Some notes from the Don Coxe call this week:
Don Coxe
May 21, 2004
Conference call from Chicago
“Is The Boom Really Over?”
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Thank you and thank you all for tuning in to the call which comes to you today from Chicago. The chart that we faxed out was the CRB futures and the question that we asked rhetorically was "Is the boom really over?”
Those of you who are faithful listeners of the call can assume that the answer I'm going to give to that is "No". You might ask why even bother having that as the title of the call and frankly it's because of the amount of stuff that I'm hearing from institutional clients and reading about that the commodity boom was to a very large degree driven by the excess liquidity created by the Fed's monetary policies and by the excess demand generated from China when they were letting things get out of control there.
And therefore, when China cools things off, we'll take away the extra demand and when the Fed starts tightening we'll take away the liquidity and therefore the commodity boom will be like all past commodity booms - I put it in Basic Points - short, followed by a nasty and brutish period as commodities will go back to the miserable returns they've given over the past two decades on five-year rolling average bases.
Now, although I discuss this in such detail in the current Basic Points, the reason I wanted to discuss this on the call is because what we're getting is some cross-currents developing in this and I think it's very important to start to separate out what is happening in crude oil to what is happening in commodities generally.
I think I'm probably guilty on these calls of having sort of lumped in the commodity boom without distinguishing there can be a point where the heavyweight commodity, which is oil - with help from natural gas - produces such constrictions on buyers that what you do is you take away demand from other kinds of commodities. So that you reach the stage where they become inversely correlated against each other.
Also, oil is different from the others in that it's the only commodity where you've got a gigantic geopolitical content. Now there's geopolitical content in most commodities but nothing like what we have in oil. Furthermore, I'm governed by my Rule of Page Sixteen, and the Rule of Page Sixteen - for those of you who haven't heard me refer to it lately - is that you neither make nor lose serious money by the outcome of a story that's on page one. You make or lose serious money by a story that's on page sixteen which is on its way to page one.
So since the peak of the triple waterfall, where I have week in and week out - and Basic Points month in and month out - been recommending the commodity-oriented stocks. And commodities were such a tiny weight in the index - I mean at the peak of the market commodity stocks were about 4% of the weight of the S&P. This was a true page sixteen story. What has happened with oil and to a lesser degree with the others, is it's become a page one story and the China story is also a page one story which affects commodities as disparate as soybeans and copper.
So, my concern then is that, following this through, when you have a story like this that's really on page one, I was really so concerned because there was a day this week when I was on the road which meant that I watched CNBC for more than I usually do, and by actual count, more than three quarters of one hour was devoted to discussions of oil prices. Well, that to me means that this is a story which is not going to mean any great returns for those who get on board at this point.
Having said that, the rollover in the CRB futures index has been cited also by some strategists as evidence that those two forces, the cooling in China and the tightening of the Fed mean that commodities generally are going to give up their gains and we're going to go back to the kinds of things that Wall Street makes its money on which is financials and tech stocks and consumer stocks and you know, generally "good stocks" type of thing.
So, the rollover and the breaking of the uptrend line on the CRB futures is a significant event. So I'd like to address this because it also goes along with something else that I did not anticipate, which is the rolling over the XOI, which is the oil index.
Now to me, what there was was a nearly perfect correlation going back to early last year between the XOI and the price of crude oil. And to me this was just a continually better argument as to why you should buy the oil stocks. Because when oil rose - at its peak it was up 43% year over year - well, the XOI meantime was only up about 22%, so to me this was an indication these stocks were just getting better and better because obviously the cash flow of the industry was getting better than merely looking at the rise in the price of oil.
If the industry was making X amount of cash flow with oil at thirty dollars then its cash flow is going to be dramatically better, and not just a third better, with oil at forty dollars. So, what the rollover of the XOI in breaking through its fifty day moving average which was producing ululations of joy on Wall Street that oil prices were about to fall, I thought was worthy of comment.
Let's look at this in the perspective of what happened to oil stocks when we had oil crises in the past, which is that they indeed did underperform when there was perception that there was going to be government intervention against the profiteering by the oil companies.
Now if you look at the performance of Valero (VLO), which has dramatically outperformed the producers - Valero is the biggest refiner in this country - the refining margins have just exploded. So what we have here is that's a situation which is getting a lot of publicity and what we can expect is there's going to be - if we should get two dollar and a half gas in this country - there's going to be more than just threats from the political sector, there's going to be something more than that. And whether it be an excess profits tax or something, I don't know, but there will be talk of it.
