Resource Commodity Stocks

Oil is selling in the range of $113 per barrel, down from its recent high of $146. Gold is selling below $800 per ounce, down significantly from its springtime high of over $1,000. With a drop in excess of 20 percent for each item, it’s fair to say that we are in a bear market for both oil and gold.

Prices for other items, like natural gas, coal, silver, platinum, copper, zinc — and even a ubiquitous food commodity like corn — are all down sharply from much higher levels in recent months. So what’s going on with the pricing for energy and commodity resources?

And while we’re at it, what’s going on with the share prices for energy and resource companies? Are these price dips just short-term phenomena? Are we in the midst of a summer fire sale on energy and commodities? Is this merely an August swoon, something that cannot last for long? Or are we looking at a new direction for price and demand trends with energy and resources? Are we encountering something that will be with us for a while? Do we need to change our medium- and long-term thinking?

Facts About the August Swoon

First, you need to know that August is almost always a tough month (depending on how you look at it) for resource prices and resource stocks. A lot of people take vacations in August, including some folks who are key players in the resource markets. So the market makers are on holiday, as are the markets.

Indeed, no less an authority than Rick Rule was discussing this at the recent Vancouver Investment Symposium. “August is when a lot of things go on sale,” according to Rick. Rick views August as a good time to buy great resource stocks at relative bargains.

Also — at least in U.S. markets — August tends to be a time for net selling. Traditionally, a lot of parents and grandparents sell stocks and redeem mutual funds to come up with tuition payments for private schools and colleges. This insight comes from an old acquaintance of mine who helps to manage the endowment funds of Harvard. He told me that Harvard makes money both ways. Harvard gets paid the tuition. And the endowment fund buys stocks that are relatively cheaper in August.

So even in the face of some dramatic declines of late, my goal is to keep it all in perspective. Don’t panic yourself out of the market just because some things happen in August. This is only one month in the year.

Dollar Strengthening

Let’s look at some other issues that have affected the marketplace. The U.S. dollar has been strengthening in the past month. The dollar has gone from about $1.60 per euro to about $1.50, a gain of about six percent or so. That kind of currency swing in just one month — between two of the world’s major currencies — is evidence of a powerful wave out in the world marketplace.

What kind of wave? Call it sentiment. Call it perception. Or as Groucho Marx once said, “Call it a banana.”

But the bottom line is that people are buying dollars and selling euros. This is based on their beliefs about the future, and not much else. Really, it’s not as if just one month is enough time for anything major to occur within the structure of either the U.S. or the European economic spaces.

For example, new industries and labor markets don’t rise and fall in just one month. Tax codes don’t revise within a matter of weeks. Demographic shifts don’t occur in a month. But a month is plenty of time for peoples’ attitudes to change from “sell” to “buy,” and vice versa.

For our purposes in this newsletter, we worry about energy and resources. And in the space of one month, it’s not as if the underlying values of energy and resources are falling. People still need and want oil, corn, copper, etc. (At $113 per barrel of oil, they want less of it, to be sure.)

But in this summer’s monetary phase — driven by sentiment — the dollar is strengthening. So pricing is weakening for energy and resources and their stocks.

But really, how strong is the dollar over the medium to long term? Will the U.S. somehow magically balance its budget? Is there any hint that Congress will change the U.S. tax code to make American industry more competitive?

The dollar is looking good because the alternatives are looking less good. That’s hardly a ringing endorsement for the future. So again, the evidence points to us experiencing a short-term correction.

World Economy Weakening

Then there’s an article in today’s Wall Street Journal titled “World Economy Shows New Strain.” The first paragraph in the lead article on Page 1 states: “The global economy — which had long remained resilient despite U.S. weakness — is now slowing significantly, with Europe offering the latest evidence of trouble.”

Later on, the WSJ article states, “The global weakness marks a sharp reversal of expectations for many corporations and investors, who at the year’s outset had predicted that major economies would remain largely insulated from America’s woes.”

OK, so here we have some evidence that there’s a medium-term “demand” issue at work in the world economy. The U.S. is on the cusp of a recession, what with the broken banking system and chronic monetary mismanagement of the currency. The perception of lower demand going forward is hurting pricing for energy and resource plays.

And euroland, particularly the German economy, is in a recession. This reinforces the worldwide nature of the slowdown. Lower demand hurts current pricing power.

So what’s left? Asia? Will the “China growth story” continue into the future? Actually, I expect China (and the rest of Asia) to grow, but not at rates we’ve become used to seeing in recent years. In particular, I expect to see fewer subsidies for energy use, especially as the world economy adjusts to oil priced over $100 per barrel.

And I expect to see credit tighten in China as the central bank attempts to keep a lid on inflation in the Middle Kingdom. Just a little bit of inflation in China means a whole lot of wealth destruction for Chinese savers and Chinese capital creation.

The Chinese might take some risks that they deem acceptable, like using underage girls on their Olympics gymnastics team. But the Chinese are way too smart to risk igniting long-term inflation in their economy. That would be bad for social harmony, and the Chinese are big on social harmony.

Where Are We Now?

So what’s the bottom line? Where are we now? We’re in the midst of a short-term correction. There are many great buys out there, but I can understand if you want to be cautious and sit on the sidelines and accumulate cash.

If you do buy resources or stocks, just be careful and nibble away. Don’t try to buy everything all at once.

Until we meet again…
Byron W. King
August 26, 2008

The Daily Reckoning