Dubai: Floating on an Island of Debt

By Dian L. Chu, Economic Forecasts & Opinions

See this post also at Seeking Alpha, Business Insider, zero hedge, Straight Stocks, Daily Markets

Stock markets around the world cracked on Friday with the Dow Jones industrial average down more than 150 points (Fig. 1), and commodities plunging as Dubai debt woes unnerved investors, and sent tremors of uncertainty throughout all markets.

The crisis flared after Dubai, a part of the United Arab Emirates (UAE) federation, asked to delay interest payment for six months on $60 billion of debt issued by the state-run conglomerate Dubai World and its main property unit Nakheel.

Concerns that a government-backed investment company risked default ripped through world markets. Investors read it as a sign of yet another sovereign implosion after Iceland and Ireland, and recoiled from risk and piled into dollars.

Las Vegas on Steroids


Dubai World has served as Dubai's main driver of growth, operating ports, transportation groups, spearheading real-estate & infrastructure projects both at home and abroad. Its real-estate subsidiary Nakheel built Dubai's iconic palm-tree-shaped island, packed with luxury villas and hotels, many still under construction. Real estate and construction accounts for about 23% of Dubai’s GDP.

With little oil, Dubai financed much of this rapid real estate development with debt. After incurring its estimated $80-$90 billion of debt in a four-year construction boom to transform its economy into a regional financial and tourism hub, Dubai suffered the world’s steepest property slump in the first global recession since World War II.

Deutsche Bank estimates that Dubai’s property prices, both commercial and residential, have halved since August last year, and could fall a further 15-20% this year.

U.S. Banks Less Exposed

Most analysts believe U.S. banks are probably less exposed than European rivals to a potential debt default by Dubai World, but a lack of transparency and the interconnection of the modern financial system make it difficult to know which institutions are ultimately exposed.

Dubai World's largest creditors are reportedly domestic banks in Dubai and Abu Dhabi. MarketWatch noted data from the Bank for International Settlements which put cross-border banking exposure for the UAE as a whole at $123 billion at the end of June. Of that total, European banks hold 72%, with the United States and Japan only holding 9% and 7% of the exposure, respectively. The United Kingdom is by far the biggest creditor with a share of 41%.

Reminder of Other Risks

On a global scale, Dubai World's debt problem seems relatively minor, but it illustrates the impact from one tiny country in an increasingly interconnected world. The Dubai news also cast doubt over the strength of the U.S. economic recovery, and the prospects for a bottoming of property prices.

Commercial Real Estate

As pointed out in my previous article that the commercial real estate sector posed a much greater threat than the over-hyped “mother of all carry trades.”  The Dubai debt crisis further reinforces this viewpoint.

The potential for contagion from Dubai's debt woes could further unhinge an already fragile U.S. commercial real estate sector, whose values have already fallen 42.9% from their 2007 peak, close to the lowest since 2002, according to Moody's. (Fig. 2) The latest Moody's projection is for prices to bottom at 45-55% below their peak, but could drop as mush as 65% from their peak in a "stress case".

As commercial property values fall, debt defaults rise. The $3.4 trillion outstanding in debt backed by commercial real estate poses a real threat to the recovery. Trepp LLC reported that last month, delinquencies on U.S. commercial real estate loans that were packaged into commercial mortgage-backed securities reached 4.8%, more than six times the year earlier level. Hotel loans, at 8.7% distressed, have begun falling into delinquency faster than any other kind of commercial real estate debt.

Write-downs and losses at banks around the world have risen to more than $1.7 trillion since 2007 as the credit crisis undermined the value of assets owned by financial institutions, according to data compiled by Bloomberg. Any further deleveraging and the resulting credit tightening from commercial real estate would impede the financial sector and probably derail the U.S. economy sending it into another recession. 

Housing Market Mortgage Crisis

So far, the appearance of recovery in the housing sector is being driven primarily by reduced prices combined with federal programs to lower mortgage rates with the goal of bringing more buyers into the market.

Based on a study released by Zillow.com, the foreclosure crisis has moved beyond subprime mortgages and into the prime mortgage market. (Fig. 3) While subprime borrowers are still a factor in the current foreclosure epidemic, it's becoming increasingly apparent that the weak labor market is the driving force behind the mortgage crisis we face today.

According to the Mortgage Bankers Association, one in seven U.S. home loans was past due or in foreclosure as of Sept. 30, putting that quarterly delinquency measure at its highest level since the report’s inception, 1972, and up from one in ten at the beginning of the year.

The continued surge in delinquencies suggests that a recovery in the housing market could be hindered by the weak job market as well as by further fallout from the easy money and loose lending practices of the past. The foreclosures and delinquencies are expected to keep rising well into 2010, not leveling off until the unemployment rate starts to moderate.

In a study by First American CoreLogic found that one in four of all U.S. mortgage-borrowers owe more than the value of their properties in the 3rd quarter. And many experts didn't expect U.S. home prices to hit bottom until early 2011, perhaps falling another 5-10%, as more foreclosures get pushed onto the market.

Negative equity is another outstanding risk hanging over the mortgage market.

Dubai Is No Lehman

The circumstances behind Dubai's moves are murky, making it hard to gauge the exact risk to the pertaining bonds and Dubai's own general creditworthiness. UBS cautioned that Dubai's overall debt "might be higher than the generally assumed $80 billion to $90 billion, due to potential off-balance sheet liabilities. These could include unlimited and unquantifiable amount of credit default swaps (CDS) and other derivatives against the underlying assets, and once unraveled, could potentially erupt into a subprime-like crisis.

The current expectation; however, is that there's a good chance that Dubai's problems will probably prove a local issue. Most likely, Dubai, or its neighboring emirate, Abu Dhabi, won't risk tarnishing their images and reputation further, and will come up with a reasonable resolution.

Even if Dubai goes into sovereign default, the amount is probably not enough on its own to threaten the financial system since any actual losses would be a fraction of the total. So, the problems in Dubai are unlikely to be as serious as last year's Lehman Brothers collapse, nor is it a reflection on the ability of emerging markets to lead a global economic recovery.

Rational Expectations?

But Dubai could well spur a broader crisis of investor confidence in overly leveraged economies as market confidence world-wide is still fragile from the severity of the financial crisis.  The debts of many emerging markets have risen even further as the countries governments have fought the ravages of the global recession by issuing more stimulus debt to fill the gap voided by private investment.

The spread of credit-default swaps on developing-nation’s bonds jumped 14 basis points after the Dubai news broke, the most in a month, to 3.24 percentage points, according to JPMorgan Chase & Co.’s EMBI+ Index. There is also a clear sign of potential contagion effects of global risk aversion on basically all risky assets, with the dollar and yen being the prime beneficiaries.

Rational expectations or not, for now, the Dubai crisis is simply a reminder that the severe global recession has relegated much debt to near junk status, and there still remains a high degree of uncertainty as to the percentage recoverable on all outstanding debt which is going to be coming due over the next 5 years.

Despite some seminal signs of green shoots in the news headlines during this 9 month liquidity driven rally in many asset classes around the globe, we should be reminded that all that glitters is not gold, and that the global economic recovery is still on shaky ground.

#  "I know the odds are against me, but if there's a win I'm gonna find it!"  ~Goku  #

Economic Forecasts & Opinions

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Fed's Alan Blinder vs. Peter Schiff: When Will the Dollar Lose Its Reserve Status?

Note: Peter Schiff shared a panel discussion in Manhattan on Nov. 22, 2009 with St. Louis Fed President James Bullard and former Fed Vice Chairman Alan Blinder.  This portion is on the dollar's reserve currency status, reposted here from Yahoo Tech Ticker to share with friends and readers.

Alan Blinder vs. Peter Schiff: When Will the Dollar Lose Its Reserve Status?

Nov 26, 2009 09:00am EST
by Peter Gorenstein, Yahoo Tech Ticker

The almighty dollar ain't what it used to be.

The decline of the dollar was one of the topics of debate Sunday night when St. Louis Fed President Jim Bullard and former Federal Reserve Vice Chairman Alan Blinder faced off against longtime gold bug and dollar bear Peter Schiff at a panel hosted by Princeton's Business Today.



Bullard, who doesn't often discuss the dollar, does have hope for the greenback. When the world was in full panic mode last year, Bullard notes the dollar actually gained value in a "flight to safety" trade, even though the Fed was flooding the market with supply.

While that may be true for now, Blinder "can imagine the Chinese currency being the dominant reserve currency in the world in 30, 40, 50 years from now."

Peter Schiff, in predictable fashion, says the dollar's day of reckoning is coming much sooner than they think, citing artificially low interest rates and America's rising debt obligations.

Article & Video Source: Yahoo Tech Ticker Sphere: Related Content

Coal, Copper and Ore: More Than Just Mines

By Dian L. Chu, Economic Forecasts & Opinions
Also on Seeking Alpha, Mining.com. zero hedge, iStockAnalyst, Business Insider, Treehugger, Daily Markets

Broad capital spending cuts, and curtailed production have landed machinery companies in the pits but mining equipment makers will likely be among the first to emerge from under the recessionary rubble. The reason is that commodity prices are up substantially from their recent lows, at a time when the world is running out of all those precious natural resources.

Highly Coveted Resources

The main commodities driving original equipment and aftermarket parts demand include coal, copper, and iron ore. Developing nations are heavy users of natural resources including copper, coal and iron ore. The developing world is estimated to use roughly three to five times more commodities for every one percentage point of GDP growth than the developed countries.

Coal – Rush to Power

While coal production in the U.S. has slowed in part because of environmental concerns, such concerns haven't slowed developing nations coal rush to fuel industry and generate electricity.

According to BP Statistical Review of World Energy released in June 2009, global coal consumption rose by a “below-average” 3.1% in 2008, yet coal remained the fastest-growing fuel in the world for a sixth consecutive year. China is the world’s largest coal consumer with a 43% share in 2008.

The main driver of demand for coal (and natural gas) is the inexorable growth in energy needs for power generation. Coal remains the backbone fuel of the power gen sector. In its World Energy Outlook published on Nov. 10, 2009, the International Energy Agency (IEA) projects coal to see by far the biggest increase in demand globally over the projection period of 2007 to 2030. The IEA further expects coal’s share of the global generation mix rising 3% to 44% by 2030. (Fig. 1) China will account for the lion’s share of power gen capacity growth.

The US EIA also projects world coal consumption increases by 49% from 2006 to 2030 (Fig. 2), and that China’s coal consumption to grow at an average annual rate of 2.7% through the year 2030. Because China has limited reserves of oil and natural gas, coal remains the leading source of energy in its industrial sector. As China boasts 13% of the world’s coal reserves, the country is expected to continue to meet a majority of domestic demand with coal-fired power through 2030.

Copper – Hard to Substitute

Right now, China seemingly is the only buyer of size in the global copper market. China's $586 billion stimulus package, launched late last year, is starting to stir demand, particularly among wire fabricators. In addition, strategic stockpiling and private speculative demand have reportedly also helped push copper prices up by more than 100% in a year (Fig. 3), as copper imports into China have more than doubled in the first nine months to 2.6 million tons.

State-backed research group Antaike predicted that in 2010, China's real refined copper consumption is expected to rise 8% on the year supported by the power, building and home appliance sectors. This year's consumption is estimated at 5.4 million tons, up 10.2%.

Another bullish sign for copper is the announcement of a technology agreement between Codelco and Rio Tinto (RPT), two of the world’s biggest copper mining companies. This type of collaboration would have been unimaginable not so long ago. It also seems to suggest a supply constraint on the horizon for these two rivals to start this joint effort to discover new ways of uncovering more geologically difficult deposits.

While plastics, fiber optics and wireless have replaced copper in some of the piping and telecommunication applications, wiring for emerging economy’s essentials such as cars, motors, and power generation & distribution are seen as fairly protected from substitution.

Ore – Drive to Build

BHP Billiton (BHP) chief executive Marius Kloppers underlined the scale of demand expected from fast-developing nations when he said China alone may require five times as much iron ore in the next 15 years as it had in the past 15 years. Also fuelling China's resource hunger will be further urbanization, with the country expected to have 220 cities of more than one million people by 2030, compared with Europe's total of 35 now. BHP is the world’s biggest mining group.

In Its 3rd quarter 2009 earnings release, Vale S.A. (VALE), the world’s largest ore producer, indicated it is restarting iron-ore plants idled during the economic contraction and boosting output of the steelmaking ingredient to meet higher demand from China, Europe, Japan and Brazil. Third-quarter ore shipments rose 36% sequentially, while average prices increased about 20%.

In the quarter, Vale S.A. sold a record 39.8 million tons of iron ore to China, where rising imports are almost certain mainly due to high local production costs. Vale S.A. estimated world steel output may rise 9% in 2010 to levels before the global financial crisis.

Auction & Rental Also Thriving

One interesting trend in the equipment sector is the thriving rental and auction business. Tight credit and slumping demand has incentivized companies to increase their equipment rental budget, thus avoiding large capital commitments, while equipment dealers are forced to farm out their fleet in the auction market.

United Rental (URI) Hertz Global Holdings, Inc. (HTZ) and are two big players in the heavy equipment rental sector. Meanwhile, equipment giant Catertpillar, Inc. (CAT) has crawled into the auction territory through Cat Auction Services, which is owned by CAT dealers and the Big CAT supports the brand.

Investment Threshold Crossed

Although coal and copper prices have declined from relatively high levels in 2008, prices currently remain above the investment threshold for new equipment, which is generally considered to be $1.30/lb for copper and roughly $41/ ton for coal, according to Caterpillar, Inc. (CAT).

Higher Margin Recovery

As customers are delaying new purchases opting to maintain existing equipment with after-market parts, the sector has seen its backlog taking a hit. But now companies are saying there’s an increase in activity in regions including Australia, Latin America, and China. China alone accounts for 25-30% of global copper consumption, and is the biggest consumer of coal in the world.

Analysts said these regions and products tend to carry margins that are comparable to levels seen in the U.S. In addition, commodity related products in mining usually carry above average margins.

Increases in mining equipment demand will partly depend on the effects of government stimulation packages, and the continued stabilization of financial systems. Commodity prices, though tenacious, are extremely volatile. Nonetheless, the rally in commodities prices has led to increased investor optimism in recent months for mining equipment makers such as Bucyrus International Inc. (BUCY), Joy Global, Inc. (JOYG) and Terex Corp. (TEX). (Fig. 4)

Mining Gear Required

Goldman Sachs last week raised price targets on several coal miner stocks noting "Coal stocks have performed well... We believe the last leg up for coal stock multiples will come from greater recognition of supply constraints in the Pacific."

Increasing commodity production often requires incremental new equipment to meet the higher production schedules and also serves to increase utilization of existing equipment in operation. This trend should help with increased demand for the original-equipment business, as well as its after-market business going into next year and future years to come.

Play on Commodities & Emerging Markets

The mining equipment sector also serves as a good alternative to investing directly in the commodity and emerging markets.  The sector should continue to benefit long-term from developing countries improving their infrastructure while consuming more raw materials. The valuation discount relative to their machinery peers should continue to narrow as commodity prices climb on developing regions demand and supply constraints.

# Let me ask you: does a machine ever experience fear? ~- Vegeta #

Economic Forecasts & Opinions

Disclosure:  No Positions

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Weekend Reading: Nov. 21, 2009

Outsourcing: The Culprit Is Capitalism, Not Wall Street (Harvard Business Review)
Doug Kass: The Quant Bubble (TheStreet.com)
A yuan-sided argument: Why China resists foreign demands to revalue its currency (The Economist)
Efficient Markets or Herd Mentality? The Future of Economic Forecasting (Knowledge at Wharton)
SocGen: Worst Case Debt Scenario: Protecting Yourself Against Economic Collapse (zero hedge)
Weighing The Facts: Will The Next Leg Be Up or Down? (Yahoo Finance)
Devon Energy’s U.S. Gulf Asset Sale May Draw China’s Interest (NYT DealBook)
The Future of Energy: Crisis Averted? (FT.com)
Valero refinery shut-down another sign of woe (Chron.com)
Banks In "Utter Chaos" Dealing WIth Off-Balance Sheet Assets (Business Insider)
Gloomy Gross Loves: Utility stocks? (MarketWatch) Sphere: Related Content

China - The Sleeping Lion Awakened

By Dian L. Chu, Economic Forecasts & Opinions
also at USA Today, WSJ One Spot, NPR, Current, Florida Today, Seeking Alpha (Editor's Pick), zero hedge, iStockAnalyst, StraightStocks , Daily Markets

U.S. President Barack Obama has begun a nine-day tour of Asia at a time when the U.S. economy is struggling to emerge from a deep recession. But nothing looms bigger than China, the largest holder of U.S. debt (around $797.1 billion, up 10% this year), has emerged from the global economic downturn in an ever stronger position. When Obama sets foot in China for the first time, he will confront a dramatically altered balance of power between the two nations.

Two Decades of Explosive Growth

This seismic shift is driven by China's astonishing economic growth over the past two decades and has accelerated during the global financial crisis. Its 9% to 10% annualized GDP growth rate in the past two and a half decades is unprecedented in world history.

In 1992, Chinese gross domestic product (GDP) was less than 7% of America's GDP. By 2000, the figure topped 12%. When Obama won the election in 2008, the Chinese economy had grown to equal more than 30% of U.S. output. New data show that China is on track to grow more than 8% in 2009, driven by high industrial output and retail sales.

Impressive Stimulus Package…and Working

During this global recession, China's astonishing growth did slow down, but unlike most developed economies, China never entered a recession.

The Chinese have launched the world's biggest investment program (about $585 Billion) after the start of the financial crisis last year. Beijing's stimulus program is estimated to amount to about 13% of Chinese gross domestic product, making it almost twice as large as the U.S. program and close to five times the size of its German equivalent.

The government's massive economic stimulus program has transformed the country into an enormous construction site. As a result, China’s industrial production rose 16.1% year-over-year in October, the most since March 2008 and a slide in exports eased to 13.8% the slowest pace this year. However, behind the impressive economic data, troubles might be lurking.

China Bubble Forming

China’s purchases of dollars to prevent appreciation gave it foreign-exchange reserves totaling $2.3 trillion in the third quarter, the world’s largest. Meanwhile, its sale of Yuan to keep it fixed to the dollar contributed to a 29% jump in its money supply, and the peg helped spur more than $150 billion in speculative funds from overseas in the past six months, according to China International Capital Corp.

China's main index, the Shanghai Composite, has gained 52% this decade and rallied 75% this year alone as government stimulus and record lending drove the nation’s economic recovery. (Fig. 1) State-owned banks have begun issuing new loans, leading to a 150% increase in lending compared with 2008.

In addition to playing the stock market, a lot of the money is being diverted into houses and land.  There are also reports of excess capacity created by the aggressive stimulus effort.  Record apartment prices and a high flying stock index this year are prompting warnings against "financial risks" and the development of bubbles in real estate markets.

Yuan-Dollar Peg Angers Many

Beijing has kept the Yuan pegged at about 6.83 per dollar since July 2008, seeking to help manufacturers battered by the collapse in demand abroad. The Yuan advanced 21% in three years from July 2005. (Fig. 2 & 3)

The discontent about China’s currency peg to the dollar isn’t confined to the U.S. Capitol Hill, corn growers, steelmakers, and textile companies. From Mumbai to Bangkok, Asian companies also say Chinese rivals have an unfair advantage because of the Yuan-dollar link. The dollar has declined 14% in the past year against the currencies of six major trading partners, while other neighboring currencies of China have strengthened.

For instance, South Korea’s won gained 8% against the Yuan in the past six months. Japan’s yen has risen 6%, while India’s rupee gained 6% and the Thai baht 4%. This has prompted Asian central banks this year to increase their holdings of U.S. dollar assets, including Treasuries, to prevent their currencies from appreciating and thus making exports more expensive relative to China’s, all the while blaming Beijing.

China Quashes Yuan Policy Speculation

Most expect that in Obama’s meetings at the Asia Pacific Economic Cooperation (APEC) summit and then in Beijing, China’s fixed-rate policy will likely be part of the discussion. On that note, investors are seeing a rising Yuan. Twelve-month non-deliverable forwards for the Yuan in Shanghai are signaling trader bets on a 3.5% gain from the spot rate of around 6.83.

However, in what seems to be an official effort by Chinese authorities to dismiss the renewed speculation of Yuan appreciation in the near term spurred by a recent language change from The People’s Bank of China, on Saturday, the state-controlled Chinese news agency Xinhua reportedly said that the government would not allow the currency to gain against the dollar in the short term.  Goldman Sachs also just reiterated its three, six and 12-month forecasts for the Yuan to stay at 6.83 against the dollar.

Yuan to Appreciate…Eventually

China’s drive to create jobs and maintain social stability through export-led growth means politicians aren’t ready to loosen controls on the currency. In addition, China’s trade surplus will probably be half last year’s level at $200 billion, which means a bit less  pressure on the Yuan to appreciate. The U.S. doesn’t want a stronger Yuan either because that would cause a collapse in the dollar in the short term.

Over time, China will likely be under pressure to open and let the Yuan appreciate in the next 24 months, and possibly as early as the 2nd half of 2010, albeit at a very gradual and modest pace, while most likely still pegged to the dollar.  Eventually, the Yuan will appreciate considerably due to China’s high growth rate and its population’s high savings rate (35-50% range) .

On Nov 11, in Singapore, World Bank chief Zoellick calls the dollar's role as a reserve currency "relatively secure," but says over the next 10-15 years the Yuan (Rrenminbi) will provide an alternative once it is internationalized.

Strong Growth Prospect  

China is a communist country with capitalist power.  Despite China bears’ prediction of a Chinese size collapse, for a country with such a tremendous resource base and centralized system, busted bubbles in sectors most likely will not derail the country’s global leadership path started over two decades ago.

In a speech a few days ago at a conference organized by the Monetary Authority of Singapore, International Monetary Fund (IMF) Managing Director Dominique Strauss-Kahn called on Asia to play a leading role in guiding the global economy to a new, more sustainable path for global growth.

The IMF expects Asia’s GDP growth, driven mostly by Chindia, to be 5.75% next year—almost double the 3% rate forecast for the global economy. Specifically, the IMF projects China annual growth to be 8.5% and 9% for 2009 and 2010 respectively. In contrast, advanced economies annual growth in 2010 is projected to be about 1.25%, following a contraction of 3.5% in 2009. (Fig. 4) 

Chinese Exposure Desirable

China’s surging asset prices, a dollar collapse and a double-dip global recession are the biggest risks investors face in 2010. But many analysts are bullish on China for the long-term as 500 million educated and unemployed Chinese spur greater domestic spending and production.

Yet, Americans are estimated to have only 2% to 20% foreign stock exposure. That means Chinese stocks represent probably a low single-digit percentage, at most, in the average portfolio. With very few high investment return prospects, China is one market that should be given some serious consideration as part of a long portfolio.  

There are many ways to play the Chinese market. The following are just a brief overview of some that I will discuss in this article.

B Shares

For investors interested in adding some Chinese exposure, B shares are a good bet for those who hold dollars and want to benefit from China’s fast economic recovery. The shares traded at an average discount of 49% to their A-share listings, according to BNP Paribas.

China's dollar-denominated B shares at the Shanghai Stock Exchange jumped 9.42% to 251.19 points last Friday, posting an 18-month high. The surge mainly resulted from market expectations of Yuan appreciation.

Though it is difficult to pick a good individual B shares stock right now as most are probably fully valued, it is best to avoid stocks of property developers as a way to minimize the risk of a potential real estate bubble. According to Morgan Stanley, the sector’s share price has gained about 155% on average in the past year.

ETFs

An EFT is a convenient way to invest in China. But it could be a bumpy ride as a three-year measure of volatility for China ETFs is more than double that of the S&P 500.

The two most popular China ETFs are iShares FTSE/Xinhua China 25 Index (FXI) and SPDR S&P China (GXC). Both of these are very heavily weighted towards financials. On the other hand, PowerShares Golden Dragon Halter USX China (PGJ) has only about 6% exposure to financials, and has been around since 2004.

For currency plays, the WisdomTree Dreyfus Chinese Yuan (CYB) and Market Vectors Renminbi/USD ETN (CNY) are two ETFs specializing in the Yuan. But a recent WSJ article cautioned investors about the pitfalls of the Yuan ETF because it is in a contango market similar to that of the United States Natural Gas Fund (UNG).

Consumer and Commodity Blue Chips

Since B shares and China ETFs may have more risks and volatility than some might like, blue chip companies with an increasing presence in China could be a less risky way to ride the Red Dragon.

Chinese President Hu Jintao recently said that the government is focused on expanding domestic spending, “especially consumer demand” to strengthen the economy.  This could present opportunities for consumer-related stocks. U.S. blue-chip companies such as Wal-Mart (WMT) and McDonalds (MCD) are likely to benefit from this trend.

Similarly, with China’s insatiable appetite for all natural resources, non-U.S.-based producers such as BHP Billiton (BHP), Rio Tinto (RTP), and Vale S.A. (VALE) could also provide good portfolio diversification.