So the industry that has all this geopolitical risk on the supply side, may have a particular political risk on the profit side if it looks like it's making too much money at a time that consumers are getting hit hard.
I don't think there is going to be any meaningful attack on the industry in North America. And now, if we go to sixty or seventy dollar oil as a result of an al Qaeda attack on Saudi oil facilities, some kind of emergency legislation might come in. But the reason I don't believe we're going to have any broad-brush attack is that first of all the Bushies aren't going to do it and if Paul Martin decides he's going to do it in Canada then it will simply remind everybody of the way the Liberals treated the west in the Trudeau era. And although the Liberals are not expecting to do well in Alberta, they don't want to revive the absolute hatred that occured back then.
So, my reading is that that would be a very stupid thing for Paul Martin to do and I don't think he's a stupid man, I think he's a very shrewd man. And as you notice, my comments on him in Basic Points which have been largely laudatory, I just think that that is an unlikely outcome.
Now admittedly if we are talking sixty or seventy dollar oil and we had some kind of excess profits tax it presumably wouldn't be using a base of twenty five dollar oil. So the fact that we've also had some cooling out in the price of oil that it's gone back from forty one and three quarters back to the forty dollar range is a reason some people use for selling the stocks, but ha!, the stocks never ever moved up to the kind of level of forty dollar oil being priced in.
So, what we're going to be seeing when the second quarter earnings numbers come out, I believe, as I've stated in Basic Points that this will prove to be the biggest P/E discount for the oil group to the S&P, on record. And so you start out with a thing, if you really believe that a group is cheap relative to the rest of the market then even if you don't have a view about the longer term squeeze on oil - as discussed in the previous issue of Basic Points - what you can simply say is, this is a doggone good place to be.
And if you're talking about the big oil stocks, the BP's, the Exxon Mobil's, the Conoco Phillips, or in Canada, Imperial Oil and PetroCanada, the fully integrated companies, they got lots of nice features attached to them. They've got expanding refining margins, they pay dividends, they're just plain nice stocks to own.
But as far as the producers are concerned, there's only one negative that I can think of out there and it's not government intervention. It's that we will have even more in this quarter and going forward of what we saw in the Encana first quarter numbers. Which is that with record top line, because of huge prices for oil and natural gas, that it didn't flow to the bottom line because of their hedging as they call it. And that therefore the marking to market of their hedges will just blow away what should have been a great quarter. And I am not in any position to interpret that, that's only for the specialist, company by company as to what the companies are doing.
But if one looks at the producers in this country, in the United States, their earnings statements have not shown that kind of impact. Yes some forward sales, but not something that savages earnings the way we saw with Encana. So that's the only risk factor I see out there that's of significance in buying the producers here and one has to believe that when you've got this kind of fundamentals on the demand side, it's a great industry to be in. Not too many industries out there are in a position where demand exceeds supply and it's going right through to the price of the product.
Now it is still fashionable to suggest that oil prices are the result of some gigantic conspiracy. This just amazes me that people still do that. If they understood the concept of the triple waterfall, they would understand that after twenty years of working off the excess supply and during which time demand was rising fairly steadily and then it spiked in the last few years because of China that you say that simply unless once China and then India - we'll get to that in a minute - came in on the demand side, that we'd have to be adding a lot of new production, we'd have to add a lot of new refining capacity. Well we haven't done that. Nor are we likely to be able to do it.
There just isn't the stuff out there or the fields out there to bring on new production. You know, there's so much emphasis on the fact that OPEC could - between Saudi Arabia and Kuwait - bring two and a half million barrels a day on in a hurry. Well, if they did, that wouldn't give us twenty five dollar oil. And secondly, Matt Simmons - of course you've heard me writing about him - says he doesn't think they've got more than a million barrels of capacity.
Well, if you take the difference between the conspiracy theorists and the Hubbert Peak theorists, what it means is that unless we have a global recession, then sometime in the next number of months...there will be zero excess capacity in the world and we will go into a negative. And it seems to me that's a pretty good reason for owning these stocks.
If you're a believer in a global recession, then presumably you're selling stocks generally. But if you're not, if you think that the global economy is going to continue to grow, then what you're looking at here is a truly historic situation. We're going to be back to where we were in the early seventies, where demand exceeded supply and the free market operated.
