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Market Wrap

Energy Stocks Power S&P to Five Week High

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In a continuation of the Labor Day rally the energy stocks bucked the trend and rallied strongly to push the S&P within three points of a new four-year high. I say bucked the trend because those gains were in the face of falling oil prices. Crude prices fell to close at just over $64 and well under the pre-Katrina levels. The gains came after the Dept of Energy released a report saying winter energy costs were going to be 24% higher than in 2004. The DOE said total energy costs would soar to $1.08 trillion for an increase to consumers of $209 billion. The report provided lift not only to oil stocks but coal, gas and even uranium issues. Also helping to push the indexes higher was a surge in homebuilders and materials stocks as the cost estimates for Katrina continue to grow.

Dow Chart - Daily

Nasdaq Chart - Daily

SPX Chart - Weekly

Friday was devoid of any material economic reports but there was plenty to move the market. The only economic report for the day showed Import Prices rose +1.3% in August and inline with expectations. Excluding energy prices remained flat. Export prices fell again for the third month out of the last four. The main driver for the headline import price increase was a jump of +7.1% in oil prices. This brought the rise for the year to 42.5% for oil prices and +7.6% for import prices overall. This data was all gathered before Katrina struck. Import prices should show another sharp jump over the next few months as the demand for building materials increases prices from around the globe.

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The main focus for the day was the cost of rebuilding in the aftermath of Katrina. New estimates are now saying the cleanup could take as long as two years and rebuilding as long as five years. FEMA is saying the sludge being left behind as water is pumped out contains a combination of toxic materials and dangerous bacteriological material. The bacteria comes from carcasses of dead animals onshore as well as fish washed ashore and dying in the stagnant water. There is also bacteria from flooded sewage systems and treatment plants. The toxic materials come from flooded chemical plants and waste storage companies. FEMA says homes flooded with this toxic cocktail are no longer fit for human habitation. They fear an outbreak of disease and are forcibly evacuating all remaining residents of the affected areas. Entire neighborhoods could be bulldozed including the top foot of topsoil to remove the toxic sludge.

Damage estimates have risen well over $100 billion and could reach $200 billion or more before it is over. Insured losses are now estimated at between $40 and $60 billion but much of the individual losses are uninsured. We will be hearing about Katrina cleanup for years to come with untold billions of dollars spent for rebuilding.

That spending is still not expected to add to the GDP in 2005. The official estimates are still for a reduction in Q3 GDP of -0.5% and Q4 GDP of -1.0%. Because the massive rebuilding effort is likely to gain traction by Q1-2006 the estimates are for an addition of +1.0% to GDP for all of 2006 and beyond. This will go down as the worst national disaster in U.S. history and that means the recovery effort will rival the Job Corp projects of the early 1900s. Companies in the building sector that have any presence in the south are soaring with regional companies seeing the biggest jump. Materials companies from around the globe are also seeing strong gains in stock prices from anticipated material demand. Waste companies, Waste Management (WMI) and Allied Waste (AW) stand to make windfall profits as the majority of demolished material makes its way to their landfills. Cleaning up the toxic problems will go to companies like Clean Harbors (CLHB) who clean up contamination problems. Actually the water being pumped back into the lake is very polluted and will cause serious problems for the lake. Groundwater has been contaminated and the more toxic water pumped into the lake the worse the future problems will be.

The gains in materials, construction and energy stocks sent the S&P soaring to a high of 1243 and only -3 points from a new four-year high. This is a major departure from historical norms but it was only the first week of September. It is entirely possible that the magnitude of expectations for the rebuilding process will overcome any historical Q3 decline. I am watching the process with a skeptical viewpoint while enjoying the gains in my energy stocks.

