The Energy Revolution Intensifies

Energy is the dominant story of the month. It’s hard to ignore when crude futures are setting new highs daily on their way to $60. But there’s more to the energy story than oil. And Dan Denning shows us there’s more than just rising commodity prices and a falling dollar to explain oil’s rise…

This latest rise in energy prices will have at least three distinct impacts. First, the stock market will see new leadership from the oil and energy sector. Oil and energy indexes and ETFs will gain in popularity with institutional and retail investors alike.

Second, rising oil prices are going to have knock-on effects in the world’s currency markets. Oil, of course, is priced in dollars. And as it rises, governments around the world will have to decide how to handle the double whammy of rising oil prices and a falling dollar.

Already, governments in Russia, Japan, and South Korea have decided to "diversify" by owning fewer dollars and more euros. You’ll see more dollar diversification as governments hedge their dollars (and rising oil price risk). This will also have an effect on U.S. interest rates.

Third, rising energy prices are going to intensify the great game of geopolitical chess that’s unfolding before our eyes. There are many players in the game, but the key ones are Iran, Russia, China, and the United States.

Wall Street does not believe in $40 oil. But prices shouldn’t have anything to do with belief. There is a deep institutional skepticism that oil is now priced "petro-politically," or that the political premium in oil means the base price for crude is now $40, not $25-30.

Saudi oil minister Ali Naimi – at the mid-March OPEC meeting in Tehran – said the Kingdom thinks oil should trade between $40-$50 per barrel, in order to ensure steady global growth. He also said he thinks that oil at $55 per barrel is "too high."

There are lots of people on Wall Street who agree with him. You wonder if these oil skeptics have a basic grasp of supply and demand. First of all, in real terms, oil is still trading well below what it was during the oil shocks of 1970s.

Oil is still cheap! It would have to rise to $80 in today’s dollars to reach its past highs. In other words, the big bull move in oil – even after a doubling in crude futures in the last year – may not have even started yet.

Oil: Demand Rises; Supply Doesn’t

And why is that the case? Supply and demand. In its constant quest to turn news into an explanation for price movements, Wall Street pays religious attention to the forecasts of the International Energy Agency and the inventory figures produced by the American Petroleum Institute. But seasonal or monthly fluctuations in oil inventories or demand don’t begin to give you the fundamental picture.

The fundamental picture is very simple, almost childishly so. Demand is increasing; supply is not. That’s it. No hidden logic. No secret turn of events. More people are competing for the same scarce energy than ever before. If anyone tries to tell you that oil ought to be at $25 and that this is a bubble top, ask them what recent forecast showed an increase in the world’s oil supply. Don’t be surprised if they look at you like you have three eyes. No such forecast exists.

There are other factors affecting the oil price. The dollar is one. But a long-term increase in demand is the biggest one. The demand for oil is leading commodities to take over as the asset class of choice for the world’s investors. Since stock markets peaked in 2000, the Dow Jones AIG Commodity Index has absolutely outperformed the S&P 500.

The Dow remains the most difficult of the three to forecast. Economically, high oil runs the risk of slowing economic growth and damaging corporate earnings, which is generally bearish for stocks. Obviously, the entire energy complex (shippers, refiners, explorers, major integrated stocks) is the exception to the rule.

There is also the possibility (or even likelihood) that oil’s climb to 1970s levels will be a stair-stepping process, ascending in big gaps and pausing to collect itself. This gives the Dow and other major indexes a chance to "price in" the move. Big daily changes in the Dow are less likely in this scenario.

But we can’t really forecast the Dow without factoring in volatility. Volatility – as measured by the VIX – has been so low for so long that nearly everyone expects it to increase soon. It’s one of the market’s strange ironies that low readings on the VIX do not actually mean the market is stable, but that pressure is building for a big move. But which way? Will increased volatility on the VIX be bullish or bearish for the Dow?

The answer is "bearish," but for traders, the Dow isn’t the index to watch when the VIX rises. Individual Dow components will react differently to a rising VIX. But in general, rising volatility means a decline in speculation.

Oil: High Oil Price’s Effect on Bonds

What about bonds? If the early price action is any indication, high oil is bullish for bonds. In my speech at Investment University in Delray Beach, Fla., I said that higher oil prices would force investors to choose between emerging markets and U.S. bonds. Up till now, investors have had the leisure of chasing higher yields in emerging markets without the worry that oil prices would hit less-developed economies hard. Not anymore.

The net effect – again based on the early trading patterns – is that investors are selling emerging markets and buying (gulp!) U.S. Treasury bonds. This is the classic "flight to safety" move we’ve seen in the past. Selling emerging markets because of rising oil prices makes sense to me. Buying U.S. bonds as a measure of safety does not.

