US$200 a barrel oil is unlikely any time soon
Spikes in the price of oil are upon us at a time when tightness in the oil market appears to be abating. Oil prices have shot up to US$125 per barrel and sights have been set on US$200 over the next few years, according to prominent analysts and economists. This event is conceivable but highly unlikely in the near term. It is far more likely that oil prices will recede over the next two years as the developed world undergoes a phase of below-potential economic growth.
First let us set out the bull case for oil, of which I have long been a proponent. Cost inflation in the oil sector is raising the marginal cost of production. Higher oil prices have prompted increased spending across the oil sector. Nominal investment has increased 70% from 2004 to 2006 to more than $240-billion per year. Factor in cost inflation, however, and the real effect of that spending increase is essentially nil. The marginal barrel of oil now costs roughly US$90 to produce, according to a recent report by Goldman Sachs.
Staying on the supply side, production has increased, but not overwhelmingly so. Supply has increased by 5.8 million barrels per day (mbd) since 2006, about one million barrels more than demand. Much of that supply has come from OPEC, most from Saudi Arabia.
Non-OPEC supply rose by 1.8 mbd over that time, but there are doubts whether Non-OPEC supply can continue to increase at a meaningful rate. Many countries are seeing production peaks. Russia, currently the world's biggest producer, has seen production fall over the past four months, with some industry experts questioning whether it will ever rise again.
The emerging and developing economies account for more than 90% of the rise in oil consumption since 2002. China alone accounted for 30% of oil consumption growth from 2004 to 2007, according to CLSA's Greed and Fear report. Growing oil demand in the emerging markets has tipped the balance in oil markets to one of higher prices.
What is most surprising is that oil prices have more than doubled over the past year during a recessionary period for the United States. North American oil demand is expected to fall by 0.4 mbd in 2008, according to the International Energy Agency.
The aforementioned bull case for oil is not a new story. I laid it out quite clearly in January, 2007, when oil prices were close to US$50 per barrel. It is strong evidence that we are in a new era of higher oil prices.
High oil prices are one thing, but US$200 oil is highly unlikely any time soon. There are a number of reasons why oil prices appear to be excessively high in the near term and could soften over the next year or two, most obviously weaker demand in the OECD.
The IEA has repeatedly cut its estimates for oil demand for the OECD over the past few months, lowering associated demand from North America, Europe and Japan by 0.57 mbd in the first quarter of 2008. A mix of high prices and flagging economic activity are the reasons for the change.
The prognosis for the U. S. economy is poor over the next 18 months given the deterioration in its housing market. House prices continue to decline and are expected to fall by as much as one-quarter on average when all is said and done. Japan and Europe are expected to suffer knock-on weakness, too.
China is certainly picking up the slack in oil demand and will play its part in driving demand higher this year by roughly 1.0 mbd in total, according to the IEA. This means that there is less respite for oil supply to recover, despite falling demand in the OECD, than would otherwise be the case.
Still, oil prices may rise for the time being. The cost of capital for the average oil producers is roughly $45 per barrel, up from roughly US$20 per barrel in 2004, according to the Goldman Sachs report. However, the current price of oil per barrel is nearly three times the average cost of capital, which would seem excessive.
Rising supply is the factor that could cool off oil prices in the near term. The oil market is adequately supplied, currently. There are no oil shortages and OECD stocks are high, near the top of the five-year average range.
There is every reason to believe that they will continue to move relatively higher over the balance of the year as demand for oil remains weak in the developed world. OPEC spare capacity is low but rising, and is on its way back to levels last seen in January of '07 when oil prices had plummeted.
Investors tend to suffer from myopia when valuing securities, the recent housing bubble being a case in point. Yet a rise in oil prices beyond current levels suggests that investors are uncharacteristically looking well past the current cyclical economic downturn in the U. S. to potential oil supply issues five years out. This is a case of euphoria driving the herd.
