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Market Wrap

Winning Streak Continues

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The markets continued their climb higher with the Dow and S&P posting gains for the last three weeks and the Nasdaq stretching its gains to four weeks. While those statistics are exciting the Dow transports are really blazing a trail higher. The Transports have broken the 4000 barrier and are setting new all time highs. The decline in oil prices is aiding this move but oil at $57 is still not a bargain. This suggests the economy is healthier than the reports would indicate and any further drop in oil should light the next stage of this rocket.

Dow Chart - Daily

Nasdaq Chart - Daily

SPX Chart - Daily

Friday was Veterans Day and the bond markets were closed. This led to very low volume in the equity markets, the lowest since August 29th. The low volume did not keep the markets from moving higher but the moves were somewhat muted as the indexes neared very strong resistance levels. A critical earnings report from Dell may have held the Nasdaq to only a +5 point gain but that was enough to post a close over 2200 and only 17 points away from a multi year high at 2219. The Thanksgiving rally is still alive and well despite its advancing age.

The rally has shaken off several bouts of negativity from individual stocks and from some stressful economic worries. This week Dow component GM warned of an accounting problem and the need to reinstate earnings for past years. This is never a positive event and GM fell -$2 on Thursday. The Dow shook it off and ran for big gains anyway. Dell reported earnings on Thursday that disappointed the street and suggested that Dell may be losing its momentum in the PC space. As the PC price wars heat up for the holidays Dell finds itself playing catch up instead of leading the sector. Dell had already warned on Halloween and suffered a -10% drop so the actual earnings on Thursday may have depressed the sector but Dell stock actually posted a small gain.


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Also slowing the Nasdaq bounce may have been memories of the disappointing earnings from Cisco on Wednesday. The Cisco impact was felt early Thursday but traders shook it off on the afternoon rally ahead of Friday's holiday. Those few traders actually in the market on Friday may have seen it as questionable confirmation of a slow tech rebound. Much of Cisco's sales gain was due to government orders rather than strong sales to businesses. Given the negativity from Dell and Cisco, two of the largest tech heavyweights, the Nasdaq gains were actually more bullish than they appeared on the surface.

The energy sector shook off a sharp drop in oil on Thursday and rallied on Friday despite an embezzlement scandal at PTEN. The company said Thursday a former officer might have embezzled $70 million over five years using payments for equipment that was never delivered. The company fell from $34 on Tuesday to touch $29 on Friday. Up until the news broke PTEN had been very close to setting a new high at $36 and was one of the strongest charts in the sector.

Dow theory always wants the transport sector to confirm any Dow breakout for that move to gain traction and increase velocity. In times when the transports confirm a Dow breakout the combination typically produces a Dow move of +14%. However this is not the case in the current rally. The transports have broken to a new high while the Dow languishes below multi year highs and more than -1000 points from its all time high. Typically a breakout by the transports ahead of the Dow results in a minimal Dow gain of less than +4%. Statistics are fun, informative and provide additional insight but you should not rely on them for trading.

That is not keeping the truckers and airfreight companies from moving higher with FDX near a new high at just over $100. This is not just a move on lower oil but that definitely helps. Freight loads are improving and not just in loads headed for the hurricane zone. Overseas airfreight is picking up as well, most likely due to last minute product deliveries ahead of the holiday season.

Chart of Dow Transports - Weekly

Even the homebuilders are trying to rebound despite the lowered profit outlook by Toll Brothers last week. Mortgage interest rates are comfortably over 6% with bridge loans and construction loans at 8-9% or even higher. There is a new analysis viewpoint starting to make the rounds concerning the 10-year note. In 1994 when the Fed was within 2-3 months of ending their hikes the yield on the ten-year note peaked on Nov-4th and started trending lower. Typically the ten-year yield leads the Fed funds futures by several weeks in predicting the direction of future rates. The ten-year yield has plateaued just under 4.65% for the last three weeks after a two month climb. The high at 4.68% was on Nov-4th. Bear in mind it is only a three-week pause but that 4.65% range is strong resistance and the high seen last March. The ten-year could be telling us that the Fed is closer to ending their measured pace hike than the Fed futures are suggesting. This is all speculation but analysts are comparing this hike cycle with the +300 point rate cycle in 1994 and hoping for a similar outcome. The "neutral rate" then was 6.0% after the last hike in Feb-1995 but was quickly followed by three cuts of -25 points each after the Fed decided they went too far.