Nevertheless, I would advise against commodity futures ETFs due to the intensifying regulatory scrutiny and the potential “rolling effect” commonly experienced in a contango market as discussed in my previous article.

Let's see you stop this one. ~Pikkoro Jyunia

Economic Forecasts & Opinions

Disclosure: No Positions

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Weekend Reading: Nov. 13, 2009

Stephen Roach on Preparing for the next Asia (Video & Transcript, McKinsey Quarterly)
China not to let yuan gain in short term: experts (XinhuaNet)
U.S. Dollar May Lose Reserve Status in 20-30 Years (Bloomberg)
If the economy's stagnant, why are stocks up? The answer is disturbing (Slate)
America Leaves Itself Behind: A world of trade deals without the U.S. (WSJ)
Interactive Graph: How the Government Dealt With Past Recessions (New York Times)
Wall Street Is Setting Investors Up for Another Hurting, Robert Prechter Warns (Yahoo Finance)
Key oil figures were distorted by US pressure, says whistleblower (Guardian)
Did The US Pressure The IEA Over Oil Supply Forecasts And Why? (DailyMarkets)
Barrick shuts hedge book as world gold supply runs out (Telegraph)
Gold - a six thousand year-old bubble (FT.com)
The Twenty-Five Most Valuable Blogs In America (24/7 Wallst, Seeking Alpha is #11) Sphere: Related Content

Saudis Ditch NYMEX WTI - A Global Paradigm Shift

By Dian L. Chu, Economic Forecasts & Opinions
See it also on USA Today, Seeking Alpha (Editor's Pick), Zero Hedge, Daily Markets, Business Insider, iStockAnalyst

Saudi Aramco, national oil company of the world’s largest oil producer and exporter, decided earlier this month it will drop West Texas Intermediate (WTI) as the benchmark for pricing its oil for sale in the US market.

In January 2010, Aramco will use the Argus Sour Crude Index (ASCI) to price its oil for the market; it’s heavier and has higher sulfur content than WTI. The index, launched in May, uses the volume-weighted average of daily spot sales of the three U.S. Gulf Coast medium sour crudes: Mars, Poseidon, and Southern Green Canyon.

The news instantly sparked speculation that other major producers would follow. Chavez (not surprisingly), reportedly already indicated Venezuela would follow Saudi’s lead adopting the new index. Several Canadian companies, who expect to use TransCanada Corp. (TRP) proposed Keystone XL pipeline to send oil sands crude to the U.S. Gulf Coast, have also expressed interest in using the Argus benchmark.

Global Crude Oil Benchmarks

Crude oil benchmarks, also known as oil markers, were first introduced in the mid 1980s. There are three primary benchmarks, WTI, Brent, and Dubai. WTI, a lighter and sweeter crude, usually trades at a premium to Brent and Dubai. Benchmarks are used because there are many different varieties and grades of crude oil (around 200 different blends). Using them is a way to give stability and transparency to the global oil market.

While Brent remains the dominant benchmark for oil pricing outside the US, the U.S. oil imports are usually priced off WTI. As much as three quarters of the world's physical oil is priced each day using Brent and WTI. Saudi Aramco has priced its U.S. deliveries against WTI since 1994.

Shifting Energy Landscape 

US Gulf oil output, currently at about 1.2mn b/d, is expected to climb to 1.4mn b/d next year and 1.9mn b/d in 2013 boosting spot market trading volumes. This decision by Aramco in part demonstrates the emerging importance of the US Gulf as the new center for price discovery.

Meanwhile, the abandonment of WTI, a longtime standard since the 1980’s, for a five-month-old Argus index by Saudi Arabia is a big deal in the crude pricing assessment world. The move not only highlights some specific problems of WTI, but also signifies ongoing shifts in the global energy landscape, as emerging countries take an increasingly prominent role in the oil trade.

Guilty by Disassociation

In principle, the movement in WTI prices is supposed to reflect supply-demand conditions in the US, the largest consumer in the world, burning almost one quarter of the of the 86.14 million b/d consumed worldwide in 2007. And sour crudes usually should sell at a discount to light crudes such as WTI because the latter are cheaper to refine.

However, distortions caused by logistical or inventory constraints at Cushing, Oklahoma, the WTI delivery and pricing point, can dislocate WTI prices away from North Sea Brent and US gulf crude prices.

Historically, WTI has traded pretty much in line with Brent and gulf sour crudes. But WTI price movement has become increasingly volatile in recent years. The recent inventory glut at Cushing, OK due to the demand slump, coupled with new pipelines transporting Canadian Oil Sands crudes has distorted the WTI price against other benchmarks throwing the global oil market into disarray.

According to FT, In January, WTI, which usually trades at a premium of $1-$2/b to Brent, fell sharply reaching a record discount to Brent at around $12/b.  (Fig. 1)  In February, the sour, heavier ASCI crudes were even selling at an $8/b premium to WTI. Then, just one month later, WTI had soared and ASCI had fallen to a $6 per barrel discount. This bounce around has made it difficult for Saudi to price its crude competitively and at the same time has annoyed its customers.

Guilty Also by Speculation & HFT

Some analysts believe Saudi Arabia's decision likely reflects a "wider discontent" from its customers that want a new benchmark that more accurately reflects true supply and demand. ExxonMobil (XOM) and Valero (VLO) are among the US biggest buyers of Saudi crude oil.

Meanwhile, others blame NYMEX for failing to protect the integrity of the WTI contract as it has become the global speculative vehicle for mega commodity funds like the United States Oil (USO) and high frequency trading (HFT) strategies.

A Sour Move.. Plus an Eastward Shift

As the North Sea and onshore American wells deplete their reserves, the lighter and sweeter crude supply is also dwindling. The crude we burn is getting heavier and more sulphurous. According to BP, as much as two thirds of the world’s crude oil supply is now sour crude. New refineries with expensive desulpherization units and hydrocrackers are chasing the sour spread, hoping to make higher profit margins by buying cheaper, heavier crude oil.  (Fig. 2)

In addition, the underlying oil market is fragmenting, in geography as well as in chemistry. The only growth in the oil markets is now in Asia (think Chindia), while the demand in the developed countries, including the U.S. has already peaked (Fig. 3).

According to energy consultants Douglas-Westwood, the Middle East share of world oil and gas production is expected to grow from about 23% today to an estimated 30% by 2025 (Fig. 4). And a majority of the new and existing Asian and Middle East refineries are set up to process sour crudes.  As energy markets are moving east and sour (Fig. 3 & 4), this shift tends to render WTI, which is a lighter and sweeter crude grade, less relevant as a proxy for the price of oil.

WTI to Remain A Global Key

At its inception about five months ago, ASCI said it will use WTI as a basis for its price assessments. So, in essence, by switching to ASCI, U.S. Saudi marketed oil will still continue to price its Gulf crudes, at least in part, based on WTI.

In addition, NYMEX WTI futures are the most traded energy contracts and thrive on liquidity. So, WTI should continue to have a key role in spite of the Saudis move to ASCI, in part because of WTI's liquid NYMEX derivatives market.

However, if an active OTC or futures market based on ASCI eventually arises, then the dynamics could change. Both the CME and ICE have said that they will launch futures contracts tied to the Argus index. Of course, gaining volume and traction on a brand new financial product is an entirely different matter.

This benchmark change most likely will be a battle between the exchanges (CME and ICE) and the index providers (Platts and Argus), and not represent a dramatic change in the dynamics of the U.S. crude market in the medium term.

Speculation Knows No Benchmark

Realistically, crude oil is the most widely traded and speculated commodity in the world. Logistic and storage issues at Cushing aside, without a fundamental financial reform on a global scale, speculative price distortions will still occur regardless of the commodities exchange or benchmark.

WTI Problem Is Not New

For market participants, the periods of dislocation for the WTI do not pose serious problems. Exporters like Saudi Arabia can overcome pricing issues by adjusting their price differentials, while traders can hedge the dislocation risks by resorting to various other financial instruments. In short, the system has created mechanisms to deal with its own problems.

In the environment of high oil prices like last year, exporters seem to be happy selling their oil using less than perfect benchmarks. That is, a pricing system, however flawed or problematic, can survive unchallenged as long as market players have an interest in its survival.

So, Why the Change of Heart by the Saudis?

Taking this into consideration, in the context of growing Gulf States’ discontent with the U.S. monetary policy, and EIA data showing Saudi crude exports to the US plunged to a 22-year low in August, this move seems to be another effort by the Saudis to move away from dollar dependency and its relationship with the U.S.

It also signals Riyadh’s total loss of faith in one of its oldest allies and trading partners. This should not come as a surprise in light of the IMF`s repeated slams against the dollar, and the U.S. government’s continued printing and spending binge.  Furthermore, it seems to suggest Saudi is trying to push and eventually take control of the world crude oil trading volume.  Or perhaps this is all part of a bigger movement towards a New World Order which many financial powerhouses, including George Soros, have advocated? Sphere: Related Content

Weekend Reading: Nov. 6, 2009

Asia and Pacific: Building a Sustained Recovery (IMF)
Just Deserts and Markets Being Silly Again (GMO Jeremy Grantham)
The Post-recessionary Global Economy: In Search of the New Normal (Knowledge at Wharton)
Has Buffett Gone Bonkers or Was $44B BNSF Buy Another Stroke of Brilliance? (Y! video & article)
Investing with Harvard Economics Professors (The Harvard Crimson)
David Einhorn, Greenlight Capital, “Liquor before Beer… In the Clear” (Reuters)
Trader Vic: Buy Gold, Sell Oil (IndexUniverse)
White House Tally Appears to Overstate Stimulus Jobs (WSJ)
Developed countries face threat of soaring prices and food shortages (Guardian)
Single Best Investment in History = 258,449% (The Big Picture) Sphere: Related Content

Houston Chronicle: ‘Worst is behind us,' UH economist says

Note:  This is an article by Ms. Wooty Sixel, business columnist at Houston Chronicle, where my views are cited along with Dr. Barton Smith and Mr. Bill Gilmer in the 11/06/09 print edition .   

By L.M. SIXEL
HOUSTON CHRONICLE

As the U.S. economy stabilizes, most of the key sectors in Houston will show year-over-year job gains by next fall, a local economist predicts.

“I think we can say the worst is behind us,” said Barton Smith, director of the University of Houston's Institute for Regional Forecasting. He made his comments during his annual economic forecast to 950 developers, bankers and other business leaders at a luncheon Thursday.

In 2010, Smith predicts Houston will lose about 13,000 jobs, or 0.5 percent, with most of the cuts occurring earlier in the year. Toward year-end, Houston will start to show some job gains, he said.

However, construction, manufacturing and perhaps finance will continue to struggle, according to Smith, who characterized 2010 as a “hold on to your seat” year.

The news comes as a welcome relief during a year that's been very difficult for many Houstonians.

In just one month alone — in March —the Houston area lost 15,000 jobs on a seasonally adjusted basis, said Smith. That's more than any month of job loss during the energy bust in the 1980s.

While job losses have slowed since the spring, Smith predicted Houston will end this year losing 62,000 jobs, a 2.5 percent decline, compared with 2008.

That's a whole lot more than Smith predicted a year ago. The best-case scenario, he said then, would be a 11,000-job loss for Houston. But if the global downturn deepened, he said, a loss of 37,500 jobs was more realistic as Houston lost its energy cushion when oil and natural gas prices fell.

But Smith also warned a year ago that his story wasn't pessimistic enough if natural gas fell to $4 to $4.50 per thousand cubic feet. Natural gas prices ended up falling below $3 this fall, a blow to the local energy industry, where 85 percent of exploration is geared toward natural gas.

“That was the killer,” Smith said Thursday.

Sees no good signs

Bill Gilmer, vice president and senior economist for the Houston office of the Federal Reserve Bank, said he isn't seeing signs the grip of recession in Houston has loosened significantly.

“While the U.S. economy is improving, that's not the pattern that's emerging in Houston,” said Gilmer, who predicts that the local economy is on pace to lose about 100,000 jobs this year.

Fundamentals bad

The fundamentals of the oil industry and natural gas are bad: low demand, low prices and very high inventories of heating oil natural gas, he said.

“Houston is still a commodity-driven city and commodities will probably be one of the last parts of the economy to recover,” he said.

While Gilmer is predicting small but positive job growth for 2010, it won't happen until the latter part of the year and it will lag the nationwide improvement, he said.

Houston market analyst, trader and financial writer Dian Chu is expecting to see more job cuts, especially in the oil services sector. The service providers were very cautious in their most recent round of earnings releases and weren't ready to say the market for natural gas has hit bottom yet, she said.

“That indicates to me they're not planning to add jobs anytime soon,” said Chu, because they don't see a recovery on the horizon.

But Chu is expecting to see some signs of improvement during the second half of 2010.

lm.sixel@chron.com

Source:  Houston Chronicle

Sphere: Related Content

Nouriel Roubini on U-Shaped Recovery, Carry Trade Bubble and Housing

By Dian L. Chu, Economic Forecasts & Opinions
Also on Seeking Alpha, Daily Markets, Zero Hedge, Business Insider

In this interview with CNBC on Nov. 4, 2009, Dr. Nouriel Roubini, professor of economics at the Stern School of Business, New York University and chairman of RGE Monitor, cautions investors of the coming asset bubble and crash caused by the dollar carry trade, and at the same time shared his views on the economy and housing.

This is the second time in many weeks that Dr. Roubini warned of a growing dollar carry trade and threatening to cause a global implosion. The following is a summary of his CNBC interview along with my comments.


Video Source: CNBC

The Economy

Roubini: The recovery will be U-shape rather than V-shape due to "extremely weak" labor market resulting in lower consumer spending, and low capacity utilization (currently at around 70%) discouraging business investment. But the market is pricing in a V-shaped recovery, where in fact the recovery is going to be U-shaped.

My Take: By predicting a U-shaped economic recovery, Dr. Roubini implicitly diverged from his assertion less than two weeks ago that we have averted a depression.  Note: I refuted his macro view in my article dated 11/03/09.

Dollar Carry-Trade

Roubini: The current monetary policy of the Fed will further weaken the dollar and thus, prolong the dollar carry trade. Eventually the carry-trade will be unraveled. Once this occurs, the dollar could have a sharp snap back probably 15-20% creating a huge asset bubble 6 month to a year from now.

"In the Meanwhile the bubble's going to become bigger globally and the bigger the bubble the bigger is going to be the crash."

This unraveling process is not expected to be "orderly", unless the central banks start more aggressively phasing out the quantitative easing, which is not the indication right now.

My Take: Carry trade has been around for decades. People involved in carry trade are among the most sophisticated investors. There could be 15-25% correction, but the unwinding process will most likely be gradual and orderly. The “crash trade” scenario could happen only with a once-in-a-life-time event such as the 9/11.

Housing

Roubini: Quantity has bottomed out with supply and demand both falling 80% from peak. However, the gap between demand and supply is so large that home price could fall another 10% before the end of next year, off 40% from peak. The situation in the commercial real estate sector is even worse. 

My Take: Commercial real estate valuations have been falling over 35% since October 2007. Over the next three years, about $1.5 trillion in commercial real estate loans are coming due. If anything is going to implode, commercial real estate would trump carry trade as the number one candidate.

Disclosure: No Positions Sphere: Related Content

Gold: It’s All about the Dollar…and Yes, Dr. Roubini, Inflation

By Dian L. Chu, Economic Forecasts & Opinions
Also on USAToday, Zero Hedge, Seeking Alpha, Daily Markets, Business Insider, Jim Sinclair's MineSet, iStockAnalyst

Gold prices surged to a new high Tuesday on news that India's central bank bought $6.7 billion worth of gold from the International Monetary Fund (IMF). December gold jumped as high as $1,087, before settling at $1,084.90 an ounce on the NYMEX breaking the previous record of $1,072 an ounce on Oct. 14. Prices are now up 22.7% for the year heading for a ninth straight annual increase. (Fig. 1)

Unusual Correlation

Historically, gold moves in an opposite direction to stocks because of bullion’s traditional role as a safe haven in times of crises. But gold has recently climbed in tandem with rising equities. For example, the Dow Jones Industrial Average, a bet on the economic recovery, is up about 15% this year. (Fig. 2)

This unusual correlation is driven mostly by excess liquidity, return of risk appetite, and a weakening U.S. dollar. The creation of the U.S. national marketable debt to a record $7.01 trillion to revive growth, along with the Federal Reserve’s maintaining the benchmark interest rate near zero since December 2008, and the prospect of heavy government borrowing to fund deficits, threatens to weaken the dollar and fuel inflation and increased economic volatility later.

Economic uncertainty, inflation worries and the weakening U.S. dollar helped push gold to a new high this year. Weakness in the dollar benefits gold, which is often used as an alternative asset hedge to a depreciating dollar. The Dollar index (DXY) has declined about 10% this year. (Fig. 2) Right now, the general trend is still for further dollar weakness on the back of the Fed’s easy monetary approach, which will be supportive for the whole commodities complex.

Gurus Now the New Gold Bugs

During the bull market just a few years ago, gold was the last place people would look to put their money in for an asset class. Nowadays, almost everyone from investment gurus to store clerks is either piling into or at least talking about gold.

Fund manager John Paulson increased his bets on gold this year, while David Einhorn of Greenlight Capital was buying gold for the first time. Andrew Hall, the star trader of Philbro, has also reportedly been buying gold this year.

Meanwhile, Paul Tudor Jones, also told clients on Oct. 15 that the time to hold gold is now "as faster inflation and increased purchases through exchange-traded funds, and by central banks boost demand amid stagnant mine output."

Roubini: Gold Has Nowhere to Go

Contrasting to the renewed enthusiasm in gold, Dr. Nouriel Roubini, in a recent interview with IndexUniverse, says gold will go up only for two reasons: inflation or another Armageddon depression.

He indicates that there is currently no inflation risk, as we are still in massive deflation due to a glut of capacity, weak demand, and high unemployment. He went on to say that we’ve also avoided the “tail risk of another depression.” So, without inflation and depression, gold likely has nowhere to go in the next three to four years.

Dr. Roubini did conclude that there is “a wall of liquidity" chasing assets, and a correction could be coming in risky assets with an anemic recovery.

No Inflation & Avoided Depression?

The warning of a deflationary threat from many mainstream economists such as Dr. Roubini suggests a group-think mentality that the output gap and anemic economic growth would keep inflation low (in the next three to four years, according to Dr. Roubini), in spite of central bank policies creating massive monetary inflation this year.

But Dr. Roubini’s assertion that we face no inflation risk, AND at the same time avoided another depression in the next three to four years seems to defy logic. The “no inflation risk” assumption is a recessionary scenario, if prolonged, would lead to depression, i.e. the W-shaped double dip.

On the other hand, if we have averted another Armageddon depression, which implies resumption of growth. Economic strength typically leads to inflation with everybody chasing assets. Ergo, there is got to be one or the other, i.e., we should either have inflation; dip into recession/depression or…both, most likely before the end of year 2011.

Money Supply & Velocity Spells Inflation

It is well established that there is a positive correlation between the money supply and inflation. The amount of dollars in the system has increased dramatically. (Fig. 3) But the inflationary pressure from the “wall of liquidity” has been offset by a decline in the velocity due to reduced economic activity and tight credit conditions. (Fig. 4)

This reduced velocity in money is part of the reason why when stripping out the two stimulus plans, cash-for-clunkers and the home buyer tax credit, the U.S. economy grew a mere 1.64% in the 3rd quarter, with quite a subdued U.S. consumer and underlying producer price inflation data.
 

However, based on the latest Federal Reserve data, the decline in velocity seems to be ending. (Fig. 4) If the reversal trend takes hold with an improving GDP outlook, we are likely to see renewed growth in the price inflation level.
 
Gold Should Be at $2,300?

The fast ascent to new record highs this year has some of gold proponents worried it might be getting ahead of itself. But on an inflation-adjusted basis, the prices of almost all commodities have reached their 1980's level, except for gold and sliver. On that note, gold would have to double to $2,291.55 to reach its 1980`s high, which its supporters believe means gold could go much higher.

Confidence Lost at Central Banks

In addition, many U.S. creditors have fundamentally lost confidence in the US dollar and are incrementally diversifying into hard assets and non-dollar currencies. There are indications that China, for example, could be shifting to a partial gold standard through reserve accumulation.

The Reserve Bank of India (RBI) yesterday said it had bought $6.7 billion worth of gold from the International Monetary Fund (IMF). The purchase RBI made is nearly half the 403.3 tonnes gold that the IMF decided to sell in September to raise resources for lending to low-income countries. Most speculate that China would be the buyer for the remainder of the gold for sale by the IMF.

The deal represented one-eighth of the IMF’s total gold stock. This is the first time since 2000 that the IMF has sold gold to a central bank. India's affirmation of current gold prices is a big sign that the nation sees the recent surge in gold isn't likely to abate any time soon. It also signals that the fall in the US dollar seems to be pushing central banks to strengthen their portfolio with gold.

The purchase will lift the share of gold in India's 285.5-billion foreign exchange reserves from near 4% to about 6%, which is much less than most of the developed world and four times China’s. This lower gold to reserve ratio also suggests the China and India could continue to be the buyer in the gold market.  

More than Just Skin Deep

There are others who are concerned that the relatively high prices of gold could crimp jewelry demand from India and China, which accounts for two-thirds of the total gold demand. But, culturally speaking, most Asian countries see gold as the ultimate instrument for value preservation. This tends to keep the demand level of gold fairly stable regardless of the price of gold.

Even if the jewelry demand drops due to the high flying gold prices, the current trend is that investment demand for gold could exceed that of the jewelry demand, similar to the trend of the 1970’s. This change primarily stems from the investment community losing confidence in current monetary policies and corporate earnings.

Dollar & Inflation to Support Gold

Of course, people no doubt will keep arguing about whether gold is a legitimate currency. Either way, gold has done well in periods of economic and financial difficulty, such as the 1970s, when the dollar was weak, inflation was high, and confidence in government was low. The weak dollar and inflation perspectives discussed here are enough to support a continuing gold rally for the next few years in the asset class.

Portfolio Strategy

Investors should consider using gold as a way to insure their portfolio by allocating no more than 10% of their holdings to bullion and gold stocks. However, beware that the battered greenback could weigh on operating costs of producers with significant operations outside of the U.S. Companies like Barrick Gold (ABX), Kinross Gold (KGC), Jaguar Mining (JAG), Newmont Mining (NEM) and Yamana Gold (AUY) have substantial operations in Canada, Australia and Brazil, making them vulnerable to a depreciating U.S. Dollar.

By Dian L. Chu, Economic Forecasts & Opinions
Disclosure: No Positions Sphere: Related Content

Weekend Reading: Oct. 30, 2009

A Global Question: Is It Time to Raise Interest Rates? (Knowledge at Wharton)
Soros Says ‘Bloodletting’ Yet to Come for LBOs & Commercial Real Estate (Bloomberg)
Soros on Global Economy, Currencies and China Being Part of a New Financial World Order, Oct. 23, 2009 (Video and Transcript, FT.com)
Carbon trade 'to become world's largest commodity market by 2015 (Platts)
China Investment Corp. Warns of Global Asset Price Bubble (FT.com)
Will Barbarians Cause Another Financial Crisis? (Boston Consulting Group study & WSJ Video)
TrendWatch: Oil Trader Vitol Grabbing Petroplus Antwerp Refinery (FT Alphaville)
Nouriel Roubini: Big Crash Coming, But I Don't Believe in Gold (IndexUniverse)
John Mauldin: Double Dip in 18 Months, Tax Hikes Hurt "Recovery', Which Isn't Real Anyway (Yahoo Finance) Sphere: Related Content

Peter Schiff: Recession Is Not Over & the GDP Growth is Not Real

Video Source: YouTube

By Dian L. Chu, Economic Forecasts & Opinions:
Also on Daily Markets, iStockAnalyst

In his latest market commentary video and article dated 10/29/09, Mr. Peter Schiff rains on the "recession-is-over" parade celebrated on Wall Street today.

The better than expected 3.5% third quarter U.S. GDP growth has encouraged some more risk appetite into stocks and commodities, as the U.S. dollar weakens. Weakness in the dollar also helped gold breaking five straight sessions of losses. Gold has been rising along with stocks and other investments positively tied to economic growth and partly to the weak dollar.

In his commentary, Mr. Schiff says that to proclaim the recession is over with just one quarter of positive growth is a little premature. He recalls that during the Great Depression in the 1930's, the depression continued even with four years of consecutive growth. Calling attention to the rising debt levels and plunging savings rate, Mr. Schiff cocludes the economic growth in the 3rd quarter is mostly propped up by the stimulus plans and therefore, not legitimate.

Indeed, according to the Bureau of Economic Analysis (BEA), Cash-for-Clunker added 1.66% to the U.S. GDP growth figure reported. In addition, home buyer tax credit is estimated to have inflated the GDP by 0.25%. Thus excluding the two aforementioned stimulus aids, the U.S. economic growth would have been a still recessionary 1.64% in Q3.