Monday, May 19, 2008
Wednesday, January 2, 2008
Housing Woes to Continue in 2008
The prognosis for the housing market remains poor, and any expectations that sector has bottomed is premature. Housing starts and prices are likely to continue deteriorating throughout 2008, recent interest rate cuts by the US Federal Reserve notwithstanding. Since mortgage defaults are the base cause of the global credit crunch that started in August, the prognosis for financial markets and the US economy remain poor for the next year.
A recent report by Moody’s Economy.com entitled Aftershock: Housing in the Wake of the Mortgage Meltdown makes for sobering reading. The authors of the detailed report forecast continued weakness in housing starts to mid-2008, falling by 55 percent, and a fall in house prices by 13 percent before the market hits bottom in early 2009. House prices have fallen roughly 5 percent to date according to the Case Shiller Index.
Falling house prices and weak sales and housing starts will amount to greater losses for financial institutions holding mortgage-backed securities and collateralized debt obligations (CDOs). Many of the CDOs are comprised of subprime mortgages that are seeing rising delinquencies and default rates which seriously compromise their value. Expect further write-downs from Wall Street and European investment banks.
Mortgage defaults are very high and expected to rise to 1.5 million units on an annualized basis in the third quarter of 2007 according to the Moody’s report. With roughly US$250bn. in adjustable rate mortgages expected to reset in 2008 according to First American Core Logic, defaults are likely to rise. An estimated 3 million loans are expected to be defaulted on between 2007 and mid-2009, according to the Moody’ report. The President’s mortgage restructuring plan will obviously reduce these pressures in the near-term, but it will also serve to extend the length of time that these imbalances are worked through the system and could prolong the weakness in the housing market.
Banks are curtailing lending to even creditworthy borrowers because the severe losses they are enduring is reducing their capital-asset ratios. These ratios need to be maintained according to international banking regulations. You can bet that the lower the credit-worthiness of borrowers, the lower is the availability of loans, the effect being fewer potential house buyers and more downward pressure on the housing market. In fact, mortgage origination for subprime, Alt-A and Jumbo loans fell heavily in the third quarter of 2007.
Inventories of home for sale are unfortunately rising to levels not seen before in the Post World War II period according to the Moody’s report. The current vacancy rate, at 2.6 percent, representing 2.1 million vacant unsold homes, is well above the long term “unwavering” historical average of 1.7 percent between 1980 and 2005. New and existing home sales are below 6 million units per annum, a level so low it representing sales not seen since a decade prior.
I have repeatedly suggested that homebuilder stocks were vulnerable to this weakness and could be shorted by buying puts on the PHLX Housing Sector Index. The index is down roughly 40 percent since February when I suggested that US housing was vulnerable and down 30 percent since July when I recommended this specific short. The Moody’s report suggests that it is partially due to the “hubris” of homebuilders that the housing oversupply remains high: “The substantial financial resources of these firms allowed them to continue building longer even in the face of weakening demand.” Most recently, homebuilders appear to be retrenching: single-family housing starts fell 5.4 percent in November 2007; it is tough to see how homebuilders can be profitable in this type of environment.
The US economy has slowed dramatically in recent months and the risks of a full-blown recession are rising. Consumer spending has slowed but has held up reasonably well, all things considered. The specter of further retrenchment by the consumer looms large over the US economy and suggests that investors should continue to play it safe when investing. Commodity stocks, the Canadian dollar and U.S. financial and consumer stocks remain vulnerable to further weakness in the US economy. Falling interest rates in the US are supportive of financial stocks, but only where companies have had minimal exposure to the mortgage securitization business. Those banks that danced this dance in recent years remain fraught with risk.
A recent report by Moody’s Economy.com entitled Aftershock: Housing in the Wake of the Mortgage Meltdown makes for sobering reading. The authors of the detailed report forecast continued weakness in housing starts to mid-2008, falling by 55 percent, and a fall in house prices by 13 percent before the market hits bottom in early 2009. House prices have fallen roughly 5 percent to date according to the Case Shiller Index.
