The Long and Short of It
by Brian Pretti CFA, Contrary Investor. April 23, 2010
It has been a very long while since I’ve taken up a big chunk of a discussion to write about crude oil. The time is now for a multiplicity of reasons. You know the old market truism that after bear markets in equities, old leadership rarely emerges as new leadership. And of course energy was the sector leader of the last 2003-2007 equity bull. Without fail, so far in the current journey energy has lagged in terms of relative performance big time. At least over the recent past, energy has been plagued by a number of headwinds. Very near term US dollar strength has not been a big positive for oil and energy broadly, to say nothing of the aggregate commodity complex. Secondly, at least as measured by banking system derivatives exposure, derivatives related commodity exposure still remains very meaningfully weighted in terms of institutional exposure. Bank commodity derivatives exposure, being reflective of this institutional exposure, is down from its peak a few years back, but not by much. Still a “crowded trade” on the derivatives exposure side? Not wildly so, but certainly not a neglected trade either.
And in terms of energy equities as a sector weight within the S&P, even oil prices climbing to what most would have considered unimaginable levels over the last 18 months only brought energy stocks as a sector percentage of the total S&P up to the average weight of the last three decades. Hardly a bubble and just a bit less than half the weight of financials just two years ago.
Without question physical oil demand worldwide has suffered a bit over the 2008-mid-2009 economic downturn period, but has been strengthening meaningfully over the last few quarters with incredible global reflation efforts. The following data courtesy of the IEA shows us exactly that as we look at the reality of global supply and demand numbers over 2008-2009. But as global governments and central banks have acted to resurrect growth, you can see the IEA expects crude demand to pick right back up in the current year to very near all time highs. Indeed the energy sector has just not been as attractive as the slingshot rebounds we have seen in consumer discretionary, tech, etc. during the current rally. For now, earnings from the energy sector remain maybe 10%+ below the prior peak.
In terms of the big oil consuming dawg on planet Earth, the US, oil imports have declined more than noticeably over the past year or so, again very reflective of the general tone of the domestic economy. Certainly this has caught investor attention. Yes, the media and politicians crow about the incredible economic recovery we are seeing, but oil demand does not lie, only people do. Although indicators like year over year rate of change in industrial production, cap spending, retail and manufacturing numbers look good perceptually, absolute levels of economic activity are at two to four year lows as we speak, exactly paralleling the rhythm of US crude imports we see below. Reality, what a crazy concept, right? If you want to know the truth about the tone of the US economy, look at oil imports, utility capacity utilization, etc. – the reality of energy that powers US economic growth. Certainly what you see below is more than well known and not a resounding near term crude positive.
Finally, one of the perhaps most important short term headwinds for energy prices, even if only important perceptually, has been the fact that as of about a year back, crude was in pretty darn serious contango (longer term crude futures prices well above current spot prices). But that has all changed in the last year as the “contango curve”, if you will has flattened significantly. What does this mean? Although I do not have the hard numbers, over the last year you have heard that a number of investors (think hedge funds) and large banks have supported speculative demand for crude because of this very contango circumstance. Buy the oil and store it, and sell a futures contract at a higher price (the very essence of contango) that basically guarantees or locks in some type of profit (after all purchase and storage fees are paid). So now that the contango curve has flattened, the speculative investment demand created by this financial market circumstance will be no more. The numbers no longer work in terms of the economics of the transaction we described. In other words, the fear is that the contango trade cannot be rolled over economically at present and the prior stored oil that was accumulated while crude was in contango will now hit the market as increased physical supply. Just how much oil is out there in speculative storage, so to speak? Enough to have accounted for about 5% of the world’s crude tanker fleet has been a number that has been thrown around. Bottom line? Speculative demand for crude is gone and big time real supply is about to come on the market. That's the fear. If there is any saving grace here at all, it’s that this supply should theoretically be hitting at the exact calendar period of increased seasonal demand for crude (the summer driving season). At least historically, a collapse in contango circumstances has not been a wonderful short-term event for crude (or any other commodities in similar circumstances for that matter). Only issue being, this fact should now be more than well known and we’d expect discounted in prices.
So now what? Do we face a collapse in crude prices short term? Who knows? Energy equities as a percentage of the S&P are simply now in line with historical averages. There is no bubble in the energy equity sector, per se, as was the case in 1980 (30% of the S&P as opposed to less than 12% today) or was seen with tech in the late 1990’s (also over 30% of the S&P). Secondly, at least over the period from December of last year until the present, the rise in the value of the greenback has not sunk crude prices.
Yes, commodities in general have traded inversely with the dollar in recent years, but the recent dollar rally has not dented crude in the least up to this point. Derivatives are a wildcard. I wish I could quantify risk and reward, but I have absolutely no idea of the structure of these vehicles given the incredible lack of transparency in bank financials these days. On the contango front, yes, it’s an issue to be reckoned with, but it’s more short term in nature than not and is clearly not new news. These concerns are about the short term.
Finally demand. The global demand picture for crude is expected to pick right back up, as the IEA numbers show us in the chart earlier in this discussion. The pickup is due to continued strong demand in emerging economies, China being the poster child for this phenomenon. The domestic US picture for crude demand remains tepid at best. The chart of imports is loud and clear on the subject, and very much in line with the reality of domestic, non-financial US economic recovery. And remember, the headline strong point for recent anecdotal US economic recovery has been the energy intensive manufacturing sector. And still crude imports lie well below prior highs.