Like many investment and fund managers including Einhorn, Paulson and the latest convert, Mr. Paul Tudor Jones, Mr. Schiff reiterates his recommendation of investing in gold to hedge against inflation as well as dollar depreciation.

While Mr. Schiff's recent call for $5,000 gold implying a sub-zero dollar scenario seems overly "Armageddon", I do agree with his assessment on the state of the economy and monetary policy. His investment advise on gold is also in line with the anti-dollar & anti-inflation strategy recommended in my previous article; however, I think gold might be overbought at the moment, and due for a correction before taking off again next year.

Below is a related market commentary from Mr. Schiff's EuroPac.net by Trader Mark for your reference.
----------------------------------------------------------------------------------------------------------

Global Market Wrap-Up
By Trader Mark (via EuroPac.net)
October 29, 2009

Bulls scurried out of hiding upon release of 3rd quarter Gross Domestic Product during the premarket. The S&P 500 gained 2.2% and the NASDAQ 1.8% - the broader Russell 2000 mirrored the gains of the S&P 500.

Stocks logged their best day in three months as investors rushed into the market on word the economy grew faster than expected during the summer.

The obvious focus of the day was the GDP report:

• Fueled by government stimulus, the economy grew last quarter for the first time in more than a year. Federal support for spending on cars and homes drove the economy up 3.5 percent from July through September. But the government aid -- from tax credits for home buyers to rebates for auto purchases -- is only temporary. Consumer spending, which normally drives recoveries, is likely to weaken without it.

• Millions of Americans have yet to feel a real-world benefit from the recovery in the form of job creation or an easier time getting a loan.  

• The economic growth came in ahead of the 3.3 percent rise forecast by economists polled by Thomson Reuters. 

• Federal government spending rose at a rate of 7.9 percent in the third quarter, on top of a 11.4 percent growth rate in the second quarter. 

• The rebound reported Thursday by the Commerce Department ended the record streak of four straight quarters of contracting economic activity.

While there are many flaws with just about every government report; the GDP included - we won't rehash the subject. The bottom line for the market is they were content with the number even if reports indicate that 1.6% of the "growth" was due to Cash for Clunkers alone.

In the weekly jobless claims, the report continues to stay firmly at over 500,000; however long term claims dropped substantially this week meaning either one hundred fifty thousand net jobs were gained last week, or in a more probably scenario - countless more Americans exhaust benefits, move to welfare, or to disability.

• The Labor Department said workers filing first-time claims for unemployment dipped 1,000 to a seasonally adjusted 530,000 last week.

• However, the number of people receiving unemployment benefits on an ongoing basis dropped sharply by 148,000 to 5.8 million, below economists' expectations.

One would think the show of "strength" would help the US dollar, but instead it faltered and with it our now familiar inverse trade took off; all risk assets - priced in dollars or otherwise - surged. In the commodity space, crude oil regained all of yesterday's losses to finish just under $80. 

• Oil prices rose sharply Thursday on new signs that the U.S. economy has rebounded, though crude levels globally continue to grow and there are few signs that actual demand for it has increased significantly. 

Meanwhile the precious metals rebounded from selling the past week - gold added $16.60 to finish at $1047.10 while silver gained 42 cents to close at $16.66. Speaking of gold, hedge fund legend Paul Tudor Jones has joined the Euro Pacific Capital bandwagon and converted to a gold bull. Via Bloomberg:

• The time to hold gold is now as faster inflation and increased purchases through exchange-traded funds and by central banks boost demand amid stagnant mine output Paul Tudor Jones, Tudor Investment Corp said.

• “I have never been a gold bug,” Jones, whose company manages about $11.6 billion out of Greenwich, Connecticut, told investors in an Oct. 15 letter, a copy of which was obtained by Bloomberg News. “It is just an asset that, like everything else in life, has its time and place. And now is that time.” 

• “As one would expect, rising inflation suggests higher gold prices, especially when the Fed is perceived to be behind the curve,” according to the letter. “Gold appears to be cheap. In our view, gold’s value should increase as its scarcity relative to printed currencies increases.”

Europe followed in gains with all major markets up for the day: Britain's FTSE 100 rose 1.1%, Germany's DAX index 1.7%, and France's CAC-40 1.4 %.

Asia had closed for business before the domestic good cheer could turn their indexes towards gains; but one could expect them to gain overnight. India fell 1.4%, Japan 1.8% while both Hong Kong and China dropped 2.3%.

Brazil roared ahead 5.9% wiping our yesterday 4.75% loss...and more. #

Sphere: Related Content

Dr. Marc Faber: Dollar Due for a Rebound & Now Is Time for Emerging Market Stocks

Video Source: WSJ.com

By Dian L. Chu, Economic Forecasts & Opinions
Also on Seeking Alpha, Daily Markets

Dr. Marc Faber, managing director of Marc Faber Ltd., in a video interview dated 10/29/09 at Barron's Art of Successful Investing Conference, comments on the dollar, global economy, and his advise to investors to increase holdings in emerging markets.

Markets Now Have More Risk

Faber sees that we are ahead of the fundamentals in terms of the economic recovery. The economy will continue to disappoint, so markets have more risk today. On that note, he is now more cautious about getting into equities than when he was in March.

Dollar a Long-term Bear

In general, Faber believes the U.S. dollar is probably at a low point and could have “some kind of rebound”, but it remains in a “structural long term bear market” in terms of purchasing power. Sadly, other currencies are not any better either.

Protectionism Not the Answer

Faber observes “some kind of protectionism” in the world, for example, the U.S., but he does not believe currency devaluation would solve anything as some tend to believe. .

Emerging Markets, Now Is the Time

Since most investors are underweight on emerging markets, Faber recommends that now is a good time to increase the holding in emerging market stocks in countries such as Thailand and Vietnam, as price levels are still low and could “hold there for a long time.” He did caution investors about the Thailand stock market because the King is ill; however, he thinks overall the upside potential far outweighs the downside risk.

Zero Rate Kills Cash

Faber also says cash at current zero percent rate is less attractive than equities in the long run.

Disclosure: No Positions Sphere: Related Content

NY Times' Andrew Ross Sorkin: Banks Look Stable But "There's Got to Be Another Leg Down"

Source: Heesun Wee, Yahoo Finance Tech Ticker

Note: This video and article dated 10/23/09 from Yahoo Finance calls attention to another banking/financial sector bubble.  Though it is a contrarian view of the broader trading community, fundamentally speaking, Mr. Sorkin does have point.  Posted here to share with my readers.  

Also on Daily Markets, iStockAnalyst

Andrew Ross Sorkin: Banks Look Stable But "There's Got to Be Another Leg Down"
By Heesun Wee, Oct 23, 2009 11:00am EDT

JPMorgan, Goldman and Morgan Stanley recently reported whopping quarterly profits, perhaps signaling a record year for U.S. financial institutions -- only one year after the government offered $700 billion in life suport at American taxpayers' expense.

But are the banks really safe?

"It feels like it's getting better inside the banks. It feels like it's getting better inside some companies," says our guest Andrew Ross Sorkin, a New York Times columnist and author of "Too Big to Fail. But "it feels like there's got to be another leg down."

As with many others, Sorkin notes the disconnect between the ferocious stock market rally and the lack of revenue growth for most big firms, as well as the rising unemployment rate and general sense of malaise on Main Street. "So maybe things look like they improve for 12 months but at some point the rubber is going to hit the road," he says.

Sorkin also cited other concerns:

Weak bank lending: While banks are rightfully criticized for sitting on bailout funds, demand for lending -- at the consumer and corporate level -- remains weak.

No level playing field: Despite the bailout's intention to create uniformity among the banks, in fact, the strong have only gotten stronger, and vice versa. "It's only going to get worse,'' Sorkin says.

Sure, Goldman, JPMorgan and Morgan Stanley gave back their TARP money -- plus a return for taxpayers! -- but that was a "head fake," Sorkin says. Taxpayers aren't supposed to pay attention to struggling institutions that also were bailed out -- AIG, Citigroup and Bank of America -- and have little hope of paying back the government. Oops.

Crack down on excessive Wall Street pay: The Obama administration has moved to flatten compensation at the seven firms that pocketed large sums of government aid. But the administration may be caving to populist pressure and seeking a band-aid solution to the larger, more salient issue of meaningful, financial reform, Sorkin says.

Bottom line: Expect more separation of wheat from the chaff as stronger banks like JPMorgan to take advantage of the new pay rules and poach top talent from weaker firms. The rich getting richer -- not a good foundation for a sound financial system.

Source: Heesun Wee, Yahoo Finance Tech Ticker Sphere: Related Content

Euro Bests Dollar by 79% in This Millennium

Note: This is my view of the dollar and its potential impact in comparison to the opinions of Mr. Peter Schiff also posted on this blog.

By Dian L. Chu, Economic Forecasts & Opinions
Also on Seeking Alpha, iStockAnalyst, StraightStocks, Zero Hedge, Investmentpostcards, BusinessInsider, Daily Markets

The dollar's value against major currencies has fallen in recent months as the U.S. fiscal outlook worsened and amid expectations that interest rates will remain close to zero for some time to fight the economic downturn.

This week, the euro broke above the psychologically important level of $1.50 driving gold prices to record levels, prompting many global central banks intervening on currency markets to slow the dollars fall.  (Fig. 1)

How Did We Get Here?

Since the financial crisis last fall, currency markets have taken their cues mostly from stock markets. When stocks plunged in March of this year, investors rushed to the safety of U.S. government bonds, pushing the dollar index up to 89.62, the highest point this year.

Since then, however, it has been a steady downward drift for the greenback. As markets steadied into a rally, traders sold Treasuries and Dollars for riskier assets and higher returns, pushing the dollar lower against other major currencies.

The value of the euro has risen by 79% in nine years since euro hit 0.84 in Oct. 2000 (Fig. 2), and the White House has done little to curb the dollar's slide during this period. Loose monetary policy and a weak U.S. dollar are part of the consequences resulting from the U.S. recent trends of unprecedented spending, fiscal deficits, and accumulations of government debt.

“Strong Dollar Policy”…Not

Although the current Administration officially supports a strong dollar, the latest indications came from Federal Reserve Chairman Ben Bernanke and Larry Summers, President Obama’s chief economic advisor.

Mr. Bernanke said this week that the U.S. should cut down on its budget deficit and increase the savings rate in order to reduce global imbalances. Bernanke’s statement chimed with that by Summers earlier this year, when Summers said that

“the rebuilt American economy must be more export-oriented and less consumption-oriented… and less oriented to income growth that disproportionately favors a very small share of the population."

World War III - Currency

There are only so many paths you can take to be “more export-oriented”, and at the same time save more/spend less. We could increase our savings rate; however, with the unemployment rate around 10%, it is certainly a challenge, to say the least, for middle class Americans. Therefore, the most likely options are

1. Devaluation of the dollar to help exports
2. Slapping taxes on imports; or
3. A national sales tax or a value-added tax (VAT), which seems to have gained traction in Washington, to discourage spending and fund federal deficits.

The problem is that much of the world is also working on increasing its exports to help recover from the global financial crisis. Many countries fear that strong domestic currencies (against the dollar) could harm their still fragile recoveries. A steep drop in the dollar has already enraged our chief creditors and trade partners resulting in Gulf States, Russia, and China reportedly ready to stop pricing oil and gas in dollars, and U.S. clashes with EU and China on trade.

Tails, Dollar Loses

There have been increased signs recently that central banks and governments in many parts of the world may gradually end the massive quantitative easing programs. Australia, for instance, hiked rates to 3.25% and highlighting inflation concerns. The U.S. Federal Reserve, on the other hand, has shown little indication that it is anywhere close to removing the massive liquidity injected into the system.

In fact, last Tuesday, San Francisco Federal Reserve President Janet Yellen said she doesn't expect the central bank to tighten monetary policy “in the next few months.” This suggests the U.S. will stay on its current course of stratospheric fiscal deficits, zero interest rates, easy money, and… a weak dollar in the near term. Worse yet, in a recovering world, any good news about growth could provoke dollar selling.

Double Dip, Hyperinflation or Both?

A weaker dollar would be beneficial to exporters and to the balance of payments with a narrowing trade deficit as imports would fall faster than exports. So, with domestic demand depressed from the recession, a short to medium term boost to exports could be good for the US.

However, the flip side is that the diminishing purchasing power of the dollar will inevitably drive up prices for goods and services, among other long term effects. This could only result in three likely scenarios manifesting by the end of next year:

• W-shaped double dip recession as higher prices crimp recovery
• Hyperinflation, if we have a stronger than expected economic growth 
• Another plausible scenario is that the U.S. could lapse into a double-dip recession with high inflation in commodities, i.e., a stagflation scenario.

Based on the latest economic data and the near 50% one-year gain of the Goldman Sacks Commodity Index (blue line in Fig. 3), my money is on stagflation.

Dollar Status Intact, For Now

The U.S. remains the largest economy in the world. The absence of a credible alternative to the dollar, means that, despite its declining value, its status as the world’s reserve currency is not seriously under threat. In addition, the complexity, geopolitical realities would arguably rule out the re-pricing of oil in non-dollar currencies at this time. All that might change in the future, but it will be a very long, long (think decades) debate.

Strategy: Anti-Dollar & Anti-Inflation

Meanwhile, the dollar will continue to weaken as interest rates in many countries and the eurozone are higher than the current rock-bottom U.S. rates, providing currency traders carry-trade opportunities. This will encourage more selling of the dollar and buying up stocks, commodities and other currencies, which has been the general trend since spring.

So, based on the discussion so far, prudent investors should allocate a portion of their portfolios to hard assets like silver, agri products, and non-dollar currencies such as Brazil’s Real (BRL) or the Australian Dollar (AUD) to hedge against inflation risk and the US Dollar`s devaluation.

Disclosure: No Positions Sphere: Related Content

Houston Chronicle: The Quarterly Report

Note: This is my interview with Ms. Wooty Sixel, a noted business columnist at Houston Chronicle, as part of a four-person panel in the print edition of Sunday Houston Chronicle 10/25/09. See it also on iStockAnalyst, StraightStocks

The Quarterly Report

Houston business experts cautiously optimistic about holiday retailing, outlook for hiring

By L.M. SIXEL

HOUSTON CHRONICLE

Oct. 24, 2009, 9:23PM

Houston's diverse economy may be the port in the economic storm, but that still doesn't mean the city will have a better-than-average Christmas or that employers will start taking on lots of workers anytime soon, according to local economic experts.

The city's strong energy base has helped the region weather previous downturns, but with natural gas prices so low and oil prices so volatile, the buffer isn't as strong as it once was. Employers are still nervous about hiring, and until they see more concrete signs Houston is on the way back, any recovery may likely be without much job growth.

We questioned four experts — a career counselor, a real estate management executive, an energy analyst and the head of a project management association — to get their thoughts on the effect of low natural gas prices, on the likelihood of a commercial real estate bust, and on when they think Houston employers will begin hiring again.

Here are excerpts from that conversation:

Q: The chairman of the Federal Reserve has said the recession is likely over. Is Houston on the rebound, too?

A: Market analyst, trader and financial writer Dian Chu isn't quite so bullish.

“I don't believe the recession is quite over yet,” she said, calling Ben Bernanke's comment more of a “positive assertion” than solid proof. But Chu said she believes the nation is on the way toward a recovery.

“Houston isn't quite there yet,” she said. Energy prices have been very volatile this year and natural gas prices are low. Because of that uncertainty, energy companies will be hesitant to make large investments.

While she thinks Houston will recover during the second half of 2010, at the moment it's wavering because of mixed signals like an increase in industrial production but a dip in consumer confidence.

Brent Smith, Houston manager of Marcus & Millichap, a real estate investment services firm, is also not ready to proclaim the nationwide recession over. Many of the same economists, he noted, are the same ones who predicted recovery in late 2008.

But if they're right about a jobless recovery, then the return of consumer spending will be delayed along with a full recovery, he said. On the plus side, though, consumers are spending less and saving more, and that saving will lead to a more sustainable long-term recovery

A recovery? John Alston, president of the Innis Co., a career management consulting firm, doesn't see it.

“It's really hard to find a new job, especially at the executive level, and it's as bleak as I've ever seen it,” said Alston, whose firm specializes in coaching senior executives. “It's even worse than the 1980s.”

Compounding that is the sour outlook for small businesses, which are suffering from the lack of consumer spending and credit availability, he said.

Q: When do you think employers in Houston will start to hire once again?

A: Smith is projecting the second quarter of 2010. There's certainly some optimism in corporate America now, but companies will probably want to see a quarter or two of sustained growth before they jump back in.

There has to be a clear signal the economy is on the way up, Chu said. Until then, companies won't be willing to make a large investment.

Chu's best guess? As long as the economy doesn't sink back into recession — the dreaded W-shaped recovery — a rebound will probably start taking hold during the second half of 2010. But it won't be until 2012 that the unemployment rate will drop significantly, she said.

The president of the Project Management Institute-Houston Chapter is already seeing improvement.

Jobs are opening up in the oil and gas sector for experienced project managers as well as information technology for project management office experience, John S. Gorman III said.

Companies are focused on increasing efficiency, cutting costs and increasing revenue, and they can do that by managing projects well, Gorman said.

Q: How does it look for Christmas spending this year? Will we spend more, less or about the same as we did in 2008, which turned out to be one of the bleakest years on record?

A: Gorman is forecasting a slightly better Christmas, more for psychological reasons than for any huge improvement in the fundamentals.

A year ago the Dow Jones industrial average was on a decline, he said, but now it's on more of an uptick. “Hopefully we'll feel more comfortable spending money this year,” Gorman said. And if the unemployment numbers go down, Christmas spending will go up.

Alston expects shoppers to stay in bargain-hunting mode this Christmas season. Parents bought their back-to-school clothes at the discounters this year instead of at more expensive department stores, he said. Instead of buying a $20 bottle of wine, they're buying a $5 bottle; instead of eating out, they're eating at home.

When shoppers don't have to spend, they won't, Chu said. Consumers are still very worried about job security and the economy.

Q: How will a potential national commercial real estate meltdown affect the local market?

A: “We're not forecasting a meltdown,” Smith said. “Certainly we're in a downturn, but we see this as a debt crisis, not a commercial real estate crisis.”

It's not a problem of overbuilding, he said, but how to refinance the estimated $535 billion of commercial mortgage debt that will mature over the next two years. Because of declining real estate values and tighter lending criteria, refinancing those mortgages may be a challenge.

But most of the properties have positive cash flow and lenders are interested in working those deals out, Smith said. However, there will likely be foreclosures in the next two to three years.

As the commercial real esate market deteriorates, a lot of community and regional banks have loans on that real estate, Alston said. When lenders have trouble repaying, that creates a capital call on the banks.

And that, in turn, will drag more banks down, he said.

And then there are those empty storefronts.

“Any time any of us drives past an empty strip center, what does that do to your level of confidence of where we are?” Alston said.

“I think it's pretty serious now, but it will get significantly worse.”

But there is an upside.

Gorman said the spike in bankruptcies will likely mean more available space. Companies can take advantage of that by moving to cheaper space and consolidating their existing vacant space.

Q: What is the effect of low natural gas prices on the energy economy in Houston?

A: “Not good,” Smith said. “That's the short answer.”

He pointed to prices at seven-year lows and enormous supply-side pressure. That translates into fewer rigs coming on line and overall rig levels staying below the 2008 peak.

As a result, he said, local businesses that supply parts for gas drilling will be met with a continuing slump in demand, which isn't good for Houston's manufacturing base.

At the moment about 70 percent of domestic rigs are drilling for natural gas, Chu said, but she doesn't see that going up any time soon because natural gas prices are so low.

However, companies are reluctant to let too many workers go, she said, or they'll likely face a skilled labor shortage later.

In the end, oil will lead the drilling recovery, she said. “You can see the Gulf is still pretty busy.”
lm.sixel@chron.com
Source: HOUSTON CHRONICLE

Sphere: Related Content

Dr. Doom Peter Schiff: King Dollar Forced to Abdicate

Source: YouTube, Schiff Report Video Blog

Note: This video and article are by Mr. Peter Schiff, aka Dr. Doom, dated 10/23/09 detailing his views on the recent movement of the dollar and its impact on the economy and the broader market. Posted here to share and compare with my views on the same subject.

King Dollar Forced to Abdicate 
by Peter Schiff, via EuroPac.net
October 23, 2009

For the most part, the value of the dollar is given cursory attention by the financial media. Typically, its movements are assigned an importance on par with much less determinative metrics such as natural gas futures and construction permits. It's only when major milestones are reached that anyone really takes notice of the dollar. We are living through one of those times.

The great dollar rally of 2008-2009 has come full circle. When the financial crisis exploded in its full ugliness in mid-2008, the dollar, which had steadily declined over the previous four to five years, put in a rally for the record books. By March 2009, as investors across the world sought safety from the financial storm, the index had surged more than 25%. Since then, the dollar has steadily declined to the point where nearly all those gains have vanished. In short, the panic rally has given way to the long term trend.

So, as the dollar index makes fresh 52-week lows on a nearly daily basis, discussion on the greenback is heating up. And while real insight on the topic is hard to find, the debate centers on the battle between two conventional opinions – both of which are wrong.

The first camp, which is generally supportive of government intervention in the economy, argues that dollar's decline is a positive for both the economy and the stock market. The second camp, which tends to fall on the more conservative end of the political spectrum, views the dollar's decline as a problem but feels that tough talk and slightly higher interest rates are all that is needed to restore ‘King Dollar’ to its throne.

First of all, a weak dollar is no better for Americans than a lower paying job is for a worker. And although I would prefer that the dollar remain strong, I know that currency values are a function of supply and demand, not wishful thinking. The past years of reckless monetary and fiscal policy have created conditions that must push the dollar down. Vastly expanded debt levels and monetary expansion have created a greater supply of dollars, while poor investment performance and diminished industrial capacity have lessened the demand for dollars.

The regrettable truth is that while the weak dollar will help rebalance the global economy, it is not a panacea for the U.S. The fall is no more worthy of celebration than a student celebrating falling grades on his report card. If the dollar does not recover eventually, Americans will suffer diminished living standards. To avoid this we must make difficult reforms now. If we continue our current policies, we run the risk of a complete dollar collapse. Far from helping to solve our problems, this would be a true nightmare scenario.

On the other side of the argument, those who correctly equate a weaker dollar with a weaker America mistakenly believe that mere posturing by officials or trivial rate hikes would be sufficient to restore the dollar's lost vitality. We are long past that point. The best we can do now is to accept the penalty of a weaker dollar as punishment for our prior failures, and start building for the future.

To save our currency, the Fed must get very aggressive with interest rate hikes and rein in the supply of dollars that have flooded the world over the past few years. The federal government must also do its part by cutting spending, which means no more stimulus and no more bailouts. Undoubtedly, these actions will have unpleasant economic and political consequences. A student who studies harder may have to miss a party or two. A simple analogy, but unfortunately it is that simple.

Even in the unlikely event that our political leaders take these courageous steps, the near-term trajectory of the dollar may still be uncertain. A dollar rally that results from higher interest rates and a narrowing federal deficit may soon fade as the recessionary forces that such moves would unleash act to weaken the dollar once again. But at least we would be building a foundation upon which the dollar could eventually find some footing.

With a restructured economy, higher savings, more capital investment, lower government deficits, and higher interest rates, the United States would once again attract international investment. Funds would flow here not out of fear, as they did last year, but out of confidence. The dollar's strength would not rest on the willingness of foreign governments to buy our debt, but the willingness of foreign consumers to buy our products.

Only then could King Dollar regain its throne.

Surce: Peter Schiff, EuroPac.net & YouTube Sphere: Related Content

Weekend Reading: Oct. 23, 2009

Nouriel Roubini: Real Estate Prices to Fall Another 7-10% (Video & Article, Wallstreet Pit)

Devaluation of Dollar (United News Network)

Is Buffett Becoming A Lagging Indicator? (24/7 Wallstreet)

Rally fueled by cheap money brings a sense of foreboding (FT.com)

How the U.S. Economy Could Prosper Again (National Inflation Assoc.)

What a U.S. Decline Means for Investors? (WSJ.com)

Niall Ferguson: U.S. Empire in Decline, on Collision Course with China (Video & Article, Yahoo Finance)

Looming Gas War on Take-or-Pay Contracts in Europe (Timesonline)

Death of 'Soul of Capitalism': Bogle, Faber, Moore (MarketWatch) Sphere: Related Content

Crude Oil - Déjà Vu Year 2008, No Fundamentals Required

By Dian L. Chu, Economic Forecasts & Opinions
See it also on Reuters, BusinessWeek, Zero Hedge, iStockAnalyst, Investment Postcards , Daily Markets , Greenlight Advisor, StraightStocks, Seeking Alpha,

Last Friday, U.S. crude oil futures finished above $78, the highest level in a year, surging more than 9% during the past week making it the largest weekly gain since the height of the summer driving season, even though the U.S. continues to sit on ample supply of petroleum.