Compx Chart - Weekly

SOX Chart - Weekly

Some of the gains on Friday came from the chip sector after updates from three major companies. Intel affirmed their forecast for the quarter on the strength of notebook demand. Still INTC fell to $25.20 from $26.10 after the release. Their outlook was positive but the expectations had already been priced in over the prior three days. Those hopes were removed very quickly. Texas Instruments also released their Q3 update and TXN raised their earnings estimates from 31-31 cents to 36-38 cents. TXN also finished in the red but only by a penny. National Semi (NSM) announced earnings that fell -27% but beat the street. They also raised their outlook saying that their business was stronger than expected for the quarter. NSM also closed down for the day. The combination of the three chip updates and the positive outlook sent the SOX higher by +3.35 to 482 and very close to a new 52-week high at 486. This broke the SOX out of recent range from 465-475 and under normal circumstances would suggest a breakout ahead. Despite the chip gains the Nasdaq was only able to post a +9 point day. This is very anemic given the gains in the other indexes.

Not all companies are benefiting from the potential rebuilding effort. Yellow Roadway warned that Katrina would lower their earnings for the current quarter. An area the size of Great Britain has been taken out of their shipping universe for potentially an entire quarter. YELL fell -3.20 to a new 52-week low. Also near a new low is FDX at $79.80. Both of these companies should experience a dramatic jump in shipments into the hurricane area once the rebuilding effort begins.

Airlines are moving lower every day as they struggle to work around the airline blackhole in Louisiana and the loss of huge numbers of business and tourist travelers into the area. Also impacting them is the high cost of jet fuel and the low availability. Jet fuel cost $1.00 a gallon in Q1 and a level that was already causing problems. It had risen to $1.73 in early Q3 and airlines expect to pay an average of more than $1.89 before the quarter is over. The rising price of fuel is squeezing the life out of the carriers. Continental said today that it will spend $2.6 billion for fuel in 2005 compared to only $1.6 B in 2004. How do you deal with a $1 billion increase in fuel costs in just one year? CAL said fuel would account for 24% to 26% of total costs in Q3 compared to only 14.7% in Q1. Delta said on Friday that every penny of fuel increase will cost them $25 million a year. When we see the price of oil up 50-75 cents a day we don't realize that this is hundreds of millions of dollars of impact to airlines and to transportation of all kinds. This is why the transports closed at a two month low on a day when the other major indexes are near 52-week highs.

Oil prices completed their fifth day of declines in anticipation of foreign supplies hitting our shores any day now. However, there have been some holdups in the 2 mbpd promised from the 20+ nations in the EIA. There is an extreme shortage of tankers to carry the product and organizing which tanker filled with what type of product goes to what port/refiner is also a challenge with four of our major refiners still offline. 5% of our daily refining capacity is still offline and will likely be offline for months to come. Four refineries, each individually owned by Exxon, Conoco, Murphy and Chevron accounting for 901,000 bbls per day have sustained severe damage and it is possible two of them may not be back online until December or even later. These refineries happen to be the "smart" refineries that can refine different types of crude including the sour Saudi crude. This means light sweet crude will be in higher demand than ever in an effort to refine gasoline and jet fuel. Jet fuel continues to be in short supply with numerous airports running at low levels. Airlines report having to top off tanks at airports with fuel and fly with more fuel than normal to those airports on short supply. This assures the planes will have enough fuel to return if a shortage occurs. Flying with full fuel loads burns more fuel because of the increased weight but it is better than having to wait for the next fuel delivery before being able to take off again. Continental said there was currently a daily shortfall of -100K to -150K gallons of fuel and that will grow as the fall flight schedule increases.

Some of the oil coming from overseas will come in the form of gasoline and jet fuel instead of crude oil. This is good considering the shortage of refining capacity but bad for users since this fuel will have a higher cost than that refined here in the U.S. Some refiners in Europe have higher costs resulting in higher sales prices plus there is the added shipping expense to the U.S. Most Americans don't realize that gasoline has been selling for over $6 a gallon in Europe for some time. Most people also don't realize that before the hurricane 10% of our gasoline was imported, mostly from Mexico and South America. Everybody in the U.S. is whining about $3 gas but the outlook is clear, prices are going higher. As the world's largest consumer we have been sheltered from the prices others have been paying but our time is running out.

