price increases, possibly as early as this year," he said.

CERA said it expects many new projects in Angola, Nigeria, the Gulf of Mexico, deepwater off Brazil, Canada's oil sands and Venezuela's hard-to-extract heavy oil to be postponed or canceled.

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Opec has finally turned bearish on oil prices. At a meeting in Vienna over the weekend, the oil producers cartel refrained from cutting production beyond the 4.2m barrels per day pledged last September 2008, 12% of the 2007 daily average. The cartel also admitted that it won’t achieve its price goal of $75 a barrel this year.

The restraint is sensible. Opec’s statement that it is worried about the fragile state of the economy could earn points for good public relations. The cartel is pitching in to prevent a destabilising oil price spike. Such solidarity will play well in big oil consuming nations, noticeably the US.  The restraint, though, was pretty much making the best of a weak position. Opec did not have had much choice. With demand down, it would take big cuts in Opec quotas to push the price up by two-thirds to Opec’s stated target.

The members of the cartel, which produces more than a third of the world’s oil, wouldn’t agree to take the revenue strain. As it is, only 80% of the agreed September 2008 production cuts have been made, according to the International Energy Agency (IEA). That leaves about 800,000 barrels of daily production to be removed from the market.

Saudi Arabia, the cartel’s most influential member, has stuck to its production cuts. But leading members including Iran, Venezuelan and Angola, are still producing beyond their quotas, according to the IEA. Meanwhile, big non-Opec members, such as Russia, have kept up production.

Saudi Arabia may be tired of carrying almost all the weight of production cuts. But whatever the internal Opec politics, it certainly doesn’t make much sense to set unrealistic production targets. Opec’s credibility and authority are at stake. If those are lost, the always fragile cartel could be weakened. So Opec has followed an old maxim: when you can’t get what you want, it is better to want what you can get.

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For most oil producerss operating in an environment of low crude prices and low demand, discretion is the better part of valor. But Cnooc (ticker: CEO) surprised the market Jan. 20, 2009, by saying it would raise spending by 19% to $6.76 billion this year, in contrast to peers like ConocoPhillips (COP) and Chevron (CVX), which have been sharply trimming budgets or holding them flat with 2008 levels.

Cnooc's plan, accompanied by aggressive 16% to 18% production-growth targets for 2009, would let China's top offshore producer, by capacity, strike it rich, if oil prices rebound substantially from lows in the $30s anytime soon. It is a big if. Goldman Sachs says it expects benchmark West Texas Intermediate crude to average $45 a barrel this year, while Deutsche Bank sees it averaging $43 in 2009 before rising to $55 in 2010.

Contagion from weakening demand in the U.S. and Europe is reaching Asia, where export-oriented factories in China are closing, as orders thin out and energy-intensive industries such as steel and cement scale back output. The International Energy Agency said this month that it expected 2009 global crude demand to contract 1.1% from 2008. This would be its biggest annual fall in 27 years.

A glance at Cnooc's financials reveals little cause for concern. The rally by crude to record highs above $145 a barrel last July helped Cnooc amass a sizable cash hoard of 44 billion yuan ($6.4 billion), estimates Tokyo-based Daiwa Institute of Research. As a pure exploration-and-production play, Cnooc hasn't been exposed to the refining losses that depressed earnings of domestic rivals PetroChina (PTR) and China Petroleum & Chemical (SNP), known as Sinopec.

However, Beijing-based Bradley Way, BNP Paribas' head of Asian energy research, says Cnooc's plan quickly will whittle down this cash pile, noting that the company's 19% year-over-year increase in capital spending in 2009 comes atop about a 40% rise in '08. Way views a $52-a-barrel average oil price in 2009 as a key threshold. Lower than that, Cnooc will have spent in just one year all the cash it built up during a six-year bull market for crude.

"Other oil companies are tightening their belts, and holding on to their war chests for acquisition opportunities," says Way, who rates Cnooc a Hold with a target price of HK$7 (about 90 cents). Cnooc's shares in Hong Kong fell 2.6% on the first day of trading after the capital-spending program was unveiled, reflecting concern among some investors that the company will burn up vast sums to bring projects on-stream when returns are low, due to the subdued oil price.

The stock is down 48% since the start of July, compared with a 41% decline in the broader Hang Seng Index. "If the WTI oil price were to average $60 a barrel or below, we might see a negative free cash flow for [Cnooc in] 2009," says Daiwa analyst Andrew Chan.