Given the continued sluggishness of the economy, high unemployment rate and large amounts of excess oil production capacity around the world, analysts said a sudden upward spike was still unlikely, while others are predicting an immanent correction down below $70.

However, if you take a closer look, it is evident that the current crude oil market is almost entirely detached from fundamentals. Furthermore, there are several factors supporting oil rising to new levels, as fundamentals are out the window in the near to medium term.

Technical Breakout

Oil has been locked roughly in a band of $65 to $75 a barrel since the start of June as traders weighed optimism over the prospects for a recovery in global demand against a supply glut. (see chart) Typically, the longer it is trading in a sideways pattern, potentially the more powerful a breakout is going to be.

And breakout it did on the first sign of a seemingly positive indication. In addition to dollar weakness, the oil rally last week was sparked also in part by government data that showed surprise inventory drawdowns in domestic gasoline and distillates (mostly due to lower refinery runs at around 81%).

This, coupled with stronger-than-expected China trade data, was enough to send a ripple through the markets midweek boosting market bullish sentiment on global economy recovery hopes along with oil demand.

Now that oil blew past its previous 2009 high of $75, many analysts believe the recent increase is a sign that prices will now trade at a higher range.

U.S. Dollar Policy...If There Is One

The recent rallies in commodities, including crude oil, and even the stock market to some extent, have been driven primarily by the floundering dollar on the lack of fundamental support from the demand side since the recession. (see chart below)

The U.S. dollar dropped to a 14-month low against a basket of currencies on speculation the Federal Reserve will keep interest rates low trailing other central banks and the unprecedented levels of government debt. Crude and most commodities are priced in the dollar; therefore, tend to rise when the U.S. currency falls.

Though the correlation between the dollar and oil has not been statistically established, dollar is clearly part of the “causation” of crude movement this year, as investors sold dollars and bought oil as a hedge against inflation and uncertainties in other asset classes.

With a concrete “dollar policy” and “dollar intervention” conspicuously lacking, traders and investors are wondering if U.S. officials merely wanted to slow the rate of decline of the dollar, and that the Administration really does not care if the dollar depreciates, only how fast.

On that note, markets will no doubt keep testing the U.S. dollar resolve, and if government actions do not follow their rhetoric (highly probable from current indications), we could all say good bye to the dollar as it could free fall to no man’s land. And anyone could guess what that would do to the price of oil as well as inflation.

Capital Flow & Asset Rotation

Under normal circumstances, oil prices and stocks typically have an inverse relationship. That is, rising oil prices pressures stocks, and falling stocks push investors into oil.

However, since the recession last year, oil and stocks have been trending in lock step largely due to the huge amounts of easy money freed up by global governments to rebuild their economies and companies.

The stock market is rising with the Dow breaking the 10,000 mark last week, which is an indication that cash in general has come back into the market. In fact, most of the price movement in the crude market is clearly stemming from financial flows based on activities on the NYMEX and ICE.

When there's so much liquidity in the system, it will have to go somewhere. So, we should still expect crude and stocks to move in tandem, but the rotation of assets has deepened more in hard commodities because of the rising skepticism in equity markets. This means crude oil could outperform equities in the medium term.

Better Fundamentals Won’t Hurt Either

Even though fundamentals won’t play a significant part in the oil market for the foreseeable future, any positive data points could further bolster the non-fundamental factors discussed so far.

The International Energy Agency (IEA) did just raise its forecast for global oil demand for the current year and for the next year citing a more optimistic economic prognoses and stronger preliminary data from America and Asia.

Déjà Vu Year 2008 

You may recall the start of the U.S. Federal Reserve's cycle of interest rate cuts in 2007 spurred the influx of cash into commodities markets. Oil prices surged during the period, peaking at a record $147 a barrel in July 2008 as the money flowed in amid projections of strong global demand driven by emerging markets like China.

Right now, the US Dollar is driving the oil price. In order for the trend to change, the U.S. dollar has to strengthen against other currencies, and that is unlikely to happen without some intervention by the U.S. government relative to its current monetary policy.

The dollar has not collapsed but the trend has been downward this year and fear is the trend could continue with massive and growing national debt and quantitative easing policies by the Fed. Until we get any strong change in fundamentals for the dollar, it will continue to weaken further and everyone will flock to crude as one of the primary hedges (gold being the other).

Even though there are ample supplies of petroleum products due to the recession and there is little chance of a shortage in the near term, based on the technical and dollar indicators, it is likely that the next technical breakout would move crude oil to the $85 level. While some option bets of $100 crude by the end of 2009 seem overly aggressive; nevertheless, crude could trade above $100 within 12 months based purely on non-fundamental factors.

Bubbles Will Deflate

Investors should expect crude oil to be much higher during the heat of 2010`s summer driving seasonal run-up, with the peak price probably well above $110 at this pace sometime by next July, before the Fed is pressured to curb high commodity prices by raising rates. 

The Administration will face a considerable dilemma with both a high unemployment rate and sky high gas prices at the pump from the oil run-up due to a weak dollar policy. The unemployment will not be magically solved by itself, the easier solution would be to raise rates to curb commodity inflation.  But by the time the public is up in arms about high gas prices, it is too late, the inflationary damage is done.

So once again, we have managed to create yet another bubble in asset prices. Until we have a longer term view for monetary policy, expect asset bubbles to continue, and invest accordingly to prepare for the eventual and inevitable deflate.
 
Economic Forecasts & Opinions

Disclosure:  No Positions Sphere: Related Content

Weekend Reading: Oct. 16, 2009

Putin: Russia ready to abandon dollar in oil, gas trade with China (Rianovosti)
Iran to completely drop dollar from foreign exchange (PressTV)
The rumours of the dollar’s death are much exaggerated (FT.com)
Deficit Dilemma: How to Dig Out? (WSJ.com)
Don’t Inflate the Old Bubbles (Washington Post)
Banking: To Trade or Lend, That Is the Question (iStockAnalyst)
'Too Big to Fail': Can Regulation Control Systemic Risk? (Knowledge@Wharton)
Bull in a China Shop (The Economist)
Asian Currencies: Hot Air (The Economist)
Commodities Cycle and Food Crisis, Jim Rogers Says (Video & Summary on Yahoo Finance)
The world-wide recovery continues, but will lose momentum early next year (UniCredit Research) Sphere: Related Content

What’s Next for Natural Gas?

By Dian L. Chu, Economic Forecasts & Opinions
See also it on Zero Hedge, Daily Markets, Seeking Alpha, First Enercast Financial, iStockanalyst

Unlike oil, which can be transported and traded around the world, natural gas (not in the liquid form) is tough to transport, and thus boxed in within the producing continent. The inventory glut due to diminishing demand since the recession hit in the 4th quarter of 2008 has been pressuring U.S. natural gas prices. As a result, on Sept. 4, the NYMEX October futures contract for natural gas closed at $2.73/mmbtu, a 7-year low, as the ratio of oil to natural gas prices exploded to 25-to-1, compared to its energy conversion ratio of 6-to-1.

Now, just one month later, natural gas has rebounded 75% to close at $4.77/mmbtu for NYMEX November delivery last Friday on record high levels of natural gas in storage, leaving investors to wonder if prices have bottomed out and it's time to jump back into the market, or if the sector is dead.

During the past month, several factors have emerged to spur enthusiasm in the futures market, though spot gas continues to suffer in price.

• Generally, macroeconomic forecasts have been upgraded for 2010 on the back of Federal Reserve Chairman Ben Bernanke stating that the recession was "very likely over." This lends itself to a bullish demand outlook for natural gas from the industrial sector.  
• The presence of colder weather in early October, notably in the Rockies Mountain region, helped support natural gas prices. The National Weather Service forecast for Oct. 16-22 calls for below-normal temperatures across the Midwest, the mid-Atlantic and parts of the Northeast. The cold temperatures are expected to spur some early heating demand for natural gas. 
• Natural gas rig count has dropped more than half from its historical high of 1,606 reached in Sep 2008, implying an improved supply picture fueling bullish price anticipation.   
• The rally was also helped by traders and speculators who had sold positions expecting natural gas price to decline, and speculators who were betting against United States Natural Gas Fund LP (UNG). When those bets failed, speculators and traders canceled positions by buying back futures, sending the contract higher.

With the 2010 strip priced around $6.00 on NYMEX, traders clearly are betting that the recent supply/demand trend will lead to falling inventory levels. Is the futures market right about this? Let’s review some of the key trends in the U.S. natural gas sector.

No Help from the Fundamentals

During injection season, producers store natural gas to ensure ample supply for the winter when high demand typically normalizes inventory levels. This winter, however, may be difficult as storage levels were at all time highs going into the injection period, production from new shale gas fields still continues to flow (albeit at a slower rate), and a dismal economy dented end user demand, particularly in the industrial and electric power sectors. (Fig. 1 & 2) As a result, storage levels could hit maximum capacity of approximately 3.890 trillion cubic feet by the end of the injection season (October 31).

Rig Count Has Declined, Production is Still High

The latest U.S. EIA report shows that marketed natural gas production in the Lower-48 States rose by 2.9% year-over-year through July 2009, despite a more than 40% decline in the working rig count since the start of the year.

Most investors and analysts tend look at the total number of rigs drilling for natural gas in the U.S. as an indicator for future natural gas supply. However, a better gauge of the natural gas production trend is the horizontal rig count instead of the total gas rig count.

Horizontal rigs are used predominantly in shale gas wells, which typically produce about twice the output of a conventional well on average, and are the primary reason for the surge in natural gas supply during the past few years. While the total gas rig count has fallen 55% from the Sep. 2008 peak, the horizontal rig count has dropped only about 27%, according to data from Baker Hughes, Inc. (BHI). This is part of the reason why natural gas production levels have not dropped proportionally to the decline in the total natural gas rig count.

Lagging Effect from Price to Production

In general, rig counts, and the actual production lag the Henry Hub price by between 6 weeks to 6 months due to the technological complexity of shale gas drilling and production operations, which is another factor for the seemingly slow response from the natural gas production side.

Producers Hedging Positions

Another reason is that some independent gas producers have entered into favorable hedge positions for part of their 2009 and 2010 production. For example, in its 2nd quarter earnings release, Anadarko Petroleum Corp. (APC) said that it has locked in fixed price contracts for 80% of its 3rd quarter 2009 natural gas volumes, and other various hedges on 75% of its 2010 production volume with a middle floor price of $5.60. EOG Resources Inc. (EOG) also has about 47% of its 2nd half 2009 production hedged at $9.03, and 60 mmcfd of its 2010 production hedged at $10.27.

Higher Natural Gas Prices Could Encourage More Drilling

The EIA currently expects the total U.S. marketed natural gas production to increase by 1.5% in 2009 and decline by 3.8% in 2010. This production forecast implies a slight increase of horizontal rig counts to 491 and 509 for years 2009 and 2010 respectively. (Fig 3)

However, most shale gas plays need a natural gas price of about $4.50 or more to be profitable. So, if natural gas prices rebound to the $5-$6 range next year, as predicted by many analysts as well as by the futures market, natural gas drilling and production could increase again before the existing overhang is burned off, as smaller producers need the cashflow, and majors need to meet production guidance.

For instance, Royal Dutch Shell PLC (RDS.A) just announced that it plans to increase natural-gas production in North America. Though gas prices are low now, Shell believes long-term prices will recover, justifying the company's interest.

Demand, Storage & Weather

While the hurricane season will soon pass with no disruptions for the Gulf of Mexico's production, the market's focus is shifting towards winter weather forecasts and storage depletion. Whether winter demand will be enough to normalize supply levels will depend on the weather, production and industrial demand.

On the weather front, the EIA Short-term Energy Outlook currently expects slightly milder weather than last winter which will contribute to lower heating use in many areas. Though there are some signs of economic improvement, they are yet to translate into a turnaround for natural gas demand from the industrial sector. From all indications, demand for natural gas will likely remain relatively flat, but we should expect a larger decrease on the supply side. This means the market probably will remain unbalanced until the 2nd half of 2010.

Moreover, any upside in prices will likely be offset by a corresponding increase in production by cash-strapped producers. This, coupled with the existing inventory overhang, as well as expanding global capacity shipping liquefied natural gas (LNG) to the U.S. from overseas, could keep gas prices trading with considerable volatility in a range of $3 to $6/mmbtu for the next three or four years.

LNG Holds the Future

It's going to take at least three years, probably 2012 or 2013 before we can expect a marked increase in domestic demand for natural gas, along with the maturing of the global LNG market to gradually transform natural gas from being a regionally determined market to that of an internationally traded commodity along the lines of the crude oil market.  Until then, crude oil and natural gas, though similar in their energy generating capability, will likely stay on separate path in terms of market price and trading patterns. 

Disclosure: No Positions Sphere: Related Content

Weekend Reading: Oct. 10, 2009

Bulls Ignore Warnings from Soros, Roubini and Other Skeptics (Yahoo Finance, Video & Summary)
Pickens Says Increasing Oil, Natural Gas Exposure (Reuters)
Deutsche: the End Is Nigh for the Age of Oil (FT.com)
UN Calls for a New Reserve Currency (Breitbart.com)
U.S. Dollar Rumours Push Gold to Record High (The Globe and Mail)
Saudi Bank Boss Rubbishes Dollar Talk (Upstreamonline.com)
Bremmer and Roubini: How the Fed Can Avoid the Next Bubble  (WSJ.com)
We Aren't There Yet - Unwarranted Optimism about the U.S. Recovery (Forbes.com) Sphere: Related Content

Brazil Puts the B in BRIC

By Dian L. Chu, Economic Forecasts & Opinions
Also on Zero Hedge, Seeking Alpha, iStockAnalyst, USAToday, Daily Markets, BusinessWeek

Brazilian stocks rallied, along with the nation's currency, as investment prospects brighten on the news that Rio de Janeiro will host the 2016 Summer Olympics, making the Bovespa the world's best-performing major index last Friday.

The victory was heralded by some as signaling Brazil's arrival as a major economy. Despite worries about Rio's high crime rate and lack of infrastructure, the chance to bring the Olympics to a continent that had never hosted the Games obviously worked in Rio’s favor.

The B in BRIC

Brazil is the B in BRIC, a term first coined by Goldman Sachs in 2001. The main distinction is that “Chindia” has been developing a gigantic appetite for natural resources – energy, metals and agriculture, etc. to fuel their growth. In contrast, Brazil and Russia, are two of the very few resource rich countries capable of supplying these increasingly valuable commodities to the growing Asian economy.

Brazil’s credit rating was raised to investment grade recently by Moody’s Investors Service after the country built record foreign reserves and averted a prolonged recession amid the global financial crisis with a 1.9% GDP growth rate for the first quarter, powered by domestic demand. This growth by domestic consumer demand makes Brazil look very attractive to investors right now.

Growth Prospect

Rising commodity prices this year have led investors to buy emerging market assets where the economies tend to be more commodity-dependent. Both emerging markets and industrial metals group are outperforming U.S. equities so far this year.

The Bovespa index has surged 57% in 2009 (see chart) on speculation that record low interest rates (currently at 8.75%) and rebounding prices for Brazil’s commodity exports will bolster economic growth without fueling inflation.   Based on Credit Suisse`s latest forecast, Brazil’s economy will grow 0.2% this year and expand at a 5% rate in 2010.

The World Bank is predicting Brazil's economy would be the fifth largest in the world by 2016. The Olympics, together with the discovery of oil in the pre-salt area and the hosting of the 2014 World Cup soccer championship, will boost Brazil’s global stature and add about 3% to 4% of gross domestic product in the coming years.

According to studies by a Sao Paulo business school for the Ministry of Sports, the two games will help sustain Brazil's economic growth by injecting $51.1 billion into Latin America's largest economy through 2027 and add 120,000 jobs annually through 2016.

Spend to Impress

Among the biggest problems for Rio de Janeiro hosting the Olympics are infrastructure, crime and security. The city is served by a number of expressways though traffic jams, due to the large car fleet, are very common. Streets are regularly closed because of shootouts and gunfights on subways are not uncommon. The city transportation policy has been moving towards trains and subway in order to reduce traffic congestion and increase capacity. Other problems also include power-supply shortages.

Brazil already plans to invest $11 billion to host the 2016 Olympics. In order to win the bid for the 2008 Olympics, China also pledged to spend $14 billion on infrastructure, but the official figures state that the country has actually spent over $40 billion. So, one could safely assume that Brazil would spend probably a lot more than the planned $11 billion in the next decade or so due to its some of the serious problems mentioned here.

Olympics Effects Driving the Commodity Rally

We need to look no further than the C in BRIC for the Olympic effects on growth when China hosted the 2008 summer Olympics. The boom within and outside China in three key areas — Infrastructure, commodities, and investments — pretty much sum up the ‘Olympics Effect’.

The Olympics brought a wave of construction projects in China consuming vast amounts of cement and steel, crude oil and other commodities from 2001 to 2008. The games have provided a venue for investment benefiting infrastructure related sectors such as base materials, engineering and construction contractors. Other sectors attracting investments also include travel related sectors like hotel properties and services.

Brazil, due to its rich domestic resources, could supply most of the Olympics related commodities needs locally. However, the domino effect could leave China and India scrambling to fill their resource needs, thus bidding up prices of commodities in the coming years.

Investing Strategy

Similar to many developing economies, the regulatory environment in Brazil is not sufficiently clear to attract private investment capital and the stock market is very sensitive to inflows of foreign capital. So, if you are interested in adding Brazil as part of a diversified portfolio, the best way to do so is probably via ETFs like Ishares MSCI Brazil (EWZ) or WisdomTree Dreyfus Brazilian Real Fund (BZF) for a currency play.

For individual stocks, with growth in the rebuilding of infrastructure, the demand for base metals such as steel and copper should increase: Thus benefiting companies like Gerdau S.A. (GGB), Latin America's largest steel maker, Vale S.A. (VALE), the second largest mining company in the world and the largest logistics operator in Brazil, and Companhia Siderurgica Nacional (SID), the second largest Brazilian steel manufacturer. In addition, energy companies like Petroleo Brasileiro SA (PBR) could benefit from the infrastructure spending, as well as hotel operators like Hoteis Othon.

Copacabana Carnival

While Chicago, Tokyo and Madrid are still recovering from the after-shock, the Games are set to take place against impressive backdrops, Rio's stunning beaches and famous landmarks. Although data on the exact economic benefit of an Olympic Games has always been somewhat sketchy, one thing for sure is that the 2016 Olympics is good for business in Rio and Brazil. And most importantly, the commodities market is going to hitch a ride with them.  So, see you on Copacabana beach in 2016 and let the Carnival begin.

Disclosure: No Positions Sphere: Related Content

Fed or Freight, Roll Your Dice

By Dian L. Chu, Economic Forecasts & Opinions
See it also on Zero Hedge, Daily Markets , iStockAnalyst, Seeking Alpha, StraightStocks

Last Friday, the Commerce Department announced that orders for durable goods decreased in August by 2.4%, or $4 billion in total, defying economists' estimates of a 0.5% gain. Sales of new homes inched up 0.7%, also less than forecast. Meanwhile, masked by the cash-for-clunkers program, one of the closely-watched leading indicators, ISM Manufacturing Index, rose a larger-than-expected 4 points to 52.9, and the index has been in expansionary territory since April.

The Great Market Debate

These conflicting reports only reflect the uneven nature of the recovery raising worries about how broad the economic recovery may be. The debate centers around two chief concerns: Have stocks jumped ahead of the economic recovery? And if so, Are they setting up for a big correction? This week is crucial as some key data is set to be released such as the ADP employment report, GDP, Case/Schiller housing index, and consumer sentiment, which will either foster a technical breakout pushing the S&P (SPX) towards much higher year-end goals of 1150-1200 or convince investors to take major profits before its too late with a 20% retracement so fast it will make your head spin. Remember the old adage, stocks often stair-step up, but take the elevator down.

Freight as a Leading Indicator

To better gauge the real economic condition, I typically like to look at commercial trade related indicators to verify just how good or bad business is doing. Among them, freight is probably one of the most ignored leading economic indicators. In reality, freight volume provides a more fundamental snapshot of not only the U.S. economy, but also trends around the world.

Of course, “Peak Season” is an oxymoron this year, as freight volumes fell far below the demand cycle of years past. Nevertheless, a review of some key freight indices should provide a much more sobering picture of the US economy.

Port Traffic

The latest Port Tracker report by IHS Global Insight and the National Retail Federation indicated that in July, major U.S. ports container volume was down 17% from July 2008’s volume, the 25th-straight month to register a year-over-year decline.

The report also projected total import cargo volume at major U.S. container ports to reach 12.5 million in 2009, which represents a 17.7% annual decline and the lowest level since 2003. The report further suggests:

“The projection is not for any return to the booming double digit annual volume growth rates…primarily due to …household savings rates will remain positive and more limited consumer credit availability both work to constrain import spending.”

Air Cargo

According to the latest Economic Briefing by the International Air Transportation Association (IATA), air freight is a leading indicator as it typically falls faster than world trade at the start of a downturn and then starts to rise faster than overall world trade a few months before the bottom of the cycle in industrial production.

In its latest Monthly Traffic Analysis, the IATA indicates that air freight volume remains depressed were 9.6% down on year earlier levels in August, and down over 20% in the first half of the year. The association further concludes that growth so far has been due to an end or pause in destocking and large government stimulus spending programs. In addition, a sustained recovery of air freight is still not yet assured given the large overhang of private sector debt and excess capacity in many economies.

Railroad Volume

Demand for rail service occurs as a result of demand elsewhere in the economy for the products that railroads haul. Thus, freight rail traffic is a useful economic indicator, both for the overall economy and for specific sub-sectors.

The Association of American Railroads (AAR) reported last week that for the first nine months of 2009, U.S. railroads cumulative total volume was down 17.3% from 2008. Fifteen of the 19 carload freight commodity groups were down from last year. Metallic Ores and Metals and Motor Vehicles & Parts were the two primary commodities which experienced the most cumulative year-over-year declines of 50% and 46.2% respectively.

Truck Tonnage 

American Trucking Associations (ATA) reported last week that U.S. for hire truck tonnage fell 7.5% year-over-year in August. Though it was the best year-to-year showing since November 2008, the ATA cautioned that most economic indicators suggest freight tonnage will exhibit moderate, and probably inconsistent, growth in the months ahead.

Trucking serves as an important barometer of the U.S. economy, representing nearly 69% of tonnage carried by all modes of domestic freight transportation, including manufactured and retail goods.

A Realistic Snapshot

The freight indicators suggest that some of the recent positive trends were mostly due to the government stimulus efforts which masked the real state of the economy. They are also harsh reminders of the magnitude in which global trade has collapsed since mid 2008.

Liquidity programs and prospects for a turnaround have run their course, but the fundamentals are not in place to truly support further advances as consumers are reluctant to spend due to widespread job losses, slowing income growth and tight credit markets. Corporation’s cost-cutting and "stabilization" programs may not provide the propelling fuel needed either, as slow sales are restraining top-line growth as well as business investment. The volatility could worsen as some government stimulus efforts, such as the one time tax credit for first-time homebuyers and the Federal Reserve support for the banking system, wind down.

Era of the New Normal

It is hard to digest the “jobless recovery” scenario suggested by government officials as consumers account for about 70% of total US GDP growth. It will take the U.S and the OECD nations probably a decade or more for personal wealth to return to the levels of pre-Lehman. Recovery is far from certain and there is still considerable debate upon examining the freight indicators as to whether the recession is indeed truly behind us. As freight volumes are in their fourth consecutive year of decline, attested by the haunting image of the ghost fleet of recession, it is not a stretch to admit that the lack of real growth is, in fact, "The New Normal.”

## Nothing Was Solved, But Nothing Mattered ##

By Dian L. Chu, Economic Forecasts & Opinions

Disclosure: No Positions Sphere: Related Content

Bonds & Equities: Expect a Major Shift

See it also on Zero Hedge , Daily Markets, Seeking Alpha, Investment Postcards from Cape Town; iStockAnalyst, Best Way to Invest

By Dian L. Chu, 09/24/09

The S&P has skyrocketed 58% since its bottom in early March, while the Dow is up 50% and the Nasdaq has surged 68% during that time. Meanwhile, bond prices led a rally as rates on the benchmark 10-year note have declined some 40 basis points since early August. This is good news for business: higher bond prices make it easier to refinance debt and stay in business.

Meanwhile, across the country, Main Street investors are weighing whether they should jump back into the market. However, the price correlation between equities and bonds of late has some argue that typically, if equities are trending higher, then bonds would head lower, and yield would be higher, due to concerns of higher inflation. This essentially describes “the Fed Model”, which is a theory of equity valuation popular among security analysts.

Now, the fact that bonds and equities in general are both firm seems to beg the question - which rally would end first - equities or bonds? This is an intriguing question which I will attempt to examine here.

