Slick Oils

By Eric J. Fry

"Full Disclosure:  I am long Exxon Mobil, Chevron Texaco
and Conoco Phillips in my personal account," declared an
email that arrived in your New York editor’s in-box
yesterday.  The email’s author was Richard Morrow, a
commodity futures broker and hedge fund manager who is very
bullish on energy prices.

However, unlike most of his commodity-trading peers, Morrow
believes the equity markets provide the best way to
capitalize on the rising crude oil prices he anticipates –
not the futures markets. This unique commodity trader is a
big fan of oil stocks, especially big, boring integrated
oil stocks like Exxon and Chevron. We, ourselves, do not
own these stocks, but we are persuaded by his argument.

Richard hails from Memphis, where he earns a handsome
living brokering futures trades and running a hedge fund
devoted to trading agricultural commodities.

Professionally, Richard never dabbles in stocks. But in his
personal account, he does whatever he wishes. And lately,
he wishes to own oil stocks.

"Lately, I have had several customers who are bullish on
energy," Richard relates, "and they have asked me how to
make money on the long side of crude. Most of them want to
buy ‘way out’ month crude oil futures.

"The 2007-2010 crude contracts are trading around $40 which
is a $6-$8 discount from the 2005 contracts.  Obviously, it
would be in my financial interest to shut up and let them
buy the back month futures contracts. Instead, I have been
advising my clients to buy the major integrated oil stocks,
not back month futures."

Intrigued by Richard’s idea, we asked him for a bit more
detail. "What’s your thinking Richard?" we wanted to know.

"It’s pretty simple," he replied. "At the end of the day, I
think being long the integrated oils makes more money – or
loses less – that being long crude futures. Let’s consider
three possible scenarios: Oil prices fall, they stay the
same, or they rise.

"For starters, let’s assume my bullish outlook is misguided
and oil drops back below $30," Richard continued. "If you
were long back-month crude futures, you would lose about a
third of your investment, assuming you were unlevered. On
the other hand, if you bought the integrated oils, you’d
probably be much better off. Let’s use Cheveron Texaco
(NYSE: CVX) for an example.

"CVX is a $58 stock that is going to earn around $12 or
more over the next two years…The near term earnings are
pretty much locked in whether crude goes up or down, since
CVX hedges its production. "

In other words, CVX has hedged so much of its near-term
production at prices between $30 and $40 that a drop in the
crude price would not greatly affect this year’s earnings.
What’s more, even if oil trades below $30 a barrel after
2006, the company would still earn about $3.50 a chare,
according to the analytical sages at Goldman Sachs.

"My point is," said Richard, "even if I’m wrong and oil
goes to $28, you would own CVX with a 14.5 PE and a very
strong balance sheet.  Its tough for me to see how this
scenario loses much money for the CVX longs.

"Under scenario number two," Richard explained, "oil hangs
around in the $40 area. In this case, the back-month longs
probably make a little money. But the CVX longs should fare
even better. CVX becomes an automatic cash cow if crude
stays in the $40s."

In other words, cash flow surges as the old hedges below
$30 a barrel roll off the books, and the company sells its
production at higher prices. In this case, says Richard,
"CVX probably makes $7 or more per share in 2006 and
beyond. Assuming $40 oil, CVX is a company with an 8ish PE
ratio and a very strong balance sheet…Any PE expansion
would convert straight to paper profits for the CVX long."

Now, for the most delicious scenario….

"Let’s assume crude prices climb above $60," Richard
imagined. "In this case, the back month futures longs would
make 50% or so, plus interest income, giving a total return
of 60% to 80%. But CVX also comes out a big winner.

"$60+ oil probably takes earnings over $10," Richard
estimated. "Lets assume $9 to be safe. Furthermore, if oil
goes to $60+ several years down the road, the integrated
oils are going to get a more normalized PE of say 15.
Therefore, if CVX earns $9 with a PE of 15, we’re taking
about a $135 stock. Notice that I still more than double my
money in a bullish crude environment if I’m long CVX.  If I
want that type of return in the futures, I’d have to use a
lot of leverage.

"Net-net," the oil-stock-buying commodity broker concluded,
"CVX makes money under 2 out of 3 scenarios. Futures only
make out-sized returns in 1 out of 3 scenarios. Even if the
futures make big money, CVX probably makes more."

"Thanks, Richard."

Did You Notice…?
By Contrary Investor

It’s no mystery that all of the academic commentary and
theory regarding a declining dollar being good for U.S.
export markets is falling flat on its face in the current

And it’s not hard to understand why…

As you can see below, since the value of the dollar peaked
back in February of 2002, our trade deficit has only
widened.  As of the November trade report, we’re now
officially 33 months past this dollar peak and we have
nothing to show for it in terms of trade reconciliation.
In February of 2002, U.S. imports exceeded U.S. exports by
roughly 40% on an absolute dollar basis.  As of November of
last year, we’re now looking at a 63% dollar valued gap
between U.S. imports and exports.  As you can see, November
is a record spread.

Although we won’t drag you through the charts, back in the
1980’s when the major G7 countries agreed on allowing the
dollar to drop and the U.S. trade deficit to shrink, the
lag between the peak in the dollar and the beginning of the
reconciliation of the U.S. trade deficit was close to 24
months.  So what’s different this go around?


Average Monthly Deficit Over Prior Year ($billions)

Annualized Monthly Average ($billions)

% Of Total




24 %

North America




















Although we’re only breaking out the major trading blocs,
you can see that 35+% of the total U.S. trade deficit is
with two countries who either have a definitive or de facto
currency peg to the U.S. dollar – China and Japan…When we
aggregate all of the smaller countries (Hong Kong,
Malaysia, etc.) who have either definitive or de facto
dollar pegs, the number climbs higher to 45% of our total
trade deficit.

The existing foreign currency pegs and de facto pegs to the
U.S. dollar negate any potential currency cross rate
movement in terms of global trade.

THIS IS completely different than was the case in the
1980’s and really explains for us the meaningful difference
between the two periods.  It also suggests to us that until
the mercantilist global flows of capital that continue to
flow from Asia to the U.S. financial markets either stop or
reverse, and until the pegging and de facto pegging of
currencies in a manipulated manner comes to an end, the
U.S. is facing a structural trade deficit problem, not a
cyclical one.

And, of course, longer term, capital flow and currency
cross rate reconciliation will not occur without pain.
Pain will be shared among many countries, not just the U.S.
The larger the imbalances grow, probably the greater the
ultimate reconciliatory pain.

And the Markets…



This week

















10-year Treasury





30-year Treasury





Russell 2000


























JPY 105.54

JPY 105.45



Dollar (USD/EUR)





Dollar (USD/GBP)