2011 Halftime Report: Oil and Copper

Sunday, July 24th, 2011

2011 Halftime Report: Oil and Copper

By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors

Last week we recapped commodities’ performance for the first six months of the year and offered our outlook on gold. If you missed it, you can read it here. This week, we’re discussing our outlook for two other commodities that are poised to have an exciting back half of the year.

Oil Outlook Remains Strong
This year has been eventful for the oil patch. Natural disasters, revolutions, terrorist attacks and political maneuvering kept oil bouncing around $100 per barrel and 3.8 percent higher on the year at the end of June. Despite the volatility and large number of external forces affecting oil prices, the International Energy Agency (IEA) said in its most recent Oil Market Report that “the bull run evident since autumn 2010 therefore looks in large part to be justified by supply and demand fundamentals.”

Oil industry analyst PIRA estimates incremental demand will outpace supply by 1.1 million barrels per day on a year-over-year basis during the third quarter of 2011. The U.S. Energy Information Administration (EIA) says long-term supply/demand drivers indicate the market will remain tight for the foreseeable future as growing demand from emerging economies for liquid fuels and slowing non-OPEC supply growth “maintain upward pressure on oil prices.” The IEA forecasts oil prices to average $98 per barrel this year and $103 per barrel in 2012.

Oil Demand
The IEA forecasts the world will use 91 million barrels of oil per day in 2012, an increase of 1.5 million barrels per day. The IEA also revised its 2011 oil demand projections upward by 0.2 million barrels per day. Projecting outward to 2016, the IEA’s baseline scenario assumes a healthy 4.5 percent global GDP growth and an average oil price of $103 per barrel. With these assumptions, annual oil demand growth should average 1.2 millions barrels per day through 2016.

Emerging markets are almost entirely the source of this increased demand, with China accounting for 41 percent of demand growth over that time period, the IEA forecast says. The chart illustrates how developing (non-OECD) country oil demand has dramatically increased since the mid-1990s while developed world (OECD) demand has decreased. Through two financial bubbles and a global financial crisis, non-OECD demand has stair-stepped its way to nearly doubling in less than 20 years.

How is this possible? Many non-OECD markets have favorable demographics, rapidly urbanizing populations and industrializing economies that have returned many developing economies’ GDP growth rates to pre-crisis levels.

Rising incomes have also outpaced rising oil prices and sustained emerging market demand despite a general reduction in subsidies, the IEA says. Rising wealth has also established a new global middle class that the World Bank estimates will be more than 1 billion strong by 2030. In fact, the World Bank was cited in a National Geographic article earlier this year forecasting that for the first time ever, more people in the world will be classified as middle class than poor in 2022. Today, roughly 70 percent of the world’s population is classified as poor.

Major emerging market countries, such as China, India and Saudi Arabia, have reached the important GDP per capita range ($3,000-$20,000) where oil demand historically “takes-off.”

China carries the biggest stick among emerging markets when it comes to oil demand. Strict tightening measures from Beijing and rising inflation slowed the country’s oil demand growth to its lowest level since 2009 in June. However, China’s oil demand is still expected to grow 7 percent this year, which is in line with the country’s five-year average demand growth rate, according to Deutsche Bank. The summer months have historically been weak periods for oil demand in China but Deutsche Bank estimates growth rates will recover during the fourth quarter.

Chinese auto sales growth has slowed but still registered 10.9 percent year-over-year growth in June. In an interview with Maria Bartiromo for USA Today, Ford CEO Alan Mulally called China’s car market a “very exciting development.” The company is projecting China’s auto sales will reach 32 million by 2020—28 percent of the entire global market. Ford isn’t the only U.S. auto manufacturer tapping into China’s booming auto market; General Motors’ Buick brand is one of the most popular in the country. According to the Brookings Institute, General Motors sold 10 cars in the U.S. for every one car sold in China in 2004. Today, that figure is nearly 1-to-1.

In the developed world, the outlook for oil demand is less bullish. OPEC says the “austerity measures, combined with high levels of both debt and unemployment, are likely to dent the fragile recovery in major OECD countries.”