A split Personality Spells Uncertainty

Based on the Fed Model, bond yields should have an inverse relationship with the stock market in general. We can start by comparing the S&P 500 index (SPX) and the 10-year Treasury notes yield. As displayed in Fig. 1 by the two dotted trend lines, the correlation between stocks and bond yields is time-varying and, on average, negative over the last decade. Nevertheless, it appears, within the last two years, the negative correlation is more pronounced during the bear phase of the stock market from approximately May 2008 to March 2009 (Fig. 2 green circle).


This simple observation is actually supported by economic research suggesting that the lower expected inflation and the real interest rate is likely to increase the negative correlation between stock prices and bond yields; and that the sharp inverse between stock prices and bond yields in the 1990s bull market can be partially attributed to the lower inflation risk during this period.


The following are some plausible drivers of the current price co-movement between bonds and the equities market:

1. Fast money from Institutional and hedge funds is being allocated to both equities and bonds.

2. Flight from money markets to Treasuries due to the ultra-low interest rates in money markets and massive amounts of cash in the system as a result of the most synchronized global quantitative easing in history.

3. Depreciating US dollar is pushing up everything across the board from commodities, equities as well as bonds.

4. Market’s low expectation of future inflation signaled by the TIP spread of only about 1.75%. That is bond market’s 10-year expectation of inflation is now around 1.75%, lower than the inflationary expectations from 2003-2007 of around 2.5%. Low inflation expectation tends to push down bond yields and drive up the equities market.

5. Investors over-react to the “positive assertions” such as Federal Reserve Chairman Ben Bernanke statement that the recession is “likely over.”

Inflation & Interest Rate Expectations

There is often a multi-year lag between the cause (money-supply growth) and the effect (rising prices). So, even though we will probably be in the deflationary phase for the next 12 months or so, once economic growth starts kicking in, we’re bound to experience inflation.

What’s more, the current low inflation expectation of 1.75% is signaling the stock market is most likely mispriced and overvalued right now. Wider recognition of the inflation problem will eventually emerge. Inflation plus a recovery means sooner or later the Fed is going to have to start raising rates.

Higher interest rates and inflation expectations, coupled with the overvaluation in the equity markets could lead to a bear phase and the dreaded W-shape double dip economic scenario. This would mean a major decline in both the stock market and Treasury bond prices (a major rise in bond yields) and borrowing costs for companies will increase exponentially, thus further hindering future growth prospects in the economy.

Expect A Major Correction

The stock market is overvalued and due for a substantial pullback based on any measure of future earnings. Ultimately, bond yields are unsustainable long term, and must rise significantly to pay holders of US Debt for the risk of holding Treasuries against the backdrop of inflated government balance sheets, larger budget deficits, and associated interest expenses on the national debt.

It’s ironic that the takeaway from all this is that both the equities & bond market are mispriced and headed in the opposite direction over the next 24 months. Equities are way overpriced and headed for a major correction (Dow 8,000 level) is a more rational valuation even taking into account improved earnings in 2011.

Expect the 10-year Treasury yield to rise above the 5.25 level in 2011. Increased borrowing costs, a jobless recovery, the collapse of commercial real estate will provide quite a headwind for anyone thinking of making a killing in equities over the next 2 years from the long side.

Bottom Line – Portfolio Repositioning

Start investing in alternative investments like residential real estate, which is where most of the smart money will seek outsized returns, as slowly but surely the favorable long-term demographics start to kick in, as the population increases, excess housing inventory evaporates completely providing for a housing squeeze in 2011. Real estate is actually the best inflation hedge of all, as they call it “Real” for a reason, unlike the US currency.

##I Say Let's Evolve##
Disclosure: No Positions Sphere: Related Content

What Does A Flattening Oil Contango Mean?

View this also on Zero Hedge, Seeking Alpha (Editor's Pick) & Daily Markets.

By Dian L. Chu, 09/23/2009

Starting about ten months ago, if you have access to oil storage tanks plus enough financial resources, sky was the limit to buying spot crude oil and selling a year or so forward on Nymex. For more than six months, it was a highly profitable trade when the spread between the near-month and forward contracts was about $10/bbl or more with a return of more than 15% (Fig. 1). During the super contago phase of late 2008 and early 2009, the spread was so ridiculously wide that the rate of return was close to 70% at one point of time.


Why is the Contango Flattening?

You may recall that the spread gap opened just a few weeks after Lehman Brothers (LEH) failed and AIG (AIG) required a capital infusion. Those few who had a role in taking advantage of the super contango ended up boosting the spot oil price back to a more normal relationship to the outer months. This is one of the reasons that the contango in the WTI Nymex crude market has weakened over the last few months quite substantially (Fig. 2).


In addition, the weakening contango in Nymex might also be related to an investigation by the Commodities Futures Trading Commission (CFTC) and other authorities into long-only funds and ETFs. Since much of the long-only fund buying has taken place in the futures, their liquidation in response to the regulatory investigation is likely putting downward pressure on futures contracts, narrowing the contango in WTI Nymex.

Reviewing Market Fundamentals

Spot prices becoming more expensive relative to future prices will typically encourage refiners to convert crude into product drawing down crude inventory. It will also dis-incentivize speculative crude storage hoarding, and provides incentives for producers, and OPEC in particular, to start some of the shelved projects. The same goes for non-OPEC producers. So a weakening contango, if sustained, will likely help normalize the crude supply and inventory levels.


However, the demand outlook remains dismal. The U.S. EIA just reported domestic consumption of liquid fuels and other petroleum products declined by almost 6.3% year-over-year during the first half of the year, one of the steepest declines on record. Total consumption is now projected to decrease by about 4% year-over-year in 2009 and grow only 1.4% in 2010 (Fig. 3). The latest EIA weekly petroleum report also showed the year on year U.S. gasoline inventory was 23.1% higher, while distillate fuels rose to their highest level since January 1983 (Fig. 4).


Is it Bullish?

A narrowing contango is traditionally seen as a bullish sign for the crude market, but investors interpreting the current flattening contango as such should probably beware. Based purely on market fundamentals, crude oil should be priced around $40 a barrel. At the moment, the murky economic and demand outlook is not yet supportive of the current oil price levels. The risk is likely on the down side in the near term, as any further increases in crude prices are less likely without an increase in consumption.

Goldilocks of Oil Prices

Nonetheless, once economic recovery returns, demand may jump sharply and then the existing oil reserves would come under pressure. In addition, crude prices of late have been tied to the equity markets, which have been trading irrationally on a weak dollar rally. Amid expectations of a further weakening U.S. dollar against emerging markets currencies, coupled with the current seemingly satisfactory oil price levels to both consumers and producers, crude price could well be sustained at around $60 to $75 a barrel range quite possibly through 2011 or 2012 barring any Force Majeure events.


#I Say Let's Evolve#

Disclosure: No Positions Sphere: Related Content

The Wild, Wild West of Natural Gas Trading

* Note: This article is also published on Zero Hedge & Seeking Alpha & Daily Markets *

Author: Dian L. Chu, 09/17/09

In my last article, I discussed two of the major factors to this week’s run-up in natural gas - Operation Flow Orders (OFOs) and pre-configured stop orders being hit. Here, I’d like to take a look at some of the other concurrent distortions in the natural gas market.

UNG Rolling Effect

After a nearly year-long run, the United Natural Gas Fund's (UNG) assets shot past $4.5 billion at one point. Just in a two-week period in May, the ETF's assets doubled despite lagging performance (UNG share price has retreated about 55% this year.) The fund has been rumored at times to hold as much as 80% of open interest in the NYMEX front-month contract.

As reported by FT.com, this is a rollover week for UNG. The fund also has just become an active buyer of fresh futures again. Essentially, the UNG roll is another reason for the natural gas surge this week on lack of market fundamental support.


On many days, UNG has dominated in the natural gas market, but a victim of its size and structure, UNG has also become a large and predictable player that has to roll because it has no capability of taking the contract to expiry.

The fund’s swap counterparties know just when and how much it has to roll; and everything will depend on the hedging of counterparties. Accordingly, UNG usually fails to fetch a competitive price and the contango between the front and second month increases at each roll. For this reason, the fund will almost always underperform the natural gas futures it is supposed to track (Fig. 1).

NYMEX Natgas Bubble

What's more, UNG said it plans to restart new issues on Sep. 28, which is also the day that the October contract expires. Trading wise, this not only means that the Oct/Nov contango could still widen during the roll this week, but also that during October there could be another upside volatility to natural gas outright prices as the UNG could come back to buy outright November contracts.

Compounding the “UNG rolling effect” is that CME Group (CME) just announced much more aggressive position limits on futures contracts, and this may have prompted some short-covering. Meanwhile, Goldman Sachs (GS) recently predicted that natural gas prices will triple by this winter while a speaker at a Barclays energy conference said natural gas is the ‘trade of the year.’ With natural gas at the confluence of all these concurrent events distorting the already volatile marekt, a NYMEX natgas bubble as described by the Schork Report seems inevitable.


UNG Investment Risks

Though UNG has become a very popular vehicle for investors and traders to participate in the futures market, the fund has been trading at a sharp premium to its underlying net asset value (NAV) since Aug. 12, when it announced that it couldn't issue new shares because of limits on how many natural gas contracts it can buy.

The share was trading at a 16% premium to NAV on Aug. 21, but now that's down to around 4%. The premium along with the share price should continue to fall from now till the new shares get issued. As such, short interest for UNG surged 135% to 30.9 million shares in the two- week period ended Aug. 31 (Table 1).


In addition, UNG itself states there is no longer any predictability to when it feels like being in an issuing cycle and when it doesn’t. This predictability issue is noteworthy enough to earn a sell, sell, sell from Jim Cramer, the host of Mad Money on CNBC.

Caveat Emptor

Therefore, from all indications, retail investors dabbling in energy markets better take heed, the above being proof of just how complex and volatile the market can be. I would agree with Cramer’s call to sell if you bought UNG at a premium to its NAV before it drops even further. Meanwhile, new investors should stay away from UNG.

For now, the best way to play the natural gas market is probably buying natural gas producers such as Chesapeake Energy Corporation (CHK) and EOG Resources, Inc. (EOG) on the dip. Since these producers typically all have aggressive hedging programs in place to protect future production, investors could benefit from their market expertise without the complexity and risk as investing in UNG.

Disclosure: No Positions Sphere: Related Content

Why Has Natural Gas Spiked 60% Since Labor Day?

Note: This article is published on Zero Hedge , Seeking Alpha, & Daily Markets .

Author: Dian L. Chu, 09/13/09

As reported by Zero Hedge on Thursday, September 10, 2009, natural gas was up by about 16% on no real change in the fundamentals of the commodity. By the end of the trading day, natural gas saw its biggest one-day gain of 15% in almost five years (Fig. 1). Natural gas price has spiked almost 60 % since Labor Day and prompted investors to believe a V-shape recovery might be near for the brutally battered U.S. natural gas market. However, don’t break out the champagne just yet until you learn more about three of the major factors driving this latest run up, Operation Flow Orders (OFOs), and trader's perspective.



Operation Flow Orders (OFOs)...What?

On the surface, the Thursday gain was sparked mainly by the Energy Department’s weekly data that showed a “smaller-than-forecast” increase in U.S. stockpiles. Though the news did not really change the overall supply and demand picture, it did send traders scrambling to buy back previously sold positions.

However, according to industry insiders, the "smaller-than-expected" increase in gas storage was largely due to what the pipeline industry called Operation Flow Orders (OFOs). Pipelines may issue OFOs in the event of high or low pipeline inventory. OFOs require shippers/producers to balance their gas supply with their customers' usage on a daily basis, within a specified tolerance band. Shippers may deliver additional supply or limit their supply in order to match customers’ usage. If the supply isn’t balanced, shippers may incur noncompliance charges.

In other words, when OFO's are issued in an oversupply environment like we are in right now, shippers/producers either comply, i.e., sending less gas to pipelines & storages, or pay a penalty. As most shippers logically chose to comply with the OFOs, the volume that normally goes to storage ended up overflowing to the spot market pressuring prices to around $1.84/mmbtu on the Friday just before Labor Day.

Storage facilities and pipelines typically raise their tolerance band after Labor Day to prepare for the higher winter usage season. So, the lift after Labor Day normalized the market and is a major contributing factor in the 60% rise of natural gas prices since Labor Day.

Although some producers already shut down production in response to the current OFOs, more production shut-in is expected as pipelines continue issuing new OFOs.

The Trader's Perspective

One alternative explanation, from a trader’s perspective, is that a large natural gas player saw the opportunity to make a huge profit by blowing out the stops of the large contingent of traders who were short the natgas market. For example, someone like John D. Arnold, the former Enron trader who is one of the large players in the natural gas market. To the point, the move in natural gas from $3.00 to $3.30 during late day trading on Thursday was strictly due to the pre-configured stop orders being hit.

Still a Very Short and Decoupled Market

Based on a Bloomberg report, although the number of shorts did decline 3.9% from a week earlier, speculative short positions still outnumbered long positions by 169,846 contracts on Nymex for the week ending September 1st, 2009, according to the Commodity Futures Trading Commission (CFTC). In a short market, things can get extremely volatile and completely decoupled from any fundamental or technical indications.

Crude oil and equities markets, which traditionally have a negative correlation, have moved in tandem for the most part of this year. The upward momentum has some investors chasing natural gas, which theoretically should have a fair amount of correlation with oil.


However, as discussed in Oil and Natural Gas: Ratio Explodes in 2009, natural gas tends to be regional, while crude is more globally driven. If we look at the price movement of crude oil, natural gas and the S&P 500 (SPX), it is evident natural gas has completely decoupled and gone off on its own downward spiral (Fig. 2). This suggests in general that commodity and equities markets will likely be irrelevant to natural gas in the near to medium term, given the fact that there is no fundamental U.S. demand.

Heading for a Sub-Zero Price Zone?

Despite the signals given by Thursday's spike, U.S. natural gas storage currently stands at 3.392 bcf, 17% higher year-over-year, and fastly approaching the maximum storage capacity of about 3,900 bcf. The September 2009 EIA Short-term Energy Outlook now expects another 12% build in working natural gas inventories reaching 3,840 Bcf at the end of the 2009 injection season, i.e., October 31st (Fig. 3).

So, there will likely be a painfully lower gas price on hand in the next 6 to 10 weeks or so until winter withdrawals begin. During this period, we could have a short and sharp collapse in the spot price in the sub $2.00 range.


A colder than usual winter season as currently forecasted by weather bugs is likely to boost natural gas prices higher; however, if this weather pattern fails to materialize leading to a max-out storage capacity, then we could be looking at a brief sub-zero price scenario similar to one the UK experienced in 2006.

Crystal Ball into 2010 & Beyond

Natural gas prices are down about 42% so far this year as demand has been sluggish during the economic downturn, while production from onshore gas fields has remained robust. The EIA now estimates that total domestic natural gas consumption will likely decline by 2.4% in 2009 and remain flat in 2010. As the economy starts to recover and production cuts kick in on a larger scale, natural gas prices should rebound averaging close to the $5.00-$6.00 range in 2010 and gradually ramp up from there. Investors and traders should brace themselves for quite possibly the darkest days in the next 2 month for the natural gas market in over a decade before the dawn finally breaks.

Economic Forecasts & Opinions

Disclosure: No Positions Sphere: Related Content

China et al: Puts Floor in Gold Market

**Note: This article is published on Zero Hedge, Jim Sinclair's Mine Set, Reuters, Seeking Alpha , Dailry Markets , and CommodityOnline

Author: Dian L. Chu, 09/10/09

Gold finally made its run above the magical $1,000 mark on Tuesday, September 8th, 2009 breaking free from a two-month trading range between $930 and $970 an ounce. For the third time, gold soared past the $1,000 level, causing the market to eye the precious metal's record of $1,033.90 reached in March 2008. While Citigroup is predicting a $2,000 scenario by next year due to continuing dollar weakness, a number of bullish factors, both near and long term, have converged to boost gold.

Technical Rally


Gold rallied to $997.20 an ounce last week after an earlier slide in stock markets pushed it through key technical resistance levels of $962 - $976 triggering buy orders (Fig. 1). Currently, the $1000 - $1035 is a technical pivot point for gold. In dollar terms, gold broke the 1,000 resistance, with the next hurdle of February’s peak of $1,005 followed by the March 2008 record of $1,035. In euro and sterling terms, spot bullion broke above its 100 and 200-day moving averages, both considered as buying signals.

China Effect

China has been increasingly vocal about their concern for the U.S. dollar and the U.S. bailout policies as of late, and has explicitly called for replacing the U.S. dollar as the world's reserve currency in favor of Special Drawing Rights (SDRs) from the International Monetary Fund (IMF). Beijing followed up that rhetoric by announcing their intention to purchase up to $50 billion in SDRs from the IMF. Russia and India have likewise indicated an interest in purchasing SDR-denominated IMF bonds, putting more pressure on the dollar.

Beijing also has been actively seeking to diversify its $2 trillion stockpile of foreign-exchange reserves into other assets, especially commodities. According to an April 2009 report, China has boosted its gold reserves to 1,054 metric tons, up about 76% since 2003. The increase makes China the world's fifth-largest holder of gold. Last year China ranked as the world's largest gold producer with 12.2% of world output, equivalent to 288 metric tons. Another news report suggests that the Chinese government is pushing the general public into buying gold and silver bullion, which could have a dramatic effect on the markets

From all indications, China has emerged as the driving force in the global gold market and will likely buy whenever there is a price dip, putting a floor under any correction. However, don’t expect China to bid the prices too high, as Beijing is also cautious not to “over-stimulate” markets.

Risk Aversion



Asset-diversification demand for gold and other precious metals by nervous investors amid unstable equities markets has contributed to gold's latest rally. Historically, gold has an inherent inverse relationship with the U.S dollar as well as equity markets (Fig. 3). Gold has tripled in value over the last seven years, vastly outperforming equities, and is now benefiting from uncertainty over the strength of the economic recovery. Investors are buying gold as a diversification from risk, while those who believe it is sustainable choose the metal as an inflation hedge.

Global monetary authorities have long held gold in their reserves for economic security in addition to asset diversification. Emerging sovereign-wealth funds are buying gold as well due to volatility in their economic and/or political environment. When these sovereign-wealth funds are not actively purchasing gold they are at least reconsidering the level of gold in their reserves.

Inflation/Dollar Hedge

Gold has attracted many investors since the collapse of Lehman Brothers last year. Growing investor concerns that the sharp rise in major country debt levels and aggressive quantitative easing will impact sovereign ratings, currency values and potentially cause inflation to rise sharply appears to be causing investors to raise their holdings of hard assets.

The agreement last week by the G20 to keep the economic stimulus flowing until the global recovery was well entrenched led to rising speculation across markets regarding central banks’ exit strategies, as well as dollar weakness. Hedge funds have bought heavily into gold as a bet against the ability of central banks to stimulate economic growth without triggering inflation.

Supply & Demand


Distrust of any paper investment due to the global economic crisis has pushed up gold demand when global gold production is falling (Fig. 2). According to the World Gold Council's Gold Demand Trends report for the second quarter of 2009, investment demand for gold rose 46% from earlier in the year but was down by 9% year-over-year. Demand for gold exchange-traded products also rose with a total net inflow of 1.9 metric tons for June 2009, compared with net outflows of 38.1 metric tons a month prior.

Fundamentally, lack of exploration expenditure in the 1990s, coupled with the inherent delays between discovery and production mean that the gold supply will remain inelastic and is likely to reduce slowly over the coming few years.

To Hong Kong, with Gold

Hong Kong is repatriating its physical gold reserves from London to high-security vaults at home, and it is inviting the region's central banks to store their bullion there. The move raises a potential price-settlement hub in Asia to rival the New York and London daily spot-price fixes. The Hong Kong Monetary Authority is also targeting a new gold bullion ETF using the new vault as a repository, which would remove yet more physical supply from the market.

De-hedging by Barrick Gold

Citing a bullish outlook for gold, Barrick Gold (ABX) indicated that it will eliminate all of its gold hedges and raise about $3.5 billion in a share offering to help pay for the move, giving the company full exposure to changes in the precious metal's market price. Barrick's dehedging & buying since the end of the second quarter reportedly had been a major contributor to the nearly $100 rise in the price of gold over that period. To investors, this move spells a very bullish golden outlook from the world’s largest gold producer.

According to an August 2009 analysis by Société Générale, the majority of the global hedge book is still under the control of two main players, Barrick Gold (ABX) and AngloGold Ashanti (AU). Thus, there remains significant scope for the two companies to act as a swing factor in the world’s gold market.

Seasonal & Regional Effects

September is historically a strong month for gold, partly because it precedes the wedding season in India, when jewelry demand typically picks up. Although jewelry demand for gold sank to a five- and-a-half-year low in the second quarter of 2009, gold is still considered the best possible protection against upheaval, both political and economic in much of Asia, the Middle East, and the Indian subcontinent.

Gold Rush to Continue?

Even with resurging investment demand, gold's recent rally has been largely technical, amid weakening physical demand. Nevertheless, China, inflation/dollar hedge, risk aversion and supply/demand are all longer term bullish factors underpinning gold prices. Dollar movements and external economic factors will continue to greatly influence precious metals' prices. While a resurgence of inflation fears would ultimately skyrocket gold prices, it is not a likely scenario in the near-term, as we are still pretty much in the deflationary cycle.

Technically, if gold breaks the $1,035 point, expect to see a lot of new funds inflow and short covering bidding prices even higher. However, if the yellow metal fails to break higher, there could be a sell-off from profit taking and/or panic. Fundamentally, a sustained rally in the gold price beyond $1,000 remains doubtful, as commodity prices in general are overbought, and there could be room for a correction.

Therefore, from all the factors examined so far, gold is likely to remain range-bound around $900’s to $1,000’s in the near-term, while markets and the global economy stabilize.

Sector Strategy

As discussed, since gold prices have a virtual floor built in, buying on the dip at around $940 price range should be a good strategy for the physical futures market.

To get the upside on gold with less risk and volatility, equity investors could focus on gold mining companies such as Freeport-McMoRan Copper & Gold (FCX) and NovaGold Resources (NG) with a favorable gold production cost structure. Jaguar Mining Inc. (JAG), one of the very few unhedged miners, could be worthy of a look as well.

For new gold ETF investors, ETFs like the SPDR Gold Trust (GLD) and Market Vectors Gold Miners (GDX) offer good inflation protection. Investors already own gold related holdings could consider diversifying to precious metals ETFs such as PowerShares DB Precious Metals Fund (DBP) or broad commodity ETFs like DB Commodity Index (DBC).

Disclosure: No Positions Sphere: Related Content

Oilfield Services Sector & Forget About Natural Gas

***This article is published on Zero Hedge, Seeking Alpha & Daily Markets on Tuesday 9/8/09.***

Author: Dian L. Chu, 09/07/09

The market's upward momentum this year has hordes of investors still looking for opportunities with good entry points. Finding them is tough because markets can turn quickly and many sectors are already fully valued. Nonetheless, with crude prices hovering around the $70 per barrel range, even with reduced demand, oilfield services remains one of the more promising sectors still with room to grow.

The following are some of the emerging trends setting the medium to long term outlook for the sector:

North America Natural Gas – Check Back in 2011

Baker Hughes (BHI) and BJ Services (BJS) $5.5 billion stock and cash deal is the first major merger in the oilfield services sector since energy prices collapsed last year and the biggest merger in the sector for a decade. It will boost the size of Baker Hughes’ pressure pumping business to provide more than 20% of its revenue, from less than 1% today. Baker Hughes (BHI) once owned BJ Services (BJS) but spun it off in the early 1990s.

This merger tells investors three things:

( 1 ) BJ Services (BJS) is the number three player in the pressure pumping business with 73% of its revenue generated from the North America region. BJ Services’ exit at this point suggests the North America onshore shale gas market is not expected to rebound any time soon, and this is a marriage made in recession.

( 2 ) This is a strategic move by Baker Hughes (BHI) suggesting a diversified suite of services is becoming more important to compete and win contracts with majors and larger independents.

( 3 ) The better revenue prospect lies in the overseas market, as BJ Services (BJS) has far less the international presence of Baker Hughes.


In addition, as the graph indicates natural gas has decoupled from the commodity and equities markets. (Fig. 1) Both the fundamental and technical signals are extremely bearish for natural gas with some analysts predicting a sub $2/mmbtu price scenario. Due to various market factors, it is likely that natural gas will stay on this bearish path at least through 2010, and unlikely to be a factor for the services sector, assuming no major hurricanes or an unusually cold winter.

Deepwater Oil to Drive Growth

BP PLC (BP) announced a major new oil find, called the Tiber well, one of the latest in a string of discoveries in the Gulf of Mexico (GoM) that cements the prospects for the Lower Tertiary region as one of the oil world's most promising exploration regions. Tiber, with an estimated 3 billion plus barrels, is at a depth of more than 35,000 feet, greater than the height of Mount Everest.

This is part of a new frontier in exploration where oil companies are spending billions of dollars to find oil on the bottom of seas offshore in places such as Brazil, The North Sea, and West Africa. These discoveries were made possible by new technologies now capable of unlocking deep deposits that were before either undiscoverable or too costly to exploit.

