Big Ben Battles Despair From China:

Is It Already Time to Buy Oil Back?

By Dr. Duru written for One-Twenty

April 27, 2006


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If you didn't know any better, you would look at the final results on the major indices on Thursday and think all is still well with the market. But you might wonder why a bunch of European markets were down as much as 1%. And then if you looked under the American covers, you would find some serious drama. Trader Mike gives a great review of the madness. I will just summarize by saying that we opened the day down with much despair after the U.S. market learned that China had raised interest rates from 5.58% to 5.85%. This was China's first rate hike since October, 2004, and the Chinese were not so kind as to warn us like our own Fed has done for many moons now. Given that China is so often fingered as the reason why commodities have soared and why the global economy remains buoyant, you can understand the immediate consternation and agitation market-wide. Commodities have already been troubled for a week now and if any other sellers needed an excuse to get out of the way, the Chinese provided a bright red exit sign. At that point, my declaration calling for a contrary opinion on oil sure seemed timely. But then I found out that Ben Bernanke, Big Ben, the new Federal Reserve chairman, was doing another one of those dreary check-ins with his "over-seers" over at the Capitol Building (the Joint Economic Committee). No way Big Ben was going to further agitate the market, right? Right! In fact, he more than delivered by stating:

"The FOMC will continue to monitor the incoming data closely to assess the prospects for both growth and inflation. In particular, even if in the Committee's judgment the risks to its objectives are not entirely balanced, at some point in the future the Committee may decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook. Of course, a decision to take no action at a particular meeting does not preclude actions at subsequent meetings, and the Committee will not hesitate to act when it determines that doing so is needed to foster the achievement of the Federal Reserve's mandated objectives."

Now, you know I am not one to harp on any given quote, but this was all the market needed to get its hopes back up. As Trader Mike points out, after all was said and done we ended green but the final result belies general market confusion. Should we finally worry that the good times are coming to an end soon? Or do we believe that the Fed will ultimately succeed in guiding us to a sustainable jolly good ol' time? I cannot answer that for you (although I strongly expect we are not going to be happy owning stocks come this September or October), but I was most intrigued by the action in commodities, and oil-related stocks in particular. The churn was highest here, and if I had the time I would post some of the most fascinating charts. Suffice it to say that stocks like FCX, PD, VLO, GLG, PAAS, and oh so many others caused both bulls and bears to lose money. But in the end, many ended down, unlike the major market indices, and the violence of the move, coupled with the high volume, had me wondering whether the weakest hands and the eager sellers have already been shook?! When I claimed it might be time to get contrary about oil, I was thinking that we would get a persistent decline, steep, but not sudden and abrupt. But these sellers may have all left for the exits at once today thanks to the scare from China. I cannot help but cease the bearish attitude and re-open the radar for opportunities. A quick scan has provided me with a bountiful basket!

This is as good a time as any to re-visit Lone Star (LSS), an oil-related steel stock (tubular piping to be specific) that I have spoken about on several occassions. LSS reported earnings the evening of the 25th, and the market up-chucked. The move down was sudden and violent and a sharp attempt at a rally was squashed in brutal form. The stock is now perched precariously on the 200 day moving average and is already down about 15% from the 52-week highs it clocked right before earnings. Since I was already growing wary of the oil-patch, I did not dare hold on to this bad boy through earnings. But the correction was steep, I had to investigate further. I honestly did not hear anything that sounded alarming. So, I am suspecting that the results from competitor Maverick Tube (MVK) must have spooked folks or at least added to the current despair. I took a few notes down from LSS's conference call:
  1. Steel costs down 5%
  2. Tubing revenue down 5%
  3. Steel is 65% of the cost of goods sold
  4. Capacity is 85-90% utilized, 93% is considered "full out"
  5. Expect pricing to hold line on margins
  6. Price increases are coming May 1, 2006
I realize that is not a whole lot, but, like I said, I did not hear much to get me excited either way: bull or bear. So, I can only think of this latest despair in the stock to be yet another buying opportunity in the saga that is LSS. (Just take a look at the long-term chart. LSS is still in a long-term up-trend, yet there have been many times the stock has gapped down sharply only to recover in due time). There is no guarantee that LSS will recover yet again, but I sure did not hear anything to make me think they cannot. The stock is still "cheap" at a backward and forward P/E of around 7 and price-to-sales at 1.29. And, again, cheap does not mean that LSS cannot get cheaper still....especially if the oil correction continues. (Click here for my disclaimer).

Some final thoughts on oil before I go. Quotes that should stick with you for a while.

During the question and answer period with the Joint Economic Committee, Big Ben warned all of us not to expect relief anytime soon from high oil and gasoline prices: "Unfortunately there's nothing, really, that can be done that's going to affect energy prices or gasoline prices in the very short run. This is a situation that's been building up for a long time."

Steve Chazen, CEO of Occidental Petroleum (OXY), was interviewed on CNBC after his company reported another quearter of stellar results (Click here for video from April 27 - may require subscription or registration and link is subject to expiration). During this interview he actually said in response to the interviewer's question "I expect you think that oil will stay at these high levels?" Chazen responded: "No. Not at these levels...We're not very good at forecasting. We have a terrible historic record at this...these seem to us to be unusually high levels." When pressed as to why his copmany his investing so heavily in oil production, he responded that the return on these investments is not dependent on these high levels, they are betting more on $50. $50?!? Does that sound familiar to you all? I take that target much more seriously coming from OXY, but note they are just being prudent to make sure they are investing in the kinds of projects that can pay off even if oil were to go into a steep decline...as it has done in the past after very strong cyclical runs.

Walter Lukken, Commissioner of the U.S. Commodity Futures Trading Commision (CFTC) had some interesting words during his testimony in front of the Committee on Agriculture in the House of Representatives. The link I provide to the pdf file provides a transcript where Lukkin talks about the energy futures market and what drives them. Lukkin assures us that "Although U.S. energy prices have been volatile in recent months, it is precisely during such volatile times that the risk-management and price-discovery features of futures markets are needed most by commercial users of energy products. The evidence we have seen indicates that futures markets for crude oil and unleaded gasoline and other energy products have been properly performing their risk management and price discovery roles." This tells me to continue to like the companies that trade in energy-related optins and other derivatives like CME and ISE. Even if the market were to go into a tailspin, you can bet that trading will only increase, not decrease! Lukkin also tells us right at the beginning of his remarks that "Based on our surveillance so far, we believe that crude oil and gasoline futures markets have been accurately reflecting the underlying fundamentals of these markets." In other words, they have not detected any market manipulation (so politicians, you have one less potential {and easy} scapegoat for these high prices!). Even more importantly, that the fundamentals are supporting high prices...period. Sorry again pundits who claim otherwise!

So, in sum, expect more "exciting" times. I do not know whether the Chinese will bring us more despair by trying to cool down their hot economy with more financial controls. But currently, they seem to be raising rates once every 18 months. I cannot get too excited by that. On the other hand, we have a Fed in the U.S. who has been raising rates consistently, for, what, two years? And the Fed has yet to cool down the economy as a whole one bit. Heck, a financial stock like Bank of America soared on Thursday to all-time highs?! Goodness. This market is one stubborn cookie.

Regardless, be careful out there! (Next up, I will talk about this week's madness in housing stocks! Meritage (MTH) had me exuberant and then Centex (CTX) brought the whole house crumbling back down again!)

DrDuru, 2006



Grammatical and format corrections made on 8/7/06