While demand growth in OECD countries is underwhelming, consumption rates have recovered from recession lows at a much faster rate than many expected. You can see that OECD demand contributed heavily to the recovery in global oil demand from early 2009 to late 2010. In fact, the developed world contributes little to global oil demand growth but still consumes more than half of the world’s total demand.

Despite China’s rise, OPEC says the fate of the U.S. economy is the most influencing factor for oil over the next 12 months. Oil demand in the U.S. was revised upward in May and the U.S. economy is forecasted to see 2.5 percent GDP growth in 2011.

PIRA says the U.S. economy is signaling strength in the second half of the year. It cites business capital expenditures as improving, which generally leads to employment gains and increased household consumption. It also expects a 20 percent hike in auto manufacturing output from the second quarter and an increase in consumer spending.

A big determinant of U.S. demand and consumer spending is gasoline prices, which the EIA forecasts to average $3.56 a gallon in 2011—up from $2.78 in 2010. U.S. consumers have already shown to be sensitive to higher prices with total motor gasoline consumption down more than 2 percent on a year-over-year basis during the second quarter. While OPEC expects U.S. gasoline consumption to return to normal rates, OPEC calls it oil’s “wild card” for 2012. Gasoline consumption could be negatively impacted by economic turbulence, such as a dip in employment.

This is just a portion of the Outlook for Oil, click here to read about factors constraining supply and why today’s market is much different than the 1970s.

Read full report

The Cues for Copper
Copper slightly disappointed investors, ending the first half of the year with a decline of 3.50 percent. Worries about global inflation and, more specifically, the potential slowing of China’s economy weighed on copper’s price. The red metal rose 5 percent quicklyin the new year, but similar to zinc, lead, palladium and platinum prices, declined sharply at the beginning of May.

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Copper Supply
Since the end of June, copper has been slowly inching its way up, with the past three weeks having produced positive results. Part of this rise is due to reduced supply issues. Chile, the world’s largest copper producer, has been plagued by power outages, strikes, accidents and heavy rains. Reuters recently reported that a “once in a half century winter storm” caused more than 12 mines to slow or stop operations after the open pit roads became too slippery in the South American country that mines about one-fifth of the world’s copper.

The election of Ollanta Humala in Peru–the second-largest producer of copper–has also been a drag on copper prices as investors debate the probability of Humala electing a mining-friendly cabinet. As I discussed in “Is Peru’s Humala Jekyll or Hyde for Mining?,” investors have worried the president-elect could retract policies that encourage mining investment.

The announcement came this week that Humala will appoint Luis Miguel Castilla, Peru’s former deputy finance minister, as the new finance minister. Carlos Herrera will lead the mines and energy ministry. However, according to the Financial Times, it is still not clear whether Humala will increase the corporate tax rate paid by miners and enforce tighter state controls. The actions of this leader will have an influence on the direction of copper prices for the remainder of the year.

Copper Demand
In terms of demand, copper is a necessary ingredient for numerous building projects. Electrical power cables, electrical equipment, automobile radiators, cooling and refrigeration tubing, heat exchangers and water pipes all require copper. With all the construction and infrastructure building in China over the past several years, it’s not surprising that this country is the No. 1 world consumer of copper. It’s estimated that China accounted for nearly 40 percent of global copper consumption last year.

Because of this large demand, similar to our outlook for oil, copper prices hinge on China’s ongoing development. While some have begun to wonder about the health of the country’s continuing growth and development, Macquarie Research believes that “real demand in the country remains robust.”

Take developer activity, for example, which Macquarie says has been a huge driver of construction growth in 2011. The media has focused its attention on ghost cities and lagging sales of property in China. Yet Macquarie thinks it’s important to consider the property sales across all different sizes of cities. In its Commodities Comment, subtitled “Chinese social house – another reason to buy copper and iron ore,” Macquarie acknowledges a weakness in property transactions in China’s larger cities. This was due to the government restricting investment demand to slow growth. However, these larger cities account for only 20 percent of the total market, says Macquarie.

