Living in the Material-Energy World

I hope that your summer moved along nicely, dear Whiskey readers. As many of you already know, I was out at the Agora Financial Investment Symposium in Vancouver back in July, where I met and enjoyed your company. To all of you who made the trek to British Columbia, thank you so much for participating in what one attendee called “perhaps the best financial conference anywhere for the individual investor.” Hey, we do it all for you. I hope to see many of you in Vancouver next year.

After the Vancouver event ended, my family and I headed north for another visit to the great state of Alaska on behalf of my Outstanding Investments subscribers. Among other things, I looked at some old gold mines and new mining prospects and had some serious fun hiking in the forests of the southeast coastline along the Pacific Ocean. I even had a chance to explore my “inner Army Ranger” by zip-lining across the treetops at the edge of the Tongass National Forest, traversing deep gorges on rickety rope bridges and rappelling down steep cliff faces. In all honesty, I did that for me.

Now I am back at home in hot, muggy Pittsburgh, PA. But as compensation for the present and rather uncomfortable weather, the local sweet corn, fruits and other vegetables are coming in, and it has been just a great (and delicious) growing season. The Steelers have a new coach and a lot of exciting prospects ahead of them. And by the end of this month, we will enjoy the glorious fall weather and colorful foliage of Western Pennsylvania that make this part of the world such a delight. So let’s try to look forward with a positive attitude, despite the many heartbreaking issues that form the daily news headlines.

The Grand Old Duke of York

Looking at the stock markets and the headlines they’re making of late, I am reminded of the Grand Old Duke of York. He had 10,000 men. He marched them up to the top of the hill. And he marched them down again.

Except in the case of another York, this one being the New York Stock Exchange and its bellwether Dow Jones average, for example, the march went up to 14,000 points or so, courtesy of a long-term credit expansion that flooded the markets of the world with excess, if not seemingly endless, liquidity in an environment of apparent disregard of risk. Then in mid-July, the New York Dow started its retreat when a piece of the subprime mortgage market went critical. Liquidity contracted like a hangman’s noose.

Risk was rapidly revalued, if not repriced, downward at the rate of the acceleration of a man falling through the trapdoor of the gallows. And in mid-August, in what may be the early phase of a long march down the proverbial hill, the soldiers of the Grand Old New York Dow marketplace pitched camp near the 13,000 level. What next?

Are we watching the Dow Jones marketplace dig in and make a stand? Or is this just one more daily stop along the line of retreat, if not a slow-motion rout? Things change, of course, and in the stock markets of the planet, sometimes they change very fundamentally. By way of analogy, recall that what started as the road to Stalingrad for the Germans eventually became the road to Berlin for the Russians. It was the same line on the map, but a different outcome, depending on who was marching where.

When You’re Up, You’re Up

Getting back to that Grand Old Duke of York, he once said, “When you’re up, you’re up.” Are our stocks up? That certainly makes for a good day, except you also have to remember to sell at the top if you want to book the gain. What? How does one know that it is the top of the market? Just listen for the bell. Doesn’t somebody always ring a bell at the top, as the cable car drivers do when they reach the crests of the hills of San Francisco?

And When You’re Down, You’re Down

And as the Grand Old Duke of York also said, “When you’re down, you’re down.” So are any of my favorite stocks down? That makes for a bad day, except that maybe it is also a buying opportunity in the context of the long perspective. Again, how does one know that it is the bottom of the market? Just read tomorrow’s newspaper, of course. I’d be glad to loan you my copy, but I must have mislaid it somewhere.

And When You’re Only Halfway Up…

Finally, as the Grand Old Duke of York said, “And when you’re only halfway up, you’re neither up nor down.” Well, it depends upon when you joined the ranks of Outstanding Investments subscribers. If you have been with us for a while, you are probably up despite any recent market retreats. If you enlisted recently in the subscribing ranks, you may be down a bit, but not down as much as the poor wretches who failed to pad their portfolios with energy and natural resource shares. Long term, the material-energy world is the world of reality. It is the place to be. I’ll take you there if you’ll click here to subscribe to Outstanding Investments.

What Is Going On?

So you ask, “What is going on?” I hesitate to offer any categorical answer about the state of the stock markets. I have no universal field theory for why the stock markets of the world are doing what they are doing, and hence do not want to say anything that is outside my bailiwick. But I see that, for example, the price of oil has pulled back and I know a few things about the price of oil.

The Price of Oil

Back during mid-summer, oil was pushing $78 per barrel, and there were many forecasts for higher oil prices going forward. At one time or another in the not-too-distant past, players as diverse as the president of oil superpower Venezuela, Hugo Chavez, and the oil analysts at money-managing superpower Goldman Sachs were predicting oil at $100 or more per barrel. And really, would the reviving military superpower Russia have bothered to send an expedition to claim the resources of the North Pole if its leadership thought that long-term energy prices were going to decline? Can superpowers ever be wrong?

Still, within a couple of weeks, oil dipped back into the $72 range per barrel. If you listen to some commentators, the economy is unwinding and we will soon be back to $2 gasoline. But not to worry, dear readers. The Peak Oil paradigm is still with us, and we will surely see $100 per barrel of oil, sooner or later. Be patient. We will get to that $4 gasoline, and probably much more, in due course. Really, when you think about it, the collective American addiction to driving and traffic congestion seems to subliminally demand higher prices.

