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Oil’s TAIL is Supply

We've started discussing some of our TAIL prices and themes lately, which relate to a duration of three years or more.   Following its dramatic re-flation year-to-date, oil is now trading very close to its TAIL price; a breakout above would be bullish for a longer term duration.  We've discussed the longer term bullish case for oil in a number of notes, and it relates to long term supply constraints. 

The best evidence of supply constraints is simply to look at global oil production over the last five years.  According to BP's 2008 Statistical Energy Review, in 2004 global oil production was 80.2MM barrels per day and in 2008 global oil production was 81.4MM barrels per day.  This is unique in that the global economy was growing and the price of oil was increasing, which of course led to massive investment in oil exploration.  Despite that massive investment and increase in global demand, oil production had a very difficult time keeping pace.

The simple fundamental reality of resources such as oil and natural gas is that they have decline rates.  That is, the amount of oil that can be extracted from any field over time will naturally decrease over time, so for production in a region, or the world, to grow, the amount of new oil supply brought online must offset the natural decline rates that exist.  The last five years show us that we have barely been able to budge the global decline rate.  As a point of fact, global oil rig count hit a 20+ year high in 2008.  This means that more wells were drilled and completed in 2008 than since any year in the past 20 years.  Rig count has been on a steady up tick from the 1990s, and accelerated over the past five years.  Once again, massive investment in production, but a very tepid increase in supply.

This simple conclusion from the combination of massively increasing drilling activity and flat global production levels is that oil is supply constrained.  I'm not necessarily a peak oil theorist (I'll leave that to our VP of Marketing, Todd Enders and his San Francisco brethren), but when it comes to TAIL investment themes, those with a duration of three years or more, this thesis that it is much harder to get incremental oil out of the ground than it has ever been in the past is one to keep front and center, especially as oil breaks out on longer durations and the fundamentals begin to show incremental improvement.

And, on the margin, oil fundamentals are improving.  Some fundamental data points that we've picked up and wrote about in recent notes include:


  • - The International Energy Agency increased its forecast of global oil consumption by 120,000 barrels per day last week. The Agency's new projection is for 83.3MM barrels per day in demand, which is down 2.9% y-o-y. This data point is noteworthy for the fact that this is the first time in 10 months that the IEA has raised their oil demand forecast, so signifies an inflection point in demand even if levels are well below y-o-y levels.


  • - Last week IEA's head Nobu Tanaka told Reuters that OECD stock levels for oil were at 63 days, but he expected them to be at 57 days by year end. It is conventional wisdom that that 50 days of forward cover is very bullish for oil prices, 53 days is bullish, 57 days bearish and 60 days very bearish.


  • - Earlier today, the DOE reported the oil inventories in the U.S. declined by 3.9 million barrels, which was the second week of declines. Both of which we substantially greater than expectations.

Clearly, so far in the year-to-date, US dollar strength and inflation concerns have been driving the price of oil in US dollar terms, but there is a fundamental case staring at us from the TAIL.


Daryl G. Jones

Managing Director

Oil’s TAIL is Supply - tail



Keith is a cowboy

Research Edge Position: Long COW

I suspect that Keith is a Canadian cowboy at heart. I arrived at this suspicion based on several clues: 1) last Halloween he came in to the office dressed in full cowboy regalia, 2) when he and I first met it turned out that one of the few friends that we had in common was the former two-time national Bull riding champion of Canada (it takes one to know one principle, myself notwithstanding), and 3) his tendency to shout "Hoowah!" when trades work out better than anticipated.

Thus when he first asked me what I thought about the ETN COW last year, I realized that I had to take it seriously, because it might well end up in the portfolio.  Since then it has remained on the back burner of my market universe. Our decision to go long this week was based on a convergence of factors: Keith was attracted by the technical set up that it was presenting, several underlying fundamentals looked compelling, and it ties in with our overlapping macro view on reflation and the US consumer.

COW tracks an AIG commodity sub-index that consists of Live Cattle and Lean Hog front month futures contracts. The mix is currently 62.27% front month Live Cattle, 37.73% front month Lean Hogs. 


Although earlier today I wrote that I have a bias against historical comparables, for agricultural commodities, the seasonality is undeniable.

Traditionally, US beef consumption is greatest during cold weather months, and supply levels are driven by the spring calf breeding cycle/late summer slaughter cycle. The start of slaughter cycle coincides with lower consumption patterns to drive prices down in late summer, while prices tend to rise in March and April when demand typically is still  high but supply is at its lowest after the slaughter cycle has ended and the breeding cycle just begun.