I mentioned last week that the -22% drop in auto sales at Ford and GM was likely to take a significant chunk out of Q4 GDP if they did not launch a new round of incentives to push inventory out the door. On Friday GM announced it was going to have a Red-Tag Sale from this Sunday until Jan-3rd. It will feature sharp markdowns on all 2005 and 2006 GM vehicles except the Corvette, Buick Lucerne and Pontiac Solstice. Dealers said the new prices offered even bigger savings than the employee pricing incentive because of the larger overall discounts. This comes just in time for the new SUV lines to benefit from the drop in gas prices. Consumers will undoubtedly decide that the gas spike was completely hurricane related and just another once a decade spike like the prior energy spikes in the 70s and 80s. They will jump into those SUV and CUV models and happily head to the filling station to get some $2.25 gas. Enjoy it while you can because it is only temporary.

I spent two days at a PEAK Oil conference this week and the outlook is not good. We heard from Matthew Simmons, Chairman of the investment-banking firm Simmons and Co, Jeremy Gilbert, Chief Petroleum Engineer for BP (ret), and Henry Groppe, from Groppe, Long and Littell, a 50 year participant in the energy industry. Also presenting were Chris Skrebowski, Editor of Petroleum Review and Tom Petrie of Petrie Parkman. These were just a few of the industry experts attending and all were in agreement that there is permanent trouble ahead. I am not going into a long discussion here but I will hit some highlights. I will put all my notes into a new paper over the next couple weeks and make it available to everyone.

The bottom line to the endless flow of charts and grafts presented by the experts was a coming end to cheap oil. Not an end to oil but an end to cheap oil and everything that implies. Currently OPEC is pumping flat out over 30 mbpd with Saudi Arabia carrying the brunt of the load. Various sound bites, print comments and excerpts from producers around the globe continue to paint the picture that we could see the global peak in production as early as September 2006. Output problems are continuing to crop up in mature fields with accelerated depletion rates and sharp drops in previously stable flows. Current global production is averaging about 84 mbpd with spikes to 85. This is offsetting the nearly 1 mbpd still offline in the Gulf. Current official estimates for excess production capacity are in the 1.0-1.5 mbpd range and just enough to offset the Gulf loss as long as the demand destruction caused by the hurricanes remains in place.

The problem remains in the production levels that OPEC must maintain to keep ahead of demand. The swing producer is still Saudi with several other OPEC countries unable to maintain prior flows as depletion takes its toll. This means Saudi must open the valves to dangerous levels to keep up, currently 9.51 mbpd and a four year high. Whenever they stress their aging fields to this extent they are risking a catastrophe. Over producing causes reservoir damage, sometimes irreparable damage that can cause significant drops in future production due to increased water flow, loss of pressure or sudden acceleration of the gas cap. The best way to maximize production from any field is to pump at low levels for a very long time but that does not satisfy current demand. This allows the oil to seep through the formation without disturbing the fragile balance of conditions that allow the oil to flow. Saudi can't afford the luxury of slow production. They are depended upon to fill the gaps left by other producers.

For EVERY field ever found there is a natural bell curve where production begins at a low level as initial wells are drilled and completed, a rise to peak production as the full build out of wells come online and then a decline back to zero as the field becomes depleted. It is a function of simple math. There is only so much oil in every field. As you take it out the pressure declines until it reaches zero. Water or gas can be pumped into the edges of the field to push the remaining oil towards the wells and pumps are used to apply a vacuum to lift that remaining oil to the surface. Once the well goes wet the end is near. Of the many thousands of fields ever found they all have the same characteristics. The only difference is the speed of the decline. The faster you took the oil out the faster the decline will be when it appears. This is called depletion.

