It is the Oil Price Stupid!

The sub-prime crises might have been what precipitated the credit crunch, but it was arguably the high oil prices that first pushed the world towards recession by catalyzing the US slowdown at the end of 2007.

Whereas historical oil price shocks were primarily caused by physical disruptions of supply, the price run-up of 2007-08 was caused by strong demand confronting stagnating world production. According to a paper by James Hamilton of UC San Diego, although the causes were different, the consequences for the economy appear to have been very similar to those observed in earlier episodes, with significant effects on overall consumption spending and purchases of domestic automobiles in particular. In the absence of those declines, it is unlikely that we would have characterized the period extending from Q4 of 2007 to Q3 of 2008 as one of economic recession for the U.S. The experience of 2007-08 should thus be added to the list of recessions to which oil prices appear to have made a material contribution.

Of course the hand that takes can also give. The fall in oil prices has now helped the world economy to stabilize. In comparison to the stimulus provided by oil, government handouts are peanuts. Last year the world was consuming 88 million barrels per day at an average cost of $100 per barrel, at an annual cost of $3.2 trillion. If this year's average cost of crude oil around $50 per barrel holds up, the annualized savings will be about $1.6 trillion. The International Monetary Fund estimates that the fiscal stimulus to be provided by the G20 countries for this year and next will amount to $1.2 trillion at best, excluding bank bail-outs.

According to a just released report by the International Energy Agency( (IEA), global investment in oil and gas projects is expected to slump 21% this year from a year ago, falling for the first time in a decade.

More than 50 major oil and natural-gas projects around the world have been cancelled or delayed by at least 18 months since October, the IEA, the energy advisor to 28 major energy consuming countries, said in the report. According to the IEA, $170 billion worth of projects, involving around 2 million barrels a day of oil production and 1 billion cubic feet a day of gas output have been cancelled. In addition, 35 projects, involving 4.2 million barrels a day of oil capacity and 2.3 billion cubic feet of gas capacity, have been delayed by at least 18 months

With oil demand expected to rebound next year, following two consecutive years' decline, failure for oil production to keep up with a rising demand could drive up oil prices and put a nascent global economic recovery on screeching halt.

Renewable Fuels: Ready for Prime Time?

The Obama administration's stimulus package contains $56 billion in grants and tax breaks for US clean energy projects over the next 10 years and a budget calling for $15 billion annually for renewable energy programs.

The government dole outs usually do not work. If you need proof, you don't have to look farther than the ethanol boom and bust of the past three years:

• 21% of the US ethanol capacity is currently idle;
• Many ethanol companies are bankrupt: VeraSun, Greater Ohio Ethanol, Gateway Ethanol, Renew Energy, Northwest Biofuels and recently, Aventine Renewable Energy.

For the renewables to take off long term, they must be able to compete with fossil fuels economically without government assistance. We must be realistic about how much renewables could add to the energy mix and within what time frame. Estimates of the potential contribution to the US energy supply of the renewables varies from 10% to 20% in 20 years. Therefore, there is ample time for the investors to jump in. Value investors may have a feast in a few years gorging themselves on these assets for pennies on the dollar when the renewable bust comes.

Gas Pains

Natural gas inventories in the US continue to bloat. IEA has reported that the inventories rose by 20 bcf last week compared to expectations of 14 bcf. Current inventory level is 36% above last year. This data point is the continuation of a very bearish trend whereby supply is trumping demand by about 5 bcf/d.

The supply-demand mismatch is largely due to: (1) demand weakness caused by the recession; (2) improved supply mainly because of the successful exploitation of large shale resources by horizontal drilling methods and (3) increased drilling efficiencies overall.

Production additions per gas rig hit a high of 23 mmcfpd/year in 1999 and recorded a low of 12 mmcfpd/year in 2005. Barclays Capital estimates that this metric jumped to over 14 mcfpd/year in 2008 due to improved drilling efficiencies. The horizontal rig count hit an inflection point of 150-200 rigs in early 2005 hitting a peak of around 650 in September, 2008. Concomitantly, the US onshore production increased 12% in the same period, arresting the decline of US gas production.

With demand down sharply in the rest of the world, LNG cargoes heading to the US are on the increase and pose a serious upwards risk to the supply glut. Slowing global activity as LNG production surges raises the risk that US LNG imports will surge in 2009-2010. Asian demand for spot LNG cargoes has fallen sharply and European spot gas prices have plunged in the past few weeks. US imports are likely to rise 50%+ in the current quarter as more gas will become available as new trains start production.