In the chart below I illustrated the 20,15,10 and 5 year average indexed price returns for the front month LC contract under the current year. Although earlier today I wrote that I have a bias against historical comparables, in this instance the seasonal inflection is undeniable. Clearly the futures are currently underperforming historical seasonal averages as macro factors weigh on anticipated demand.


Pork demand also follows a seasonal pattern, but the price pressure inflections for that market are different because the breeding and slaughter cycle tends to be based on the corn harvest since farmers breed heavily in advance of the cheapest feed prices. As such, supply is at its lowest in midsummer during comparatively low demand.  Like cattle, Lean Hog futures are currently outside typical seasonal inflections.

Now keep in mind that these are just general rules based on long term historical observations (which I have stated on multiple occasions that I tend to discount), but in agricultural markets it is dangerous to ignore seasonality.


  • Current USDA forecasts anticipate that both Beef and Pork production will be reduced for 2009 based on statistical data showing declining slaughter and carcass weight measures.
  • Canadian Pork exports are forecast to decline more sharply than US production as overlapping local factors have driven feed prices higher simultaneous to a strengthening Currency versus the US Dollar. Next Friday's quarterly USDA Hog report should provide a better picture of the developing import situation.
  • Argentina's Ministry of Agriculture officially estimates that cattle production will decrease by 13% this year due to decreased demand from customers like Russia. Unofficially the disastrous policies pursued by the Kirchner regime have driven Argentine farmers to despair and it has been reported by some media sources that the country may become a net importer for the first time since 1871. Getting hard data on the impact will be difficult as the Ministry stopped generating monthly data in November of last year.
  • Although the work Howard Penney is doing in the restaurant sector shows that the dining industry continues to face a challenging environment, the data continues to suggest that the situation has not deteriorated to levels initially anticipated for mass market food retailers as cheap gasoline; cheap food prices and cheap money have left broad domestic consumption patterns relatively unscathed.


So now we have COW in our portfolio with supporting seasonal inflections, a solid technical setup and a some positive fundamental data points. That doesn't mean there aren't risks involved, primarily tactical in nature. For starters there is always a liquidity risk trading livestock futures, and during summer months the volume can get especially thin. Also, since the ETN tracks the Index, during each delivery month the product must "roll" into the next series: this roll impact will result in a divergence between the continuous front month levels and the ETN performance.

For now we remain long US livestock and will continue to own the COW for as long as the data supports our thesis.

Yipppie Kay Yay.

 Andrew Barber



Yesterday's CPI buys more time for the "free money" cycle. Buying time can be expensive.

Keith and I talk about history frequently. I know a bit about a fairly broad range of economic and political history, in part because of my education and in part because of my interests. Like many students of history, I have a tendency to massively discount its importance in the decision making process. To my mind, the more you know about past events, the more you understand the unique factors involved with each and, as such, the less confidence you will have in drawing conclusion solely based on corollary. When discussing yesterday's consumer inflation data I told Keith that the current environment seems anomalous to me, and those looking for clues in the reflation puzzle will be frustrated by historical comparisons.

At -1.28%, yesterday's CPI reading arrived at the lowest level since 1950 when the massive deflation/reflation cycle that followed the end of WW2 were wreaking havoc on global commodity markets (see chart below). 


This reading leaves the fed with ample room to keep easy money train rolling at next week's board meeting and also provides the market with clear signals that the return of year-over-year inflation growth will not arrive until mid to late Q4. This breathing room gives the economy more time to recover but that time may come at a steep cost:  with the scales tipped so far in one direction, even modest catalyst could trigger inflationary pockets rapidly, providing a nasty "snap-back".

One of our core ideas coming into 2009 was the demise of correlation of returns for different asset types, and this will be critical in our approach as we position ourselves to profit when inflation does finally raise its head.  We anticipate significant divergence inside the commodity matrix as overlapping demand factors and currency valuation throw the momentum mentality that worked perfectly in the 07-08 boom out the window in favor of market specific fundamentals. In other words, in the cycle that we see on the horizon, soybeans won't necessarily go up because Chinese demand for coal increases, and gold won't necessarily go down because the Brazilian cotton crop is larger than expected. 

As such homework will be required and, if history is any guide, many investors will not do the assigned work and fail the exam.

Andrew Barber

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The benign commodity environment and DRI increasing focus on cutting out fat will leave the street focused on same-store sales for FY4Q09.

In FY3Q09, DRI blended same-store sales were down 3.2% at the three core brands largest brands; slightly better that the Knapp-Track industry average of 5.7%. Note we have adjusted the Knapp-Track industry average to comply with DRI fiscal quarter and include DRI's same-store sales trends.


In FY3Q09, Red Lobster reported same-store sales decline of 4.6%, which was 1.1% above Knapp-Track. For the same period the Olive Garden reported same-store sales decline of 1.4%, which was 4.3% above Knapp-Track. Longhorn Steakhouse same-restaurant sales decreased 5.4% for the quarter, which was 0.2% above Knapp-Track.