Falling house prices and weak sales and housing starts will amount to greater losses for financial institutions holding mortgage-backed securities and collateralized debt obligations (CDOs). Many of the CDOs are comprised of subprime mortgages that are seeing rising delinquencies and default rates which seriously compromise their value. Expect further write-downs from Wall Street and European investment banks.
Mortgage defaults are very high and expected to rise to 1.5 million units on an annualized basis in the third quarter of 2007 according to the Moody’s report. With roughly US$250bn. in adjustable rate mortgages expected to reset in 2008 according to First American Core Logic, defaults are likely to rise. An estimated 3 million loans are expected to be defaulted on between 2007 and mid-2009, according to the Moody’ report. The President’s mortgage restructuring plan will obviously reduce these pressures in the near-term, but it will also serve to extend the length of time that these imbalances are worked through the system and could prolong the weakness in the housing market.
Banks are curtailing lending to even creditworthy borrowers because the severe losses they are enduring is reducing their capital-asset ratios. These ratios need to be maintained according to international banking regulations. You can bet that the lower the credit-worthiness of borrowers, the lower is the availability of loans, the effect being fewer potential house buyers and more downward pressure on the housing market. In fact, mortgage origination for subprime, Alt-A and Jumbo loans fell heavily in the third quarter of 2007.
Inventories of home for sale are unfortunately rising to levels not seen before in the Post World War II period according to the Moody’s report. The current vacancy rate, at 2.6 percent, representing 2.1 million vacant unsold homes, is well above the long term “unwavering” historical average of 1.7 percent between 1980 and 2005. New and existing home sales are below 6 million units per annum, a level so low it representing sales not seen since a decade prior.
I have repeatedly suggested that homebuilder stocks were vulnerable to this weakness and could be shorted by buying puts on the PHLX Housing Sector Index. The index is down roughly 40 percent since February when I suggested that US housing was vulnerable and down 30 percent since July when I recommended this specific short. The Moody’s report suggests that it is partially due to the “hubris” of homebuilders that the housing oversupply remains high: “The substantial financial resources of these firms allowed them to continue building longer even in the face of weakening demand.” Most recently, homebuilders appear to be retrenching: single-family housing starts fell 5.4 percent in November 2007; it is tough to see how homebuilders can be profitable in this type of environment.
The US economy has slowed dramatically in recent months and the risks of a full-blown recession are rising. Consumer spending has slowed but has held up reasonably well, all things considered. The specter of further retrenchment by the consumer looms large over the US economy and suggests that investors should continue to play it safe when investing. Commodity stocks, the Canadian dollar and U.S. financial and consumer stocks remain vulnerable to further weakness in the US economy. Falling interest rates in the US are supportive of financial stocks, but only where companies have had minimal exposure to the mortgage securitization business. Those banks that danced this dance in recent years remain fraught with risk.
Friday, December 21, 2007
Housing Woes to Continue in 2008
The prognosis for the housing market remains poor, and any expectations that sector has bottomed is premature. Housing starts and prices are likely to continue deteriorating throughout 2008, recent interest rate cuts by the US Federal Reserve notwithstanding. Since mortgage defaults are the base cause of the global credit crunch that started in August, the prognosis for financial markets and the US economy remain poor for the next year.
A recent report by Moody’s Economy.com entitled Aftershock: Housing in the Wake of the Mortgage Meltdown makes for sobering reading. The authors of the detailed report forecast continued weakness in housing starts to mid-2008, falling by 55 percent, and a fall in house prices by 13 percent before the market hits bottom in early 2009. House prices have fallen roughly 5 percent to date according to the Case Shiller Index.