In response to lower prices, producers have started curtailing drilling activities. These cuts should tip a plateauing US supply profile into sequential decline. The pace and depth of the supply pullback are tied to the depth of the cuts, still in progress. The rig count is likely to fall too low to balance the market, prompting price recovery in 2010. The size of the supply response will also be paced by the rig count.

Given these factors, it is reasonable to expect that the prompt month prices will remain soft throughout 2009 because of the brimming inventories. However, we run the risk that soft prices will cause a sharper fall in rig counts than is warranted resulting in steeper production declines as demand revives in 2010. Therefore, we may enter the second half of 2010 with record low inventories. If this thesis is correct, we should see a steepening of the futures curve with the contango increasing into 2011.

Energy and Materials Performance Following Steep Yield Curves

Recently, the major U.S. banks disclosed that they have been profitable on an operating basis, during January and February. Many commentators have attributed this to the steep yield curve where the banks are borrowing at low rates and lending at much higher rates. Researchers at Bespoke Investment Group have looked at the performance of various sectors one year before and one year after a peak in the yield curve (yield on ten-year treasury minus yield on three month treasury) going back to 1962. The current yield curve maxed out on November 13, 2008.

What they found was energy sector was up 78% of the time for an average of 10.7% one year before and 89% of the time for an average of 16.1% one year after the peak in the yield curve. Materials sector was up 67% of the time for an average of 9.7% one year before and 78% of the time for an average of 11% one year after the peak in the yield curve.

Provocative Research: Downgrade Integrated Oil

Credit Suisee downgraded integrated oils to 20% underweight recently, citing:

1. Price outperformance of about 30%;
2. Rich valuation with (a) P/Es close to the top of the historical range relative to the market ex-financials and (b) stock prices reflecting $60 per barrel oil, 31% above the current levels.
3. Oil Price: There is a good chance of demand disappointing and the prices staying low for longer. (a) at current prices, most other commodities have around 10% to 30% of production operating at a cash loss, compared to virtually none of oil production - yet, cartel and depletion rates are similar to other commodities (indeed, only around 10% of oil production is operating below berakeven, compared to 54% for steel and 17% for copper); (b) oil demand is likely to disappoint. The IEA expects a mere 1.2% decline in oil demand this year; yet, half of demand comes from developed countries, all of which are going through a severe recession (only 8% of demand comes from China). In the last major US consumer recession in the early 80s, US oil demand fell by 22% (compared to 7% so far). Miles driven in the US are still falling, down 4% yoy in December, despite gasoline prices halving. If demand disappoints, then OPEC discipline may crack (with OPEC spare capacity now at 6.5% of global demand); (c) bear markets in oil historically last 11 to 27 years. Investors appear to have too much faith in depletion rates and OPEC to protect against downside risk.
4. Big oil consistently appear as overweight in analyst recommendation;
5. High dividends of integrateds are inconsistent with low leverage of these companies.

HIGH RETURN PAIRS TRADING USING ENERGY ETFs

No one knows when the stock market will enter a sustained bull phase again. I like generating income with a hedged investment style, while waiting for the markets to turn. I am buying XEG.TO, iShares S&P/TSX Energy ETF, and selling XOP, SPDR Oil & Gas Exploration & Production ETF. XEG has a yield of 5%, whereas XOP's yield is 1.4%. Our studies show that the correlation between these two securities is about 95% and a hedge ratio of 42% is appropriate (e.g. buy 100 shares of XEG and short 42 shares of XOP). The economics of the trade would be as follows, if the trade is held for a year (all prices are as of March 10, 2009; no commissions):

Buy 100 shares of XEG and pay $(985.85) {$(1,267) Cdn.}
Sell 42 shares of XOP and receive $ 1,050.42
Borrow/Interest Costs @2% are $21.05
Net Investment $ (43.53) {positive cash flow}
Net Dividends Received $ 37.73

WE ARE PRINTING MONEY; BUT......

In trading this pair, one has to keep in mind that one is exposed to basis risk and he will have to monitor the position for a change in the relationship between the two ETFs. The price ratio of XOP to XEG averages around 2.3. However, it has been as high as 3 and as low as 1.9 in the last 3 years. In the same period, the difference in the two prices have been as high as 44 and as low as 12, with a mean of 24. That metric stands at 14, currently. In a bullish and speculative environment, XOP is likely to outperform XEG. The US market is much larger and XEG is not known to most individual US investors. Also, XEG contains lower beta income trusts and pipelines.

Other factors to watch would be the additions and deletions to each ETF and the dividend rates over time.