Note: percentages above taken on stock portion of portfolio only

PERFORMANCE

EIS = Energy Investment Strategies account
OIH = Oil services ETF
IYE = Broad oil and gas ETF
SPY = S&P 500 without dividends reinvested

Click here to see complete historical information regarding performance.

LOOKING FORWARD

SUMMARY

Stocks are in a bear market as the U.S. economy heads toward recession in the short term. It will not be a short recession for a number of reasons:

1. In the modern era of less manufacturing and lower inventory levels the economic cycles have gotten longer, so this down cycle could also be a long one.
2. Real interest rates are already low. The Fed has little ability to lower them much further to take the economy out of recession.
3. The U.S. economy is being “taxed” very substantially by its oil and other trade deficit which has a greater depressant effect on the economy than does the stimulative effect of the Federal budget deficit. Thus we are unlikely to get a Keynesian sort of stimulus effect.
4. The American-led economic weakness caused by credit market problems and a housing bust is spreading to the rest of the world. EU countries are even weaker than the U.S. Chindia is expected to experience much lower growth.
5. Housing prices are still declining. A slowing of the decline of home prices may happen, but that is still not a stimulus to the economy. When the decline stops, the bottom will be in sight.
6. The housing price decline is spreading to the stock market. Weaker stocks may continue as I expect, causing further declines in consumer spending, a vicious cycle. There will be short, energetic counter-trend rallies which some will misinterpret as the end of the bear market.

In two to three years - I expect to see much higher oil prices caused by peaking and then declining production. Much higher oil prices would deal the U.S. economy another strong blow. Since the economy will already be in a weakened posture, such a blow could be very serious.

In sum, the odds favor lower and possibly very much lower stock prices going forward. Therefore I have sold nearly all stocks and hold mostly cash and some options on longer dated oil futures.

If home prices show signs of improving or if the price of oil were to drop well below $100 I would want to reconsider the above strategy. At $80 oil or something close to that, the oil service and some E&P companies could be very compelling bargains.

CRUDE OIL

Crude oil is testing lower levels. Ordinarily I would expect it to hold above $100 through the winter bolstered by higher winter demand and potential efforts by OPEC to defend the $100 price level. However this is an election year. The Saudis may want to avoid high oil prices during the U.S. election to foster the election of a Republican. Moreover, fundamental supply and demand forces are all negative now and look to remain negative, possibly for as long as 2 more years.In theory oil service and drilling stocks should not be much affected by lower oil prices since the global demand for finding and retrieving oil from ever more difficult and expensive new fields should be strong so long as oil stays above, say, $80. But the fact is that as oil has pulled back from $147 to about $103, the OIH fund of oil service and drilling stocks has done only slightly better than the IYE index that combines oil exploration and production companies with oil service and drilling companies. The theory has not worked in stock market reality.

NATURAL GAS

Gas has been weaker than oil because gas inventories are adequate and because gas production has been increasing significantly due to new unconventional plays of major size that can now be developed using new horizontal drilling and new fracing technologies. Demand for gas is likely to grow based on its lower cost. New transportation uses in North America look to be coming on stream along with new electrical generating demand and potentially new industrial demand as natural gas intensive plants move back to North American from which they had migrated a few years ago when the price spiking above $15 for a short time.

Eventually there will be a recovery in natural gas prices, but perhaps not in my lifetime (just kidding, I hope). I doubt the price will slide much below $7 since high marginal cost wells would be shut in at that point.

This entry was posted on Friday, October 10th, 2008 at 9:39 am and is filed under Monthly Portfolio Results and Market Comments. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.