The Minerals Management Services report for Friday showed that shut in oil from the Gulf had risen from 58% to 60% of capacity instead of falling as better data became available. This has been dropping much slower than expected and more damage is being discovered every day. It is not likely to completely recover in 2005. Shut in gas has recovered to only 38% but that is still amounts to over 4 billion cubic feet per day. This is putting a huge crimp in the electric generation sector. Coal demand is soaring with companies like Peabody Energy (BTU), Fording Coal (FDG) and Console Energy (CNX) hitting new all time highs.

The IEA also released a report on Friday saying that 90% of Gulf production would be back online within 3-6 months. They estimate a loss of 55 million bbls of production through December. They said there was substantial pipeline damage with 37 platforms in shallow water completely destroyed and four in deep water. Shell's deep water platform, Mars, had suffered extensive damage. Shell estimates six months to repair it. The Diamond Offshore rig, Ocean Warwick, is expected to take a year to repair after breaking free and running aground 66 miles away. The IEA said 20% of offshore platforms and 12% of rigs remain evacuated two weeks after the storm. Because of the hurricane and some slowdown in other areas of the globe the IEA lowered its demand growth by -240,000 bbls for 2005 to 1.35 mbpd. Demand growth for 2006 was still expected to be in excess of 1.77 mbpd. The committee will meet on Sept 15th to assess the hurricane impact and the result of their 60 million bbl release into the system.

On Friday oil prices fell in anticipation of foreign oil hitting our shores. However, energy stocks rose in anticipation of higher prices ahead as fall demand exceeds our current production capability. The pause we saw this week was simply profit taking from the Katrina bounce and uncertainty of how fast production would come back on line and how fast European oil would hit our shores. Now that the smoke is clearing the picture is still the same and buyers are coming back to energy.

The bounce in energy, materials and builders sent the indexes to four-week highs but not over strong resistance at those levels. There is also a quarterly S&P rebalancing in progress where funds increase their holdings of stocks, which have risen significantly and reduce positions on those who have dropped in price. Since energy already accounts for 9% of the S&P and nearly all energy stocks have risen strongly over the last year it stands to reason that funds have to increase positions in energy stocks. This would make me question the validity of Friday's energy bounce in the face of falling oil but I will take the profits it produced.

For next week the markets are at a crossroads. We have rebounded to strong resistance at 10700, 2180, 1245 and we could not make it over those levels after several tries in July. I would be very surprised if we made it this time but then the strength of the Labor Day rally has already surprised me. With the S&P over 1225 we are in long territory but only with tight stops. A breakout here could develop some strong momentum very fast and quite a few bears will end up even more surprised then me. The anticipation of a September decline has many hedge funds in short positions and a sudden breakout would have them scrambling to cover.

SPX Chart - 5 min

If you look at an intraday chart of the SPX the high was set about 1:45 and we closed at the low of the afternoon. The Nasdaq high was in at 12:30 and it also weakened into the close. It looked to me like the beginning of a resistance fade on both indexes. However, given the lack of any material selling on a Friday afternoon after a strong rally I have to discount that possibility. That leaves me with only a slightly negative bias on a technical basis and bullish bias on an emotional basis. I would love to see a breakout and a rally for the rest of the year but there is no real justification for that desire. Late commentary suggests the Fed will continue raising rates and oil prices should stabilize either at the current level or higher. Both will continue to drag on the economy and eventually the market. Therefore, I plan on taking any profits we get on the long side but expect a failure at 1245 until the market proves me wrong. I did take another insurance short at the close on the Russell futures. If oil stocks move higher on Monday I will close the short and celebrate. If the reverse occurs I am protected against any drop. I am looking forward to my commentary on Tuesday night since odds are good it will be after strong directional move. Until then, remember to enter passively and exit aggressively and definitely don't get married to your positions or your bias.
 

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