The Golden Weapon of Choice
Return of Revulsion
Blame It on the Fed?
The Other Freight Index
Meanwhile, In the Gas Patch...
Florida: Open for (Oil) Business
Healing for Asia
The Japanese call October "the godless month". Legend has it that October is the time when the gods retreat to a far-off land to host a giant festival, leaving mankind to fend for itself without any divine oversight. Long-time stock investors might indeed feel a distinct lack of godly protection during the autumn. This is typically the time when markets grow unsteady, sometimes crashing dramatically.
This week we look at what's on tap for the fall season this year. We moved into September this week. And with the end of summer came a palpable change in market sentiment. The economic world is turning, and we'll look at what the data is telling us about how investors are feeling. We'll also discuss what the next big investment trend might be for large, institutional investors and how at least one commodity (gold) might benefit.
Lest I be labeled a constant pessimist, we'll also take a look at some encouraging news for the commodities complex out of China. At least one indictor shows that Chinese demand for bulk goods continues to strengthen. A good sign for producers around the globe. We'll also look at what's happening for a less-fortunate group of producers: natural gas companies. Gas hit new record-lows this week. And unfortunately the downpour shows no signs of abating. We'll take the pulse of the industry, and as a bonus look at what I think might be one of the most critical happenings in the North American petroleum sector in several years. There's a lot to cover on a lot of different fronts, so let's get right to it.
The Golden Weapon of Choice
Noted American poet T.S. Eliot once wrote that, "April is the cruelest month." April may be cruelest for poets, but September and October are undoubtedly the most difficult months for stock market investors. This week we moved into September, a month when markets historically fall more often than rise. We are also now into the autumn "crash window", a period when some of the greatest stock market train wrecks have materialized. Last year being the most recent example.
The end of summer had some noticeable effects on the market. The most obvious being a $40 jump in the gold price. The move brought gold within a couple of dollars of the $1,000 mark, raising a lot of excitement amongst investors. Especially since this is the third test of the "millennium mark" so far in 2009. I'm not a technical analyst, but many who watch the gold market are. And this kind of "triple topping" behavior is very important to many observers in the gold space.
There is no doubt that interest in gold has grown during the first few days of September. This week, daily trading volumes on New York's COMEX gold market have doubled, from 80,000 contracts on August 31 to 180,000 contracts yesterday. This is biggest volume we've seen in COMEX gold for several months. Apparently there are some big investors out there with a big interest in gold.
Here's the interesting thing about this spike in gold buying. It doesn't seem to be driven by strength in the broader commodities complex. I mentioned that daily trading volume for gold contracts hit multi-month highs this week. Not so for other metals traded on COMEX. Silver did see increased trading this week. But the daily volumes were well below the average for the past month. Trading volumes for copper actually declined, after having hit highs back in mid-August. Trading volumes for crude oil were also below average. It would seem that gold is the "weapon of choice" for commodity investors so far in September.
Return of Revulsion
So what's going on? I've discussed before the idea of "sector rotation" amongst large, institutional investors. These investment funds are extremely nimble, with the ability to move in and out of different investments in a matter of weeks or even days. As such, they are constantly looking to get into "the next hot story" before everyone else does. They make money by recognizing an investment theme that is likely to appeal to a wide audience and then getting positioned early. If and when the story goes "mainstream", they ride the wave of incoming buying, booking significant profits.
And gold could well be the next big story. Base metals were the last investment hit for many funds, with copper rising over 100% in 2009 on the back of the "super China" theme, the belief that Chinese government stockpiling of metals would drive copper, zinc, aluminum and nickel higher. Share prices of most base metals producers performed even better than the metals themselves this year.
But that horse appears to have run its race. Copper has been churning in the $2.75 to $2.90/lb range for a few weeks now. Of course, it could go higher from here. But the easy money has been made. As I mentioned two weeks ago, there is good evidence that professional investors such as funds are now exiting the base metals play, passing off their metals holdings to individual investors who are just now getting excited about the space. That leaves funds with a lot of cash that needs to be re-invested. There will be a lot of managers asking themselves, "What's the next big theme?"
It might be "correction". Nearly every observer admits that we've had a phenomenal run in almost every investment class imaginable over the last six months. Stocks, corporate bonds, commodities, emerging markets and energy have all staged double-digit rallies since hitting lows back in March. This is an incredible performance for so many sectors in such a short period of time. There is now a sense that it may have been too good. With the traditionally not-so-good months of autumn upon us, perhaps we’re due for a correction.