As one reader pointed out to me at Delray Beach, however, good investors do not confuse what should happen with what is happening. You can outsmart yourself by coming up with too many reasons why investors should not buy U.S. bonds. And just for grins, I can think of three of them right off the top of my head: $59 billion, $113 billion, and $666 billion.

Fifty-nine billion dollars was the February trade deficit. Americans continue to consume more than they produce. The last I checked, this was still NOT a way to get rich. The next number, $113 billion, was the federal government’s February deficit. The Great Fiscal Father in Washington continues to set a bad example to a nation of fiscal children by spending more than he takes in. This, too, should be bond bearish. Yet it isn’t.

Finally, the diabolical last number, $666 billion. That was America’s current account deficit for 2004. It was a 24% increase from the year before. It now amounts to 5.7% of GDP. But those are just numbers.

Let me put it in plain terms for you: America is increasingly dependent on foreign central banks to sustain the value of the dollar. High consumption is made possible courtesy of the world’s savers. We are getting a free ride into indebted servitude to foreign bondholders. The ride into indebtedness may be free, but getting out is going to be very expensive.

That trifecta of debt ought to be enough to scare the daylights out of U.S. Treasury bondholders. But in the context of high oil prices, the debt numbers take second place in investors’ minds – at least for now. U.S. bonds are getting a bid.

Fundamentally, the stage is set for a huge dollar sell-off. With the deficits soaring, demand for the dollar is bound to wane. When it does, the dollar will go down, interest rates will go up, and a whole series of secondary reactions will unfold in the markets.

Regards,

Dan Denning
for The Daily Reckoning

April 07, 2005

Dan Denning is the editor of Strategic Investment, one of the most respected "big-picture" investment newsletters on the market. A former specialist in small-cap stocks, Dan has been at the helm of Strategic Investment since 1999 – where, drawing from his network of global contacts, he has designed an investment strategy that takes into account global political and economic trends.

Dan Denning’s trading service, Strategic Options Alert, specializes in a very specific strategy, and it’s a serious system for active investors. It uses a new investment strategy based around specific Super Stocks…that are baskets of stocks that you most likely haven’t used before.

This past weekend marked an important anniversary. On April 2nd, 1917, Thomas Woodrow Wilson stood before a joint session of Congress. "We must put excited feeling away," said the president, and then launched into one of the greatest mob-inciting harangues ever delivered. Wilson was urging Congress to declare war against Germany. The Huns, he said, were governed by a "selfish and autocratic power."

What they had done to justify trying to kill them was a matter of great dispute. Robert "Fighting Bob" La Follette, senator from Wisconsin, thought they hadn’t done much of anything. They were accused of bayoneting babies and cutting off the arms of boys in Belgium. But when a group of American journalists went on a fact-finding mission to get to the truth of the matter, they could find no evidence of it. Clarence Darrow, the lawyer who made a monkey out of William Jennings Bryan in the Scopes Trial, said he would offer a $1,000 reward to anyone who came forward whose arm had been cut off by the Germans. A thousand dollars was a lot of money back then…for this was when the Fed had barely settled down to work…equal to about $20,000 today. Still, no one claimed the money.

The Germans had also sunk a few ships. But there was a war going on in Europe and Germany had tried to impose a blockade of English ports with the only weapon it had, submarines. You took a risk trying to sail into England, especially if your ship was carrying ammunition, and everyone knew it. The English were blockading German ports too. The difference was that the English had a bigger navy and were better at it. Try to run their blockade and you were almost certain to die; so few ships dared.

It was a long and complicated story. In retrospect, the United States was better off minding its own business. Robert La Follette knew it. He told anyone who would listen that the struggle in Europe was best understood as a political and commercial rivalry. The Germans were challenging the English everywhere. The German economy was growing faster. While Britain seemed to be peaking out, the Germans were building new factories and developing new markets. In Africa, German colonialists were menacing English territories; in Europe, German manufacturers were taking market share from their English competitors. On the high sees, the German navy was growing more competent. And so, the English and the Germans were having it out. Leave them to it, said "Fighting Bob."

But Woodrow Wilson had his own ideas. "Civilization itself" seemed in the balance, he told the politicians. "We shall fight for the things we have always carried in our hearts – for democracy, for the right of those who submit to authority to have a voice in their own governments, for the rights and liberties of small nations, [he did not mention, Mexico, Puerto Rico, and Nicaragua – countries to which he had already sent troops to meddle in internal political issues], for a universal dominion of right by such a concert of free peoples as shall bring peace and safety to all nations and make the world itself at last free."

