OIL: weekend thoughts from KM and DJ

Below are our collective thoughts, in response to some thoughtful client questions:
The immediate term “Trade” in Oil is up from where we bought it ($69). The intermediate “Trend” is as nasty as anything I see in macro right now. The challenge is to maintain those 2 opposing thoughts in your melon, and remain sober enough to make money.

There are two major “Trend” lines in Oil to keep on your screen, $93, then $114.

My summary point of DJ’s fundamental outlook on the “Trend” is simply that scarcities become surpluses during global recessions.

  • Here’s my simplistic take on oil, the demand side will continue to be weak in the U.S. and weaker than expected globally probably into the back half of 2009 (potentially much longer). This is obviously not unprecedented. From 1978 to 1983, Oil demand in the U.S. was down for 5 years in a row for an aggregate peak to trough decline of 19.1%. I’m not saying that will happen again, but there is a reasonable scenario where U.S. demand is weak for awhile and if you see U.S. demand drop by 19% over the next five years, China better be growing more than expected to sustain the price of oil.

  • On the production side, while I totally buy the long term supply constraint argument, in the short term and this is very simplistic, if OPEC has to cut production to maintain price than scarcity value should not be priced into Oil anymore (I think that was part of the argument that people were making when Oil was on its way to $140 i.e. there is a premium above marginal cost for scarcity), thus Oil should trend towards its marginal cost . . .$60/$65?
  • From a trading perspective, we have been watching Oil futures fairly closely and, as I’m sure you know, they are solidly in contango. Which means in the short term, it pays to store oil and we will likely see inventories building, which is a negative fundamental data point. In support of this, while the weekly IEA data doesn’t show inventories that are well above their historical average, days of supply is now close to 24 days versus 21 days a year ago (inventory is normal but supply is down 5%+ y-o-y), which suggests inventory will continue to build in the U.S. in the short term, which will lead to incrementally negative data points.
  • In terms of interest rates, our macro view is that the “Trend” will become higher, and perhaps dramatically, into 2009, which should strengthen the U.S. dollar and, obviously, act as a cap on the price of Oil into 2009 as well.

    From quant perspective, and I’ll let Keith weigh in, Oil is oversold, no doubt there, and there is a potential short term catalyst in the Fed cutting rates again, but even the Fed Rate must be at least partially priced in since the fed futures, last I looked, are close to fully discounting a 50 bps cut.
  • So, in summary, I have a hard time getting excited about Oil in the next 6 – 12+ months. KM likes it, but I can see him unloading it on price in 6-12 days! If that’s what it takes for us to keep outperforming in this market, so be it. Obviously the bearish “Trend” side of oil is no longer a contrarian view at this point, but facts are facts.
  • Daryl Jones
    Managing Director

SP500 Levels Into the Close...

We've been bouncing around a critical momentum line throughout the day. That line in the SPX is 955.98 (see chart). A close below it takes you to 875.66 on the downside. A close above that gets you another +8% to the upside to 1035.11.

That's our math, and we're sticking to it.

SONC – Management Not Conservative Enough

Just three and a half weeks ago, SONC issued its FY09 EPS expectations of up 12%-14%. Even in that short time period, management stated today on its earnings call that the landscape has changed rather dramatically. Although SONC did not change its guidance today, management said that current credit conditions could impact its franchise development target of 155-165 new openings, on which the 12%-14% EPS growth relies. SONC then went on to say that a lot of its franchisees are well capitalized. When asked specifically why they are not lowering their EPS guidance to a more cautious range based on the risk to the company’s development schedule, management said, “If we thought we should pull back, we would” so there appeared to be a lot of hedging on the part of management as it relates to current visibility.
  • Prior to today’s call, I thought SONC’s FY09 EPS expectations were aggressive, and although they still seem to be, I did not realize before today that half of this growth is expected to come from refranchising gains. So really only 6%-7% of SONC’s EPS growth relies on operations and those targeted 155-165 franchise drive-in openings. Instead, SONC’s ability to achieve 12%-14% EPS growth focuses largely on the timing of partner drive-in sales to franchisees. Despite management’s assurances that so far no transaction has been impacted by the current credit markets, this remains a real risk for the company.
  • I am also less than confident in SONC’s ability to return to flat partner drive-in same-store sales growth for FY09 following the 3.9% and 6.3% declines in 3Q08 and 4Q08, respectively. Although the company will be lapping easier comparisons in the back half of the year, if current trends continue into 1Q09 and 2Q09, SONC would need to generate 5%-plus numbers in 2H09, which would be a significant improvement from current trends. SONC’s partner drive-in’s average check has been hurt by the introduction of its Happy Hour promotion, which drives increased traffic at the expense of average check and margins. The company will be lapping this introduction in November so that should benefit numbers on a year-over-year basis.
  • SONC’s 1Q09 results should continue to be hurt by lagging sales results because although the company is seeing improved customer service scores, I don’t think SONC will see a quick turnaround in trends in this environment. Additionally, SONC expects its commodity cost to be up high single digits in the first quarter as it is currently experiencing beef prices (12% of SONC’s costs) up in the 30%-35% range.

