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Oil Lubricates Gains

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Oil Lubricates Gains

Oil rebounded on Friday from three-week lows and the rebound in oversold oil stocks powered the market higher. The S&P remained stubbornly in positive territory on Friday while the Dow and Nasdaq struggled to find buyers and languished in the red. Almost single handedly the rebound in the oil sector, led by the OSX, pushed the S&P steadily higher. A late day buy program provided the final spark that triggered yet another short covering spree. These factors combined to rescue the indexes from closing negative for the week.

Dow Chart - Daily

Nasdaq Chart - Daily

It was a tough week for stocks as alternating good news/bad news earnings reports competed for the spotlight. Good earnings news was matched with either higher expectations or lower guidance and many stocks were knocked for huge losses. On Thursday and Friday there were over 25 companies that either posted lower profits, missed estimates or warned on future guidance. Still, the markets failed to crack and we remain pinned to the recent highs. Buyers are all trying to chip away at this resistance but are only showing marginal gains for their efforts. The good news may actually be the lack of a drop. They tried to take the indexes lower several times but were unable to make any progress in that direction either. The result is a range bound market that is murder on traders.

TThe economic news for the week was dominated by the dual appearance by Greenspan in his biannual testimony on the state of the economy. It was clear from his remarks that there is no end in sight for rate hikes and a 4% ceiling is just wishful thinking by investors. He also continues to claim the economy is on firm footing and growing steadily. Another good news bad news event with steady growth offsetting the fear of higher rates. The market shook off any rate/inflation fears and tried to move higher. This was likely the last testimony to be given by Greenspan who faces mandatory retirement in January.

On Thursday the government reported that Jobless Claims for the prior week fell -34,000 to 303,000. This was the lowest level since April but there could be trouble on the horizon. This week turned out to be the biggest week for announced layoffs since January 2001. Leading the list was HPQ with a cut of -14,500 and KO cutting -10,000. Automakers continue to cut staff with the total cuts for the year at -78,000 for this sector. These were just some examples but there were many others. The cuts announced were scheduled for many months into the future so next weeks Jobless Claims should not show a sudden spike but there are growing signs of employment problems contrary to this weeks Jobless Claims drop. Next Tuesday's Monthly Mass Layoff report could show signs of an accelerating layoff cycle.

This was an off week for economic reports with a very light schedule but those that did appear showed strong gains. The Philly Fed Survey jumped to 9.6 from -2.2 and the Chicago National Activity Index rebounded to 0.28 from -0.03. Next week starts out slow but finishes with a bang on Friday with the GDP, NAPM, ECI, PMI and Consumer Sentiment.

This was a very strong week for earnings bringing the total S&P companies reported to 145. 72% have beaten estimates, many times lowered estimates, 15% announced inline and only 13% failed the earnings test. Analysts credit this imbalance with the dumbing down of guidance due to Sarbanes Oxley concerns. Next week we have 153 S&P stocks and four Dow stocks reporting. Actual earnings have averaged +9.1% growth and slightly ahead of estimates of +8.4% growth. All things considered, even discounting INTC, MSFT, GOOG and YHOO, it was a decent quarter. Earnings growth is decelerating but the outlook is still healthy. It is just not as good as we have seen over the last two years. The real question is not what level is considered good at this stage in the cycle but is this level of earnings growth and guidance sufficient to push the markets higher? So far earnings have been good but guidance has been only fair. Still the markets failed to sell off and the stalemate continues.

Last week oil prices fell to three week lows and took energy stocks along with it. Fortunately other stocks were reporting earnings and offsetting the weakness in energy. On Friday energy stocks were bolstered by the OSX led by comments from Haliburton and Schlumberger. Haliburton, the second largest services company, said they expected energy prices to stay high. They said customer spending in the exploration sector was very strong and the chances for it to continue were very good. They said world economies appeared to be absorbing the higher prices with minimal impact to GDP. Schlumberger said its profits jumped +36% on rising demand as customers worldwide stepped up their exploration activities. They said they saw this demand increasing driven by the lack of spare production capacity in the industry. SLB said there was more than enough work for everyone as they themselves were stretched thin by the increased demand. Both companies beat earnings estimates, which had been raised continuously by anxious analysts. Energy stocks rocketed out of their doldrums with many of the OSX stocks hitting new highs. Examples included gains in DO +3.50, RIG +3.35, NE +3.62, BHI +2.61, WFT +2.68, APA +3.86, SUN +5.06, NBR +3.56, EOG +3.30, BR +3.32, HP +3.04, VLO +3.63, AHC +5.51. Oil prices soared as well to $58.70 and a +$1.52 gain. This was well off Thursday's low of $56.50.