In fact, the data show that investors have been growing increasingly more wary over the past several weeks. The most obvious evidence being U.S. government bond yields. U.S. Treasury bonds are seen around the world (rightly or wrongly) as being a safe haven investment in times of trouble. When things start to look bad, investors buy more bonds. This drives up the bond price and lowers the yield. During the peak of the financial crisis last year, yields on the 30-year U.S. bond fell from 4.5% to 2.5% in just a few weeks because of panic buying from around the world. Buying was so intense that yields on 1-month and 3-month bills actually went negative (briefly). Meaning that buyers were receiving no interest, and were actually paying the U.S. government to take their money! That's how desperate the world was to get its funds into a perceived safe investment vehicle.
Of course, the panic eventually passed. And bond-buying subsided. With less buying, bond prices fell and yields began to rise. By June of this year, the 30-year bond that yielded 2.5% back in December was yielding a hefty 4.5%. Money was moving out of the "safe haven" and back into riskier investments. Bond yields remained elevated throughout the summer. As recently as August 12, the yield on the 30-year bond clocked in above 4.5%.
But it has been a different story over the past couple of weeks. In the third week of August yields began to fall, signaling that some investors were moving back into bonds. Between August 13 and August 31, yields on the 30-year dropped from 4.53% to 4.18%. This week, the buying got even stronger. On Wednesday, the 30-year yield plummeted to 4.09%. The lowest yield we've seen since May 15. "Risk revulsion" is back. There are some large buyers out there moving money away from risky assets and back into the safe haven of Treasuries.
This increased buying of Treasuries could signal that "risk aversion" is going to be the next big theme for large investors. Especially given that this week also saw increased buying of gold, also a noted safe-haven investment. If September and October do turn out to the cruelest months for the stock market, these bets will make another hot story for early investors. At the very least, the risk revulsion theme is one that could easily catch on amongst other investors and generate some "knock-on" buying to drive prices up.
Blame It on the Fed?
Remember the infamous Eighties singing duo, Milli Vanilli, and their hit song "Blame It on the Rain?" I know many readers have a similar tune running through their head after reading the above data on Treasury yields. Namely, "Blame It on the Fed".
We know that the Federal Reserve has been a regular buyer of U.S. Treasury and Agency bonds since April. So far this year, the Fed has bought $375 billion in American debt. So could they be behind the recent surge in Treasury prices and corresponding drop in yields?
The data say no. Treasury yields have been dropping since mid-August. During that time, the Fed has indeed been active in the Treasuries markets. But the scale of buying suggests that the Fed have not been the ones moving yields. Since August 20, Fed Treasuries purchases have been running about $8.5 billion weekly. This is well below the $12.5 billion weekly that the Fed has been averaging since March. We saw many weeks this summer when the Fed purchased up to $25 billion in Treasuries and failed to bring yields down at all. The fact that yields fell so much over the last two weeks with only moderate Fed purchases suggests there are other forces at work in the market.
In fact, it appears that the Fed is making good on recent promises by officials that the organization will wind up its Treasuries purchasing program. Over the last two weeks, the Fed nearly ceased its purchases of 10-year notes. And in the second-last week of August, the Fed was a net seller of 30-year bonds, divesting $4.3 billion worth. The first weekly bond sale by the organization since it began its purchasing program six months ago.
The Other Freight Index
Seeing as the first few sections of this letter have got us off on a rather gloomy note, I should point out that there are still some encouraging signs out there for the global economy. One of the strongest being shipping of freight.
Most investors are familiar with global freight shipping rates as reflected in the Baltic Dry Index (BDI). The BDI tracks prices for shipping a variety of bulk goods like coal, iron ore and grain along 26 shipping routes around the globe. The index's handlers compile rates from all of these routes into a single weekly number, reflecting the general cost for moving goods around our planet. When the economy is humming along, there is greater demand for goods and therefore greater demand for shipping. The BDI rises. When we hit an economic speedbump, demand for goods falls, shipping drops off, and the BDI moves lower. Thus this index is seen as a proxy for world economic health.
But the profile of the world economy has changed over the past year. Economic activity has fallen off in almost every part of the globe. Save for one: China. Today, the world is looking to China to be the engine that pulls us out of recession. The health of the global economy rests on what happens in the East.