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VFC: Let’s “YouTube” These Guys

Interesting to see the progression of management’s tone on key business drivers over the past 5 quarters. Here’s the progression…From their mouth to your eyes…

Be sure to click on pictures below to enlarge text.
Source: VFC Press Releases and Conference Calls

Oil : Holding the Maginot Line... Buying it for a "Trade"

We added a long position in Oil yesterday in the Hedgeye Portfolio. The commodity was providing us with a strong green buy signal and from a fundamental perspective the ~$70 price per barrel is also at, or near, an important level for some of the major producers around the world. Fortuitously, the initiation of our long Oil position was met with comments from the Qatari Oil Minister overnight that OPEC needs to cut production by 1MM barrels of oil a day or more, so Oil is trading up close to 5% this morning.

According to PFC Energy, the breakeven point is for many members of OPEC is just below $70. The higher cost producers break even points are as follows: Saudi Arabia’s break-even point is $49, Venezuela’s is $58, Nigeria’s is $65. While the OPEC producers break-even at prices below $70, the price is obviously perilously close to levels where the higher cost producers do not break even, so it is a line that is need of protection.

More important than OPEC, as it relates to $70 oil, is Russia. According to the Russian Finance Ministry, the nation’s budget for 2009 breaks even at a price of $70 oil per barrel. Per the International Energy Agency, Russia was the world’s largest producer of crude oil in 2007 (at 12.4% of the world’s total) and the second largest exporter, just behind Saudi Arabia. As a result, this price of $70 becomes a very important number to watch.

The French constructed the “Maginot Line”, which was a long line of concrete fortifications, tank obstacles, and machine gun posts along its border, in the run up to World War II. The concept was based on the success of static trench like warfare during World War I, which enabled the French, generally, to impede German progress. Ultimately, the antiquated defense measures of the Maginot line were limited in their ability to hold back German troops and France, as we know, was conquered by the Germans.

One has to wonder how long the antiquated defense of production cuts will enable OPEC to hold the current attack on Oil’s Maginot Line.

The “Trend” in oil is negative. Buying oil is for a “Trade”. KM’s lines for oil prices are:

Buy “Trade” = $68.94/barrel
Sell “Trade” = $81.85/barrel

Daryl G. Jones
Managing Director
(chart courtesy of

Eye on Regionalism: Italy, "I've got your back"...

Another data point in the narrative of EU divisiveness…

Some key data points arrived this week in regards to Italian economic health. On Tuesday CPI numbers were released for September which came in slightly better than August on a year-over-year basis, though still up almost 4%. Today, industrial activity data for August was released showing an unsurprising drop in both sales and orders.

A more telling measure of Italian economic credibility came from three Libyan government entities: The Central Bank of Libya, Libyan Investment Authority and Libyan Foreign Bank. These three entities boosted their holding in floundering UniCredit to 4.2% and committed to participate to the tune of almost 10% in an upcoming 6 billion Euro secondary. UniCredit, Italy’s largest bank, has seen its balance sheet shredded by the credit markets and has been rushing to shore up capital.

Italy has always been one of the weaker hands at the EU table and their finance industry has a long history of unsavory practices and corruption. The fact that one of their preeminent financial institution is receiving a bailout from a country that has just reemerged from rogue status and remains controlled by an unbalanced megalomaniac dictator (recall our 9/5 post) says a lot. This isn’t Warren Buffet to the Rescue – this is Muammar Qaddafi.

As a point of fact, Libya has a long investment history in Italy. During the decades when the rest of the world shunned doing business with them because they sponsored terrorism. The Libyan government acquired stakes in Italian banks, utilities & sports teams, but the timing of this move coming so closely on the heels of Berlusconi’s pledge to compensate Libya monetarily for colonial period abuse suggests that Italy and Libya are becoming increasingly chummy.

This is unnerving.

Andrew Barber