Now it's been a very rare thing for oil, because the price of oil was set by the Texas Railroad Commission in the fifties and sixties, then it was set by OPEC from 1972 onwards. Now there's variations on this of course but I'm speaking in broad terms and what I'm saying is that we are now within sight of a situation where it will be driven entirely by demand.
There's just no way that you can see great new production being brought onstream and in any case we're going to need lots of new production just to offset the relentless and inexorable decline from the existing fields. Again, reading the press commentary on this - the fevered, feverish commentary that you see - what they do is a very neat thing in so many of the stories, they add the potential new production on there to the current production of the world, and then they get a surplus.
The wonderful thing is their assumption, that every well that we've got that's producing now will continue to produce at its current level but we're just going to bring on new production. That's really stupid.
Because what we have is a situation where existing wells - as a group - are in decline. And therefore we need to be bringing on lots of new stuff to make up for it. I mean it's bizarre, so much of the commentary. And therefore it feeds into a basic bias of the liberal press which is that Bush is in league with the oil industry in Texas and Louisiana and with the Saudis to gouge oil consumers in some Faustian bargain to make money for his family.
Well, you know, there's lots of people who believe that, but I don't and I wouldn't dignify it by commenting on in it in these calls except that I know you're seeing this in the media. And there's a book out that maintains this and you know I loved Bush's comment in talking about his economic stimulus package that he has apparently provided enormous stimulus to the book industry because of all these books that come out and say he's a liar. And he commented and said I would be lying if I told you I'd read the books.
Well, I believe therefore that although I'm not expecting to see oil prices move up from here at least over the next few months, I'm not looking for them to collapse either. But if we take a look a the CRB futures, as opposed to the Goldman Sachs index - the Goldman Sachs index is over sixty percent weighted to energy, but the CRB futures, we're looking at three of the seventeen. So that's why I chose that chart, because if we start flipping through the components of that, what we see is that we've basically moved back, in some of these cases, to where prices were before the carry trade really took over in speculation.
Now, part of the thesis of the current Basic Points is that we did have, because of excess liquidity and late converts to the China story, we did have some speculation moving in, in things like copper and soybeans and therefore as soon as some glitches developed, we had some huge sell-offs. But, the sell-offs that have occurred have just taken us back to where we were quite recently. For example, the pullback in copper from a buck thirty nine down to one twelve, which produced some huge sell-offs in the base metal stocks - that got us back to where we were in early February. Big deal.
Now, if we go through to the soybeans, which are, again, levered on China, the stories have come out and they've received enormous publicity about buyers in China who've defaulted on their purchase orders because the crushers cannot make money, they lose money buying soybeans at the current price in order to produce oil and soybean meal.
Look, in any situation with a raw material, where the price spikes far beyond what ordinary operators in an industry had allowed for in their pricing structure, what you're going to get is defaults and bankruptcies and that's one of the ways that the market reallocates resources. But if you take that, because of this panic selling, of those ships backed up in China once again I know that's a page one story because of the number of people who've told me that in the last week "Did you miss this story Don?", and pardon me, but I'm always amused by people who - gently amused - by people who ask if I've seen a story which is on the front page.
Now it's true that as a believer in page sixteen that I read that in more depth than I read the front page because that's organized to sell papers on the newsstand and therefore it's designed to be surprise and shock and fear stories. Still, I would really have to be in some kind of another world if I'd missed that story. But that still has taken us back to where we were in mid-Feburary. Big deal, because in mid-February, with soybean prices at these levels, we had soybeans at eight sixty up from six dollars and a quarter in September. That's still a huge gain.
Corn? Well, it's roughly the same story. Corn prices collapsed along with the beans and we've gone down to the two eighty range in corn but look, as recently as year end we were two fifty. So from the standpoint of an Illinois corn farmer, who's looking at two hundred and twenty five bushels an acre, that differential is enough to buy him a couple of John Deere’s in the fall.
Now to take a commodity again, that's even not correlated to anything else, feeder cattle, we're back up to where we were and indeed above where we were when they found that mad cow in the US.
So I will come back to my basis thesis which is that the basic materials, which have been victims of the two-decade long triple waterfall which squeezed producers and eliminated marginal production and so this still is a broad based move on a year over year basis they're up substantially. And if you look at that chart, you'll see that on a year over year basis, even with the sell-off, the CRB is up a heck of a lot better than stocks are.