Conversely, many smaller cities, such as Anquing, Guizhou, Luzhou, Mudanjiang, and Shijiazhuang, have had double-digit year-over-year growth in unit sales so far this year. In the case of Hohhot, the capital city of Inner Mongolia, sales growth has tripled. Government investment has led to urban space increasing from 80 square kilometers in 2000 to 150 square kilometers last year, according to the city’s government website. Hohhot, which means “green city” in Mongolian, has grown to more than 2 million people and has become a hub for agriculture and manufacturing.

Most importantly, Macquarie says the tremendous sales activity in these smaller cities indicates “there has been enough cash to keep construction activity going.”

In addition, China’s social housing project should drive incremental demand for copper. Macquarie indicated that China is “aiming for 10 million social housing units, up from 5.8 million in 2010.” The country has built only 3.4 million units so far this year, but based on China’s habit of exceeding its objectives, Macquarie thinks the target will be met.

Even if the naysayers think China’s growth will slow because of the government’s monetary policy restrictions, there’s consensus among research experts that the country’s inventory of copper is getting low. Goldman Sachs’ discussion of the copper market indicated that in the second half of 2011, the “winding down of destocking will lead to a stronger Chinese pull on global supply.” China seems to have no choice but to go back to the market for copper, if only to replenish its supply.

Tom Kendall, Credit Suisse’s vice president for commodities research, agrees. In a Mineweb interview on copper’s fundamentals and expectations of further growth, Kendall stated he has seen a “very sizeable drawdown” in Chinese copper inventories this year. He goes on to say, “some point in time, they will get to a point at which they have run down inventory levels to an uncomfortably low level and then there is no alternative to coming back to the international market.”

Tags: Baseline Scenario, Chief Investment Officer, Commodities, Demand Drivers, Demand Projections, Emerging Economies, Energy Information Administration, Frank Holmes, GDP Growth, Global Gdp, Halftime Report, India, Infrastructure, International Energy Agency, Liquid Fuels, Natural Disasters, Oil Demand, Oil Market Report, Oil Patch, Political Maneuvering, Report Oil, U S Energy, U S Global Investors
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Moment of Surrender: Regimes Fall, Oil Prices Spike (Sonders)

Tuesday, March 1st, 2011

Moment of Surrender: Regimes Fall, Oil Prices Spike

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

February 28, 2011

Key points

• Geopolitical tensions swell along with oil prices, pushing the stock market lower.
• The absence of a longer-term oil-supply shock suggests the price spike could be short-lived.
• Consumers will take a hit, but the broader economy should avoid a double-dip recession.

In this unprecedented time of ordinary people rising up to do the extraordinary—toppling multiple governments in the Middle East—we look at what the reverberations mean for the market, economy and energy sector.

My thanks go out to my Schwab colleagues Michelle Gibley and Brad Sorensen for their input on this report. It’s also been invigorating to dust off my energy analyst cap because I covered the sector as a portfolio manager for many years in the late 1980s and 1990s.

Protests for democracy, especially among the younger generation, have spread beyond Egypt and Tunisia to other countries with oppressive governments, skyrocketing food inflation and high unemployment.

Last week gave markets a crude awakening as geopolitical tensions and $100 oil prices dominated the business headlines:

• Brent Crude (European, African and Middle Eastern oil that is exported to the West) oil prices moved into triple digits last week on Libyan unrest, before settling back at week’s end.
• The US benchmark, West Texas Intermediate (WTI), has been more subdued (explanation later in the report).

Oil Prices … 2008 Redux?

Click to enlarge
Source: FactSet, as of February 25, 2011.

Our initial impression is that the move in oil prices is likely overdone for several reasons. There appears to have been much panic-buying and speculation in the run-up. Already, the Saudi Arabian government has said that it can step in and fill the void left by the supply disruption in Libya, which accounts for only 2% of global oil output.

This, of course, is contingent on unrest not spreading to Saudi Arabia. King Abdullah is a popular figure and a new $36 billion package of social benefits may keep unrest at bay. But, there remains the possibility of uprising by the Shiite Muslim minority, which constitutes 75% of the population in the eastern province, and which is also home to key oil fields.

