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Newsletter #17: August 5, 2008
The economy, the stock market, and our understanding of the future direction for energy and transportation may all be on the brink of major changes . This letter will open a discussion of these ideas.
A Very Tough Month
Before turning to the future, I must confess that the immediate past month was most painful for the EIS portfolio. Oil prices hit a violent downdraft in July, which especially impacted my “options on futures” strategy. It declined in value by about 33%. Since the purpose of these options is to provide portfolio insurance against rapidly increasing oil prices, and since the insurance is focused on the 2012 and longer time frame, when I think it is most likely to be needed, I am not all that concerned. Most insurance costs money and so far this policy actually shows a profit.
What was more troubling in July was the sustained downturn in oil and gas related equity prices. Stocks led commodities on the way up, so the weakness in oil and gas stocks that we continue to see now does not bode well for the near term future of the commodity prices.
In any event, the total EIS portfolio declined in value by 21.8% for the month, leaving it up only 4.3% year to date. Of course, many hedge funds and portfolios are down on the year, some by over 20%. The S&P is down 13.8%. So I take a little comfort from the fact that the EIS portfolio has positive returns to date this year.
On the Brink of Fear
For the past year since starting this web site I’ve believed there is a radical change in store for the global economy caused by the peaking of the global oil supply. I’ve often written that when oil becomes truly scarce the underlying assumption of our economy - namely unending economic growth - will come crashing to earth and along with it will come stock prices and standards of living.
I still believe that is true and I believe the timing is only a year to four at the most away. But until recently my sense was that until extremely high oil prices bring down the global economy things might be pretty good; we might go sailing into the storm with flags flying high. Unfortunately, that scenario does not seem to be working out.
On July 28th I sold a large percentage of the EIS portfolio’s stocks and all of the energy strategy’s natural gas options. I posted an essay called “Playing Defense” in which I wrote:
If recent weeks’ energy stock losses were simply a severe correction only in energy stocks, this might well be a buying opportunity for the group. But such is not the case. Rather, this energy correction comes in the context of a general market decline that has been eating away at portfolio values almost continuously since August of 2007 . The combination of dramatic losses in energy stocks, very weak recoveries by them, and the continuing slide in the general market suggests to me a deeper significance than just an ordinary correction in energy stocks. In short, I think the market may be signaling that there is an increasing risk that economic weakness may be spreading geographically and demographically threatening much more serious losses ahead.
I cut back the portfolio - and have since then shorted the broad market as a hedge against my existing positions - for reasons that were spelled out in detail in the essay cited above. I won’t repeat them all here. The essence is that the credit crisis that is tied to the housing bubble and related mortgage meltdown is continuing to grow. It may do a great deal more harm to the economy even before energy shortages caused by peak oil become a reality in one to four years. If peak oil comes at a time when the economy is weak to start with, I am afraid that we may see an economic era dawn that will be most unfortunate.
I don’t do independent economic analysis but I listen to people who seem to be the most knowledgeable in macro-economics. I like the work of John Mauldin and Paul Krugman, neither of whom is optimistic. And I certainly respect the work of Meredith Whitney, the financial services analyst at Oppenheimer who has been so right about banks over the past year. Her Fallout in Financials interview today on CNBC was absolutely chilling. She foresees credit problems extending to ordinary consumers and housing prices falling in the next year or two by as much as they have already fallen in the past year. That, my friends (as McCain would say), is not a happy picture.
The only macroeconomic forecast I have made (other than parroting my betters) is that I think the growth rates in China and other Asian economies are likely to fall substantially over the next year. As I wrote recently, the extraordinary growth seen in China and India faces several headwinds including shortages in electrical capacity, worries about inflation that may keep their interest rates high, and in the case of China, limits to the amount of air and water pollution caused by uncontrolled growth that will be tolerated. The negative implications of a serious erosion of Asian growth rates for the OECD economies would be substantial.
A recent report from Bloomberg discusses part of the basis for my opinion:
“
State Grid Corp. of China, which more than 1 billion people rely on for power, said electricity shortages have worsened because of inadequate coal supplies. Forty-six percent of the power stations connected to the distributor’s grid have coal stockpiles below the “caution line,” or seven days of consumption, data from the company showed today.