But the BDI only gives us a limited view of what's happening in the East. The index is composed of shipping routes from all over the world. In order to find out what's happening in China, we need to look elsewhere. And there's one lesser-known shipping index similar to the BDI that specifically focuses on China: the China Containerized Freight Index (CCFI).
The CCFI measures costs for various shipping routes between China and different parts of the world. Separate sub-indexes record rates for shipping goods to China from Japan, Europe, Eastern and Western U.S., Korea, Australia and a number of other major economic centers. Costs for all of these routes are indexed into a headline number that measures the general cost for transporting goods to China. Simply put, a higher CCFI means more Chinese demand, particularly for bulk commodities.
And the CCFI has indeed been rising of late. After falling significantly during last fall's crash, the index stabilized early in 2009. And then began to strengthen. In early June, the CCFI stood at 790. By the first week of August it had risen to 830. A gain of 5%. And over the past month the gains have accelerated, with the index rising to 940 as of today. Nearly a 15% gain in just a few weeks. Chinese demand for goods seems to be ramping up.
This is a good sign for producers in other parts of the world. Particularly encouraging is the fact that sub-indexes for Europe and America have been amongst the strongest components of the CCFI this past month, after lagging throughout much of the summer. China is buying more goods from the West. At a time when western producers greatly need the demand.
With the CCFI still going strong into September, global economic indicators will likely look good for at least a few more weeks. Perhaps staving off any major market correction in the short-term.
Meanwhile, In the Gas Patch...
One place where the news is not so rosy these days is in the "natural gas patch". Despite massive bets by investors during the month of August that natgas prices would rise, spot and futures prices have continued to decline. Henry Hub spot dipped below $2 today, closing at $1.88/mmbtu. Even futures for October, which should be solidly into the winter heating season, have dipped to $2.73. This is the lowest price for a front-month futures contract since February of 2002.
I was talking gas on an investment radio program this week and the host, a former Texas oilman, challenged me when I said that gas prices could remain low for some time still. The thrust of my argument was that shale gas in the southern U.S. has been a "game-changer" for the natural gas industry. We've unlocked a lot of new production in a relatively short time. And now we're paying the price for being so smart. And that price is sub-$2 gas.
The host wanted to know how I thought prices could possibly remain low when most shale gas wells need $5 to $7 gas in order to turn a profit. This is a commonly quoted "break-even" figure for shale gas, and is generally correct across North America. But there is some confusion as to what "break-even" means.
Most North American shale gas wells need about $7 gas in order to have a positive return on capital. That is, in order to pay back the cost of drilling the well (which can run several million dollars in some basins) and generate an acceptable amount of profit on top. But many wells have positive cash flow at much lower gas prices. The operating costs on some shale gas wells are as low as 50 cents per thousand cubic feet. Meaning that even at the current $1.88 gas price, these wells would still be generating $1.38 in cash flow for every unit sold.
The problem is that these wells need to net a lot more than $1.38 per Mcf in order to pay back the initial drilling cost. At $1.38 profit, the operating company will probably lose money on the well as a whole. But if a well has already been drilled, and the cost sunk into the ground (you can't undrill a well and get your money back), some operators will likely produce these wells as long as they are making positive cash flow. Have some revenue coming in is better than having nothing. Especially given that many producing companies have to make interest payments on debt and are still paying fairly hefty salaries to management.
For this reason, we're not seeing as much production shut-in across North America as some analysts have expected. Yes, companies are drilling fewer new wells. Although even new drilling hasn't slowed as much as we might think. A number of companies have hedged their gas sales at much higher prices, and so are still able to drill new wells profitably. And some outfits have to drill in order to hold choice acreage in strategic plays across the continent. If an area is key to your future plans, you'll do whatever it takes to hold onto it. Even if it means drilling wells at a loss.
The bottom line is we're not seeing the supply fall-off that many observers thought would come with low gas prices. Gross gas production in the U.S. for June was recently reported at 2.15 trillion cubic feet. This is certainly down from the peak of 2.29 Tcf that we saw in March. But June's production was still higher than the 2.14 Tcf produced in June 2008. And it's well above the five-year average. America is still putting out a lot of gas.