DDepletion Curve

Historical depletion rates once a field begins its decline are in the 4-6% range per year with acceleration to 8-10% in fields that were produced very quickly. If a field produced 100,000 bpd at its peak then it will initially decline at an average of -5% or -5,000 bpd the first year, -4,750 the second, etc. Typically there are some late term production efforts that prolong initial post peak production once the decline begins but once those efforts pass the decline can accelerate to the 8-10% range. After several years this decline pattern slows and some fields can produce at drastically lower levels for decades to come as the remaining oil is coaxed toward the wells. The following table shows hypothetical production from a 100,000 bbl field for ten years past its peak. Some will deplete slower, some faster depending on the prior rate of production and the geologic factors of the field but they all deplete. This is just an example.

It does not seem particularly damaging as long as new fields are coming online at the same time to offset this decline. It should be noted that dozens of oil producing nations have been in decline for decades. Only five countries are reportedly still capable of producing at their peak levels. Most experts doubt that four of them are telling the truth since they have not produced at peak for some time. Only Saudi is supposedly capable of increasing production and that is doubted by many.

Let's take that example table above and apply it to our current global production of something less than 85 million barrels per day. (mbpd) For the sake of argument I am going to illustrate the depletion rate at a straight line 5% rate. I am also going to add to that number the anticipated production coming online from known mega projects scheduled for completion between now and 2010. That total is thought to be between 9-12 mbpd by 2010. I am going to go with the 12mbpd number and be optimistic that the 3 mbpd rate will continue through 2015 despite no official visibility past 2010. There are a couple major products coming online in 2006 and 2007 with a void in 2008 and another group arriving in 2009. From that point the calendar is bare. New oil to be produced after 2010 has not been discovered yet. Chevron took out a full-page ad in the New York Times and Business Week in October. They said the world is consuming two bbls of oil for every one discovered. Since 1998 the four major oil companies have spent $8 billion on exploration for every $4 billion in oil discovered. The last major oil discovery was in 1964 and discoveries have been decreasing in number and quality ever since. The table below assumes global oil demand remains at 85 mbpd but we know without a doubt that the eventual rise in price projected by this scenario, likely to $200 a bbl or higher, would effectively destroy a significant amount of demand making the actual shortage less than illustrated but still a shortage.

ScSchedule of Global Production Depletion at 5%

You can modify this table in any fashion you desire EXCEPT by adding additional new production. Nobody, including the major oil companies, all the most optimistic experts and the OPEC nations expect any new finds to add more than an average of 3 bpd during any future year. You can guesstimate a smaller depletion rate or maybe even a series of natural disasters to wipeout significant demand but the end result remains the same. Only the dates on the calendar change. The table below illustrates the same problem with only an absurdly laughable 2% depletion rate and NO CHANGE in demand.

DDepletion Table 2%

Current IEA Demand Estimates Compared to 2004/2005

Global demand is increasing at the rate of +2% per year. Where do the 2006 demand estimates fit on the -2% depletion chart above? They don't. We are rapidly reaching a point where there will not be enough oil to satisfy the demand. This will result in a bidding war of extreme ferocity. Even that is not the end of the story. A fear among the experts that is growing day by day is the emergence of nationalism once that first real shortage is seen. As long as quasi-legitimate organizations like the EA and EIA continue to project "conceptual" reserves of trillions of bbls of undiscovered oil and OPEC nations continue to claim 2-4 times their actual reserves we are locked in a theological battle. It is a global version of the "emperor has no clothes". The emperor, OPEC, claims vast amounts of imaginary oil reserves to satisfy quota arrangements while the IEA and EIA overstate future production and demand based on these fictitious reserves in order to prevent a panic. The world blindly accepts these reserves rather than face the truth and world commerce in oil continues.