In addition to the Saudi response, the International Energy Agency (IEA) said it stands ready to release emergency stockpiles if needed, and officials from the Obama administration have stated that the Strategic Petroleum Reserve can be tapped, as well.

The bigger fear is that the oil supply upheavals spread. Bahrain, Yemen and Algeria are small producers, each with less than 2% of global oil output. But Iran produces 4.6% of global supplies.

US supply glut
While oil imports from the Middle East and North Africa (MENA) are important, Canada and Mexico are the top two sources of foreign oil for the United States. In fact, there’s a supply glut in the United States, which explains the record-wide $16 spread between Brent Crude and WTI prices.

Inventories at the Cushing, Oklahoma delivery point for light sweet crude in the United States are elevated due to higher US oil production, rising imports from Canada and lower refinery utilization. This excess has kept a lid on WTI prices. The spread could narrow but is likely to remain until several new pipelines are built during the next couple of years.

Due to this bottleneck issue at Cushing, Brent Crude prices are likely a better gauge of demand for oil globally. Additionally, prices at the pump, even in the United States, are more closely tracking Brent Crude prices.

We do have access to energy sources on domestic soil in the form of oil shale deposits and natural gas, but significant production from these sources are some time away because of environmental concerns, powerful oil lobbies and lack of political will.

The impact on other parts of the world is greater. In the euro-zone, Italy takes one-third of Libya’s oil production, Germany takes one-tenth, and Spain and Switzerland jointly take another one-tenth.

The impact in China is significant, too: 50% of its imports are from the Middle East and an additional 30% are from Africa. What’s unique, though, is that the Chinese government controls prices at the gasoline pump. It can delay pushing through price increases and force refineries to operate at a loss.

Short-term problem?
Importantly, much of the tension in the Middle East stems from economic turmoil, rendering it unlikely that leaders of these countries would want their main revenue source cut off for any length of time.

As for the protesters and possible future leaders, were they to disrupt production facilities, they would likely lose public support very quickly.

It is impossible to predict the outcome from geopolitical unrest, but outside of larger-scale conflicts, the most likely scenario is that oil-supply disruptions will be short-term in nature.

In fact, despite spiking spot-oil prices, the message from the futures market is that this is a short-term phenomenon, with longer-term prices below current prices.

Economic impact
Even before the latest outbreak in geopolitical unrest, oil prices were rising due to the improved economic outlook. Current forces behind rising demand include strong emerging economies and improving US growth, creating synchronized global growth.

We believe we are also on the verge of much-better jobs reports, which could feed into a self-sustaining economic cycle and, thus, higher oil demand.

But what is the tipping point for oil? At some point, rapidly rising commodity prices of nearly all varieties ultimately sow the seeds of their own destruction via rising supplies and weaker demand.

It’s hard to know when that’s going to occur, although the consensus is that $120-130 oil would start the process.

In the meantime, Bank Credit Analyst (BCA) estimates that every $10 increase in the price of oil shaves economic growth by 0.1-0.2% … not significant at this point, but it will add up if oil prices continue to rise.

We do know that most recessions have been preceded by oil-price spikes. You can see this laid out in the chart below (the shaded bars are recessions).

Recessions Often Follow Oil Spikes

Click to enlarge
Source: FactSet, as of February 25, 2011. Plotted on logarithmic scale.

There are a lot of comparisons being made to the most recent oil price spike in 2008. But there are important differences between then and now. The US economy was already in a recession at that point, with the employment and housing fundamentals in breakneck declines.

Today, we’re in a time when the economy has already moved from recovery to expansion, and unemployment claims are down significantly.

In addition, the manufacturing sector was in freefall in 2008. Today, it is extremely strong, with the reading this week likely to show even further acceleration.

We believe the most apt comparison is not to 2008, but to 2003 when oil doubled to a then-record $40 per barrel, in response to the invasion of Iraq.

Fears of a double-dip recession were rampant then, but the strong leading economic indicators gave the correct signal that the expansion was intact. I would argue that case for today, too.