DDecember Crude Chart - Daily

The strength in oil and the OSX not only supported the S&P but pushed it back to a close at 1233. Energy stocks comprise 14% of the S&P and with average earnings at 35% they will be the main reason S&P earnings remain in positive territory for Q2. I continually get comments from various readers and analysts suggesting increasing supply from new exploration will solve the oil problem. Most expect oil to return to under $40 levels and last for decades to come. I believe it is easy to speculate if your money is not at risk. I believe if anyone takes the time to research the subject they will come to the same conclusion that oil prices may ebb and flow but they will continue to rise forever. I traded emails with a reader this week and I am going to reprint some of that conversation here for your consideration.

I doubt anyone has a real handle on where oil is going. From the reports I read there are estimates of $40 to $75 but most of the oil commentators have not really researched the problem and are just talking from past experience and assuming those price ranges will continue.

Globally more than 30 million cars and light trucks are produced each year and growing. Less than 5 million are scrapped. (China is on track to produce more than 5.2 million cars in 2005 yet only 6 people per thousand have a car in China) Nearly 2 million large trucks are built. Over the road trucking is growing by leaps and bounds. Diesel usage is at all time highs and growing rapidly as more and more products are shipped by truck. Jet fuel demand is at an all time high with demand rising about 4% per month. All of these uses depend on light crude not heavy OPEC crude. Only a few refiners can crack the heavy crude into the "middle" distillates of diesel, jet fuel, etc.

Global population is growing by 75 million people per year according to the U.S. Census Bureau. Every new person consumes products made with oil and shipped in a truck. That usage accelerates as they begin working, driving, raising a family, etc. Even if each new person ONLY consumed a minimum of 1 bbl per year that is an extra 205,000 bbls per day of additional demand every year. Since consumption from (China) is 1.9 bbl per person per year and consumption in the U.S. is 26 bbls per year per
person you can extrapolate that average global consumption per person in advanced nations is probably more in the 2-3 bbls range. India has the lowest current consumption for a major country at 0.8 bbls per person but their demand growth rate is likely to exceed China by 2010. India could easily consume more oil per person than China within 3 years. Population in India is 1.08 billion, China has 1.3 billion. As each country accelerates into the 21st century their oil consumption per person could easily grow to that 2-3 bbls per person. Do the math. That is an extra 3 billion bbls per year. We only produce 3.1 billion bbls per year now. It would require doubling our existing production at a time when we are having trouble just staying even. Even if only 25% of those estimates come to pass there is no way we could produce that much oil.

These global usage tends to be ignored because they are so mundane but every drop used comes from somewhere. Eventually something has to give and the only answer is higher prices and less oil. You can't pump over 3 billion bbls a year forever. Once productive but now dry holes are being plugged almost as fast as new wells can be drilled. 43 nations have declining production. Only 3 nations can increase production materially, Saudi, Russia, Venezuela. Saudi and VZ produce mainly heavy crude with VZ production more like sludge than oil. Current daily global production is around 85 million bpd. Production from existing fields as quoted by numerous experts is declining at something between -5% and -7% per year. That means those fields will produce something on the order of five million fewer bbls per day in 2005 than 2004. -5 million per day less in 2006 than 2005, etc. Declining production from existing field is a natural law just like the law of gravity. It cannot be changed or ignored. Every field has a fixed amount of oil and every bbl removed makes future bbls harder to extract. Like squeezing water from a sponge. This means companies must find five mbpd of new production each year just to make up for the loss of production in declining fields and that production loss increases by 5 mbpd each year. Sure there is new production coming online but it is just replacing current production losses.

Regardless of what the arm chair analysts and the talking heads on TV say the end of oil as we know it is rapidly approaching. 2007 has been quoted by the real experts as the probable date where global production begins to decline forever. Recently several of those predictors have moved their target into late 2006. The prices we have now are a result of no material slack in the demand/production equation. Today we produce around 500,000 more bbls than demand about six months of the year. That drops to 200,000 for 3 months and then we are short 200,000 for 3 months in the fall. ANY supply disruption whether from hurricanes, terrorists, refiner problems or just replacement of critical equipment puts us into a negative position very quickly. Emily knocked out nearly 10 million bbls of production in only four days.

