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Eye On Oil: Updating Our Research Edge...

Since we sent out our last update detailed update on, Oil a good deal has changed. Most notably, the price of WTI (West Texas Intermediate) is now trading at just over $56 per barrel. I made the following point in our last update on October 18th, 2008:

“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?”

Since I wrote about the dangers of narrative fallacies this weekend, I’m not going to pretend that I called the decline in oil we’ve seen over the last few weeks, but I did want to highlight the point above because it is very important in understating the context of how Oil has traded.

Oil has traded down despite what are, ostensibly, bullish data points. Specifically, OPEC announced a 1.5MM barrel per day emergency production cut a week after my post on October 24th. Obviously this has done little to support the price of Oil as the commodity is down roughly another 10% since then. What this tells me is that the concept of Peak Oil, at least in the short term, is finally getting priced out of the commodity. And that, on the margin, suggests to me that the Oil bottoming may be beginning. Remember, bottoms are processes, not points.

On the demand side, despite consumer weakness, there is no doubt that the dramatic declines in gasoline prices we have seen in the U.S. and around the world will have, on the margin, a positive impact on demand. At a sub $2.40 per gallon price, gasoline is down by more than $1.70 from its July “Peak Oil” peak. Eventually this will have a positive impact on y-o-y demand comparisons, even if it is a quarter or two away.

The other key point I made above is that the marginal cost of production for Oil, according to many oil economists, is in the $60 per barrel range. Obviously this is a vast simplification and is subject to grades of oil and services costs, but, once again, on the margin this price level is important. At this price, many projects become less economic and at sustained prices below $60 per barrel we will see some mothballing of exploration and development projects. The excerpt below from an article in the Houston Chronicle today highlights these points:

“Oil prices closed below $60 a barrel, a level widely considered to be near the break-even point for multibillion-dollar deep-water projects that have been a key driver of Houston’s energy economy in recent years. If prices go lower still, oil companies could be forced to re-evaluate and possibly postpone deep-water projects, just as they have already done with less-costly land and shallow-water drilling plans, analysts said. At $50, they probably start canceling projects or slowing projects up,” said Eric Smith, associate director of the Tulane Energy Institute in New Orleans.”

We are not ready to call a bottom just yet, but after a ~20% decline since our last update and a 1.5 barrel production cut from OPEC, we are certainly getting interested.

Daryl G. Jones
Managing Director

Eye On US Healthcare: Mad Max?

Fire up the Thunder dome. The Democrats are in the house and the Max Baucus Plan is in motion – conference call just ended; here are our head of healthcare, Tom Tobin’s, immediate takeaways:

The scariest part of the plan is the Health Exchange, but that won’t happen for 3 years.

The idea is to push everyone into a market to purchase insurance. The question is the margin for those products. 50M additional lives is a significant boost even at 10% gross margins.

In the meantime, Medicare expands to cover younger Americans and SCHIP expands. Medicare Advantage cuts are a sure thing. This wont kill the companies and has been quantified.

No change to employer system until Exchange is created. So no near term risk of further disenrollment or margin pressure from employers anticipating a government plan. This is positive for UNH and AET.

Baucus expects to enact legislation 1H09, but I got the distinct impression he is acting on his own. This may be a problem that delays things.

CBO analysis is likely more favorable this time around as opposed to 1992.

“Devil is in the details” was the key quote.

Baucus expects the plan to lose money initially, but save later. This is the key to the CBO score and pay-go.
If there is any conclusion, device manufacturers are most at risk.

Baucus wants to create a comparative institute to score effectiveness of therapies and allow hospitals to partner with physicians to participate in cost savings initiatives. He also want to ban collaboration with docs and industry. This seems like a recipe for unit pricing declines.

This is perversely positive for R&D, the only engine to generate new products.

Thomas Tobin
Managing Director

Eye On Leadership: Jaime Dimon

This is definitely one of the quotes of the day that lines up most succinctly with what we have been saying this week - "we're not running the company as if we're in a Great Depression" (Jaime Dimon, CEO of JPM).

Nice call Mr. Dimon - we're on board with you there. People are freaking out about 2009, and you're providing some leadership to calm the fear that some investors should have had 12 months ago.

We are not going into a Great Depression. The only depression I see dominating New York's groupthink is in the bank accounts of the levered longs.

Keith McCullough

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Shrink to Grow

As an industry analyst I have deployed the shrink to grow theory many times to identify ways to make money buying companies that are right sizing their business to enhance future profitability. With SBUX reporting earlier this week, I have the shrink to grow theme as top of mind. Unfortunately, this theme is everywhere I turn and is one reason to remain cautious on the consumer. From a Macro standpoint, the US economy will likely contract before it can grow again. The US and many global economies are headed down a slippery slope which can be toxic for investors, because of the unknown of how steep the slope will be. I guess this is why I’m still bearish about the consumer.

The market swoon in October provided another shock to the consumer, the impact of which we do not know and most likely has yet to be fully digested by the market. The monthly sales figures reported by companies that rely on discretionary purchase decisions, like restaurant and automobile manufactures, were disastrous in October, and November is not off to a good start. The consumers have not bottomed yet; as a result there continues to be significant excess capacity in many sectors. These sectors need to shrink capacity before they can grow again.

There continues to be significant excess capacity in the restaurant industry that needs to close before the industry can fix the traffic related issues we are seeing today, particularly in casual dining. This is not to say that QSR is immune, but it does not appear to be as bad. QSR has picked up some traffic from casual dining, but the incremental traffic is coming from discounting. Unfortunately, the more stores that close the more people there are out of jobs. Regardless, the restaurant industry still needs to shrink to grow!

Moving to… Discussing the fate of GM is a moot point – the collapse of the credit markets, especially speculative credit, means there is no life support in bankruptcy. So that leaves one of two outcomes for GM; it’s going to file for bankruptcy and liquidate or the government will bail them out. The reality is the government will provide life support, with the stipulation that the company needs real fundamental restructuring – it needs to shrink its excess capacity and thus cut its payrolls. When the US Government bailed out Chrysler it ended up laying off 1/3 of its work force. GM needs to shrink to grow!
The US Banking and financial services has been operating with excess capacity for years. No need to rehash that story, but capacity is finally declining there, too. Shrink to grow!

We are now just beginning to see the severity of the stress in other parts of retail. The retailer du jour is Best Buy – no surprise, but reality. Recently, Circuit City and Linens ‘N Things have either shrunk significantly or liquidated. The US economy is going through a cleansing process that is healthy but takes time to fix. Unfortunately, government intervention in the process is only prolonging the process. Today, companies that are on the brink of collapse don’t go bankrupt, but become socialized by the US government.

Why we didn't cover our Japan Short (EWJ) today...

This questioned is better answered with a chart. This is embarrassing. Amidst the rest of the world (Australia, Germany, USA, etc...) putting in sentiment bottoms, the Japanese ring the gong on a fresh 26 year low.

Japan is not a place to be invested. As Wall Street great, Marty Whitman, would say "a bargain, that remains a bargain... is no bargain!"

Why Did We Cover our British (EWU) Short Position Today?

One, the EWU was down over -6%, and we cover on red meltdown days... Two, and more importantly, as bad as this morning's jobless claims # in the UK was (worst since 1992), the rate of change improved sequentially (i.e. less bad, see chart).

Everything that matters in our macro models occurs on the margin. Today's delta was an important one. Look for the British to cut interest rates again in the near future.

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