The U.S. also has lower taxes, royalties, oil payments and other levies than most other governments. This combination of financial and geologic advantages will support the continuing growth of the deep-water GoM. Since most of the oil majors have backwardly integrated services operations, and rely on thrid party services companies to supplement their own activities, this new find by BP PLC (BP) could translate into more work for the deepwater services sector over the next couple of decades.

North America Onshore M&A to Intensify

The oil and gas sector has been hemorrhaging due to the factors of the economic downturn, the credit squeeze, falling commodity prices and an extreme pricing environment. For example, during its earnings calls, BJ Services (BJS) indicated that the average pricing for its products and services was down about 35% during the 1st half of 2009. There are indications that the average oilfield services pricing was down another 10-15% from late 2nd quarter levels.

The Baker Hughes (BHI) and BJ Services (BJS) merger is one of the first signs that the valuation gap is finally narrowing between potential buyers and sellers. After free falling from the 4th quarter of 2008, the rig count in the U.S. has begun to creep upward, now breaking 1,000 from the low point of 876 in mid June. This could spur more M&A activity, particularly in the North America Onshore services sector, before values start rising again along with commodity prices.

From that perspective, both Schlumberger Limited (SLB) and Weatherford International (WFT) could be ready to acquire smaller players in the sector, with small niche players like Smith International (SII) and Newpark Resources (NR) as potential targets.

Sector Strategy

The entire oil patch is not likely to resume growth till oil prices stabilize for at least 6 months or longer around the $70-75 a barrel level, which seems to be the ‘fair price’ that OPEC demands.

Ergo, for investment in the services sector as part of a long term portfolio holding, investors should seek out companies with an international deepwater niche such as Transocean, Inc. (RIG), Technip (TKP), Oceaneering International Inc. (OII), and Tidewater, Inc. (TDW).

ETF investors should research whether the following Exchange Traded Funds meet similar investment objectives: Oil Service HOLDRS ETF (OIH), Dynamic Oil & Gas Services (PXJ) and SPDR S&P Oil & Gas Equipment & Services (XES), which can be less risky than investing directly in specific companies. Sphere: Related Content

The Alternative Fuel Vehicle and $300 Oil

*This article is published by Reuters, Zero Hedge & Seeking Alpha , and Daily Markets on Sunday, 08/30/09.

Author: Dian L. Chu, 08/29/09

It is amazing sometimes just by browsing the news you can piece together a totally different picture from the original news. Here are three of them I came across in the past few days.

Pickens: Oil Will Reach $300 a Barrel
"Oil legend T. Boone Pickens, now CEO of BP Capital, says oil prices will continue to rise… So, 10 years from now, the price of oil could well be $300.”

DOE to Spend $300 Million on Alternative Vehicles
"The U.S. Department of Energy..will allocate nearly $300 million from the American Recovery and Reinvestment Act to help fund the development of alternative fuel and energy efficient vehicles displacing approximately 38 million gallons of petroleum per year."

**Note: To put it in perspective, based on the US EIA data, dometic gasoline consumption is estimated at 378 million gallons PER DAY.

U.S. Automakers’ Small-Car Output May Outstrip Demand
"General Motors Co. (GRM), Ford Motor Co. (F) and Chrysler Group LLC (DCX) plan a 63% boost in small-car production capacity by 2015 that may outstrip demand since consumers may not be ready for that many small autos. The small-car push is being driven in part by the U.S. requirement that auto fuel efficiency rise about 40% to an average of 35 miles per gallon by 2016. Automakers also are tapping sources such as the Energy Department’s $25 billion loan program to develop more fuel- efficient vehicles."

Related Thoughts



Unlike other commodities, oil has a long, complex and global chain of supply going from offshore platforms, pipelines, tankers, ports all the way into storage, refineries and ultimately, gas stations. This is one of the reasons that oil is probably the most volatile commodity attracting the most speculators. Demand, mostly from exploding emerging economies, had outstripped supplies over the past 5 years. Speculators further exacerbated the market fundamentals and drove oil prices to historical highs last year.

Now, high oil/gasoline prices, the economic crisis and concerns over global warming have been three of the major factors leading to an increasing interest in alternative fuels and vehicles. The battery powered electric vehicle market is slowly developing while the hybrid electric vehicle market, including plug-in hybrid electric vehicles (PHEV), and electrical vehicles (EV) could move ahead more rapidly. Fuel cell vehicles, however, are in the prototype state and most likely will be late to fully participate in the big new green transportation game. Meanwhile, natural gas vehicles (NGVs) and hydrogen as alternative fuels for vehicles have their own infrastructure and storage challenges.

A study dated March 2009 by the IEA Hybrid & Electric Vehicle Implementation Agreement representing 12 member countries including the US, France & Italy, noted that the growth of the sales share of hybrids is expected to continue; however, supply might be limited due to the battery production bottleneck. The study further projects the share of hybrid cars in 2015 for new car sales is expected to below 10%. And the EV share of new car sales in 2015 is expected to be well below that 10%. The forecast by Just-Auto in 2009 believes that conventional hybrids such as the Prius from Toyota Motor (TM) will represent 3% to 8% of global light vehicle production by 2015. Other plug-in vehicles, such as Volt by General Motor (GRM) will take a much lower share.

Some of the most cited reasons EVs or PHEVs are not used on a large scale includes high initial purchase price as batteries are still expensive, concerns over adequate supplies of electricity; the lack of production and maintenance infrastructure, and limited battery range. Though alternative vehicles still have ways to go due to various production and technical constraints, the evolution and growth is bound to continue through aggressive government subsidy policies and consumer demand.

However, the fact remains that most of the alternative energy and vehicle industry currently are not economically competitive with conventional industries without substantial government funding and subsidies (i.e., taxpayers’ money). Another fact: We are still in the midst of the longest U.S. recession since the Great Depression with a real unemployment rate at 16%. In light of our newly upward revised $9+ trillion budget deficit running in the next 10 years, now is probably not the time to spend billions to fund programs not directly reviving the economy. It makes common sense that those funds could be better utilized elsewhere in the economy to create a more immediate impact.

We also need to come to a common understanding that the world needs all sources of energy, conventional as well as alternative. Worldwide energy consumption is projected to rise more than 50% by 2030, with most of that growth in emerging economies, such as China and India. Even if the use of renewables doubles or triples over the next 20 years, the world is likely to still depend on fossil fuels for about 70-85% of its energy needs, based on various forecasts. (see graph)

It is imperative that we keep investing and developing in all forms of energy to maintain a healthy and competitive energy market without any favoritism or politics. Otherwise, the emergence of lithium (used in batteries to power EVs) as a strategic commodity, and the geopolitics associated with electricity as the primary vehicle power source will mean that the alternative fuel or the hybrid/EV battery market could end up with the same volatility and speculation as the current crude oil market.

Disclosure: No Positions Sphere: Related Content

Oil & Natural Gas: Ratio Explodes in 2009

(This post is published by Daily Markets & Seeking Alpha on Wed. 8/26/09.)

Author: Dian L. Chu, 08/25/09

Theoretically, based on an energy equivalent basis, crude oil and natural gas prices should have a 6 to 1 ratio. However, due to various market characteristics, the price of oil has been following a pattern of 8-12X that of natural gas since 2006. Now, with oil spiking to its highest level this year and natural gas plummeting to a 7-Year low to below $3/mmbtu, the current ratio of WTI/Henry Hub price is close to 25 to 1, a historical high. (Fig 1)

Natural gas tends to be regionally based and is typically less impacted by external sources. Oil, on the other hand, is a commodity with global demand drivers; and along with gold, trades as an inflation hedge against a weakening US Dollar.



Natural Gas Prices Rooted in Supply & Demand

The domestic natural gas price weakness is rooted in supply and demand. Factories and power plants have slowed production because of the weak economy. The Energy Department reported that consumption of natural gas was down about 5% year-over-year in May. (Fig. 2) On the supply side, a boom in domestic production has followed improvements in recent years in drilling technology, opening immense shale gas fields across Appalachia, the Great Plains, Northern Texas and Louisiana.


The industry is laying down gas rigs at a record pace over the first half of the year. Based on the latest Baker Hughes rig count, the number of gas rigs in the U.S. has been reduced by about 45% since last August. But production has remained high partly because many of the shale wells are new and just beginning to flow. In addition, there is typically a 3-6 month lag for production to really shut in due to the complexity of unconventional shale gas operations. In fact, natural gas output this year has been slightly higher than last year despite the sharply declining rig count. (Fig. 2)

Demand & Inventory

U.S. crude and gasoline inventories are at the top of the five-year range. However, the current lofty crude price at around $72 a barrel has a lot more down side risk than that of natural gas in the near term, given the recent sluggish demand forecast by the IEA. The IEA forecasts oil demand growth next year to be 1.6% after declining 2.7% this year.

Natural gas inventories are also at 15-year high in any August month. The latest EIA Short-term Energy Outlook projects that total U.S. natural gas consumption will decline by 2.6% in 2009 and increase by only 0.5% in 2010. That means natural gas prices are not likely to rebound to the previous trading range of the last 5 years between $6-$8/mmbtu anytime soon, assuming no hurricanes or other events taking produtions off line.

Nymex Natural Gas Futures

The recent lows in the $2.70`s is far from the projected price at the start of 2009 by most analysts of around the $5 level for the second half of the year on increased demand due to an improving economy. Currently, the December Nymex natural gas contract is the only month trading at the $5 level. October & November contracts have already been adjusted down along with the recent 3-week slide in the front month contract. (Fig. 3)

It should be noted that things can change fast in the natural gas market. But still this weakness in natural gas prices due to poor fundamentals has caught many poorly-positioned. And the losses have been severe for all with unhedged exposure to the commodity.

Ratio Tightening to Come from Oil

The total divergence between oil and natural gas prices, which is reflected by the unprecedented 25 to 1 ratio is unsustainable based on the factors discussed here. We should expect the ratio to narrow with most of the tightening likely coming from the retracement of oil prices to the downside. While it is difficult to expect a 10 to 1 ratio, some tightening towards 15 to 1 level could be in the cards by next year, depending on the pace of the global economic recovery.

Investment Strategy

For long-term investors, now is a good time to add some natural gas related holdings. However, since most of the commodities ETFs, in addition to market risks, will likely face the regulatory overhaul as discussed in “Natural Gas ETF Suspends New Shares: Are There Alternatives?”, a better strategy would be to invest in the natural gas E&P equities as well as ETFs.

Here are some ideas: Natural gas and LNG producers with international operations such as Apache Corp. (APA), Anadarko Petroleum Corp. (APC), ExxonMobil (XOM) and Chevron Corp (CVN) are all solid companies worthy of a seat in any portfolios. And iShares Dow Jones US Oil & Gas Exp. (IEO), and iShares S&P Global Energy Sector Index Fund (IXC) are two good examples for your ETF considerations.

Disclosure: No Positions Sphere: Related Content

Prepare Yourself for the Inflation Invasion

(Note: This article is published by Reuters, Seeking Alpah and Daily Markets on Sunday 8/23/09.)

Author: Dian L. Chu, 09/07/09

The Treasury Department, responding to growing demand from China and other investors, will boost the sale of inflation protected bonds, i.e., TIPS. Chinese officials had indicated they want inflation-protected securities, especially as the U.S. economy starts to recover.


Inflation Expectation Eases

TIPS value fell after the announcement. The spread between TIPS and comparable Treasury Notes ended at around 1.93%, signaling that investors expect annualized inflation of 1.93% over the next decade. However, this is still below both the average 2.8% of the past 10 years, and the 2.1% at the end of last year.

Inflation’s Twin Tale

Most analysts are of two minds about inflation: One tends to argue that the Fed's printing of new money would lead to explosive inflation or even "hyperinflation.” The other group argues that there is too much "slack" in the economy for prices to rise, i.e., a stagnation scenario, due to high unemployment, falling wages, plunging home values, and damaged 401ks. So far, the latter view seems to have held up better.

Growth of Money supply


At the moment, both inflation and deflation are seemingly off the radar based on the latest consumer and producer prices. Realistically, we can’t ignore the inevitable inflationary effect from the government’s quantitative easing program.

Since the start of this global economic crisis, the U.S. government has been injecting massive amounts of new currency into the financial system to prevent deflation and stimulate economic growth. M2, a measure of money supply that includes checking accounts and money-market mutual funds, has grown about 16% over the last 12 months, or a colossal $1.12 trillion increase. All that money is going to find a home. This phenomenon will eventually devalue the dollar and push price inflation much higher, which is also referred to as reflation.

Betting on Inflation

Warren Buffett said on Aug. 18 that the U.S. must address the massive amount of “monetary medicine” that has been pumped into the financial system and now poses a threat to the economy and the dollar.

In reality, the Fed will likely be slow to act, in part because of the still high unemployment rate, which rose to 9.7% in July, from 7.2% in December. So the U.S. has got a lot of inflation or even hyperinflation issues to worry about in the future.

Meanwhile, Pictet Asset Management, which manages $60 billion in fixed-income assets, reportedly is buying U.S. inflation-protected bonds, betting that the government’s economic-stimulus measures will fuel price growth.

W-shaped vs. V-Shaped

Prominent Harvard economist Dr. Martin Feldstein indicated that the U.S. economy has improved, but he wondered "if the current recovery is really sustainable" or whether there could be "another slowdown or indeed downturn after the third or fourth quarter".

Judging from the recent commodities rally, we may have inflation, for example, in food and energy, while deflation in the rest of the economy. If this stagflation scenario emerges, we will likely experience a W-shaped recovery instead of a V-shaped one.

Commodities Rock & Rule

A large spike in prices for goods and services is expected once we finally emerge from this global economic crisis, which could be in a year or so. Hard assets such as oil, agricultural products and precious metals will experience substantial price appreciation in this future high inflationary environment. Therefore, commodities are well positioned as a sector with likely strong growth prospects over the next decade.

Investing Strategy

Based on this analysis regarding inflation and a likely W-shaped recovery scenario, here are some ideas of potentially profitable plays to consider:

Precious Metals ETF's: SPDR Gold Trust (GLD) & iShares Silver Trust (SLV)
Hard Assets ETF: Market Vectors RVE Hard Assets Producers ETF (HAP)
Agriculture Commodities ETF: PowerShares DB Agriculture Fund (DBA)
Metals Equity Play: Freeport McMoRan (FCX), BHP Billiton Ltd. (BHP)
Crude Oil Producer: Petroleo Brasileiro SA (PBR), ExxonMobil (XOM)

Disclosure: No Positions Sphere: Related Content

Natural Gas ETF Suspends New Shares - Are There Alternatives?

Note: This article is published by Daily Markets , Seeking Alpha and Reuters on Mon. 8/17/09)

Author: Dian L. Chu, 08/16/09

New Shares Suspension

United States Natural Gas Fund (UNG), the world’s largest natural gas ETF, will suspend offering new shares on concerns that federal regulators will keep it from investing in natural gas futures. This decision came after the fund won SEC approval to sell up to 1 billion new units, which would give the fund room to almost triple in size.

This move may keep the fund trading at an expanded premium to its underlying net asset value (NAV), making it more expensive for those retail investors who can only gain exposure to the gas futures market through the fund.

Under Regulatory Fire

In addition, sensing that regulation was imminent, UNG reallocated funds from futures to mostly over the counter ICE swaps. The halt of the new share issuance has broken the tie between NAV and market price, which essentially changed it into a closed-end fund. But the change to swaps alters the nature of the fund entirely. Due to the fact OTC market lacks liquidity, and it’s out of regulatory reach, this generates serious concerns about transparency, and counterparty risk for an ETF like UNG.

UNG is not the only ETF under fire. Leveraged funds such as Direxion Daily Financial Bull 3X (FAS) and Daily Financial Bear 3X (FAZ) as well as ProShares Ultra Short Real Estate (SRS) have also sparked the ire of regulators, skeptical of sales practices. A number of firms, including UBS (USB) and Ameriprise (AMP), have halted the sales of such products to their clients. The scrutiny of these funds has been led by the Financial Industry Regulatory Authority (FINRA).

The Basic Design Flaw

Fundamentally, all ETFs based on commodity futures have a basic design flaw in that they are open-ended funds that invest in futures that are close-ended. This is a major contradiction that is at the source of market dysfunctions.

It comes mostly in a declining price-environment and a contango curve. Contango poses a challenge to funds whose methodologies oblige them to keep rolling futures contracts to maintain their positions. So, with a contango futures curve, every roll registers a loss. UNG units are down about 46% this year, while NYMEX gas futures, which the fund is supposed to track, have fallen about 38% in the same period.

What’s Next for UNG?

Right now, UNG is in the middle of an overhaul and will not go down without a fight. Its rampant growth has been so large that in order to avoid a regulatory clampdown, its portfolio will most likely be shifting more into offshore energy exchanges and swaps. Another option is buying energy futures other than natural gas such as crude oil and gasoline. Whatever the fund decides spells trouble for investors, as the very essence of the fund is changing. Already a sophisticated strategy for even seasoned investors, UNG is about to become more complex.

Investment Alternatives

With new shares suspended, UNG still had the highest asset inflows of any ETF during the month of July, according to data published by Morningstar. However, it is best to stay away from UNG or other commodities ETFs until the regulatory dust settles.

As the near to medium term price momentum is likely to be on the crude oil side as compared to natural gas, investors should consider some of the oil-weighted independent exploration & production (E&P) companies. Almost all E&Ps have aggressive hedging programs in place since they do not have a refining/marketing arm like the major oil companies as natural hedges to their E&P operations. Therefore, investing in E&Ps with strong balance sheets and international portfolios would be a good hedge for existing UNG holders, or as new investments in lieu of crude oil and natural gas ETFs. Two such companies come to mind: XTO Energy (XTO) and Apache Corp (APA). There is also an ETF - SPDR Oil and Gas Exploration and Production (XOP) that could be a reasonable candidate for your portfolio.

Disclosure: No Positions Sphere: Related Content

Energy Trends: Crude Oil, Products & the Refining Sector

Note: This blog post has been published by Reuters, Seeking Alpha Editor's Pick, and Daily Markets.

Author: Dian L. Chu, 08/09/09

Crude and product futures are seeing an influx of investors who are betting that global economic activity will turn around later in 2009, with oil fueling the rebound. Buying in the oil market has focused on the improving outlook for diesel demand, which is more closely tied to industrial activity and consumer spending than other fuels. Many traders see an uptick in diesel consumption coinciding with peak winter demand for heating oil in the U.S. Northeast.

However, we need to examine the following market fundamental forces before leaving the rosy glasses on:

High Inventory Levels

The U.S. oil product market has shifted from a gasoline/distillate imbalance to a supply glut of both gasoline and middle distillates. U.S. supplies of distillate, including heating oil and diesel, are at a 24-year high. (Fig. 1) There are also an estimated 85 million barrels of oil product sitting in floating storage alone, with much of it along the Gulf Coast.



New Refining Capacity to Come Online

Meanwhile, spare refining capacity continues to increase. Refiners have invested in capacity additions after a continuous spell of demand outpacing supply, and those capacity additions are about to come on line. The considerable amount of refining capacity under development could further reduce refinery margins from current levels. Spare capacity, which was as high as 25% in the early 1980s, has declined to about 6-7% in recent years. The announced projects, if realized, would create a capacity cushion of around 20%. Merrill Lynch estimates global demand for petroleum products to fall 5.2 mn b/d below capacity this year.

Between 1995 and 2007, $385 billion was invested in global refining. In the U.S. and Europe, investment went largely for improving product quality, while in Asia and the Middle East it went for expanding crude capacity. So, the actual global capacity remains tight, but in the mid term it will become easier due to the slack in demand.

Most of the capacity requirements needed by 2012 are already scheduled to be met by announced projects, except for China. However, project delays and cancellations due to the global financial meltdown could mean the global refining capacity cushion will remain low beyond 2013, should this scenario play out.

Gasoline vs. Diesel

There is usually a direct relationship between personal income & employment and that of gasoline demand; and GDP output related to demand for distillates, petrochemicals, and other refined products. Both the gasoline and distillate markets are struggling with an incredibly weak global demand picture brought on by the recession. However, gasoline is expected to have an advantage over diesel through 2010 due to relatively favorable inventory levels and low pump prices helping demand. (Fig. 2)



At present, US refineries are working hard to reduce distillate production. Relative to a peak of 30% at the start of January, U.S. distillate yields are now down to 26.7% in May, according to the latest U.S. EIA data. This reduction is helping to clear the gasoline and heating oil market imbalances, and gasoline production is now increasing relative to heating oil. As additional refining capacity is coming online in China, India and Vietnam, middle distillates may suffer more than other petroleum products before they recover in late 2010.

However, longer term demand for diesel, which has fewer substitutes than gasoline, should grow faster because of global economic growth. Europe will continue to be a net importer of diesel/gasoil and a net exporter of gasoline. As the imbalance of net European trade flow increases, there will be growing dependence on the US gasoline market for exports and Russia/CIS for gasoil imports. We should expect increasing diesel exports from the U.S. into the higher-margin European and Asian markets.

Further Reduction of Utilization Rate Necessary

Royal Dutch Shell (RDS.A) CEO Jeroen van der Veer recently commented on the current poor refining margins, the world has more oil refining capacity than needed. So far, refining output cuts have not gone deep enough to balance the products markets and to support margins. Further cuts are expected through 2010, at the minimum. For example, stung by losses and slumping fuel demand, Valero Energy Corp`s (VLO) 16 refineries may run at just 78% of capacity during the 3rd quarter of 2009, down from its current 80-85% levels. Merrill Lynch estimates refinery utilization rates to fall to 81% down from around 85% last year. The latest data from the US IEA showed the domestic utilization rate at 83.8% in May, down from the peak of approximately 93% in 2004.

How About the Crude Oil Market?

As for future crude oil demand, the International Energy Agency and other leading forecasters still expect global oil demand to fall in 2009, though consumption is expected to improve toward the end of the year. (Fig. 3)



Based on market fundamentals, a decline in crude oil prices in the medium term is expected as extra crude oil production capacity and refinery conversion capacity becomes available. The recent increase in crude oil prices is considered to be largely due to a tighter crude supply/demand balance, although shortages of conversion sour & heavy crude capacity in the refining industry have contributed to an increase in the relative value of light crude.

Future Trend

Refining has been a low margin business for several decades and this is likely to persist. Although the industry has started to experience higher returns since 2004, the recent economic downturn across the globe has again transformed it to its traditional model of a high-investment, low-return business. As demand for products like gasoline is unlikely to fully recover in the coming years, and global refining capacity additions are expected to out pace incremental demand growth, with a flurry of proposed environment-related legislation all threatening to pressure global refining margins. Going forward, the sector’s margins will likely be sustained mainly by middle distillates, which will have steady demand.

Up till now, the refining sector is dominated by international oil companies (IOCs) despite recent nationalizations in some regions; however, National Oil Companies (NOCs) are expected to drive the refinery capacity expansion in the next few years as low returns discourage private investments resulting in China, the Middle East and India emerging as the global major refining hubs.

Where to Invest?

Instead of investing directly in the refiners, a better way to position portfolio holdings is to invest in companies like BASF (BASFY.PK), W.R. Grace & Co. (GRA) and DuPont (DD). In addition to a strong global presence and a diversified industry portfolio, these companies are also major players in the market for refinery catalysts, which play a key role to in helping refiners meet fuel standards, improvise operational efficiency, increase conversion & selectivity, and keep pace with the ever-present green movement. With the industry paradigm shifting to NOCs/international markets and increasing legislative requirements on the refineries, these companies are best positioned to take advantage and adapt to this low refining margin environment.

Disclosure: No Positions Sphere: Related Content

Health Care Reform – Good Intentions, Flawed Policy

Note: This blog post has been published on Daily Markets & Seeking Alpha

Author: Dian L. Chu, 08/16/09

President Barack Obama's plan to overhaul the US health care system got a major boost when the US House of Representatives committee approved the measure late Friday, July 31. A health care reform bill however is not yet certain as the Senate still needs to approve the bill, probably by the end of year.

The U.S. healthcare system represents about 17% of our annual GDP. President Obama's primary goal is to extend formal health insurance to low-income, uninsured individuals despite the nearly $300-billion-a-year Medicaid program. The president's health care plan would cost more than $1 trillion and increase our debt by $239 billion. More than $800 billion in tax increases would be necessary to pay for the massive administration of the government-run plan. (Fig. 1)



The President said that savings in spending on federal Medicare and Medicaid programs, as well as increasing taxes for high-income Americans, would help cover the increased costs of health care reform. A recent report by the White House Council of Economic Advisers also claims that the government can cut the projected level of health spending by 15% over the next decade, and by 30% over the next 20 years. Although the reduced spending would result from fewer services rather than lower payments to providers, and that this may be done without lowering the quality of care.