Although Cnooc's cash pile was large enough to cover the burden of higher capital expenditure in 2009, Chan says "we think persistent negative free cash flow may reduce potential merger-and-acquisition opportunities, unless Cnooc raises more cash through debt or equity financing." He forecasts Cnooc to post a net profit of CNY30.92 billion yuan in 2009, down 31% from an estimated CNY44.75 billion for 2008. He rates it Underperform.

Cnooc has teamed with state-owned China Petrochemical in two acquisition deals that are close to being finalized, people familiar with them say. Cnooc and Sinopec are working toward a deal valued at not more than $400 million for Talisman Energy 's (TLM) natural-gas assets in Trinidad and Tobago, and have also jointly offered $1.8 billion for a 20% stake in a deepwater Angolan oil block put up for sale by Marathon Oil (MRO).

But not everyone thinks that Cnooc's plan to spend big going into a recession is all that risky. Costs in the oil industry, such as steel, are coming down. Although rig rates have so far held up, industry analysts predict the highest day rates on new contracts will fall by about 15%.

Moreover, spending heavily on new projects now could make Cnooc a winner when oil prices pick up, as many of its rivals have either chosen not to expand operations significantly or have been unable to do so because of the credit crunch. ConocoPhillips plans to cut 2009 spending to $12.5 billion, 18.3% below last year's level. Chevron's $22.8 billion capital-spending program for 2009 is unchanged from 2008.

According to DBS Vickers bank in Singapore, Cnooc's aggressive capital-expenditure plan will support production growth at double-digit levels for the next few years. It rates the stock a Hold, with a price target of HK$7.77.

Many analysts say Cnooc no longer deserves a premium as a growth stock, given that its biggest projects in Nigeria, Indonesia and China's Bohai Bay are all due online by the end of 2010 at the latest, so investing heavily now could be a catalyst for the shares when the crude market recovers.

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Demand for oil will fall this year at the fastest rate since 1982, the International Energy Agency has forecast.

The rich countries’ energy think-tank has again cut sharply its prediction for world oil demand this year, and now expects it to average 84.7 million barrels per day, down 1 million barrels per day (b/d) from last year, because of the steep downturn in the world economy. This year is expected to mark two successive years of falling demand for the first time since 1982-83.

Fuel demand has plummeted in the US and is falling in many other countries, the IEA said. Even in China, one of the countries that powered the global growth in oil demand up to 2007, the rise in consumption is expected to slow sharply.

However, the IEA also warned that sharp production cuts from Opec, the oil producers’ cartel, would mean that by the end of the year there would need to be a substantial draw-down in oil stocks, unless demand weakens even further, or supply from non-Opec countries turns out to be stronger than expected.

Opec cut its agreed production levels by 4.2 million barrels per day in the second half of last year, and could well cut production again at its next meeting on March 15, 2009, in a bid to raise oil prices from this week’s levels below $40. The IEA’s forecast for oil demand this year is 570,000 b/d lower than it predicted in January 2009, reflecting the sharp deterioration in the assessment of the world economic outlook from the International Monetary Fund.

Forecasts for oil demand in the US are unchanged, as the IEA already expected a second year of decline in 2009 following a drop of more than 5 per cent to 19.5 million b/d last year. The sharpest revisions come to forecasts of demand in the European Union and Japan. Demand is particularly weak in the industrial sector; consumption of naptha, used as a feedstock for manufacturing plastics and synthetic fibres, ”virtually collapsed” in Germany at the end of last year, and has fallen ”off a cliff” in Japan.

In China, total oil demand is still growing, but the rate of increase has slowed very sharply. As demand for oil drops, the IEA warns that its estimates of oil supply capacity are also falling, as the financial crisis and the plunge in oil prices from the summer’s peak of over $147 per barrel force companies to delay or cancel planned investment in increasing or sustaining production.

That reduction in investment is already likely to have some effect on oil supply this year, the IEA thinks, but the greatest impact will not be felt for a few years. In its next medium-term analysis of the oil market, due out in the summer, the IEA will analyse the effect of project delays on the outlook for supply over the next five years, looking ahead to the hoped-for recovery in the world economy.

When economic growth picks up, under-investment could lead to supply shortages and send prices soaring again. As the IEA puts it: ”Ultimately, low prices sow the seeds of their own destruction.”

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