For me the answer is crystal clear. Demand will permanently outstrip production soon and life as we know it will change. $5 gas will definitely change the demand factors in the U.S. but not in the rest of the world. Most have been paying the equivalent of $5-$6 per gallon for quite a while and business continues as usual. The need for consumers to drive long distances suddenly diminishes but demand growth continues just at a slower pace. I know this was a lengthy diversion from the regular market commentary but I believe readers need continued justification for buying every dip in oil.

Merrill made a surprising call on Friday when they reiterated a buy rating on CVX, COP, XOM, MRO, OXY and TLM. They said factoring in geopolitics, output stability and demand growth continued to make a bullish case for these stocks even at these levels. Interesting call to reiterate a buy rating at what others feel are overblown prices and a top in the market. Oil companies are starting to report earnings with the majority of the sector due for next week. OXY reported a profit on Friday of $3.78 per share that nearly doubled the $1.46 earned for the same period in 2004. While most oils are expected to post an average of +35% to +37% for the quarter there will be many with even higher numbers. XOM, BP, TOT are expected to report in the +44% to +48% range. STO and NHY are expected to post an +80% gain. Other expectations are COP +40%, MRO +56%, MUR +35% and AHC +13%. Ironically despite these strong earnings and a history of strong earnings many are trading for barely over single digit PE ratios. COP for instance trades at a PE of only 9. They are also valued on the basis of $30 to $35 oil, numbers we are not likely to ever see again.

When I look at the indexes I continue to see them stalling at major resistance. This is what appears to be a perfect shorting opportunity except for one thing. Just like the markets can't break free of current resistance they are resisting every attempt to take them down as well. The Nasdaq touched its high for year at 2191 and was instantly repelled but found support again at 2165. The SPX continues to use 1225 as support and 1233-1235 as resistance. In the case of the SPX the current trading range appears to be narrowing with an upside bias. Of course that oil stock blowout on Friday helped to cause that upside bias.

SPX Chart - Daily

The Dow has the most clearly defined range from 10585 to 10685 and the bias now appears to be slightly negative despite the late afternoon short covering. According to various institutional traders there are quite a few hedge funds currently out of the market. Many of those are trying to get short as Friday's opening suggested. When the dip was bought once again as it has been several times in the last two weeks they panicked and covered again. With markets breaking key technical levels but failing to follow through the mixed signals are very confusing. Hedge funds don't want to commit a lot of money to a direction until it appears and despite the recent gains and new highs the market is still range bound and is giving no evidence of a direction. Were it not for the short covering spurt at Friday's close the combined weekly points for the Dow, Nasdaq, SPX and OEX would have been negative with only the Nasdaq positive by +8 points. The week was very volatile and had numerous high profile events, including earnings from heavyweights INTC, MSFT, EBAY, YHOO, QCOM, GOOG and IBM to name a few. We know earnings are coming in as expected and guidance has been only fair but the markets continue to hold their ground.

I hate to sound like a broken record but the SOX and Russell continue to defy the laws of gravity and are providing an underlying bid to the broader market. The Russell set a new all time closing high but not an intraday high on Friday with a monster buying spike in the last hour. It was definitely a program trade and likely related to short covering before the weekend by funds. Those trying to get short all week ran out of patience ahead of the weekend. It is not wise to be short a dull market over a weekend because anything can happen. Who knows, Osama is still lurking in the background and could be caught when we least expect it. The SOX rallied to close at 475 and only a heartbeat away from monster resistance at 485-490. The SOX did not participate in the end of day rally, which makes be believe even more that the end of day bounce was program trading and possibly funds covering shorts on energy stocks.

SOX Chart - Daily

Russell 2000 Chart - Daily

I had picked this week for a turning point in the market. If it appeared I have not seen it yet. There is every possibility the Thursday highs could be the highs for July but there is no confirmation. Until we get a directional confirmation with a break out of the current range my advice remains the same. I continue to suggest cautious longs over SPX 1225 and shorts under that level. As traders we don't care which direction appears just as long as one eventually appears. My negative bias for the next four weeks is slowly eroding much like the overhead resistance we continue to chip away. I have not been converted to a bull but my fur coat is getting really hot and scratchy on these 100-degree days in Colorado. Fortunately with 1225 as a clear support point it is very easy to follow my own advice. Enter passively and exit aggressively if your direction proves to be wrong.


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