China, facing its sixth year of electricity shortages, mothballed at least 2.9 percent of its coal-fired generating capacity as of July 25 as fuel supplies dwindled, State Grid said. Coal shortfalls may worsen in winter as power demand stays high and hydropower output falls to a seasonal low, it said.
Finally in terms of macroeconomics, there is this: one idea I’ve heard that makes perfect sense is that the greatest anomaly to date is what has not happened to consumer spending. It has not rolled over. Despite falling home values, rising unemployment, stagnant wages, rising food and energy costs, and now falling stock prices, the U.S. consumer has continued to spend. The notion is that the consumer has been running on fumes. She’s maxed her credit card. She’s ignored reality, pretending that things will get better as they always do. She is living in the past. That is likely not to be the case going forward, particularly as the effects of recent Federal handouts wear out. To me this notion that consumer spending, 2/3rds of the U.S. economy, is likely to begin declining is the most worrisome of any aspect of the current economic climate.
If the global economy goes into a substantial downturn we can expect both lower stock valuations and lower oil prices near term. That prospect entails a potential double-whammy for the energy investment sector that has prospered so handsomely for the past several years.
All of the above thinking led to my decision on July 28th to step aside from the stock market to a large extent. I kept my substantial position in Canadian Oil Sands Trust for both tax and fundamental reasons. I also maintained positions in deep off shore drilling companies, the business of which is unlikely to be anything but robust going forward regardless of global economic conditions or the price of oil. But now I am starting to hedge those positions. The clouds seem to be getting darker each day.
Car Talk
It seems that people finally are starting to understand that the energy problem is not about alternatives (especially ethanol, which is counter-productive). It’s about making cars and trucks operate on electricity that is generated by alternatives. We can have all the cheap renewable electricity we want - and I’m convinced we will have it in a surprisingly short time - but the electricity will do no good for solving our peak oil energy crisis if cars don’t run on electrons.
Over the past month I’ve been surprised to learn that the pleasant vision I had come to think would eventuate in a few years, lithium ion batteries powering plug-in hybrid electric vehicles (PHEV’s), may be an illusion. It seems that neither the cost nor the safety of large scale li-ion batteries is secure, which would explain why Toyota and Honda are planning for their next generation of HEV’s and PHEV’s to contain upgraded versions of the NiMH battery currently in use.
If the next five years of HEV and PHEV development are dominated by NiMH and not Li-ion batteries, two investment implications fall out. First, the lithium franchise of SQM becomes less compelling. Second, there will be a substantial need for more Rare Earth Elements that are used in NiMH batteries. One of my readers has kindly been educating me about these vital elements, their growing scarcity, and an investment opportunity related to them. I will be writing about all that soon.
Another potential option for bringing an affordable electric vehicle to market quickly is the ultracapacitor route being pursued by a small Canadian firm, Zenn Motors (Zero Emissions, No Noise). I’m intrigued by this possibility of an electric car with the range and power comparable to gasoline powered vehicles and the ability to recharge quickly. I’ve bought a few shares of Zenn (ZNNMF) and plan to learn more about the company and the EEStor ultracapacitor on which Zenn’s new product is based and in which Zenn has an equity interest.
Apparently EEStor is a very secretive private company about which two things are “known.” First they are funded, supposedly, by Kleiner Perkins, the highly successful Silicon Valley venture firm. And second, they recently got an ultracapacitor order for a military aircraftfrom McDonald Douglass [edit: wrong. The supposed EEStor contract is with Lockheed Martin, I believe.]. The buzz is that somehow EEStor’s proprietary technology allows for very rapid recharging while also allowing for slow discharge of its stored energy. If true, the product would seem to operate like a battery but one that is easily recharged. Moreover, the cost is said to be “low.” Whether true or not, the president of Zenn, who has been privy to inside knowledge of EEStor, seems to be betting his company on it.
The sum and substance of all this car talk is that the place to focus one’s attention in the “alternative energy” space is on batteries. An effective, cheap, safe battery system is what stands between our society being squeezed to death by high oil prices or being able to progress to the next level of clean, affordable, and independently produced personal transportation.