Falling house prices and weak sales and housing starts will amount to greater losses for financial institutions holding mortgage-backed securities and collateralized debt obligations (CDOs). Many of the CDOs are comprised of subprime mortgages that are seeing rising delinquencies and default rates which seriously compromise their value. Expect further write-downs from Wall Street and European investment banks.
Mortgage defaults are very high and expected to rise to 1.5 million units on an annualized basis in the third quarter of 2007 according to the Moody’s report. With roughly US$250bn. in adjustable rate mortgages expected to reset in 2008 according to First American Core Logic, defaults are likely to rise. An estimated 3 million loans are expected to be defaulted on between 2007 and mid-2009, according to the Moody’ report. The President’s mortgage restructuring plan will obviously reduce these pressures in the near-term, but it will also serve to extend the length of time that these imbalances are worked through the system and could prolong the weakness in the housing market.
Banks are curtailing lending to even creditworthy borrowers because the severe losses they are enduring is reducing their capital-asset ratios. These ratios need to be maintained according to international banking regulations. You can bet that the lower the credit-worthiness of borrowers, the lower is the availability of loans, the effect being fewer potential house buyers and more downward pressure on the housing market. In fact, mortgage origination for subprime, Alt-A and Jumbo loans fell heavily in the third quarter of 2007.
Inventories of home for sale are unfortunately rising to levels not seen before in the Post World War II period according to the Moody’s report. The current vacancy rate, at 2.6 percent, representing 2.1 million vacant unsold homes, is well above the long term “unwavering” historical average of 1.7 percent between 1980 and 2005. New and existing home sales are below 6 million units per annum, a level so low it representing sales not seen since a decade prior.
I have repeatedly suggested that homebuilder stocks were vulnerable to this weakness and could be shorted by buying puts on the PHLX Housing Sector Index. The index is down roughly 40 percent since February when I suggested that US housing was vulnerable and down 30 percent since July when I recommended this specific short. The Moody’s report suggests that it is partially due to the “hubris” of homebuilders that the housing oversupply remains high: “The substantial financial resources of these firms allowed them to continue building longer even in the face of weakening demand.” Most recently, homebuilders appear to be retrenching: single-family housing starts fell 5.4 percent in November 2007; it is tough to see how homebuilders can be profitable in this type of environment.
The US economy has slowed dramatically in recent months and the risks of a full-blown recession are rising. Consumer spending has slowed but has held up reasonably well, all things considered. The specter of further retrenchment by the consumer looms large over the US economy and suggests that investors should continue to play it safe when investing. Commodity stocks, the Canadian dollar and U.S. financial and consumer stocks remain vulnerable to further weakness in the US economy. Falling interest rates in the US are supportive of financial stocks, but only where companies have had minimal exposure to the mortgage securitization business. Those banks that danced this dance in recent years remain fraught with risk.
Levi Folk is president of Generation Capital (www.generation-invest.com), specializing in the creation of structured investment products including principal protected notes. He is also president of the Fund Library www.fundlibrary.com, an investor research Web site.
A recent report by Moody’s Economy.com entitled Aftershock: Housing in the Wake of the Mortgage Meltdown makes for sobering reading. The authors of the detailed report forecast continued weakness in housing starts to mid-2008, falling by 55 percent, and a fall in house prices by 13 percent before the market hits bottom in early 2009. House prices have fallen roughly 5 percent to date according to the Case Shiller Index.
Falling house prices and weak sales and housing starts will amount to greater losses for financial institutions holding mortgage-backed securities and collateralized debt obligations (CDOs). Many of the CDOs are comprised of subprime mortgages that are seeing rising delinquencies and default rates which seriously compromise their value. Expect further write-downs from Wall Street and European investment banks.
Mortgage defaults are very high and expected to rise to 1.5 million units on an annualized basis in the third quarter of 2007 according to the Moody’s report. With roughly US$250bn. in adjustable rate mortgages expected to reset in 2008 according to First American Core Logic, defaults are likely to rise. An estimated 3 million loans are expected to be defaulted on between 2007 and mid-2009, according to the Moody’ report. The President’s mortgage restructuring plan will obviously reduce these pressures in the near-term, but it will also serve to extend the length of time that these imbalances are worked through the system and could prolong the weakness in the housing market.
