Weekday Commentary
from Jim Puplava
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| Natural Gas Production & Inventories Declining The Price Trend is Up Could this be our next energy crisis?
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Market WrapUp for the Week
Monday l Tuesday l Wednesday l Thursday l Friday
Week in Graphs 
Storm Watch 
Geopolitical News 
Energy 
Precious Metals 
Raw Materials
Monday, November 11, 2002
Comply or War
The choice is simple: comply or it’s war. The U.N. Security Council resolution unanimously passed on Friday has key dates and conditions attached that dictate compliance or war. There is very little wiggle room. Iraq is either in compliance, in which case there will be peace, or it doesn’t comply which will lead directly to war. It is that simple. The key dates that could lead to war are as follows:
Friday, November 15 Notice of intention to comply.
Sunday, December 8 Provide full disclosure to inspectors of WMD Sites.
Monday, December 23 Inspections are to begin.
Friday, February 21 Report on inspection findings to Security Council.
Unlike previous resolutions this one has teeth, and failure to comply means war. There can be no delays, wiggle room, or exceptions. Violation of nay of the resolution requirements leads directly to military action. Although the Security Council may deliberate the actions or violations it will directly fall upon the US to decide. The most important interpretation is that of the U.S. and in particular President George Bush. In a speech at the White House Rose Garden today the President was blunt, saying “America will be making only one determination: is Iraq meeting the terms of the Security Council resolution or not?” This is a President that doesn’t mince words and means what he says.
The first key date is this Friday. In response to the resolution Iraq has already said it won’t be able to comply. The Iraqi Parliament, which rubber stamps Saddam’s dictates, said the country may not be able to meet demands. An Iraqi official said, “Saddam Hussein would defend the independence of Iraq.” The Iraqis just accelerated the war calendar. Experts still believe that Iraq will accept the U.N. plan.
Energy Prices
Crude oil prices for December delivery rose 2.8% to $25.94 a barrel. While oil prices rose today, natural gas prices fell. The oil markets are worried about war, as well they should be. However, the real crisis in energy could come this winter from natural gas. The story out today was deceptive. U.S. stock piles are down from 3.254 trillion cubic feet last winter to today’s 3.145 trillion cubic feet. Furthermore, weather patterns point to a colder winter this year. New York’s temperatures are already down in the 50’s. The National Weather Agency is already predicting abnormal weather patterns this winter due to El Nino. As of last week US drilling activity has dropped to the lowest level in 26 weeks with only 826 rotary rigs working, down 28 rigs in the latest week, and down from 1,010 the same period a year ago.
Given the nature of weather patterns, geo-political risks, and declining inventory and supply, the US faces another energy shock, which will be the fourth in succession over the last decade if it arrives this winter. With energy shocks becoming more frequent over this last decade, I believe that we are now in a long-term secular bull market in energy. I’ve written about this in my Storm Series and PowerShift. Oil and natural gas depletion is accelerating in the US, making the country more dependent than ever on imported oil and natural gas to meet the US economies voracious energy needs. The most important aspect of this new bull market is the price for energy. Oil and natural gas prices are up 30% this year. So far the price of the raw commodity has risen while the price of most energy stocks have fallen, even though they are doing better than the general market. The energy markets are being far too complacent given the current inventory of supply. In the energy patch we go from feast to famine and from peak to trough in an endless cycle that gets shorter between each new crisis. Industry veterans have remarked that energy cycles both up and down are getting shorter in duration and closer together. In each new crisis prices are rising to higher average levels than in the past. In technical terms, we are seeing higher highs and higher lows, which is bullish.
The last three-energy crises in this country were demand driven. This time it will be a supply driven crisis, which will be longer lasting and more expensive when it occurs. The last crisis in 2000-2001 was demand driven. A declining economy and warmer winter and cooler summer temperatures ended the crisis. The demand excess was driven out of the market place by the decline in industrial use and conversion to alternative forms of energy, mainly oil. This time there isn’t a cheap alternative for rising natural gas prices such as oil. Oil prices are up 30% this year and now we may be going to war with the distinct possibility of supply disruptions.
Current consumption drawdowns show this winter the US natural gas markets depending on weather could be 3-10 Bcf/day short of demand. A colder winter temperature as we are now experiencing could drive that figure even higher. When you have a supply driven deficit versus a demand driven deficit, they are much longer lasting and harder to correct. The only thing that can balance the deficit and bring it back into balance is sustained higher prices. Even though natural gas prices and oil prices are up this year, E&P companies have been reluctant to increase drilling activity for natural gas because of the uncertainty regarding price. Given the current nature of supply and demand it looks like this winter we are likely to see much higher gas prices that take us well into spring and summer. And unlike the last natural gas crisis we don’t have cheaper oil prices to convert to. Oil prices are high and could go even higher if we go to war or terrorist attacks disrupt supply. Current al Qaeda plans show the terrorist group is shifting its strategy towards energy assets by going after tankers, refineries, and oil based facilities. Some experts are predicting that natural gas prices could rise over $5.50 and head even higher if we experience severe weather.
The US has finally worked off the massive gas supply bubble that was created with regulated prices during the 70’s and 80’s. The physics of natural gas show that it tends to decline much faster than oil. Geologists mention the fact that over the last year or so the US has finally entered into the decline stage of its natural gas reserves. Oil production in the US went into decline back in 1971. Policymakers as well as users may find it hard to fathom that oil and gas are self-depleting assets. The US natural gas decline rate is currently about 25%. Since we aren’t adding enough natural gas reserves this means only one thing: production must fall and prices will rise as a consequence. That is why it is looking like we are heading into another natural gas crisis that will be triggered by a rapidly falling US gas supply with harsher weather.