I think there is no question that the next five years will see cheap renewable electricity being produced from wind, thermal solar, PV solar, geothermal, and possibly wave technologies. But I have a lot of doubts about whether a new battery technology will allow all this electricity to do us any good in terms of solving our addiction to oil.
What About Natural Gas?
The other potentially game changing development according to some true believers is using natural gas to power cars and trucks. As I wrote, some leaders are increasingly advocating this route. The question, I think, is how many North American vehicles could be converted to natural gas before the demand for gas pushes up its price closer to energy equivalency, after which there would be little point to the exercise.
I don’t know the answer to that question, but I suspect it may be “not that many.” While natural gas supply is expanding in North America, I doubt that it can expand enough to handle a large amount of passenger transportation before the price would rise to the point at which it is no longer economical to spend a few thousand dollars to add a natural gas capacity to one’s car.
My guess is that demand for gas to generate electricity will increase as unstable renewable sources like wind and solar increase their penetration. That new gas demand by itself is likely to strain natural gas supplies over the next five years without accounting for even a single passenger car converting to natural gas. In sum, I am not a believer in the natural gas “solution” to our peak oil problems. I think we need to find the right new battery to solve this problem.
Meanwhile, here’s hoping that I will be proved wrong in my pessimistic expectation for the next phase of the economy and the stock market.
Best wishes,
Tags: peak oil energy investments
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18 responses so far ↓
1 paultaut // Aug 5, 2008 at 12:40 am
Hey,
I have to revise my assessments also. While I believe that 111 on oil will hold, I can no longer stand in the way of the asset divestiture of the Financial Institutions.
It looks like XOM is cracking, the next few days will tell, depends on the volume to the downside.
Special situations will rise everything else seems to be on the block. The Russell 2000(RUT) seems to be in the right shoulder of a H&S, breaking below 666 or so would suggest the mid-500s.
Personally, I believe 10,000 on the Dow will hold on this second leg to the downside but below 9,000 is still in the offing before years end, maybe 8,400 to 8,600.
One special appears to be MMR, check it out.
2 KV // Aug 5, 2008 at 1:57 am
Jim,
Truly appreciate a very candid August newsletter.
I agree, it is very informative to listen to Meredith Whitney.
However, most fail to account for the power of inflation to correct for the past excesses fast, at least, in the US economy. We are facing an inflationary world. If the inflation is controlled, we will be OK, but I do understand the social cost. If inflation is explosive, we may revisit 1930s fast.
House price is based on affordability, and it is easy to compute. It is what would a third of the gross salary buys at the prevailing interest rates and taxes.
My question is why no significant change in Canadian Oil sands holdings in the portfolio, especially as CA$ is starting to drop in value?
3 KV // Aug 5, 2008 at 2:06 am
FYI. From NYT, Link: http://www.nytimes.com/2008/08/05/business/05econ.html?_r=1&partner=rssuserland&emc=rss&pagewanted=all&oref=slogin
August 5, 2008
Inflation Takes Steam Out of Rise in Spending
By CATHERINE RAMPELL
Consumers spent more in June, but only because the things they bought cost more.
Driven primarily by energy and food prices, inflation grew 0.8 percent over May, the biggest monthly increase since September 2005, the Bureau of Economic Analysis reported on Monday. Spending, by comparison, grew just 0.6 percent in June.
“Inflation is intensifying, and that is the main source of weakness in consumer spending,” said Dean Maki, chief United States economist at Barclays….
More at the link.
4 Jim // Aug 5, 2008 at 5:04 am
Jim, you miss the main point in using natural gas for transportation- it keeps our dollars here, not in the hands of some crooked unstable nation. Secondly, if you really believe in renewables like wind, solar, and waves, why aren’t you investing in them? They are here now and you don’t have to guess about lithium ion, capacitors, or fuel cell batteries.
5 Ed Painter // Aug 5, 2008 at 6:47 am
I too have been intrigued by the EEStor and ZENN Motors story. I was considered buying some of the ZNNMF stock as this would truly be a game changer if the EEStor ultracapacitor is produced later this year or early 2009. However I did not buy any of the ZNNMF when I checked to see that no insider has purchased any of their own stock for in the last five years. This always make me think twice before investing in a company. I am still have ZNNMF on my watchlist.