The theological battle over peak oil is fought between those claiming the peak is near and those claiming technology will prevail. It is fought between those counting the actual numbers and coming up short and those claiming that additional rising demand will produce miracles in exploration and production. Until the first shortage actually appears it will remain a "we said, they said" controversy fought in print and cyberspace and ignored by 7 billion people. Until the shortage appears and everybody accepts the truth there is nothing we can do to correct it. Once the world accepts it we can move on to resolve the problem rather than argue about its existence. The resolution to the problem is an entirely different discussion I will reserve for a later article.

The nationalism card I mentioned above is the trump card to the entire debate. There have been several recent comments by various officials that lead analysts to expect that countries will quit exporting oil once the true shortage picture appears. I have mentioned this many times as a danger in past articles and the analyst community is finally starting to see it as a serious danger. Why should a growing country continue to sell oil that they cannot replace later? Even at grossly inflated prices likely to hit triple digits within weeks of the first shortage they would be faced with paying double or triple years later IF they could replace it at all. Countries may continue to sell oil but in much smaller volumes because they are dependent on the dollar income and still retain a large portion of the oil for their future use. Since the price will soar they can continue to maintain their dollar flow while continually reducing the amount of oil they sell. It will be the proverbial sellers market until the end of time and sellers can decide how much they want to sell or even IF they want to sell. Countries with oil will be in charge of their own destiny and those importing will be at the mercy of the wolves. In the table of importers below note that 30% of the worlds population (India and China) are on the list. Japan has already gone to war once over oil and was second only to the U.S. in daily demand. China moved ahead of Japan in 2005. Demand in China grew by +15.4% last year (+860,000bpd) but demand this year had risen only +260,000bpd up until a couple months ago. However, in 2005 demand in the rest of Asia is on track to equal China's pace from 2004. On Thursday the IEA said Chinese oil demand in September surged +9% led by a huge jump in gasoline consumption of more than +14%. This brought China's oil demand to 7 mbpd in September. Note in the chart below that China only imported 2.9 mbpd in 2004.

TTop Ten Importers in 2004

In the export table below note that the OPEC countries are in red and those happen to be the same countries that are not especially friendly to the U.S. and not in favor of the Iraq war with the exception of Kuwait. Those OPEC countries accounted for 25 bpd of daily world exports in 2004. Currently that number is over 30 mbpd and amounts to 35% of total daily consumption. They control the price of oil. Not speculators, not traders. They alone have the power and we will be at their mercy once the decline in production begins.

TTop Twelve Exporters in 2004

Talking about next week's market action while the PEAK Oil debate continues is like watching TV while an electrical wire smolders in a basement wall. Ignoring truth does not make it less true. Fortunately that PEAK Oil truth should not bite us for some time and we can go on with our current lives as though it did not exist. Just don't forget that the U.S. could go from importing our current 14 bpd to 5 mbpd in a matter of weeks once the OPEC trap slams shut. Would $10 gas change your driving habits?

Oil prices are trading on short-term supply and demand rather than long-term expectations. Crude futures for Dec-2006 are still trading at $60 when historically distant years normally trade at a significant discount. While the short term December 2005 contract suffered a substantial haircut on this weeks inventory numbers with a drop to $57 and below the 200-day average the future December contracts for years 2006-2009 are still well above that level. I am sure there are some fund managers nibbling away at the December 2009 contracts and dreaming about the profits at multiples of the current price. But, for us normal traders we are faced with a warm November and a buildup of crude levels headed into the winter. With refining capacity offline there is nothing to do with the crude but store it pushing inventory levels above the five-year averages for this time of year. Warmer temperatures have prevented the normal draw downs which historically begin on November 1st. We had the perfect storm in the Gulf to erase supply and now the perfect calm is allowing that supply to catch up. Amazing how fate tends to control the numbers on the dice. Had we seen a couple of early blizzards the outcome of the Katrina/Rita story and the price of oil could have been much different.