Leading Economic Indicators Much Stronger vs. 2008

Click to enlarge
Source: The Conference Board and FactSet, as of February 25, 2011.

Consumer impact
The percentage of disposable income consumers devote to energy purchases is approaching 5.8%, up from just over of 4% at the end of the recent recession. That’s shy of the high of more than 6% in 2008 but over the average level enjoyed from 1985 through 2005.

So, there remains some room in consumers’ budgets to absorb the increase in energy prices. However, it’s the speed of any additional energy price increases that will be important to watch. Consumers tend to ignore gradual increases, but react more to sharp changes in prices.

In addition, increased energy efficiency has somewhat reduced the dependence of the economy on oil. In the early 1970s, US energy consumption as a percentage of gross domestic product was about 16%. Today it is less than half of that.

Federal Reserve to react?
The more-bearish economists are suggesting that a continued spike could trigger a double-dip recession and/or talk of a third round of buying back Treasuries also known as quantitative easing (QE3) by the Fed. We think economic momentum is sufficient to avoid the former and certainly hope the latter is not in the cards.

The weakness in the US dollar, which is likely partly due to the Fed’s second round of quantitative easing (QE2 in November of 2010), has contributed to the surge in commodity prices (they move inversely).

Why would the Fed want to exacerbate that problem with a policy (QE3) that would likely weaken the dollar further? What’s more likely is a lengthier phase before the Fed considers raising interest rates.

The Fed is only likely to react by raising rates if job growth improves meaningfully and rising wages suggest a filtering of high oil prices through to generalized price increases.

Market impact
In addition to fears about oil prices and their economic impact, there is a fear that rising geopolitical tensions could cause a general flight out of riskier assets, like stocks.

There is precedent for quick and sharp oil-price spikes to precede market corrections. Historically, there have been seven instances when oil prices have jumped more than 10% in a two-day time period, with the average decline of the stock market being about 9% during the subsequent six months.

Oil Spikes Often Bring Market Indigestion

Click to enlarge
Source: Birinyi Associates, Inc., as of February 28, 2011. Dates represent the end of the two-day oil spike.

As we’ve been noting, the market sentiment conditions (too much bullishness) were suggesting increased stock market vulnerability, and we saw that with last week’s 3% decline in the S&P 500® index.

Absent a significant further oil-price shock, we think the cyclical bull market will continue. The two key supports for the stock market—strong earnings and accommodative monetary policy—remain intact.

As such, for those investors who remain underexposed to US stocks relative to their long-term target allocations, we would recommend using any further market weakness to buy stocks at lower prices.

Sector Snapshot
As for which segments of the market look most favorable in a high oil-price environment, according to Ned Davis Research:

• The Energy sector is a clear beneficiary, on which we have an outperform rating.
• Materials is next on the list, on which we have a marketperform rating.
• At the bottom of the list are Consumer Staples (underperform), Telecommunication Services and Health Care (both with marketperform ratings).

You can also read our complete Schwab Sector Views, which provide our analysis and recommendation for all 10 sectors.
A note to contrarians: Sentiment about oil prices has become a bit one-sided. According to SentimenTrader, traders in the Rydex family of funds have piled as much money into the energy sector as they ever have.

Oil prices have generally not moved higher in the past when that’s happened, though geopolitical concerns can often trump historical sentiment readings.

The good news from a broader sentiment perspective is that optimism has waned significantly with the current geopolitical unrest and last week’s stock market drop (sentiment works in a contrarian way). Those improved sentiment conditions set up a healthier market environment.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative (or “informational”) purposes only and not intended to be reflective of results you can expect to achieve.