6 paultaut // Aug 5, 2008 at 7:08 am
ditto on Zenn, but where did you get your Insider Info?
My small Haynesville spec. is Cubic Energy which is surrounded by a few majors.
7 amadee bender // Aug 5, 2008 at 9:47 am
where should press releases be sent?
8 Jose // Aug 5, 2008 at 10:13 am
Thank you for you comment. I understand that the key explanation for selling your stocks is credit bubble.
Let me recomend the last book by G. Soros, dealing with this topic. ( I do not like Soros very much, like of “gauche caviar”, but the book is brilliant).
Regarding Krugman, he stated some months ago that oil prices would never go down fro fundamental reasons. I asked in my post he was aware of derivatives market… Also I have a bet that in 2009 price will be lower than $70/barrel. Prices will increase but not in the parabollic unsustainable way in this 1st half.
Regards,
J.
9 Mike Mills // Aug 5, 2008 at 12:03 pm
Recent declines in oil prices might be a “head fake.” See:
http://drmillslmu.com/peakoi22.gif
http://drmillslmu.com/peakoi50.jpg
10 fran // Aug 5, 2008 at 2:22 pm
several comments left for jim with 8/4/08 seeking alpha article–nat gas for vehicles.
operative word for beginning of nat gas is “fleet” use. it overcomes most apparent logistics/safety concerns while providing tansitional near in reduction of oil use[especially the rapid growth in diesel fuel. the usa and worldwide reduction of diesel [tradeoff with nat gas] is a huge potential save. maybe full use by population of drivers[personal vehicle/car] not required. use as appropriate given geographic location or fuel cost advantage.
11 Simon // Aug 5, 2008 at 4:07 pm
Thanks Jim, Great read. I think investment timing is the hardest part of the whole equation. That and risk management. Technical analysis helps but is still so.. random. I’m going to do some serious thinking about this. I’ll let everyone know if I have a huge insight.
12 Robert Essian // Aug 5, 2008 at 4:54 pm
Jim, I would like to start by thanking you on your recommendations of John Mauldin and Paul Krugman.
John I like very much, he talks my language, straight shooter, good read and seems to take things in stride. I did not find him to be overly pessimistic more on the contrary. One of those “and this too shall pass” types. He calls a spade a spade.
Anyways it all clicked for me today on all your worries short term and after digging in past articles and reading new research I have come to the conclusion that why risk the gains. I’ll wait it out a bit, buy the stocks I was in (cheaper) and look forward to the eventual new highs in stocks.
If anything makes money in this world in the next 5 to 10 years it will be OIL!!! If not then we are in for the worst time ever imagined in World Human History.
Your concerns regarding consumer spending are valid to a point. The consumer will eat, will go to work, take care of family needs and go camping, etc.. All the other frills in their budget will be eliminated.
My thoughts are that energy will be the top priority no matter the economic condition. It has engulfed us in everything and there is no substitute. So even if unemployment hits 10% of the population 90% of the people will need to use lots of it.
China and India are not going to go away. Their growth may slow because of electrical needs etc…but grow they will. The Middle East will still be using oil so the inevitable is likely but delayed.
The consumers credit cards should be torn up or limited and must be made to live within their means. I believe it will save many a foreclosures from happening in the future and teach our consuming crazy citizens to relax for awhile. I mean how many TV’s do you need.
Exports may slow but so will Imports.
My guess is that there is a lot of American money floating around the World just itching to get back home for items the World needs. That in and of itself should help some treasury float around a bit. In addition we have so much for sale at bargain prices it may be to tempting to pass up.
In concluding my thoughts I’ll take some time and watch how things work, watch all stocks that were in my portfolio. The wife will smile at the cash we made instead of what I could have lost in the last year in the (other) market and chill. A penny saved is a penny earned.
Jim, thank you for your sight I enjoy it very much. Peace…
13 Robert Essian // Aug 5, 2008 at 5:05 pm
PS: Krugman is just brilliant and with his credentials he’s a must read.