So let’s switch gears just a bit and have a look more broadly at what could drive crude prices in the future. This is not about to become another typical peak oil commentary, although I do not dismiss this concept as being meaningful looking out over the next half decade to decade. Although it may sound like a toss away comment, what is happening in the large population centers in the emerging economies is the key to future energy prices and bull markets, or not, in energy sectors and asset classes. Their policies, their subsidization, and even their efforts regarding developing alternatives must all be monitored and taken into consideration. So let’s look at some very simple data in the hopes we can see beyond both the short term and domestic only trends.
The following chart says a lot about just where we may be headed. In the bottom clip we’re looking at the top consumers of crude on wonderful planet Earth and just how much each of these geographically specific areas consumes. It’s no surprise that every “official” BRIC is in the top eight, is it? And you already know full well that the US population simply pales in comparison to the BRIC’s on a combined basis, yet the US uses more crude at present than all of these countries combined.
But what is clearly striking, speaks to the enormity of population disparities and absolutely demands monitoring as we move ahead is per capita usage. The second largest consumer of crude on the globe is China, but in terms of per capita usage it ranks near the bottom of the top aggregate users of crude. That speaks to what is to come as more cars are sold in China, the middle class develops economically, etc. You can see not even included was India on the per capita chart as it’s currently simply too small a number, but it will not be for long. If you personally believe the emerging nations will continue to develop, grow and prosper, per capita deepening in terms of crude usage is an inevitability. Remember, the incremental demand for crude in the IEA numbers looking out over the remainder of this year and beyond is really being driven by the emerging nations. And where will the oil come from to satisfy growth needs? Here’s a fact for you. 2009 marked the first time that China imported in excess of 50% of its crude needs. Yes, a record milestone, but not necessarily a pleasant one for energy prices thinking ahead. According to the Chinese National Energy Association, in 2009 China imported 51.3% of its total crude needs. The gap between Chinese consumption and production has never been wider. Never. The incremental increase in Chinese production over the years has been just that. And this is despite the assets they have been buying globally.
Although forward estimates out half a decade are to be taken with a grain of salt, the Chinese National Energy Association estimates that by 2015 China will import 65% of its crude needs and by 2020 the number will be 70%. Again, where will that physical supply come from because these needs will grow? For now, China gets a lot of its crude imports from nations not necessarily on the list of global model citizens, at least as per the US interpretation. China's crude needs satisfaction ahead will be about both prices and global politics. Nothing like adding a bit of spice to the story, no?
Another record was apparently set last year that again speaks volumes about forward global energy sector issues. Vehicle sales in China in 2009 exceeded US annual vehicle sales for the first time ever. What you see below is the history of vehicle sales in China over the last few decades. Get the picture? As you look at this, please remember the per capita numbers for crude usage looked at earlier and how small a number China represents right now relative to the trend you see below.
Very quickly a few comments. We do need to realize that a lot of sales in China are of very small vehicles. These are not your standard US midsize vehicle or truck. Price points are much lower (which actually argues for more vehicles ultimately sold). But the key issue for future energy prices and sector dynamics is how the Chinese transportation system ultimately develops. That remains an unknown for now. But at the moment, per capita car ownership of autos in China fits on the head of a pin compared to numbers seen in developed countries. The future appears pretty darn clear. Moreover, at least over the last year or so as part of stimulus, China has subsidized auto ownership for many parts of the population. We know that China is building more nuclear reactors than any other country on the planet at the moment. But for now those reactors will not power automobiles. Crude usage in China ahead will be very dependent on how the Chinese transportation system develops. That’s a key focal point in terms of broader energy investment assessment.
While I’m on the subject of China, one last controversial issue in terms of relation to crude prices over the short term. Reporting of energy stats in China is different than we see stateside. Right to the bottom line, the short-term issue of controversy is the potential and/or reality of crude stockpiling. Just how much of the increase in Chinese oil demand was for actual usage and how much was the stockpiling of crude and crude products? The Chinese government gives us data regarding exports, imports, domestic production and refinery activity. But what we do not get is actual consumption numbers or stockpile data that could help us “see” true usage related to the Chinese economy itself. The thought is, as is the case in many a commodity these days, that China has been stockpiling crude and many commodities over the past 18 months and once this stockpiling slows meaningfully, commodity prices globally will collapse. We have to believe there is a certain amount of truth to this issue of stockpiling having created some artificial demand short term, although neither we nor anyone can quantify it as per the official public numbers. But again, this issue of stockpiling is all about the short term. We have seen reports from Chinese refiners talking about significant increases in inventories over the past year. So we know this issue of stockpiling is real and could indeed negatively influence global crude prices short term if that activity, depending on magnitude, were to end.
Where will crude prices be in 3 months? How about 6 months? I’m pleased to tell you I have absolutely no idea. But what I hope is important is to keep time context in mind as we review investment possibilities. Crude faces headwinds over the near term. But I believe these headwinds at least should be very well known. Are they fully discounted in price? I only wish I knew. But as we all review really the global fundamental circumstances of potential demand for crude and energy products that lies ahead, it’s hard not to be favorably predisposed to the asset class and sector. Let’s just hope to use short term price “adjustments” to our longer-term advantage. Lastly, like many I am indeed a longer-term believer that the alternative energy theme will be very rewarding. For now it’s a lot of promise and little profits. This will change. Wildly enough, just who on planet Earth has a greater incentive to innovate, support and develop alternative energy other than China? As per the numbers and longer term thinking, perhaps the US is the answer to that question given what seems will be emerging market “crowding out” of energy commodities in the years that lie ahead. Keep the big picture in mind and allow short-term volatility to provide opportunity.
© 2010 Brian Pretti