When he finished his speech, most of the yahoos rose to their feet and cheered. Tears streamed down many jowly faces. At last, the United States was going to war! Two million people had already died in the war. For what reason, no one quite knew. Wilson had to resort to bombast and balderdash to try to explain it. But now the happy moment had come. Now, Americans would get to die too. Hallelujah!

No one recalled the weekend’s anniversary in the papers. Too bad.

It makes us think of America’s situation today. Are we not in Britain’s shoes? Are we not facing our own new rival – China?

Market cycles…and historical cycles…are like women [and here, dear reader, you may want to write this down in order to quote us correctly]…they are all the same and yet completely different. When prices are high, we know they must get down – somehow, someway, some day. When a nation is riding high…it too must someday sit lower in the saddle. For all things age. All things change. All things go away, in the end. But how and when they get where they are going is as varied, charming and mysterious as every woman we have ever met.

Just something to think about, dear reader….

And now the news, from our team at The Rude Awakening…

————–

Eric Fry, reporting from Wall Street:

"’Pair-trading’ is the non-alcoholic wine of investing. It may resemble the real thing, but delivers none of the "buzz"…or so some folks believe…"

————–

Bill Bonner, back to Jo’burg…

*** It seems that we aren’t the only ones with Fannie Mae and Freddie Mac on our minds…

Yesterday, Greenspan told Congress, "The Federal Reserve is concerned about the growth and the scale of [Fannie Mae and Freddie Mac’s] acquisition and debt activities, and recommends that they be capped by Congress to prevent a financial crisis in the future."

Greenspan went on to point out that little of the benefit that the two mortgage giants receive from billions of dollars in federal subsidies is passed on to homeowners.

"It is the stockholders and executives running the enterprises, rather than homeowners, that primarily benefit through increased profits," Greenspan said.

These comments, of course, did not sit well with housing advocates. According to an article in The Washing ton Times, Jerry Howard, chief executive of the National Association of Home Builders said, "I have learned a lesson a long time ago about not biting the hand that feeds you, and I would think Mr. Greenspan and the Fed would have learned the same message."

Hmmm. We wonder: Are the Feds biting the hand that feeds them – or just wising up?

*** Our friends at Elliott Wave International sent us this comment on the storm clouds gathering over corner offices all through Corporate America:

"As the rally from March 2003 peters out, one key indication that the developing decline is a continuation of the post-mania slide to much lower levels is that the backlash against many of the stars of the old bull market is reappearing. In August, an outline of a new wave of attacks was identified, and it is now visible across the breadth of corporate America. From Fannie Mae, where federal regulators have uncovered still more accounting irregularities, to new revelations about conflicts of interest in the investment banking industry, the scandal mills are heating up. After several investments banks settled suits, Reuters reported that derivatives litigation is ‘Set to Explode.’

"In December, when The New York Times insinuated that New York State attorney general Eliot Spitzer was about to relinquish his offensive against various financial giants, Spitzer quickly disavowed the notion. Since then, he has opened up a new line of attack against insurance giant AIG and issued subpoenas to major record labels and investment consulting firms. At the same time, post-peak revelations are spilling forth in the trials of former mania-era heroes at WorldCom, Healthsouth and Tyco. Still to come: the New York Stock Exchange’s case against its former president, Dick Grasso, and the criminal trial of Enron’s former principles. Krispy Kreme, Bally Total Fitness and OfficeMax are also in the seminal stages of accounting inquiries. Investigations of the accounting, insurance and medical device industries are also underway by the Justice Department, IRS, SEC and various state agencies.

"Don’t be fooled by reports of besieged corporate leaders; it is only a preview of coming attractions…" (See the whole article on our site…)

*** South Africa is booming. And crashing.

"You see all these tow trucks along the road?" began our hostess last night. We were on our way to the gaudiest restaurant we have ever seen – a place called Bellgables, rather far from the heart of the city. (We ate a cute member of the antelope species called a Springbok, washed down with a generous lavage of pinot noir from the Cape. The meal was delicious…and well worth the drive.)

"Recently, they discovered that some of these guys had tinkered with the traffic lights…so they were green in both directions. They just waited for an accident…and then got the business of towing away the cars."

Free enterprise flourishes on the highway.

"Right after the elections [after apartheid was eliminated] a lot of people were very worried. They left the country – moving to England or to Australia, mainly. But now, South Africans still travel a lot. When I go to London I hear Africaans spoken on the subway, for example. But now they tend to come back. Because there are so many opportunities here. It’s wild…and it’s wide open…you know, like America used to be. "