Tags: Brent Crude, Canadian Market, Charles Schwab, Chief Investment Strategist, China, Double Dip Recession, Emerging Markets, energy, Energy Analyst, Factset, Initial Impression, Liz Ann, Market Economy, Middle Eastern Oil, oil, Oppressive Governments, Report Oil, Reverberations, Saudi Arabian Government, Supply Disruption, Supply Shock, Term Oil, Triple Digits, Unprecedented Time, West Texas Intermediate
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Energy and Natural Resources Diary (October 4, 2010)

Saturday, October 2nd, 2010

Energy and Natural Resources Market

Strengths

• HSBC’s measure of China’s manufacturing Purchasing Manager’s Index (PMI) for September increased to 52.9, the highest level in five months, from 51.9 in the prior month. The PMI figure, as well as other recent economic data out of China, suggests that economic growth in the country might be re-accelerating following signs of softening after tightening measures were implemented earlier in the year.
• Copper prices hit a 26-month high of $3.65 per pound this week.
• Crude oil prices gained 6.6 percent for the week on further talk of quantitative easing from the U.S. Federal Reserve and a bullish weekly inventory report.

Weaknesses

• Natural gas futures prices slid 2 percent this week as industry supply and demand data continue to indicate surplus inventories and production.
• Steel output in Japan, the world’s second-biggest producer, will probably drop 1.5 percent next quarter because of slowing demand from carmakers, according to the nation’s Ministry of Economy, Trade and Industry.
• Consol Energy said Friday it will lay off 231 workers at two mines. The Pittsburgh company said it will lay off 135 hourly and 36 salary workers at the Emery Mine near Price, Utah, because of higher production costs, relative to the local region, and market conditions for coal. More than 250,000 tons of coal at the mine remain to be sold. Consol Energy said it will also lay off 60 employees at Mine 84 near Washington, Pa., because of the high cost structure of the mine versus current market prices for coal being produced there.

Opportunities

• In a recently published report, oil analysts at Bank of Montreal estimate that the Eagle Ford shale play in South Texas holds recoverable resources of roughly 8.8 billion barrels of oil equivalent (boe) and that production could approach 1.4 million boe per day by the year 2015.
• At an industry conference in Dalian, China, Rio Tinto indicated that Chinese ore demand this year may exceed last year’s level as it continues to run at full capacity. Further, Vale said that it expects Chinese steel demand to pick up in late 2010 or early 2011.
• China’s coal use will probably grow by more than a third in the next five years, according to Peabody Energy Corp., the largest U.S. coal producer. China’s current coal consumption of 3.3 billion tons a year will likely rise to 4.5 billion tons.
• State-owned China National Nuclear Corp (CNNC) is scheduled to spend Rmb800 billion, or US$117.6 billion, on the development of nuclear industry by 2020 (CNNC’s nuclear investment is expected to reach Rmb500 billion by 2015), according to the company.
• The International Energy Agency said on Friday it anticipated upward pressure on oil prices in the second half of 2011 due to a projected decline in oil stocks. The agency also said the most recent round of sanctions imposed on Iran by the United States and the European Union was leading to significant delays for Iran’s oil and gas developing projects. A senior oil analyst for the agency’s oil and industry markets division said that if the global economy grew at an annual rate of more than 4 percent in the first half of 2011, as projected by the International Monetary Fund, oil supplies could start to be squeezed.

Threats

• According to the Wall Street Journal, BHP Billiton and Rio Tinto are looking at revising or postponing their proposed $116 billion iron ore joint venture until the Australian government sets the terms of its planned mining tax.
• The youth wing of South Africa’s ruling African National Congress said it will spend the next two years seeking support for the nationalization of mines after succeeding in putting it on the party’s agenda for debate.
• The Department of Energy and Climate Change (DECC) forecasts U.K. oil production is likely to fall to 1.03 million barrels per day (bpd) by 2015, down from 1.39 million bpd produced last year, which was the lowest output since 1978. Britain’s oil and gas output has steadily declined over the last decade, peaking in 1999, as North Sea fields have depleted.

Tags: Bank Of Montreal, China, Commodities, Consol Energy, Copper Prices, Crude Oil Prices, Dalian China, Eagle Ford, Economy Trade, energy, Gas Futures Prices, India, Market Strengths, Natural Gas, Natural Gas Futures, Natural Gas Futures Prices, Natural Resources, oil, Pittsburgh Company, Production Steel, Recoverable Resources, Report Oil, Report Weaknesses, Rio Tinto, Salary Workers, Steel Output, Surplus Inventories
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