Looking at oil, inventories have begun a seasonal decline that looks like it should continue well into spring and summer. Global oil demand is still rising, thanks to Asia. As oil inventories drop they do so against a backdrop of geo-political wild cards. There are four of them, any one of which could cause a huge disruption in the supply of energy. They are as follows:
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War with Iraq
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Removal of Hugo Chavez from power in Venezuela
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Terrorist attacks against energy facilities
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The potential overthrow of the Saudi royal Family
Given the nature of our energy markets, the investment and the commodity markets are fast asleep. As the charts of the OSX, XOI, and XNG indicate the markets are complacent.
They are likely to remain until some event shocks them out of complacency. Many stocks within the industry are paying more than 4% in dividends, selling at net asset value or below, and as little as 3-4 times cash flow. Compare this to the S&P 500, which yields only 1.8% and sells at 29 times earnings. For income investors it is even possible to get and additional 5-6% each quarter by writing covered call. The combination of dividends and calls are producing 10% income returns at a time dividend yields and money market funds are paying below 1 and 2%.
Today's Markets
Back at the casino, investors lost money today as the major indexes fell between 2-3%. Investors are worried about a slowing economy that appears to be getting worse and high stock market valuations given the prospect for earnings. Wall Street is still in la-la land regarding its growth estimates for this quarter. In addition to valuation concerns there are enormous geo-political risks with an upcoming war and prospects for renewed terrorist attacks on US soil.
The economy is showing more signs of slowing down especially on the consumer front. This week we’ll get more clues as to the state of affairs of the consumer on Thursday when retail sales are reported. The government will also report on industrial production, which has been declining steadily. It is now looking like retail sales fell by 0.2% last month.
There are also problems with the dollar, which keeps heading south. There is growing concern that a deteriorating trade and current account deficit, low interest rates and a rising government deficit makes the US dollar extremely vulnerable to a sharp selloff. A large decline in the dollar would dramatically impact gold prices, commodity prices in general, and cause long-term interest rates to rise. The combination of a falling dollar, rising gold and commodity prices will eventually pop the bond market bubble leading to higher interest rates. Rising long-term interest rates are a crash maker.
In addition to valuation concerns there are enormous geo-political risks with an upcoming war and prospects for renewed terrorist attacks on US soil. The President’s strong warning to Iraq to comply with UN resolutions by Friday’s deadline rattled the markets. The New York Times reported that the US is in the process of sending 250,000 troops to Iraq. Unlike the last Gulf War against Saddam Hussein, this war’s objectives are much more complex: remove Saddam from office, institute a new government, maintain Iraq’s territorial integrity, remove weapons of mass destruction, and prevent terrorism from spreading. These are complex goals that make the outcome of the war that much more uncertain.
Most of the tech sectors got hammered hard today which accounted for the NASDAQ's 3% decline. Every sector within tech from the Internet, software to networking got clobbered hard. The markets are a bit nervous because of Greenspan’s meeting on Wednesday up on Capital Hill. But as the markets reaction to last week’s half a point rate cut is showing, Mr. Greenspan is becoming less and less relevant to the market other than his ability to create additional bubbles or monetize assets. The latest report of the Fed’s balance sheet indicates that the Fed has bought $64.4 billion in government securities over the last 12 months. Even worse, the latest Fed report shows that foreign holdings of US Treasuries has risen to $807.6 billion, up $76 billion from a year ago.
Given all of these factors, economic, financial, and geo-political, it appears that the market has now topped and another down leg is underway. All the major indexes have now violated their uptrend lines from the October nadir. Bullish sentiment is now back in fashion while the advance–decline line is registering lower highs in this last rally as stocks now head down. Weak breadth and volume during a rally are systematic of turning points in a market. Despite Republican victory in last week’s election and a surprise half a point rate cut, they have failed to sustain the momentum in this weak rally. What comes next to cause the market to rally? Maybe Dell, which reports tomorrow, will beat the Street. Wouldn’t that be a surprise!
Volume was low because of a government holiday. Volume on the NYSE came in at 1 billion shares and was 1.26 billion on the Nasdaq. Losing issues beat out winning issues by a wide margin. Losers outnumbered winners by 2-8 on the NYSE and by 23-8 on the Nasdaq. The VIX rose 2.55 to 36.11 and the VXN jumped 3.70 to 55.71.
Overseas Markets
European stocks dropped on concern some of the region's biggest financial companies will post losses this week. Credit Suisse Group and Allianz AG fell. The Dow Jones Stoxx 50 Index shed 0.5% to 2496.83, retreating for a fourth day. Credit Suisse fell the most, sliding 5.4%. The Stoxx 600 Index dropped 0.7% led by computer-related companies such as Infineon Technologies AG. All eight major European markets were down during today's trading.
Asian stocks fell on concern declines in the dollar against regional currencies and possible U.S. military action against Iraq will hurt earnings of exporters, such as Sony Corp. and Samsung Electronics Co. Japan's benchmarks fell to one-month lows, with the Nikkei 225 Stock Average sliding 2.7% to 8460.37. Taiwan's TWSE Index staged its largest decline in a month, while South Korea's Kospi index had its biggest drop in three weeks.
Copyright © Jim Puplava
November 11, 2002