Dr. Martin Feldstein, professor of economics at Harvard University, and president of the National Bureau of Economic Research (NBER), who served as Chairman of the Council of Economic Advisers from 1982 to 1984, recently wrote:

“Although the president claims he can finance the enormous increase in costs by raising taxes only on high-income individuals…. Experience shows that raising the top income-tax rate from 35% today to more than 45%…would change the behavior of high-income individuals in ways that would shrink their taxable incomes… The result would be larger deficits and higher taxes on the middle class. Because of the unprecedented deficits forecast for the next decade, this is definitely not a time to start a major new spending program.”

As the UBS tax case illustrates, many wealthy Americans are already successfully evading the current tax structure through offshore accounts. That means a higher tax rate on these wealthy individuals would incentivize even more UBS-like tax evasion practices.

Other economists also predict the government will most likely pay for the health care plan with a carbon tax on fossil fuels (the cap-and-trade system), and will also likely resort to raising income taxes on middle-class Americans making between $50,000 and $250,000 a year. Companies would also find it difficult under the House measure to offer consistent benefits to employees in different locations because states could receive waivers to set up “single-payer” systems with the government as the only provider of coverage.

We don't need to go far to see the failings of a government-run health care plan. Canada's system is known as a “single payer” system, where basic services are provided by private doctors, with the entire fee paid for by the government. The rates are negotiated between the provincial governments and the province's medical associations, usually on an annual basis.

Studies by the Commonwealth Fund found that 57% of Canadians reported waiting 4 weeks or more to see a specialist. Another criticism of Canada’s health care program is the shortage of medical professionals caused by the non-competitive nature of an annually-negotiated doctor pay structure. In addition, a government-run health care program could also stifle R&D and innovation in the medical and technology field.

Indeed, for the 85% of Americans who already have health insurance, the health plan means higher taxes, less health care services, and even more inefficient bureaucracy. No one denies that our current health care system needs many improvements. However, forcing the 255 million people currently with coverage into a government-run system, and destroying the entire framework of health care in America is not the way to provide coverage for the 46 million uninsured. For health care reform to really succeed, we must eliminate waste, fraud, abuse, bureaucracy and pass medical lawsuit reform. It also must allow for direct patient choice of doctors and insurance, and protect the doctor-patient relationship.

Looking back at American history, in 1941, nine years after the beginning of the New Deal, unemployment in the United States was still around 15%. One of the reasons was that taxes on the top income bracket were about 80%, which severely inhibited entrepreneurism and new business development. So, the consequences were that the economy stagnated. Between the cap and trade plan and additional taxes on the middle class required to fund the health care plan, the U.S. will likely face double-digit unemployment and economic stagnation over the next decade. Sphere: Related Content

Seismic Services and the Price of Oil

This post was published by Seeking Alpha on Monday 7/27/09. Click here to view full reader comments and my replies.

Author: Dian L. Chu, 07/26/09

There are many sectors in the food chain of traditional energy that provide critical expertise enabling the efficient and profitable use of resources to expand our supply of oil, gas, and coal. One that comes to mind is the seismic data sector.

A Valuable Insurance Policy

Seismic data is collected with the purpose of creating a 2-D or 3-D image of the earth’s subsurface. This data is then used by oil and natural gas companies to reduce their drilling risk, and to more proficiently locate reservoirs and define oil and natural gas fields. Thus, demand for seismic services is driven by the Exploration & Production (E&P) activity, which is in turn driven by the price of oil, natural gas and final consumer demand. The land seismic segment is driven more by natural gas prices due to increasing shale activity; whereas the marine seismic segment is almost entirely dictated by the price of oil.


On an intellectual level, seismic surveying is like an insurance policy for a project. The value is especially high due to its relatively low marginal cost (typically less than 5% of the total project cost), and the vital role it plays in determining the economic viability of a project.

Highly Correlated with Oil Prices

After remaining fragmented for many years, this market sector has now consolidated around 4 main players, Schlumberger/WesternGeco (SLB) , Compagnie Générale de Géophysique-Veritas (CGV), Petroleum Geo-Services (PGS) and Fugro. There is the presence of a new market entrant - Polarcus; and the ramp-up of Chinese players - BGP and COSL, which are subsidiaries of CNPC, and CNOOC (CEO).


In the past two years, oil prices have hit new highs and then rapidly dropped back to levels that have forced many producers to look again at the economics of exploration and extraction. The sector demand has exceeded capacity since 2006, but now, like most aspects of the oil and gas industry, it has been hit hard by the worldwide economic slowdown. According to ODS-Petrodata, the market has been in a downward spiral, with falling day rates and less work available, particularly for older 2-D vessels. (Fig. 1)

Mired by Overcapacity but Risk Diminishing

Although the seismic industry is facing a challenging period, revenue in 2009 is somewhat protected by backlogs. However, the real impact is expected to manifest in 2010. The seismic sector continues to suffer from over-capacity of marine seismic vessels. Based on Petroleum Geo-Services estimates, a 20% growth in capacity is expected for 6+ 3D streamers in 2009 vs. 2008 and a 25% growth in 2010. The pressure on marine contract prices (15-30%) continue as over-capacity persists. However, further cancellations/pushbacks of new-build vessels can be expected in 2009 as players adjust trying to rebalance the market.

Current Down Cycle Sets up Next Surge?

As an early cycle segment, seismic is expected to fall harder than the other E&P sectors both in terms of scope and pricing levels. The bright side is that there is limited downside. The current oil price forecasts are in the range of $50-$75/bbl for the next 2 to 3 years, which could bump up seismic budgets from 2010 onwards. For example, in its July 2009 Short-term Energy Outlook, the US EIA projected the WTI crude price to average near $70/bbl through the second half of 2009, and about $72/bbl in 2010. (Fig 2)

In addition, according to consultancy Douglas Westwood, there are already $17 billion of investments (= 2 million b/d of future oil supplies) postponed or cancelled and an additional 4.2 million b/d delayed by at least 18 months. Meanwhile, OPEC cut its five-year forecast for E&P spending by about 30%.

The reduced E&P investment could translate into a tighter oil market down the road due to the long time frame of oil projects (about 4 years). The current oil inventory overhang is expected to get worked off as the global economy slowly recovers. The US EIA already warned of severe impact come 2012 and much higher oil prices. That warning was echoed by Saudi Arabian Oil Minister Ali al-Naim that the world could face another oil price spike similar to that witnessed in 2008 within two-to-three years.

A Different Exploration Cycle

Although energy demand has fallen recently, oil and gas companies continue to search for new reserves to compensate for the 5-8% a year depletion of the oil fields, as well as for ways to extract hydrocarbons from fields that were previously dismissed as too expensive or difficult to exploit.

New technologies, such as WAZ, electromagnetics, and 4D, are changing the nature of this business. Previously reserved for the exploration of new fields, it is now being adopted as a reservoir management tool in the most mature fields due to the economies of scale allowed by these new technologies. For example, WAZ surveys provide six times more data with just four times the resources.

Sustained Revenue Stream - Multi-client Data Library

Seismic companies also have been investing heavily in multi-client (MC) data libraries, usually with high pre-funding. The MC investment and its business model should generate a long revenue stream over the next 10+ years.

How to Play the Seismic Shift?

As growth seems to be out of favor in the oil services sector at the moment, and the market remains very uncertain, the more diversified Schlumberger and Fugro (FUR.AS) are safer bets than the pure seismic players like Compagnie Générale de Géophysique-Veritas, and Petroleum Geo-Services.

Schlumberger, the largest diversified oil service provider in the world, has adopted seismic as a core business line by investing billions in the seismic sector over the last five years. This strategy is unique and strongly contrasts with its large rivals Baker Hughes (BHI) and Halliburton (HAL), which have invested little in this area. Likewise, Fugro, a European service company, is leveraged in the ROV (Remotely Operated Vehicle) segment, which has a very positive outlook in regards to growth and margins. The ROV segment is expected to benefit from continuing offshore construction activity.

Fugro stock currently trades at a discount of approximately 20% compared with the other European oil services companies like Saipem (SPM) and Technip. Schlumberger stock historically traded in the 16-27x EPS range, it currently trades at around 20x estimated 2010 EPS.

Disclosure: No Positions Sphere: Related Content

Is Hydrogen the Best of the Green Fuels?

Note: This blog post was published by Seeking Alpha and Reuters on Monday, 7/20/09. Click to view full readers comments and replies.

Author: Dian L. Chu, 07/19/09

Special thanks to Mr. Mike Johnston for contributing to this article.

Currently, the U.S. and most of the world is in what would be called the fossil fuel economy. The majority of our power source is from oil, natural gas, coal, and petroleum products. We need energy to keep our world and society running; however, fossil fuel energy also creates problems such as pollution, climate change and imported oil dependence.

The large market and sharply rising prices in fossil fuels have stimulated great interest in alternate, cheaper means of hydrogen production. A recent ExxonMobil (XOM) ad introduces the concept of an on-board fuel reformer for vehicles. These devices combine water and oil (or another feedstock) to produce hydrogen fuel for the vehicle. The energy source needed may be in the form of wind, oil, nuclear as well concentrated solar thermal. Moreover, hydrogen has been identified as a key future fuel for low carbon energy systems such as power generation in fuel cells and as a transport fuel.


The estimated costs for producing and delivering hydrogen to the fueling station using today’s technologies vary from $2.10/gallon of gasoline equivalent (gge) to $9.10/gge, before taxes. According to a National Academy of Engineering 2004 estimate, projected costs using future technology if current R&D efforts are successful would reduce the cost of hydrogen to the range between $1.75/gge to $4.25/gge. Thus hydrogen is expected to be competitive with gasoline per mile driven.

In a pure hydrogen economy, the hydrogen must be derived from renewable sources rather than fossil fuels so that we stop releasing carbon into the atmosphere. While it’s likely to be many years before a pure hydrogen economy can be achieved due to infrastructure and storage issues, a mixed hydrogen economy scenario, where all energy sources coexist to produce a single form of fuel, could be a forerunner to this as sustainable, and more environmentally friendly.

This mixed hydrogen economy has the benefit of reducing not only pollution, but also greenhouse gas and oil dependence. In addition, hydrogen is the only fuel which can be produced by essentially the same process from a variety of domestically available feedstocks such as oil (petroleum) , vegetable oil, biomass, alcohol, natural gas, and biodiesel. Even sugar and coal become players in the transportation fuel sector in this scenario. Having this variety of choices when you make hydrogen is part of what makes hydrogen a universal fuel.

The transition to hydrogen fuel produced from multiple feedstocks would create a near perfect competition in the vehicle fuel sector. Producers would have to compete for market share as hydrogen becomes a generic commodity. This could also drive the R&D of new technologies as producers strive to stay cost and product competitive. In addition, we will have a more distributed production network since hydrogen can be produced anywhere that you have electricity and water.

Hydrogen production is already a large and growing industry. Although the world hydrogen production is not monitored, but based on various estimates, it is around 45 million metric tons a year, with about 20-25% produced in the U.S. The growth rate is estimated to be around 10% per year. As of 2005, the economic value of all hydrogen produced worldwide is about $135 billion per year.

Currently, global hydrogen production is 48% from natural gas, 30% from oil, and 18% from coal; water electrolysis accounts for only 4% (see Graph). Over 95% of the hydrogen in the U.S. is made from natural gas. Each year, the United States uses more than 9 million tons of hydrogen, 7.5 million tons of which are consumed at the place of manufacture. The remaining 1.5 million tons are considered to be "merchant" hydrogen, or hydrogen that is sold. Today, most of this hydrogen is used as a chemical, rather than a fuel. As hydrogen moves from these large industrial uses to something that you and I commonly use to fuel our businesses, homes, electronics and vehicles, other resources besides natural gas are expected to be used.

The recent proposal by the Pickens Plan to switch heavy trucks to natural gas is a step toward hydrogen as it puts gaseous fuels into common usage. A natural gas truck system can also run on hydrogen fuel with different storage tanks. In addition it is really the only readily available alternative fuel for the freight transportation sector since electric or fuel cell truck technology will take longer to come to market compared to passenger cars.

Most countries currently reliant on fossil fuels are investing heavily in hydrogen development programs. For example, several years ago, the Indian supreme court mandated that all public vehicles in Delhi, should be converted to run on compressed natural gas (CNG) as a means to fight the rising pollution problem. Currently, in India, five major auto makers, Tata Motors (TTM), Bajaj Auto, Mahindra & Mahindra, Ashok Leyland and Eicher Motors, are collaborating in a project to create an optimal mix of hydrogen and compressed natural gas (CNG). The hydrogen blend will reduce NOx and particulate emissions by about 50%. The hydrogen is four times the cost of CNG but has three times the specific energy, so the improved mileage is expected to mitigate most of the cost.

Hydrogen does have the same issue as the CNG sector, i.e., the lack of transporting, distributing and storing infrastructure, as described in my article - Investing in the Picken’s Plan, One Year Later. In addition, hydrogen has another major challenge - generating enough electricity without using more fossil fuels to produce the product. Nonetheless, hydrogen is one of the more developed sub-sectors within the green tech sector, and could potentially offer faster returns on investment as it is most likely to be widely adopted.

Although hydrogen seems well positioned to ride the green wave, in the current environment, it is more prudent to capture the potential upside of the sector with the more established and diversified players like Royal Dutch/Shell (RDS-B), General Electric (GE) and Siemens (SI) as opposed to the small pure players like Hydrogenics (HYGS) and FuelCell Energy (FCEL).

Disclosure: No Positions Sphere: Related Content

Yellen's Stagnation View: A Real Possibility?

Note: The following post was originally published by Seeking Alpha on Monday 7/13/07, and also on USA Today. Click here to view full readers comments and my replies.

Author: Dian L. Chu, 07/13/09

San Francisco Fed President Janet Yellen recently said there is no real threat of an inflation surge, and is instead expecting inflation to fall to around 1% over the next year. She also believes the risk of inflation remains very low, and that interest rates could remain near zero for several years.

Her commentary is in sharp contrast with numerous analysts and economists, who have argued that the government's massive liquidity injection and quantitative easing program will result in stagflation or even hyperinflation as soon as economic activity picks up.

What Yellen described is essentially stagnation, or economic stagnation, which is a prolonged period of slow economic growth, traditionally measured in terms of the GDP growth. Under some definitions, growth less than 2-3% per year is a sign of stagnation.

Japan has experienced economic stagnation for fifteen years. Adverse financial developments were at the center of Japan’s economic morass, which is no different from our current financial and banking crisis. Although recent data points to a gradually healing economy, the following are factors supportive of a stagnation scenario:

Extremely High Debt Levels



Between 1982 and 2007, the amount of total debt grew from $1.60 to $3.53 for each $1.00 of GDP. This was made possible as the cost of money fell from 15% to 20% in 1982 to the current near zero interest rate. As interest rates fell, consumers were able to take on more debt. Increased consumer debt levels boosted GDP over the last 25 years. Household debt has increased from $.44 in 1982 to $.98 for each dollar of GDP in 2007.

Higher Savings Rate



Columbia University professor Edmund Phelps, winner of the Nobel Prize in economics in 2006 said U.S. households may take as long as 15 years to rebuild wealth lost in the recession. U.S. household wealth fell by $1.3 trillion in the first quarter of 2009 after dropping by a record $4.9 trillion in the 4th quarter of 2008.

In addition, the largest demographic cohort in the history of mankind, the post WW II baby-boomer generation, has passed its spending peak. This is going to be a decade-long process of less spending, of more saving, and above all, of paying off excessive debt and recouping the wealth loss in this recession. The economic consequences are going to be profound and will affect all sectors of the economy.

The personal saving rate fell to near 0% in 2007 and early 2008. The last 12 months of the current recession have motivated individuals to increase the personal savings rate to 6.9% as of May 1, 2009, the highest in 15 years. This is part of the reason why the economy has been so weak since consumer spending represents 70% of our GDP.

Grim Labor Market

The gloomy job picture threatens any economic recovery. The unemployment rate hit 9.5% last month. Many now expect it to stay high for a long time, eventually reaching double digits. The broader measure of underemployed also rose to 16.5% in June. The latest employment figures indicate that with another 900,000 job losses by the end of the year, which is likely, an entire decade of employment gains will have been wiped out.

The U.S. industrial capacity utilization rate stood at 68.3% in May, a historic low. With so much excess capacity, businesses will not have to materially increase investment for at least the next 2 or 3 years. People facing unemployment or wage cuts are less able or willing to spend to stimulate the economy. One economic theory, the Phillips Curve, which is a historical inverse relationhip between the rate of unemployment and the rate of inflation in an economy, posits that such excess will reduce inflation as firms with idle capacity cut prices and workers facing layoffs accept smaller wage hikes.

Banks Are Not Lending



The level of lending is an important factor in determining how fast the economy will turn around. Lending at the biggest U.S. banks has fallen more sharply than realized, despite government efforts to pump billions of dollars into the financial system.

According to a Wall Street Journal analysis of Treasury Department data, the biggest recipients of taxpayer aid processed 23% less in new loans for February, the latest available data, than in October, the month the TARP program was initiated. One factor that may have masked the still tight credit conditions is the partial thawing of the corporate bond market, with a return of investors risk appetite seeking higher returns. About $70 billion in corporate bonds have been issued in February, up from $21.4 billion in October, but still only about half the level of last May, according to Thomson Reuters. However, the corporate bond market, where big companies go to raise capital -bypassing banks, are drying up quickly as well.

Conclusion

Indeed, the era of excessive spending and debt is over. For now, a quick resurgence in inflation is only a remote possibility. There is nevertheless a possibility, considering that central banks tend to have a hard time knowing when to take the punch bowl of “excess liquidity” away. The banking system remains crippled. Lending standards are high and are not coming down, as banks work to lower their leverage ratios from 30 to the low teens. An economic recovery will be unlikely until producers exhaust their existing capacities. Debt levels are so high that any increase in interest rates will impose a significant burden on consumers and the economy, thereby stunning growth.

On the other hand, in a near 0% interest environment, investors will need to take more risks to garner higher returns. It's also unlikely that the stock market can keep up a 9%-a-year average return as asset values stay depressed. So the wealth effect is not going to be increasing any time soon.

Therefore, the near term inflation concerns are overblown, as we are still in a deflationary environment. Unlike Yellen, who projects stagnation for the next 2-3 years, I could envision the scenario playing out for the next 18 months. In my opinion, any stagnation projections beyond 18 months are highly speculative, and reliant upon too many unknowns to be reasonably considered at this time. Sphere: Related Content

Investing in the Pickings Plan, One Year Later

Note: This blog post was originally published by Seeking Alpha on Monday, 7/6/09 and syndicated on Reuters. Click here to view full readers comments and my replies.

Author: Dian L. Chu, 07/05/09

This month marks the one-year anniversary of the Pickens Plan. The Plan, which aimed to end America's growing dependence on foreign oil, calls for investing $1 trillion in new wind turbines for power generation in the middle of the country that he said could meet 20% of the nation's electricity needs. While wind is generally regarded as an unreliable source of energy, a key component to the Pickens Plan is the use of natural gas. It proposes moving U.S. heavy trucks toward compressed natural gas (CNG).



Transportation accounts for about 28% of domestic energy consumption. (Fig 1) According to the American Council for an Energy-Efficient Economy (ACEEE), trucks used in freight (medium- to heavy-duty) account for 63% of energy used to transport freight, guzzling 2.4 million barrels of oil a day (MMbd). According to the U.S. Dept. of Energy (DOE), the United States consumed 20.7 MMbd of petroleum products during 2007 making us the world’s largest petroleum consumer, importing around 60% of it. If these trucks were converted to natural gas engines over the next few years, as proposed by the Pickens Plan, then domestic oil consumption would theoretically fall by about 12% (2.4 MMbd used in freight divided by the 20.7 MMbd consumption). A recent study done on behalf of the California Energy Commission concludes that CNG vehicles produce up to 29% less greenhouse gas emissions than comparable gasoline vehicles and up to 22% less than comparable diesel vehicles. Therefore, trucks are an important place to look for energy savings in the transportation sector.

Based on a June 2008 study by Navigant Consulting, the U.S. has enough natural gas reserves to last more than 100 years. New drilling technologies such as hydraulic fracturing are unlocking substantial amounts of natural gas from shale rocks. For example, the Haynesville shale play is expected to produce 7 to 8 billion cubic feet of gas a day by 2016. In fact, the amount of natural gas available for production in the U.S. has soared 58% in the past 4 years.

The huge increase in estimated natural gas supplies comes just as concerns about energy security and climate change are prompting the most profound shift in energy policy since the oil shocks of the 1970s. The finding also raises the possibility that natural gas could emerge as a substitute for other fossil fuels to help combat global warming as it burns cleaner than both coal and petroleum. Natural gas currently accounts for about a quarter of the nation’s total energy use, and 29% of electric power generation (Fig. 1). Coal accounts for about half of the nation’s power generation (Fig. 1), while oil dominates transportation fuels (Fig. 2). So, it is logical to push some of the coal and petroleum market share towards natural gas, since we have ample domestic supplies.

However, using natural gas in transportation is not without its issues. In its recent Annual Energy Outlook, the Dept. of Energy (DOE) projected a 6% annual growth rate of natural gas used in the transportation sector from 2007 to 2030, the DOE also estimated that transmission of gas to market, compression, and taxes equivalent to those levied on diesel will add at least $7 per million BTUs to the price of gas for trucks and other transport users (Annual Energy Outlook 2009, AEO 2008, Table 13) thereby causing natural gas to lose its price advantage.

There are about 150,000 natural-gas vehicles on U.S. roads today, and 1,500 natural-gas vehicle fueling stations, with only about 750 available for public use. The majority are used by bus and transportation fleet companies like UPS. But according to a UPS case study, CNG technology has a fuel economy penalty of 10%-15% compared with diesel technology. The UPS study also indicated that CNG trucks require greater use and longer preventive maintenance inspection cycles to contain the otherwise 29% higher maintenance costs in comparison with diesel trucks.

Infrastructure poses another challenge, as the CNG sector has been unable to make any inroads with the consumer market. Until consumers can find natural-gas stations on their way to work, the alternative fuel won't attract commuters. NGVAmerica also says the very limited distribution network for natural gas stations would better serve commercial fleets and long-haul trucks. For now, Honda (HMC) is one of the very few manufactures using CNG technology to target consumers with its Civic GX at 36 mpg highway gasoline gallon equivalent (GGE).

There are also issues that could potentially affect the supply side of the natural gas equation. The sudden increase in supply, combined with a drop in demand amid the recession, has led to a gas glut, pushing prices down to $3.60/mmbtu on Friday 7/5/09 at NYMEX close, down approximately 73% from the 2008 high of $13.69/mmbtu. The current low natural gas price has made it uneconomical to drill for gas wells, evidenced by more than 50% rig count drop since Sep. 2008. In addition, the extensive use of water and chemicals to fracture shale rocks have raised environmental concerns that hydraulic fracturing will pollute drinking water, and Congress is considering tighter regulation of the practice, which could add an additional cost to natural gas drilling and production.

Oil imports cost the U.S. about $21.6 billion in May. Increasing natural gas market share as a power source for vehicles and industrial applications means less dependence on imported oil and would strengthen America's energy independence. In the power sector, utilities have been switching to natural gas from coal, thereby taking advantage of low commodity prices and hedging against costly climate-change legislation. However, in order to achieve a large scale of natural gas transition, there has to be a concerted and coordinated effort from both the government and energy industry. It will take a non-partisan effort to work out details like CNG transportation, taxes, and the CNG stations, for natural gas to be competitive with conventional fuels. With both a thoughtful energy policy and a collaborative energy industry, natural gas definitely has a niche to fill as a substitution fuel as well as a transition from fossil fuels to renewable fuels, due to the long lead time and scalability issues of renewable fuels.

For investors wanting to participate in this market sector, gas-weighted producers like Chesapeake Energy (CHK), and Quicksilver Resources (KWK) could be attractive as both stocks are trading at 60% discounts to their respective estimated net asset values. But they also present a higher risk due to their substantial level of debt. On the other hand, EOG Resources (EOG) and EnCana Corp. (ECA) currently trading at 36% and 7% discounts respectively to their estimated net asset values, would be more conservative long-term plays in this sector.

Disclosure: No Positions Sphere: Related Content

Cap and Trade Will Severely Harm the Steel Industry

This blog post was published by Seeking Alpha on Sunday, 6/28/09

Author: Dian L. Chu, 06/27/09

Landmark legislation to curb U.S. greenhouse-gas emissions was approved by the House of Representatives in a close vote late Friday, June 26, 2009. Obama and other Democratic leaders insisted it will spur job-creating investments in "green" technologies, while lessening U.S. reliance on foreign oil. The numbers are staggering. Obama's recently unveiled cap-and-trade plan would raise $645 billion in revenue from government-run emissions auctions over eight years. The nonpartisan Congressional Budget Office (CBO) projected the bill to have an annual economy-wide cost in 2020 of $22 billion, or about $175 per household. However, the CBO study failed to consider the broader effect of the legislation on employment or GDP. The hit on the U.S. GDP is the real threat of the bill.