From the standpoint of supply, there have been no major oil discoveries anywhere in the world of late. And at the other end of the economic equation, there has been no major breakthrough in the arena of demand destruction when it comes to oil usage trends going forward. Supply is tight. Demand trends are rising, as I will discuss below. So why the pullback in the price of oil?

Sometimes You Sell What You Have to Sell

In general, the price of something falls when there are more people selling than there are buying. And recently, there have been more people selling oil contracts than buying them. Why is that? Because there have been a lot of entities around the world that have had to raise cash to cover losses in the subprime mortgage meltdown, or otherwise to book some sort of gain to impress the clients. And when you have to raise cash in a hurry, sometimes you cannot sell what you want to sell. Sometimes you just have to sell things for which you can find or make a market.

Let me explain that a bit further. Many large players in the subprime mortgage arena, such as banks, brokerages and hedge funds, are heavily invested in subprime mortgage commercial paper. In most cases, they bought the subprime paper with the clients’ money, promising a certain return or yield over time and charging hefty management fees in the meantime. Up until now, the banks and others have carried the paper on their books according to a “model” valuation and have been able to keep the clients happy by sending them quarterly statements filled with fuzzy math that indicated all was well. Also, for the past few years, there was no real reason to question the underlying accuracy of the portfolio valuation model. Interest rates were low, and liquidity was available. The subprime paper traded in a reasonably orderly fashion, or at least with few evident problems. The business model appeared to be working like a Swiss watch, and in the perception of those who were living the dream, that business model displayed the soundness and inherent durability of the Swiss currency.

But starting a few weeks ago, when a number of Bear Stearns funds imploded, it became necessary to liquidate some of this commercial paper, backed by subprime mortgages, in a real marketplace and not in some la-la land of model valuation. The lesson of the Bear Stearns implosion was that the market for such commercial paper could evaporate almost instantly. The “for sale” sign was up, but nobody wanted to buy. So all of a sudden, portfolio managers across the world realized that the model valuations were sheer fantasy. When they gazed into the mirror, they really weren’t getting better looking each day. When the time came to sell, there was no market. Time to panic, right?

As I said above, when you cannot sell what you want to sell, you might be forced to sell things for which there is a market. So many banks, brokerages and hedge funds have been raising cash by selling their oil futures, for which there is a market.

Hence, presto! The price of oil has fallen. And with the falling price of oil, we have seen declines in the share prices of oil companies, oil service companies and drilling companies.

Where Do We Go From Here?

So where do we go from here? Well, there might not be a market for subprime mortgages, but there sure as heck is a market for oil.

The daily world oil supply is in a precarious state, with the depletion of numerous major oil provinces approaching crisis proportions. From the North Slope of Alaska to the North Sea, from Mexico’s Cantarell to Kuwait’s Burgan Field, the reality of depletion is hitting home. Daily oil output from older fields and regions is declining, and many new hydrocarbon projects are coming online slowly, behind schedule and over budget. Add to this the problem that there are significant constraints in the labor force and in the availability of critical equipment and mechanical systems. There is trouble out there, with a capital “T.”

Yet total world oil demand is still rising, driven by the usual suspects China and India, where oil use is soaring (as well as by the developed world of Europe, North America and Japan, where it has already soared). Deutsche Bank, for example, estimates that Chinese demand alone for oil will increase by at least 6% in each of the next two years.

Also recently, the International Energy Agency (IEA) revised its forecasts to raise its global oil demand estimate. The IEA predicted that oil use would rise by an average of 2.2% per year (about 1.7-1.8 million barrels per year) for each of the next five years. IEA also predicts that the amount of world oil usage and consumption within developing nations will rise to 46% of worldwide demand by 2012, up from the current 42%.

According to the IEA, within five years total, world demand for oil will increase to almost 96 million barrels per day, up from about 86 million barrels per day currently. These are just estimates, just extrapolations. There is almost no way that the global oil industry will be able to extract sufficient hydrocarbon product from the rock formations of the Earth (oil, natural gas liquids, tar sands, oil shale, you name it) to meet this forecast level of demand. Something will have to give, and the sure bet is that the price of oil will be rising.

Live in the Material-Energy World

So make sure that you live in the material-energy world of real oil, and real resources, as opposed to the make-believe world of “model portfolios” backed by subprime mortgages issued to people without the ability to repay them. This latter part of the economy is a mess, and it will surely get messier. What we have seen in the past month is the bow wave of a larger phenomenon that will play out over the next two years, at least. Be prudent as the markets gyrate, and be wary that the U.S. economy may contract (or worse) in an oncoming recession. This also applies to the economy of Euroland, and, by implication, to many other regions that depend on exports to the developed world.

But do not be overly afraid of using market retreats to accumulate shares of well-managed companies with oil reserves in the ground, or great oil service companies that will be critical to the future of resource extraction. You can accumulate on pullbacks, and please accept our best wishes for your future success. And thank you for reading Whiskey & Gunpowder.

Until we meet again…
Byron W. King

September 6, 2007

The Daily Reckoning