Banks are curtailing lending to even creditworthy borrowers because the severe losses they are enduring is reducing their capital-asset ratios. These ratios need to be maintained according to international banking regulations. You can bet that the lower the credit-worthiness of borrowers, the lower is the availability of loans, the effect being fewer potential house buyers and more downward pressure on the housing market. In fact, mortgage origination for subprime, Alt-A and Jumbo loans fell heavily in the third quarter of 2007.
Inventories of home for sale are unfortunately rising to levels not seen before in the Post World War II period according to the Moody’s report. The current vacancy rate, at 2.6 percent, representing 2.1 million vacant unsold homes, is well above the long term “unwavering” historical average of 1.7 percent between 1980 and 2005. New and existing home sales are below 6 million units per annum, a level so low it representing sales not seen since a decade prior.
I have repeatedly suggested that homebuilder stocks were vulnerable to this weakness and could be shorted by buying puts on the PHLX Housing Sector Index. The index is down roughly 40 percent since February when I suggested that US housing was vulnerable and down 30 percent since July when I recommended this specific short. The Moody’s report suggests that it is partially due to the “hubris” of homebuilders that the housing oversupply remains high: “The substantial financial resources of these firms allowed them to continue building longer even in the face of weakening demand.” Most recently, homebuilders appear to be retrenching: single-family housing starts fell 5.4 percent in November 2007; it is tough to see how homebuilders can be profitable in this type of environment.
The US economy has slowed dramatically in recent months and the risks of a full-blown recession are rising. Consumer spending has slowed but has held up reasonably well, all things considered. The specter of further retrenchment by the consumer looms large over the US economy and suggests that investors should continue to play it safe when investing. Commodity stocks, the Canadian dollar and U.S. financial and consumer stocks remain vulnerable to further weakness in the US economy. Falling interest rates in the US are supportive of financial stocks, but only where companies have had minimal exposure to the mortgage securitization business. Those banks that danced this dance in recent years remain fraught with risk.
Levi Folk is president of Generation Capital (www.generation-invest.com), specializing in the creation of structured investment products including principal protected notes. He is also president of the Fund Library www.fundlibrary.com, an investor research Web site.
Thursday, December 6, 2007
Oil Prices at Risk in the Near-term
Oil prices are at risk to further declines based on weaker demand in the OECD stemming from the credit crunch that began in the summer and rising production from both OPEC and non-OPEC sources. This leaves energy producers at risk to softer prices in the near term. However, any weakness should be considered a buying opportunity.
The International Energy Agency (IEA) reported a change in the supply/demand balance recently that suggests oil prices would continue to soften over the next few months. Firstly, demand was revised down for the balance of the year and for 2008. I suggested in September (Dollar Parity is Only a State of Mind) that the IEA would be forced to revise demand lower due to softer growth in the developed world stemming from the recent credit crunch.
In its November Oil Market Report, the IEA indeed lowered third quarter demand estimates for 2007 by 0.5 mbd and for 2008 by 0.3 mbd based on lower OECD economic growth forecasts for this year and next. These numbers may well be revised lower should growth continue to slow over the next eighteen months. The one risk to this forecast is the possibility of a colder than average winter as appears to be shaping up in the US Northeast.
Oil supply has also risen strongly in recent months increasing by 1.4 mbd in October due to greater output from Iraq and Angola and non-OPEC gains as well. In fact, the OPEC-12 production levels rose for the first time in October since August 2006, which represents a major reversal of OPEC production, cuts since that time, according to the IEA.
All this spells softer conditions for oil markets over the next eighteen months. Oil stocks are not particularly high nor are they uncomfortably tight either, hovering around their 5-year average, having fallen since OPEC introduced production cuts in November 2006.