A cap-and-trade system is simply a mechanism to put a price on emissions in order to compel businesses and consumers to emit less. That is, it's essentially an emissions/energy tax, since almost all economic production activities are powered by combusting fossil fuels (coal, oil, and natural gas), a process that emits greenhouse gases. Once a scarce new commodity, i.e., the right to emit carbon, is created, and businesses are mandated to buy it, the costs would inevitably be passed on to all consumers in the form of higher prices. Everyone would feel the pinch. These higher prices on electricity and gas will show up in the manufacturing sector from food to cars, all the way down to electricity bills and at the gas station. The hardest hit would be on the working families, which is about 95% of the U.S. population. As higher prices are passed along to the consumer, consumers will cut back on spending, which in turn will reduce production resulting in fewer jobs or higher unemployment. Some companies will instead move their operations overseas creating further loss of jobs.

One may also take a look at similar policies already implemented elsewhere. For example, in Europe, cap-and-trade has failed to deliver on climate change. It yielded windfall profits for utilities, but few reductions in emissions or investments in clean technology. Britain's Taxpayer Alliance estimates the average family there is paying nearly $1,300 a year in green taxes for carbon-cutting programs in effect only a few years. Spain has been touted as a global example in promoting renewable energy to create green jobs. But research shows that each new job cost Spain 571,138 euros, with subsidies of more than one million euros required to create each new job in the wind industry. Moreover, the programs resulted in the destruction of nearly 110,000 jobs elsewhere in the economy, or 2.2 jobs for every job created.

Business groups in the U.S. are split on the measure. Utilities that stand to benefit from the free-permit program support it. The U.S. Chamber of Commerce and the National Association of Manufacturers lobbied against it. The oil-refining sector that will receive 2% of the free permits, denounced the measure as "an abject policy failure." Steel companies also opposed the measure. The domestic steel industry would be one of the hardest hit sectors and could be severely impacted under the cap-and-trade system. The integrated mills such as U.S. Steel Corp. (X), AK Steel (AKS), ArcelorMittal (MT) and OAO Severstal would be among the biggest losers because they produce steel using iron ore and coke. The main input material, coke is made of carbon. If steel companies are mandated to reduce carbon-dioxide output or pay more for their emissions, they would be forced to raise prices or cut production. Under the worst case scenario, the integrated steel operations would move to developing nations without carbon restrictions, such as Brazil. In this case, the carbon emissions wouldn't be reduced, but U.S. jobs would be lost.

On the other hand, minimills, like Nucor Corp (NUE), and Commercial Metals Company (CMC) make new steel by melting down scraps. Re-melting steel emits nearly 66% less carbon dioxide in the production process. Nucor Corp. (NUE) is now the largest producer of domestically made steel, having supplanted U.S. Steel (X). However, it is not feasible to switch domestic steel operations entirely over to the minimill process, because some types of the more rust resistant steel, such as cans for food, still have to be made through the integrated steel process. While minimills wouldn't be affected as much as integrated mills by the legislation, they still oppose the current plan. Both camps are concerned the bill could give a competitive advantage to firms in countries that don't operate under emissions caps.

Another potential problem area: the House bill has a provision that would impose tariffs on goods imported from countries that don't match U.S. carbon dioxide restrictions, like China and India. Naturally, these countries would retaliate by putting tariffs on U.S. exports, which could provoke a global trade war. Protectionism deepened the Great Depression, just as climate protectionism would worsen the current recession.

Although it isn't clear how much of the House bill will survive in the Senate, in the case of climate change, we need to create strong incentives to increase energy efficiency throughout the economy and to invest in new clean-energy infrastructure. Cap-and-trade is an ineffective tool for that, because it does not reliably end fossil fuels' price advantage. Given the current economic crisis, an expensive energy policy is a very bad idea. Most economists agree that the simplest, most efficient system to reduce carbon emissions is via a direct tax, a political impossibility in the U.S.; therefore, we ended up with the cap-and-trade system. Just as the stimulus program has very little allocated to projects that will actually create jobs to revive the economy, the current cap-and-trade system, instead of being an effective clean air policy, is just another tax burden on both businesses and consumers. Sphere: Related Content

Land Driller Sector Outlook: It's All About the Natural Gas

Note: This article is published by Seeking Alpha .

Author: Dian L. Chu, 06/22/09

Baker Hughes rig count rose by 23 last week, marked only the second time this year the weekly count has increased. Meanwhile, the possibility the rig count has bottomed seems to have led some to believe it is a green light to buy shares of land drillers. The market is also anticipating a natural gas price rebound sometime late this year partly because producers have sharply cut back their gas production over the past few months, as well as seasonal factors like hurricane & the upcoming winter heating months.


Data Source: Baker Hughes & the US EIA

Domestic rig count has crashed 56% since the peak of 1,906 at the end of last August as weak demand has hampered activity. The amount of natural gas production in the U.S. has soared 58% in the past four years as a result of a five-year-long drilling boom spurred by high natural-gas prices, easy credit and new technologies that allowed companies to produce gas from the discovery of huge new shale gas fields in Texas, Louisiana and Pennsylvania. The sudden increase in supplies, combined with a drop in demand amid the recession, has led to a gas glut, pushing prices down to $3.98/mmbtu yesterday at NYMEX, down approximately 71% from the 2008 high of $13.694/mmbtu.

Tudor, Pickering, Holt & Co. now estimates that the domestic natural gas market is oversupplied by 4 bcf/d. Power companies are beginning to ratchet back investments in coal-generated plants to take advantage of low gas prices and hedge against costly climate-change legislation. Some believe coal-to-gas switching has created incremental gas demand, and further switching potential is still large. However, the production cut, and the incremental demand from the power gen sector are unlikely to balance the domestic natgas market anytime soon with the exiting inventory overhang and the expected new LNG cargos coming into the US.

Since 80% of the U.S. rigs are chasing natural gas, the poor market fundamentals could mean an extended L-shaped pattern for domestic drilling activity through at least 2010, and quite possibly 2014. This could certainly mean a shake-out coming among land drilling contractors. As lower commodity prices and an uncertain economic outlook continue to plague the oilfield service industry, the near-term market could remain volatile. For now, it is best to remain on the sidelines as utilization and dayrates of all rig classes will suffer under larger macroeconomic issues, which will likely be an overhang for these stocks. Investments with international exposure, term contracts, and companies with higher quality assets are better defensive plays. Big drillers with high quality rig fleet such as Nabors Industries, Ltd (NBR) and Helmerich & Payne Inc.(HP) are best positioned to benefit from the industry shakeout and the eventual increase in drilling activity.

Disclosure: No Positions Sphere: Related Content

TIPS Yields Signal New Inflation Concern

This blog post and chart was published by Seeking Alpha on 6/15/09:

Author: Dian L. Chu, 06/14/09

The spread between rates on 10-year notes and 10-year Treasury Inflation Protected Securities (TIPS), which reflects the outlook among traders for consumer prices, reached 2.13% last week, a 10-month high. This is the first time since the collapse of Lehman Brothers in September the spread surpassed 2%, implying an expected annualized inflation of 2+% over the next decade. That marks a turnaround from the start of the year, when deflation was the main concern. Now, the massive amount of money being pumped into the system is sparking fears that the Federal Reserve will be unable to keep prices in check.


Source: U.S. Bureau of Labor Statistics

Inflation worries began to take hold in the past few weeks also pushing the treasury yield higher. Yield of 10-year notes hit 3.99% last week, 4 bps higher than before the auction, representing the biggest yield markup since May 2003, according to Morgan Stanley, and sharply higher than March’s 2.5%. The 30-year bonds also drew the highest yield in almost two years, at 4.81% from below 4.50% just a week before.

TIPS strength was also driven by the recent sell-off in nominal Treasuries as the deflation scenario fades, while budget deficits, protectionism and regulation inevitably will drive inflation higher. So far, Treasuries have tumbled 6.5% this year, the worst performance since Merrill Lynch & Co. began tracking returns in 1978, as bond holders require higher yields to hold US debt because the current administration has quadrupled the budget deficit to $1.85 trillion while raising the risk of inflation. The U.S. may borrow $3.25 trillion in the fiscal year ending Sept. 30, almost four times the $892 billion in 2008, according to Goldman Sachs.

Interest rates on business loans to mortgages tend to move in tandem with Treasury rates. There is growing concern about the trend’s potential impact on the wider borrowing costs crucial to a sustainable recovery. Meanwhile, the industrial production decreased 0.5% in April, and was 12.5% lower Y/Y. The capacity utilization rate fell to 69.1% in April, a new historical low since 1967. This unprecedented excess capacity could remain till 2015 before all the slack is used up, and that's if GDP grows 4.75% per year, based on Goldman Sachs estimate. However, the economy is not likely to grow that fast because no significant investment will be needed for the next 2 or 3 years with so much excess capacity. The unemployment rate is heading over 10%, and maybe up to 12% next year. Even if job growth were to average 325,000 per month in coming years, it would still take 4 years to replace all the jobs lost in this recession. With so much excess labor capacity, wage growth will be weak for the next few years, which will make it harder for consumers to increase savings and spending.

The combination of higher debt, tighter credit, weaker business investment and consumer spending will make it difficult for a self sustaining recovery in the U.S. to develop in 2010. While it is likely that inflation could remain at low levels and stabilize in the next 2-3 years, it is at least as likely that it will overshoot old targets in the long run. A mixture of inflation, exchange rate depreciation and taxation are well documented responses by governments to high and rising public debts.

In order to gauge the overall inflation rate, it is important to look at the inflation rate of commodities, as commodities are directly tied to the effects of quantitative easing policies. Pricing change in commodities serves as a leading indicator to the overall inflation rate as commodities are inputs to all finished goods. If we analyze the historical pattern of the U.S. Producer Price Index-All Commodities (see chart) for the last decade, the average annual percentage change is approximately 4.3%. If history is any indication, the current expectation of an annualized 2% inflation rate for the next 10 years, given current quantitative easing policies, is grossly underestimated.

In this scenario, investors need to hold more overseas assets as returns on most domestic assets are likely to remain depressed. U.K. index-linked gilts, for example, could be a good place for a long position as the U.K. inflation rate is expected to reach 4.6% by the end of 2010, from 2.3% in April, providing higher return than TIPS, according to HSBC, Europe’s biggest bank. Investors also need to look for investment vehicles that can be highly adaptive to this new environment through alternative assets such as forestry with its protection against inflation and tax advantages to provide significant higher returns.

The stretch of 25 years, from 1982 until 2007, may be the best 25 years in U.S. economic history. But much of this prosperity was financed with debt. So, sometime in the last 25 years, we passed the point of no return. The coming new inflationary wave will likely transfer wealth from the consumers in the west to the producers in the east. The east will become increasingly attractive to free market capital as western countries become mired in the capital and wealth allocation dilemma. Sphere: Related Content

The Iron Ore Negotiation's Impact on the Steel Industry

This blog post is published by Seeking Alpha on 6/5/09:

Author: Dian L. Chu, 06/01/09

Rio Tinto became the first of the three big iron ore suppliers to agree to a 33% cut of the benchmark iron ore price starting April 2009 with Japanese mills including Nippon Steel as well as South Korea's POSCO. However, China bucked protocol and rejected the agreement. CISA (China Iron & Steel Association) is insisting on cuts of at least 40%, taking it back to at least 2007 levels. Rio's competitors BHP Billiton and Vale of Brazil, the leading supplier, have yet to announce any similar deals.

In the past four decades, traditional ore pricing was based upon long-term framework contracts between steelmakers and the big three miners, Rio Tinto, BHP Billiton and Vale, with annual negotiations to settle prices for 12-month periods. The secretive annual talks influence the billion-dollar ore trade market and the global economy as ore prices ultimately influence the prices of goods such as cars and machinery. Once the first price agreement is negotiated as a benchmark, then the rest of the industry follows. While the ore benchmark system has served the steel industry well, it has come under strain as China has grown more powerful in the global commodities market. Securing the benchmark price for China is significant for the miners, as China's demand for iron ore in 2008 was 444 million tons, more than half of the world's total.

The past six years have seen the ore price rise 500%. The 33% cut actually represents a premium when compared with current spot prices, which is around 40% lower than the long-term contract price. Spot iron ore prices slipped below long-term prices in late 2008 as demand from China crashed. The new agreement is actually a better outcome for the miners than analysts’ consensus of a 35-40% cut. Steel production and prices have plunged in recent months as the global economic downturn has battered demand. For the steel companies, the 33% cut, the first in seven years, no doubt will reduce costs and improve margins. As most mills long-term material supply contracts are renewed in March, analysts estimate overall cost of steel-making raw materials, including coal, may fall about 50% Y/Y, bigger than steel products price decline. In addition, crashing freight costs should also yield lower costs for steel producers everywhere.

This unprecedented split between China, and other top buyers and suppliers, is sowing uncertainty for the key steel-making ingredient. Miners believe China's 4-trillion-yuan ($586 billion) stimulus package and the new steel futures contracts might help spur steel demand. However, most steel companies believe that the global economy is still in contraction, and steel supply still outweighs demand.

Iron ore supply increased 30-40% last year as production capacity rose. Meanwhile, global demand for steel declined. CISA now expects China steel exports to fall nearly 80% this year. Although expectation of a China State-led construction boom has triggered a new round of inventory build-up, analysts do not expect an immediate pickup, as the stimulus package may just barely offset the weakness elsewhere. In addition, some steel producers, such as US Steel Corp. and Arcelor Mittal, have their own iron ore mines, while others such as Nucor Corp. make steel by melting scrap in electric furnaces. Based on market fundamentals, a recovery in the steel market is likely to be L-shaped as opposed to V-shaped. Steel prices should level off in the coming months as the economy stabilizes resulting in a surplus for global iron ore in 2009.

As a result of falling iron prices, steel producers have room to reduce prices and still maintain margins. Although majors like Arcelor Mittal indicated they would rather cut production than let prices fall. So expect resistance from the steel mills in passing through the raw material cost reductions. However, unlike the iron ore market where the top 3 miners control nearly 80% of the global seaborne ore market, the global steel industry is still highly fragmented despite considerable industry consolidations in recent years. As other smaller producers drop prices to secure sales, the majors may have no alternative. This is expected to be part of a long-term trend running through 2009. The gap between spot prices and long-term contract prices will narrow and spot prices may overtake long-term contract prices. It seems likely that system will continue to trend toward a mixture of benchmarking and indexing to the emerging OTC swap market. Another possbililty is that instead of being negotiated once a year, the iron ore contract could be negotiated on a quarterly basis next year amid the reduced demand. Sphere: Related Content

The New CAFE Standards - Let's Do Some Math

Author: Dian L. Chu, 05/23/09

As part of President Obama's National Fuel Efficiency Policy, the corporate average fuel economy (CAFE) rules require automakers in the U.S. to meet average efficiency standards of 35.5 mpg by 2016, 4 years sooner than planned under the Bush administration. The change in rules would for the first time combine vehicle pollution reduction with increased driving efficiency. It supposedly would save 1.8 billion barrels of oil through 2016 and reduce greenhouse-gas emissions by 900 million tons through 2016, the equivalent of taking 177 million cars off the road. It is a historical and sweeping measure. But it is also inefficient, and probably ineffective to curb fuel consumption, dependence on foreign oil and in helping the Big Three in Detroit.

Let's crunch some numbers here. One barrel of oil produces about 19.6 gallons of gasoline. If CAFE saves 1.8 billion barrels of oil between today and 2016, which means a total of 35.3 billion gallons of gasoline will not be used. This translates into lost tax revenue of about $16.1 billion on the federal and state level between now and 2016. No contingencies have been built in for that $16.1billion in lost revenue, which is supposed to fund infrastructure projects and jobs.

The new rules will also have the possible effect of encouraging driving by making it cheaper, wiping out any possible greenhouse emission benefits. From 1970 to 2001, the US made cars almost 50% more efficient, but the average number of miles a person drives doubled. CAFE is expected to add an additional $1,300 to the cost of a new car by 2016. As for greenhouse emissions, cars and light trucks subject to fuel economy standards make up only 1.5% of all global man-made greenhouse gas emissions. So, until we can rein in the emissions on a large enough scale, CAFE standards are unlikely to make a substantial difference in the environment to justify the costs. We will end up paying more for cars while continuing with similar or worse carbon dioxide levels.

The basic issue with the CAFE standards is that, rather than changing demand patterns, they attempt to control supply. American drivers behave much like other consumers. When the oil price rose sharply last year, sales of light trucks collapsed and demand for hybrid and electric cars rose. As oil prices fell, the old patterns returned. So, a gasoline tax of $1 or $2 per gallon would seem more effective in altering consumer behavior and giving a clearer signal to manufacturers to produce more fuel-efficient vehicles. Unfortunately, raising the federal gasoline tax to levels that would make a difference is not politically achievable in the US. Sphere: Related Content

Crude Oil & Equity Markets to Decouple?

Author: Dian L. Chu, 05/13/09

Crude oil and equities markets, which traditionally have a negative correlation, have moved in tandem over the past three months. Some analysts think markets will decouple as the steep overhang in crude inventories, which reached a 19-year high in the US, and ongoing weak global energy demand could eventually mute oil's response to a solid economic recovery and break the market's positive correlation. Before reaching that conclusion, we first need to look at the driving forces behind the recent market rally.

Investors have generally interpreted recent reports on employment and housing as indications of an economic rebound as well as justification to buy stocks, which had pushed the Dow up more than 29% over the last nine weeks. Markets have been helped essentially by a steady influx of money from investors cashed out during the market's plunge sitting on the sidelines.

Meanwhile, oil speculators are also making similarly optimistic bets. Oil prices touched above $60/bbl for the first time in six months on Monday. The leading global commodity index, S&P GSCI, also soared to its highest level since November and is up 20% this year.

The commodity markets were boosted by signs of economic recovery, a weaker US dollar and growing investor risk tolerance. April trade data out of China showed strong domestic demand for commodities. Imports of copper, soybeans, iron ore and crude oil are respectively up 62%, 55%, 33% and 14% year over year, with imports of iron ore and copper hitting new all-time highs. This is reflecting in part Chinese government's fiscal stimulus package turning demand around, but also Beijing's taking advantage of lower prices to build up strategic reserves. In fact, this buying by China has been the key to limiting a huge build up in global surpluses and lower prices. Nowhere else in the world in recent months has there been any noticeable recovery in commodity demand. So the real risk now in the commodities is that when China slows or stops buying, which is likely if the prices keep going up.

It is evident that recent market strength is based on financial inflows. There are already reports of money starting to flow from hedge funds and institutional investors. The rise in commodities prices has also been helped by the weakness of the US dollar, which hit its lowest level against other currencies since Obama's inauguration in January. As most commodities are priced in US dollars, their prices usually rise when the US currency weakens.

The current crude oil supply and demand picture is still weak, even taking into account China’s swelling imports. Part of the recent oil price spike is also seasonal as May starts the traditional driving season. Despite topping $60/bbl, oil prices should retreat to reflect the current market fundamentals, which only support perhaps around $50/bbl range, as speculative money was the main reason behind the oil and commodity rally.

So Far, investors have shrugged off news that some major U.S. banks need to raise capital, and that Chrysler is in bankruptcy and GM is not far behind. The commercial real estate market and deleveraging is likely the next to unravel. The markets will eventually face reality and the true risks of the economy. Before then, this current trend of money influx could continue for probably another one or two months as investors fear missing the buying opportunities. Until the oil market begins to focus more on fundamentals, movements of equities should still have a strong pull over crude. Sphere: Related Content

Ethanol Futures to Gain from Higher Crude Oil Prices?

Author: Dian L. Chu, 05/07/09

Some analysts expect that ethanol futures may be poised to rise after U.S. gasoline contract prices exceeded those of ethanol for the first time since Oct. as signs of economic recovery boosted oil. Gasoline prices have gone up on the back of rising equity and oil markets during the past 3 months.

The U.S, Brazil & European Union are the top 3 ethanol producers in the world. Prices of biofuel plunged after Sep. 15 when Lehman Bros. filed for bankruptcy. After peaking at the $1.00 mark in Oct., the ethanol crush spread has retreated sharply. Declining corn prices should help, since corn accounts for about 70% of ethanol's production costs, but some producers suffered significant corn hedging losses. VeraSun, for example, has since filed for bankruptcy.

Based on Bloomberg's data, ethanol for June delivery on CBOT settled at about $1.65/gal, vs. $1.6604/gal for gasoline on NYMEX on May. 6. On May 5, Archer Daniels, the 2nd largest U.S. ethanol producer after Valero Energy, noted that based on the current $0.45/gal tax credits, and prices of corn, "ethanol margins are cash-flow positive." In addition, ethanol could also get a boost from the planned $786 million in economic stimulus funds from the Obama Administration.

Though these are signs of hope for the ethanol industry, the market fundamentals paint a different picture. The Renewable Fuels Assoc. (RFA) estimated that ethanol production in the U.S. will be up in 2009, to about the 10-billion-gallon level, representing nearly 9% of U.S. gasoline supply, still below the industry's current 12.4 billion-gallon capacity. However, another 2 billion gallons of capacity are under construction. Although federal ethanol blending mandates and subsidies provide a floor for the industry, rapid capacity expansion has led to oversupply. Total capacity now exceeds mandated levels through 2011, putting surplus ethanol into direct competition with gasoline.

Ethanol and gasoline basically have the same underlying demand base. The recent collapse of gasoline prices have led to an inversion in the ethanol to Gulf Coast gasoline differential. Weak economics have prompted many blenders to buy renewable fuels credits to cover their requirements without using ethanol. So far, US ethanol producers have idled an estimated 20% of their capacity. Compounding this issue is the fact that US gasoline demand is heading south.

This gloomy picture will likely continue through 2009. Looking into 2010, the new administration strongly favors renewables and alternative energy; however, food (corn) as a fuel source remains controversial, the new pipelines required to transport ethanol are costly, and with other promising energy sources like algae on the horizon, ethanol outlook does not look as bright as some might think. Sphere: Related Content

Crude Oil & Natural Gas on Separate Paths, For Now

Author: Dian L. Chu, 04/26/09

U.S. crude oil inventories are at a 19-year high, and Rotterdam, Europe's largest port, is running out of space to store crude oil. Oil inventory overhang is further aided by ~3.0MM b/d of imported products, and growing ethanol supplies of nearly 700,000 b/d.

Based on the forecast from IHS Herold/CERA/Global Insight joint web conference this week, which I attended, the world economy is not expected to come out of recession, i.e., above 3% GDP, until 2011. Growth in oil demand and non-OPEC supply will return to positive territory in 2010, and resume growth in 2011. With the contago in WTI crude forward price curve moderating since early Feb, crude prices will likely be in the trading range of $45-55/bbl through 2010.

Similar to the crude oil, the U.S. natural gas has also been under pressure from excess inventories (see my 4/21/09 post.) However, Natural gas and oil are taking different paths, oil prices have gone up this year, while natural gas prices are approaching 6-year lows.

Theoretically, based on volume conversion rate, crude oil and natural gas prices should have an 6-8 to 1 ratio. However, due to various market characteristics, the price of oil has been following a pattern of 10-15X that of natural gas since 2006. The current WTI/Henry Hub price ratio is about 15X. LNG is expected to "globalize" the the natural gas market making it more competitive with crude oil. A lot of the LNG contracts now are priced to index crude. So give it some time for a global natural gas market to develop and mature, the prospects for the 8 to 1 ratio appear bright probably by 2015. Sphere: Related Content

Natural Gas Prices Continue To Show Considerable Weakness

Author: Dian L. Chu, 04/21/09

On April 8, the Henry Hub natural gas spot price fell to $3.50/mmbtu, its lowest level since September 17, 2002, when the spot price averaged $3.46/mmbtu. Natural gas price has declined about 37% this year and is down approximately 74% from the 2008 high of $13.694/mmbtu.

Domestic natural gas supply levels greatly increased in 2008 because of drilling in shale gas plays and has continued into this year. Now, LNG (liquefied natural gas) is expected to downright flood the U.S. market this year, as global LNG investments over the past several years come on stream. With slumping Asian demand, excess LNG cargos will have no place else to go but here, since the U.S. has the largest underground storage capacity.

Right now, the natural gas market has to overcome a inventory overhang of ~400 billion cubic feet, a third more than a year ago without the expected incoming LNG. The economic weakness that led to the fall in industrial demand for natural gas, which is projected to decline by 7+% this year by the EIA, may persist beyond 2009. Falling rig counts and producers like Chesapeake Energy shutting in production will eventually provide support for natural gas prices, which could take up to a year.

Consultancy Paradigm Capital estimated nearly 25%-30% of U.S. gas production comes from wells drilled in the last 12 months, with the sharp drilling decline, there is a possibility the US may need to import for the winter of 2009-2010. This suggests domestic natural gas prices may firm up a bit by the fall of 2010, but various supply and demand factors could cap the upside at $6/mmbtu, quite possibly through 2011. Sphere: Related Content