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CRUDE QUESTIONS

This note was originally published at 8am on June 21, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

"Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible."

- John Maynard Keynes

 

That’s a quote from Chapter 12 of Keynes’ General Theory, “The State of Long-Term Expectation.”  Much of Keynes’ work was marginalized by the economists that were influential shortly after him – namely John Hicks – particularly the existence and importance of uncertainty in investment.  As a result, what is today considered Keyensian Economics is hardly the economics of Keynes (Steve Keen, 2011).  Hyman Minsky – the preeminent economist on fragility in financial markets – wrote in 1975 that, “Keynes without uncertainty is something like Hamlet without the Prince.”

 

This Early Look is not on Keynes – you’re welcome – but on uncertainty and oil prices.

 

As an energy analyst, I read a lot about oil markets.  One of the latest topics #trending on the subject is the price of oil approaching the marginal cost (MC) of production; this one always seems to get popular when oil prices drop precipitously, as it’s a go-to reason to ‘buy-de-dip,’ say the perma-bulls.

 

The MC of production is the change in total cost that comes from producing one additional unit of a good – a bicycle, a bushel of corn, a barrel of oil.  It is an important economic concept that determines the price of that good for a given level of demand.  On a long enough duration, the price of oil will converge around the MC because should price fall below the MC, the MC producers will not put incremental capital to work to arrest natural production declines, leading to a shortage and rising prices; and should price rise above the MC, it incentivizes production above what is demanded, leading to a surplus and falling prices.

 

Yes, MC matters, and yes, oil prices will track it over the long-term.  But the idea that the MC of oil production, and with it the oil price, is permanently headed higher – a popular opinion – is a fallacy.  Consensus is comfortable, and after a decade-long rise in the MC from $25/bbl in 2001 to $90/bbl in 2011 why would the next ten years be any different?  But the future is, of course, unknowable, and to deal with that inherent uncertainty “the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations” (Keynes, 1937).  In other words, only after oil prices have increased 15% p.a. since 2001 does a deflating oil price seem implausible. 

 

In general, though, commodities – even non-renewables (fossil fuels) – do not tend to hold their real value over the long-term, proving poor investments.  New technologies, greater efficiency in extraction and production, and the substitution of one commodity for another (at one time our primary fuel was wood, then it was coal, today it is oil) drive the MC of production lower, and with it real prices.  After adjusting for inflation, major industrial commodity prices fell 80% between 1845 and 2002, though regained some of that lost ground over the last decade in a fantastic commodities bull market (The Economist, 2011).   Only gold and oil have held their value in real terms, and, indeed, oil has been a spectacular investment over the last decade, gaining 300%.  It is easy to forget, though, that the real price of oil in 2000 was no higher than it was in 1950.

 

We can point to a number of reasons why the MC of oil supply and the nominal price of oil have meaningfully outpaced inflation over the last decade, though easy money and China’s incredible investment boom top our list.  Others point to the decline in easily accessible oil reserves and rising social costs of Middle East nations, but we see less validity in those theses.  New technologies and greater efficiencies can counter harder-to-reach reserves; and oil exporters’ government budgets are pro-cyclical. 

 

In fact, most costs are pro-cyclical.  The relationship between the MC of oil production and the oil price is a classic example of mutual causality.  Is the price of oil higher because rig rates, steel pipe prices, production taxes, and labor costs are higher?  Or is it that rig rates, steel pipe prices, taxes, and wages are increasing because the oil price is?  Both occur simultaneously and as a result, the MC of oil production is just as much a moving target as the price is – not some Rock of Gibraltar level of support.

 

We’ve seen this movie before.  In constant dollars (year 2000) the price of US coal decreased from $31.40/short ton to $16.84/short ton between 1950 and 2003; in other words, after adjusting for inflation, coal prices have fallen more than 1% p.a. since 1950.  This trend is due to a decline in the MC, or “marked shifts in coal production to regions with high levels of productivity, the exit of less productive mines, and productivity improvements in each region resulting from improved technology, better planning and management, and improved labor relations” (Edward J. Flynn, 2000).  Those trends persist today, and the high cost coal producers are gasping for air (pull up a 5Y chart of PCX or JRCC).

 

And of course, we have US natural gas, which has fallen in nominal terms from $12/Mcf in 2008 to $2.50/Mcf today in a stunning display of how technology and innovation can lower the marginal cost and price of a fossil fuel.  Visions of permanently high natural gas prices prompted a build-out of LNG import facilities in the mid 2000’s.  Alan Greenspan (clearly an expert on the subject!) said in 2003 that, “high gas prices projected in the American distant futures market have made us a potential very large importer.”  With impeccable timing, Cheniere’s Sabine Pass received its first cargo of imported gas in April 2008, and now that same visionary company will spend $6.5B to export gas by 2017 (nat gas bottom?).  And this wasn’t the first time the gas bulls were fooled.  After years of rising natural gas prices in the 1970’s, four major LNG receiving terminals were constructed only to see gas prices peak in 1983 and decline for the next 15 years; three of those plants were eventually mothballed.