DDecember Crude Chart - Daily

Chart of S&P Energy Spyder (XLE) - Daily

The fair-weather traders are abandoning oil positions daily and even prior bulls are now predicting lower prices. Boone Pickens who correctly predicted each of the recent price spikes said on Thursday that oil could "head toward $50" as the economy slows crimping demand. An interesting call from Pickens, not that oil could dip, but that the economy was going to slow. It will be interesting to see how that prediction works out. Various futures houses are targeting $55 as a level where buying should begin but it is all in the inventory numbers rather than the price. I believe OPEC will reduce supply under $55 in an attempt to limit damage to reservoirs and maintain that $50 level now that the world has grown accustomed to higher gas prices. The shock of $3 gas has given way to relief at $2.30. That gives them a free pass to use $50 as a floor in the future. br>
The equity markets celebrated the break of $59 on Thursday with the Dow breaking into the 10600-10725 resistance range followed by a penetration to nearly 10700 on Friday. After more than a week of aimless wandering with a barely perceptible uptick the index finished firmly in the green on two days of gains with +155 points for the week. With the transports in breakout mode and oil prices falling the Dow should be clear to make a strong break over the summer resistance highs at 10719 and head for higher ground ahead of Thanksgiving week.

The Nasdaq broke out of its weeklong resistance at 2180 to close over 2200 and could easily attack the August high at 2219 early in the week. The Nasdaq overcame the negativity of Cisco and Dell and the bulls do not appear to be interested in taking profits. Considering the lagging SOX and Russell I consider this a major change in tech sentiment that could have been stimulated by the +5 point jump in consumer sentiment on Thursday. It is November and the tech bulls are feeling an early surge of that holiday cheer.

The SPX also made a critical break above 1225 and closed on Friday above downtrend resistance at 1230. Both are very positive signs. 1245 is the only remaining resistance before the S&P breaks out to new multi-year highs. Even the lagging NYSE Composite got into the act with a strong rebound from a five day low to set a new six-week high at 7566.

I could not find any negativity in any index other than oil and it appears the markets have shaken off the higher interest rates, falling home sales and prices and fears of any economic weakness. There is so much bullishness it is scary ahead of a full slate of economic reports next week. We have the PPI and CPI, several regional surveys including the Philly Fed with Industrial Production and the Semi book-to-bill to fill out the calendar. New residential construction numbers will be released on Thursday and that could rock the sector once again on any substantial drop in starts. Expectations are for a drop of -48,000 starts to 2.06 million on an annualized basis from 2.108 in September. We are hearing almost daily that builder backlogs are dropping and they should be slowing starts to prevent a buildup of inventory until the Fed quits raising rates. We also have 2.5 million existing homes for sale and an all time high if I remember the statistic correctly. For those looking for a bargain the foreclosure rate is also at an all time high. Don't expect too harsh of a slowdown because 1.2 million new households are formed each year as kids move away from home and new families are started. That is a permanent demand cycle unless zero population growth suddenly makes a surprising comeback. Using the numbers above it still appears that a surplus has developed and that is why the Thursday numbers will be examined carefully.

The estimate for the PPI is for no change in prices compared to a jump of +1.9% in September. The CPI is expected to show only a +0.1% gain after a sharp jump of +1.2% in September. Both are expected to slow as a result of the drop in energy prices. The September reports showed significant spikes as a result of a +12% gain in energy in the weeks following Katrina. That spike has now been erased and there are whisper numbers expecting a drop in both indexes.

With positive economic numbers expected, oil targets below the current price and the holidays ahead there appears to be little reason to doubt the markets will move higher. That is always a scary proposition when all the stars line up for an expected rally and no roadblocks are in sight. Nearly every time some unexpected event arises to spoil the party. Unfortunately my crystal ball is clear and I don't see any immediate danger on the horizon. I would continue to buy the dips until warning clouds appear. I will get out my long-range telescope and report back on Tuesday night but until then party hats appear to be the adornment of choice until the turkey bones hit the trashcan.

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