In FY4Q09, we are looking for blended DRI same-store sales to be down 3.1% or 2.4% better the Knapp-Track. On a relative basis, LongHorn is likely to show the best sequential results on the back of a new media strategy put in place in FY3Q. The number of restaurants with advertising support increased from 45% to 60% and the media weight by 25% (at no incremental cost).


In FY4Q09, we are estimating that Red Lobster's same-store sales decline of 3.0%, which is 2.5% above Knapp-Track. For the same period the Olive Garden reported same-store sales decline of 2.0%, which is 3.5% above Knapp-Track. Longhorn Steakhouse same-restaurant sales decreased 3.5% for the quarter, which is 2.0% above Knapp-Track. Consensus estimates for Red Lobster, Olive garden and LongHorn are -2.2, -0.2 and -4.5%, respectively.

For FY4Q, I'm slightly - $0.01 - ahead of consensus at $0.87 and $2.72 for the fiscal year. Given what we are hearing, and confirmed by the stabilization in Knapp-Track trends, I don't believe there will be much deviation from the trend I have outlined. DRI's marketing muscle is clearly a benefit during difficult times. Benign commodity trends, incremental pricing and cost cutting will lead to a 70bps of sequential EBIT margin improvement to 10.6%.


Trading at 8.0x EV/EBITDA, DRI is relatively expensive - trading at two multiple points above the FSR group. Short interest is low at 7.6% versus 13% for the FSR group. While I don't think there is another $10 million surprise in FY4Q, DRI has further fat to cut out of its cost structure.

While things this quarter look good for DRI, longer-term I'm have issues with DRI pushing hard on the organic growth engine. As I measure how DRI is investing is cash, the trends are headed south. Over the past two years the company's ROIIC has been declining - never a great sign.




CCL 2Q09 Earnings call:


Prepared Remarks:

- Just took delivery for Seabourn Odyssey today.


- Reduced fuel consumption helped them by 5 cents.  Also, better than expected pricing on close in bookings benefited them by 3 cents.

  • Mexico hurt them by 3 cents
  • Total revenue yields came in at the lower end of the range, driven primarily by the flu impact


- The capacity increase was driven by European brands growing 8%, and Costa Asia doubled in size.


- 2Q09 revenue commentary:

  • Net ticket yields were down 10%, NA down 14% (Alaska, Mexico), Caribbean & other exotic held up better. European yields fell 6%.
  • Saw benefit from bookings that occurred pre-crisis, hence the back half will not have this benefit and will be more impacted
  • Onboard spend down across the board


- Cost commentary:

  • More vessels in drydock this year
  • As a result of more focus on fuel efficiencies, they have been able to reduce consumption more than the 2-3% run rate of the last few years
  • Currency hurt them as the dollar weakened
  • Continued to find opportunities to save another $33MM and brought total savings to $150MM
  • Fuel will save them $660MM over 2008, with 2009 fuel / metric ton at $353. Fuel and currency are driving their costs down. FX, however, will also reduce their revenues by $175MM or $0.22/ share in 2009
  • 10% change in fuel will impact them by $0.14/share. 10% change in all currency impacts them by $160MM or $0.16/ Share


- Since the March conference call they completed the Italian export credits, European investment bank loan, and two other term loans for $350 million each.  They are on target to get all of their financing needs for 2010 by September.


- Booking environment:

  • Booking volumes are running 26% ahead of last year
  • Seem to have found a price point of attracting customers
  • North American cruise brands are seeing a moderate increase in pricing ability on premium product, however, the lower end stuff has been more impacted by the Mexican flu issue


- 3Q09:

  • Alaska at 39% of capacity
  • Pricing for NA is lower across all itineraries with worst impact on Alaska
  • European prices are lower but not as bad as NA
  • Caribbean prices are also lower
  • Occupancies are lower for NA and slightly higher for Europe
  • UK yields only slightly lower, other mostly mid single digit declines, overall European yields lower in the single digit yield range


- 4Q09:

  • 5.7% NA 9+% capacity increases
  • NA brands Caribbean prices are lower, but booking momentum has been strong
  • European pricing is holding up better than Alaska but lower (on NA brands)
  • Occupancies for NA are still lower, but only modestly
  • European brands pricing better than the US brands during 4Q, and while occupancies still not much lower than last year, expect pricing to be down


- 1Q2010:

  • Fleetwide capacity up 9.2% (13.3% in European brands, 5% in NA)
  • Do expect yield declines in 1Q2010, as a good portion of 1Q09 was booked during better times
  • However, volumes/ bookings are in line
  • If the strong booking momentum continues, it's possible that pricing may be close to 1Q09



- Terms of the EIB loans?