 

Is the rapid increase of the MC of oil production and oil prices any more “secular” than it was for natural gas in the 2000’s?  Will Chinese demand for commodities grow at the same pace over the next ten years as it did for the last ten?  What would sustained US dollar strength do to commodity prices, oil in particular? 

 

The confidence one can have in answering such questions is limited, perhaps even “negligible” (Keynes), but few in this Game accept that.  It’s funny – you don’t often hear investors or analysts say, “I don’t know,” but when consensus is proven really wrong, the all-too-common excuse is, “How could I have seen this coming?”

 

Our immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, EUR/USD, and the SP500 are now $1590-1614, $91.20-96.79, $81.21-82.02, $1.24-1.27, and 1333-1362, respectively.

 

Kevin Kaiser

Analyst      

 

CRUDE QUESTIONS - oil v usd 20

 

CRUDE QUESTIONS - VP 6 21


100% Cash

This note was originally published at 8am on June 20, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“Duration neglect is normal in a story, and the ending often defines its character.”

-Daniel Kahneman

 

I’m a storyteller. So are you. We tell ourselves, our families, and firms stories every day. We tend to frame each story within the framework of how we think. How we think drives our decision making. In the end, we are all accountable for those decisions.

 

I made a decision to go to 100% Cash in the Hedgeye Asset Allocation Model yesterday. That’s a first. If you’ve been reading my rants for the last 5 years, I don’t have to explain why at this point. You know where I stand. I do not think that this ends well.

 

Some people think that it will end just fine. Some people think doing more and more of what has not worked is the only way out. Many people thought the very same thing in 2008, and the moneys in their accounts are still underwater to prove it.

 

Back to the Global Macro Grind

 

You can call me short-term. You can call me the longest of long-term. You can call me whatever you want – that’s all part of the storytelling too. I was never supposed to be a name in The Game. The Old Wall was never supposed to fall.

 

The Old Wall used to get away with making up Perma characters in their storytelling. Someone was always the Perma Bull. Someone was always the Perma Bear. Some of us call that fiction. Some of us just permanently manage risk, both ways.

 

I have by no means perfected the risk management process. The day that you think you have is the day you are about to get clocked. The plan is always grounded in uncertainty. The plan is always that the plan is going to change.

 

As The Game changes, the process evolves. Sometimes the process signals that it’s time to just get out of the way.

 

To review why I am already out of the way this morning:

  1. I have no idea what our Central Market Planner in Chief is going to say
  2. If Bernanke delivers the Qe3 drugs, food/energy inflation will slow real growth further
  3. If Bernanke doesn’t deliver the drugs, a world full of Correlation Risk comes into play

In other words:

 

A)     You cannot beg for Qe and have Accelerating Growth at the same time – the world needs growth, not more debt

B)      If you do not get Qe, the US Dollar stops getting debauched, and Commodity Bubbles continue to pop

 

So that’s why, at this time and price, I have a 0% asset allocation to Stocks and Commodities. Why I have a 0% asset allocation to Currencies and Fixed Income is simply because I know how to manage my immediate-term risk.

 

I sold both our US Dollar (UUP) and US Treasury (TLT) positions before yesterday’s plundering. That doesn’t mean I cannot buy either of them back. There are no centrally planned rules associated with how much Cash I can be in. At least not yet.

 

Back to the #1 thing that Bernanke will not mention today that is driving both causality and correlation in real-time market pricing – The Correlation Risk. Here’s how the last 2 months of Correlation Risk between the US Dollar and everything “risk” has looked:

  1. SP500 = -0.91
  2. Euro Stoxx600 = -0.96
  3. MSCI World Index = -0.95
  4. CRB Commodities Index = -0.94
  5. WTIC Oil = -0.94
  6. Copper = -0.93

No matter what storytelling they continue to feed you (and they is all encompassing at this point, from the Old Wall to Washington, DC and Paris, France), this is all that matters right now.

 

Get policy right (causality), and you’ll get the US Dollar right. Get the US Dollar right (correlation), and you’ll get a lot of other market things right.

 

We’ve been right 32 out of 33 times since firm inception (2008) on the US Dollar. That’s probably why I haven’t spent the last 5 years trying to get back to a bull market top break-even. I may be wrong this time. If I am, I’ll at least know why.

 

European central planning storytellers have played their hands. In my own accounts, with 100% liquid Cash (and illiquid Hedgeye stock), I’m holding a hand of kings. For their last no-volume hurrah, Bernanke Beggars better hope he has 4 aces.

 

My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, EUR/USD, and the SP500 are now $1589-1640, $94.84-97.59, $81.32-81.97, $1.24-1.27, and 1329-1362, respectively.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

100% Cash - Chart of the Day

 

100% Cash - Virtual Portfolio


BANKS: The New Criminals

Innocent until proven guilty in a court of law is the way of the land and US banking institutions will certainly have to put forth a lion’s share of effort defending themselves in the wake of the recent LIBOR manipulation scandal. The London Interbank Offered Rate (LIBOR) is the benchmark interest rate for rates around the world, essentially. Barclays recently admitted it colluded to manipulate LIBOR and got slapped with a hefty $455 million fine and essentially escaped criminal prosecution for coming clean right away. It has cost the bank its iconic CEO Bob Diamond, who resigned Tuesday morning in addition to now former Chairman Marcus Agius.