So, no I don't think it's time to throw in the towel, but I'm just cautioning you all to have a healthy skepticism about people who have ignored this asset class, or despised it or ridiculed it, who now come in and say "Well, it was this big blip that was based on two stories that got overdone which was the Fed was printing money like mad and China was growing at a cancerous rate - so those stories are over so forget about it."
I don't think that's the case.
Now, as far as other stories are concerned, I wish there was good news from Iraq and I don't know when we're going to get good news from Iraq. We're still dominated by the Iraqi Horror Picture Show and it's effect on the morale of Americans in particular about their mission. And it certainly has hurt George Bush in the polls. He had polled in to a modest lead in the general polls against Kerry and he's now a little bit behind. But having said that, if there are no brand new type horror stories out of Iraq - if it's the same sort of thing, which is the Sunnis and the Wahabbites in the Sunni triangle, and if it's al Sadr in the Shia area, and we're back to those stories - I have a feeling if that's all it is then gradually what you will say is Bush will pull back and ahead as long as the economy continues to grow.
So, we're still going to have an effect from the job numbers. Now, given what the last job number did to the bond market and to the stock market -clocking them both - I suspect that what we're doing is building in some support underneath. So, if we have another big job number the next time, I wouldn't be surprised if that meant a rise in the stock market, not a sell-off. Because the market does have a wonderful ability to reconstitute itself and price in a new scenario.
Some of my meetings with literally dozens of fund managers in five countries in Europe and in Canada, what I can say is that the new consensus is that one should adopt a wait and see attitude here, to see how the effect of Fed tightening and China tightening play out and that the sheer scale of the sell-off in the commodity oriented stocks has shaken up a lot of he believers in the long view, the China view, and they watched profits melting away and their attitude is not to add to positions here. I'm not going to argue with that, I'm just going to tell you that what I detect is now a far greater consensus, out there, than I've seen in a long, long time. That fund managers are nervous and they're holding back and waiting to see how the story plays out.
Well given that the combined weight of all the commodity groups in the S&P is under eight percent, if we should get a good end to this story, if we get the first two or three Fed tightenings and we have not had a collapse in the mortgage-backed sector of the market and if China is seen to have been reining in its growth somewhat without a collapse, there's a wall of money waiting to come in to buy the commodity stocks.
So, I think this newly formed consensus, that's sort of like in religion, that the newly converted are always the most passionate, this new consensus is on a scale that indicates that we are on a major flex point for the market. And events are going to tell us which way it comes out, but what I sense is, if the news should turn out to be anything better than the fears of the market, the impact on the commodity stocks will be enormous and it may not be that great on the bond market, because the bond market is already pricing in a lot of activity.
So, therefore those of you who are planning to take extended summer vacations, I think if you've got short positions on in the market, I wouldn't recommend a canoe trip to the far north where you're out of touch with the markets. You might want to cover your shorts.
That's it, any questions?
Arthur Gray: The market is already put in a fifty basis point rise in the market. What do you think will happen if, as I believe, the Fed doesn't do anything in June?
Don Coxe: Oh wow. If the Fed does nothing in June then we're going to have a big sell-off. Because that would be a true shock to the market and it would indicate that the Fed is prepared to tolerate a real outbreak of inflation. The only asset group that I think would be a big winner out of that would be the golds because here you would have the world's leading central bank ignoring all sorts of evidence of returning inflation. So, if that's the case, if you're right on that call, wow, that's bad news for bonds and stocks. Thank you. I hope you're wrong. But I know you've got a good track record Arthur.
Thank you all for tuning in, we'll talk to you next week.
Don Coxe’s Profile from the BMO website:
Donald G. M. Coxe is Chairman and Chief Strategist of Harris Investment Management, and Chairman of Jones Heward Investments. Mr. Coxe has 27 years experience in institutional investing, including a decade as CEO of a Canadian investment counseling firm and six years on Wall Street as a 'sell-side' portfolio strategist advising institutional investors. In addition, Mr. Coxe has experience with pension fund planning, including liability analysis, and tactical asset allocation. His educational background includes an undergraduate degree from the University of Toronto and a law degree from Osgoode Hall Law School. Don joined Harris in September, 1993.
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