The long-term picture for oil is very attractive, however, and investors should accumulate oil stocks on weakness. Several executives of the global oil majors have gone on record questioning the industry’s ability to increase production beyond 100 mbd in response to the IEA’a calls for production increases to 116 mbd by 2020. Chrisotophe de Margerie, head of French Oil giant Total called production beyond 100 mbd an “optimistic case.” Current production is averaging roughly 86 mbd.
In a separate speech, James Mulva, CEO of US oil major ConocoPhillips doubted that the oil industry has the necessary infrastructure to push production beyond 100 mbd: "I don't think we are going to see the supply going over 100 million barrels a day” said Mulva who questioned “…where is all that going to come from?"
The fact that the chiefs of the world’s biggest oil producers are uttering these comments is downright disturbing and suggests that oil prices are likely to head higher over the long term. The other lesson here is that the oil majors are likely to have the toughest time increasing production despite the fact that they have the best technologies for finding and extracting oil. The oil majors are dealing with a number of problems including production sharing agreements that reduce their share of reserves as oil prices rise and increasingly hostile governments in many of the regions where oil is found.
Investors are best-advised to accumulate mid-sized oil producers including those operating in the Canadian oil sands on possible weakness over the next twelve to eighteen months. Any fall in oil prices should be considered a long-term buying opportunity.
The International Energy Agency (IEA) reported a change in the supply/demand balance recently that suggests oil prices would continue to soften over the next few months. Firstly, demand was revised down for the balance of the year and for 2008. I suggested in September (Dollar Parity is Only a State of Mind) that the IEA would be forced to revise demand lower due to softer growth in the developed world stemming from the recent credit crunch.
In its November Oil Market Report, the IEA indeed lowered third quarter demand estimates for 2007 by 0.5 mbd and for 2008 by 0.3 mbd based on lower OECD economic growth forecasts for this year and next. These numbers may well be revised lower should growth continue to slow over the next eighteen months. The one risk to this forecast is the possibility of a colder than average winter as appears to be shaping up in the US Northeast.
Oil supply has also risen strongly in recent months increasing by 1.4 mbd in October due to greater output from Iraq and Angola and non-OPEC gains as well. In fact, the OPEC-12 production levels rose for the first time in October since August 2006, which represents a major reversal of OPEC production, cuts since that time, according to the IEA.
All this spells softer conditions for oil markets over the next eighteen months. Oil stocks are not particularly high nor are they uncomfortably tight either, hovering around their 5-year average, having fallen since OPEC introduced production cuts in November 2006.
The long-term picture for oil is very attractive, however, and investors should accumulate oil stocks on weakness. Several executives of the global oil majors have gone on record questioning the industry’s ability to increase production beyond 100 mbd in response to the IEA’a calls for production increases to 116 mbd by 2020. Chrisotophe de Margerie, head of French Oil giant Total called production beyond 100 mbd an “optimistic case.” Current production is averaging roughly 86 mbd.
In a separate speech, James Mulva, CEO of US oil major ConocoPhillips doubted that the oil industry has the necessary infrastructure to push production beyond 100 mbd: "I don't think we are going to see the supply going over 100 million barrels a day” said Mulva who questioned “…where is all that going to come from?"
The fact that the chiefs of the world’s biggest oil producers are uttering these comments is downright disturbing and suggests that oil prices are likely to head higher over the long term. The other lesson here is that the oil majors are likely to have the toughest time increasing production despite the fact that they have the best technologies for finding and extracting oil. The oil majors are dealing with a number of problems including production sharing agreements that reduce their share of reserves as oil prices rise and increasingly hostile governments in many of the regions where oil is found.
Investors are best-advised to accumulate mid-sized oil producers including those operating in the Canadian oil sands on possible weakness over the next twelve to eighteen months. Any fall in oil prices should be considered a long-term buying opportunity.
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