 

 

BANKS: The New Criminals - LIBOR 5yr

 

 

Manipulating interest rates is a violation of the Sherman Antitrust Act and a criminal offense. It is ironic in the sense that what little “trust” was left in the markets has all but evaporated at this point. As regulators both domestic and abroad begin their probes and investigations into financial institutions and the LIBOR scandal, it is becoming clear that this could very well be the worst thing to happen to banks since the 2008 financial crisis.

 

The past six years have seen regulators and politicians dole out an immense amount of restrictions and control over US banks. From Dodd-Frank provisions like Durbin to the Volcker Rule to the (estimated and still climbing) $49 billion in mortgage putback settlements, it has not been an easy journey. Three key players in the US have to worry about the effects of what we will refer to as LIE-BOR: JP Morgan Chase (JPM), Citigroup (C) and Bank of America (BAC). These are the large cap US banks who participate in setting LIBOR. It is worth noting that Goldman Sachs, Morgan Stanley and Wells Fargo are not affected by this mess.

 

With regulators breathing down their backs, essentially zero public trust and a slew of lawsuits in the wind, the bearish case for BAC, C and JPM is getting stronger by the day. JP Morgan in particular has it rough after getting grilled over its $2 billion+ trading loss out of – where else? London.


 

BANKS: The New Criminals - BANKSFIX rollercoaster

 


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CAKE: ICSC SHOWING DOWNSIDE IN COMPS

Cheesecake Factory does not report earnings until July 20th but a data point published this morning gives an idea of how the company’s top line may have shaped up during the second quarter.

 

Cheesecake Factory reports on July 20th and we will be publishing a comprehensive preview in advance of that print.  The stock has traded strongly over the past week but we believe that the ICSC data published this morning rounds out a quarter where CAKE’s comps may have come in lower than the Street is expecting. 

 

Cheesecake Factory traffic depends partly on traffic in malls across the U.S. The two lines in the chart below represent Cheesecake Factory comps and the ICSC Chain Store Sales Index year-over-year change.  The aforementioned ICSC dataset details the weekly change but, clearly, for comparability purposes it is necessary to monitor quarterly Cheesecake Factory comps versus the corresponding year-over-year move in the ICSC data. The 2Q12 data point for Cheesecake Factory represents current consensus expectation of +1.95%.  The correlation for the data represented in this chart for 1Q02 through 1Q12 is 0.8.

 

CAKE: ICSC SHOWING DOWNSIDE IN COMPS - cake icsc

 

 

We like to monitor Google Trends (search “Cheesecake Factory”) versus the comps of many of the companies in our space, depending on how strong the relationship has been historically.  For CAKE, the correlation between the Google Trends data and the company’s blended same-store sales growth over the last four years has been 0.75, which means that we do not ascribe too much importance to the chart below but it is worth highlighting.

 

CAKE: ICSC SHOWING DOWNSIDE IN COMPS - cake google trends

 

 

Howard Penney

Managing Director

 

Rory Green

Analyst

 


XLF: The Cycle Repeats Itself

Financials have had one rollercoaster of a ride over the last six years – and that’s putting it rather lightly. This morning we took notice of the XLF (financials SPDR) and what’s been going on there over the last three years. Essentially, this ETF has seen consistent drawdowns in terms of three factors: timing, magnitude and duration. There is a cycle that has been setup which will continue for the foreseeable future that relies heavily on monetary policy put forth by central planners (read: The Fed).

 

 

XLF: The Cycle Repeats Itself - XLF Predictable

 

 

Since 2010, what happens is that in Q2 and Q3, fears begin to mount about a major recession and investors essentially get scared as seasonal adjustments of government data come in. So the market then begins to look to Ben Bernanke and the Federal Reserve for a crutch to help them out in terms of lower rates, extensions of existing market operations (Twist) or another dose of quantitative easing. This happens in the fall and then for Q4 of that same year and leading into Q1 of the following year, the market becomes overly bullish. Then the same Q2/Q3 fears kick in again and the cycle repeats itself

 

Hence, the drawdown pattern in the XLF. Life’s good when Bernanke has your back (until he doesn’t).

 


OH SNAP: Food Stamps’ Impact On Dollar Stores

The nation is hungry and the government has got to feed it. The Supplemental Nutritional Assistance Program (SNAP) – better known as food stamps – has been on the rise since 2007, recently peaking at a 30-year high of 15%. We estimate that based on the current rate of deceleration, SNAP participation growth will turn negative in the beginning of 2013.

 

What does this mean for dollar stores like DG, FDO and DLTR? It means that people with limited income aren’t hitting up these stores like they used to. Instead they are going to supermarkets and other participating vendors that deal with the SNAP program and accept food stamps. This does not bode well for dollar stores, who are currently sitting at peak margins. This only adds to our increasingly bearish stance on names like DG and FDO.

 

 

OH SNAP: Food Stamps’ Impact On Dollar Stores - SNAP foodstamps


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