14 KV // Aug 5, 2008 at 7:40 pm
From an article by Ben Stein:
…Or look at it another way: As of a year ago, everyone knew there were problems pumping in Iran, Nigeria, Venezuela, and Mexico. Everyone knew Russia was not getting as much oil to market as had been expected long ago. Everyone knew that Chinese demand was rising a year ago. The price then was about (very roughly) $70 a barrel. There is not one single brand new factor in the market to explain why that price has gone up so much except the fall of the dollar and as we have seen, that only explains most of it, not all of it.
Wait. I take that back. There has been one huge new factor. A staggering rise in purchases by speculators of contracts for future delivery of oil. This has been a new and gigantic effect in the market. This same effect gave us a bubble in high tech. It gave us a bubble in gold and silver about thirty years ago.
Some people say that buying oil futures cannot affect prices because someone else is always selling. But then if that were true, no price would ever change….
Link:http://finance.yahoo.com/expert/article/yourlife/98378 - Titled: Why Oil Will Keep Falling.
15 paultaut // Aug 5, 2008 at 10:35 pm
Short Sellers, which Congress wants to abolish, sell in the hope that they will be able make a profit. They are the ones that sell to the other speculators.
Lets say Congress abolishes naked shorting over all markets, both stock and commodity, then you would indeed have an almost one way road.
In commodities, IMHO, a very small percentage of the Futures Contracts currently being traded are not “naked”.
When a nat. gas company buys a contract to sell XYZ million cubic feet on a future date to so and so, that company is trying to hedge the company’s overall production from large downward spikes. It is a short seller that happens to have the goods to deliver. If prices go above that future price, the company will take a hit in earnings for that particular sale. If prices go down, they had the foresight to hedge their overall production.
Meanwhile, the majority of contracts traded both long and short will never see delivery. But they have to be there on both sides to make a market.
You sell a stock you own, you are shorting it. For whatever reason, you have decided that it has to go. Lets say it has doubled in less than 6 months. For you it has gone up your tolerance level. You would not expect it to double again in 6 months so you sell.
Your sell order isn’t naked but it adds to the amount of shares electronically floating around at any given moment and It Is a Short.
That role used to be the one the Nyse Specialist system was to provide. If a stock rose so dramatically that they ran out of shares they had in inventory or could find sellers on the open market, they “Created” shares to sell you, they were Naked short sellers. On the downside, they were supposed to step in to prevent a freefall by buying the shares no one else would.
In 1987, the Specialist system stepped aside and let the market freefall.
There was no bubble in gold or silver 30 years ago, gold moved in tandem with inflation and inflationary expectations. Who Knew that Volker had the guts to keep raising interest rates until the employment rate rose to 12%. That broke the back of inflation. It was not a Bubble. Meanwhile , silver’s rise was not a Bubble either, the Hunt Brothers were trying to corner the market and they might have succeeded if the public had not started to sell their silverware in droves. To make a bubble the public has to be buying, they weren’t.
The tech. Bubble Was a Bubble because the public was Buying in droves. Ditto, Housing Prices which could only go up, Ditto, the leveraged Buy outs which could only get Bigger as the Public bought into the Hype and bought into rumours no matter how slight.
Get yourself an encyclopedia and look up the “Tulip Bubble”.
All Bubbles have similar characteristics.
One of which “is not” being called a Bubble before the fact.
16 William Kennedy // Aug 6, 2008 at 7:33 am
Take your money and run. This thing about credit has a long way to go. I lived through the thirties and my father was a stock broker in the 20’s. I could spend several hours telling you horror stories. Mostly about peole who believed the market would NEVER go bust. It DID!!!
17 Robert Essian // Aug 6, 2008 at 7:42 am
William, I would be interested in anything you could share about that time. If Jim wouldn’t mind I’m sure many of his readers would welcome your insight…In my youth I heard the stories and watched how my Mother managed our home affairs but your insight would be absolutely valued…Please get back.
18 paultaut // Aug 7, 2008 at 6:52 am
Go get them William, but watch out for the “this time its different crowd”. They are here in droves.
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