  • $550MM Euros, 250MM drawn in 2009, 150MM in 2011 and balance in 2010
  • Rate is very favorable
  • Unique because the EIB looks to stimulate growth in the economy and these ships will be sailing in the Mediterranean
  • May or may not be repeatable


- Capacity for 2012 & beyond?

  • Expect capacity growth to slow but not stop (he doesn't know, basically)
  • Pricing on ships has come back down to levels of where they used to order ships -so may consider it when they have needs for particular brands (on a constant currency basis)


- 3Q09 net yields looks at the low end of their guidance, and 4Q09 forecasts big rebound (we assume he means less bad) 

  • Without the impact of the flu they would have come in at the mid-point of the net yield guidance in the 2Q09
  • For the 3Q09 - they suffered more because of the premium mix - therefore they feel the impact of yield erosion the most. The 4Q09 will be better because of mix as well, but don't see it dramatically better more just a mix issue


- The magic questions... with capacity increase will yields continue to be negative in 2010?

  • Too early to say- clearly they don't want to opine on this year and to be fair they just don't know


- The only time they saw an impact on Mexico was during the 3 week travel advisory period, as soon as they announced the new itineraries the demand rebounded at strong levels, but at lower pricing levels (expect pricing to rebound to previously depressed levels)


- Feel encouraged because everything was trending up before the travel advisory.


- Whether the % of European passengers on Europeans brands are any different than 2008

  • No but the North American Brands are carrying more non-Americans


- Fuel supplements back in place? No plans since the economy is crisis

  • In other words - they would love to but they can't because what goes into a supplement will come out in pricing - thank for the obvious question


- Onboard spending for European brands has held up reasonably well


- Mexican Flu impact

  • Nickel of extra costs for the change in itineraries - part of it fell to the 3rd Q
  • The other 5 cents was due to digging themselves out of the hole when bookings came to a standstill (7 cents in the 3Q - why not just throw the kitchen sink at it ... right?)

- 2010 is the first time when they planned itineraries in a high fuel environment.  So the savings will be high on consumption (we assume 4%)


- Costa Asia? (immaterial to the company)

  • See the summer season absorb the 2x capacity... (coming from 1 ship to 2)
  • Winter season was slow
  • Typically go to Japan & South Korea (4-6 day trips)
  • Don't see the same "RevPAR" trends as lodging because it much less penetrated


- Dividend

  • Clearly would like to see a turn in earnings and cash flow before re-instating the dividend
  • Won't risk loss of the investment grade rating


- IBERO brand

  • Haven't acquired the entire brand yet... in the approval process. Its only 2 ships. Have taken full control of the company though and have restructured it. Wont develop more ships until the Spanish market recovers


- If they can get same level of occupancy as 2009 in 2010 the pricing will be up - but that's obvious... he's just saying if they can fill all the incremental demand (9+%) than they can start raising pricing.... Again this is the million dollar question

  • Think that should cycle the price declines by the end of 2Q2010


- Since end of March they have seen yield declines start to improve. 

  • A lot of the volume they are seeing is close in volume, still behind booking levels for 2010... not enough to price though. Won't know until 3/4Q.


- Alaskan capacity will be down in 2010.



Initial claims continue to hover above the 600K line in the sand

Today's Initial claims number arrived at 608K; 3k higher than the prior week's number which was revised upwards by 4K, but still below the four week moving average by 8k. Since last week's bullish claims reading the S&P 500 has declined modestly on slightly increased volatility, while the US Dollar index has cut its decline for the year significantly from  -7% to under -2% and the yield curve has narrowed with 2 year yields rising to close the gap with the 10 year by over 10 basis points.

With Claims still hugging the psychologically important 600k line, the "glass half full " crowd are left still looking for signs of a bottom here, with accelerating declines in benefits paid  providing more clues that the rate of job losses has moderated sharply.

As always with the sometime conflicting employment data that the US government provides, interpretation is key: declining benefits paid to existing claimants could indicate a tightening job market for the newly unemployed, and could perversely cause the department of Labor Unemployment Rate metric (a lagging indicator -see our post on June 9) to rise. Despite this caveat, the declining pace of job losses is clearly evident and we currently anticipate that next month's unemployment release will likely register slightly below 10% -that critical double digit dam-buster that the bears are desperately seeking.

Our overall tactical outlook has not fundamentally changed from last week: We expect to continue to trade the equity market inside a narrow range for the near term, and while we have increased our domestic equity exposure to 15% from 12 % since last week, we have not seen enough supporting data for the equity market to join the glass half full crew yet.

Andrew Barber