The other complicating factor is that production has some room to fall, because demand in America is declining quickly. Demand during May and June hovered around 1.5 Tcf. The lowest level for these months in the last 9 years. June demand was down 45% from the January peak of 2.7 Tcf. Of course, demand generally falls off during the warmer, summer months. We'll have to wait until we start getting winter demand data to see how much of this year's demand decline was due to normal seasonal factors and how much was caused by demand destruction due to lower natural gas use from the industrial sector. Time will tell.
Florida: Open for (Oil) Business
A few months back I discussed what could be another game-changer for the U.S. petroleum industry. American lawmakers are seeking to extend sharing of revenues from offshore oil and gas development to a number of new states. Currently, only states like Texas and Louisiana have the right to collect a share of revenues from petroleum produced in their offshore waters. And surprise, surprise, these happen to be the only states that allow offshore drilling. Up until now, other states have not had the opportunity for revenue sharing. So they have been ambivalent (or outright hostile) toward allowing drilling in their waters.
But there is a movement afoot to change that. Legislation recently introduced in the Senate would allow state governments in several additional coastal states including Virginia, North Carolina, South Carolina and Georgia to receive 37.5% of royalties from oil and gas production in their waters. This would be a big incentive for these states to reconsider their stance on offshore drilling.
At least one Gulf Coast state already appears to be paying attention to the new developments: Florida. It was reported this week that Florida's lawmakers may discuss the topic of offshore exploration when they meet at a planned session this October or November, with a view toward ending the state's 20-year ban on offshore drilling.
The opening of Florida to exploration would be particularly interesting for the oil industry. The state controls a long stretch of Gulf Coast waters with a petroleum system likely similar to that of offshore Texas and Louisiana. This is a known prospective area (BP announced another major discovery offshore of Texas this week) that has gone almost unexplored simply due to politics. If it were to "open for business", we would almost certainly see some important discoveries in short order.
Some of the most important finds in the resource business have come when formerly inaccessible territories have suddenly been made available to exploration companies. It doesn't happen often (the opening of the Peruvian mining sector in the 1990s following the end of a civil war in that country is a good example), but when it does it creates big opportunities. Florida oil and gas could be one such case.
Healing for Asia
Having kids, you get to share a lot of things. Birthdays, ballet recitals and first loose teeth (my oldest daughter just lost her first tooth a few weeks ago, a big moment). The downside is you also get to share germs with all of the children they attend school, daycare or summer camp with. This caught up to me the past week when I arrived home from Colombia to receive a flat-on-the-back version of the flu. (Thank goodness I didn't catch it before coming home. With all of the concern over the H1N1 virus, going through customs with a runny nose is risking quarantine these days.)
Most of this week was spent in bed, with brief upright bouts to attend to previously-arranged speaking engagements and preparations for next week's trip to Manila and Hong Kong. One thing about being ill, it makes you carefully choose where to expend the little energy you have. In a strange way, I felt more focused this week than I normally due during a busy workday.
I will be writing next week's letter from a Manila hotel, and should have lots to tell. The markets are picking up and so too are many of the developments with Notela Resource Advisors that I have been discussing of late in these pages. Many of these projects are in that frustrating "final details" stage when everything must be fine-tuned before it can be released. But I promise to have some announcements in the very near future. Stay tuned.
In the meantime, I hope you are all well (or at least more well than I was this week) and enjoying these intriguing economic times in whatever capacity your work brings you into contact with them. Best of fortunes in all your endeavors, and have a great weekend.
Here's to everything turn, turn, turning,
Pierce Points Weekly Newsletter
Note: The information provided in this newsletter is based on the independent research of Dave Forest and Notela Resource Advisors Ltd. and is intended solely for informative purposes and is not to be construed, under any circumstances, by implication or otherwise, as an offer to sell or a solicitation to buy or trade any securities or commodities named herein. Information contained in this newsletter is obtained from sources believed to be reliable, but is in no way assured. All materials and related graphics provided in this newsletter and any other materials which are referenced herein are provided "as is" without warranty of any kind, either express or implied. No assurance of any kind is implied or possible where projections of future conditions are attempted. Readers using the information contained herein are solely responsible for verifying the accuracy thereof and for their own actions and investment decisions. Neither Dave Forest nor Notela Resource Advisors Ltd., make any representations about the suitability of the information delivered in this newsletter or any other materials that are referenced herein for any purpose whatsoever.
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