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Markets: Out of Gas?
New York: September 18, 2006
By John R. Stephenson

Wow! What a difference a few weeks makes. Not too long ago, people were wondering just how high commodity prices could go. Today, the speculation is rampant that the commodity bull market we have enjoyed for the last four years is finally over. With commodity prices cracking, stocks are moving up. Natural gas prices have retreated even faster than oil prices and now are at their lowest level in the last two years. So, what to do? Is now the time for investors to switch out of commodities and start loading up on tech companies?

No. The commodity story is one of globalization, as literally hundreds of millions of people around the world join the middle class, they will demand homes and household appliances. Not only homes, but automobiles too. That's good news for oil stocks and the producers of base metals (copper, lead, nickel and zinc) used in the production of dishwashers, stoves and fridges. It is this demand, coupled by a twenty-year under investment in productive capacity, that causes commodity prices to march higher. Not only that, but commodities are negatively correlated (prices move in the opposite direction) to what is likely to be the worst performing sector on North American stock markets — shares in technology companies.

Figure 1: Natural Gas Prices Have Tumbled

Source: First Asset Investment Management Inc.

With demand surging and supply struggling, commodity prices have had nowhere to go but up. But lately, the global economy has been slowing, and that has caused commodity prices to fall. The reason? When supply outstrips demand, commodity prices tumble. With a slowing worldwide demand, commodities have made a hasty retreat. In the U.S., house prices appear to be rolling over, not to mention that capacity utilization and manufacturing output have dropped. If Ford Motor Company's recent announcement of layoffs is any indication, auto sales are weaker than many anticipated.

In China, the story is similar. While the country continues to grow by leaps and bounds (10-12% growth per annum), the government seems intent on slowing things down, because they are concerned about the severity of an eventual correction. Slower, more manageable growth, is the objective. To do that, they have been looking at foreign direct investment (FDI-or direct investments by foreign firms), which has been running at a clip of 30% in the first half of the year. By targeting FDI, Chinese officials hope to slow the overall economy by slowing the rate at which foreign companies are investing in China (to a 20% growth rate by year-end). To do that, the Chinese have toughened up the standards for the approval of land sales. If you can't buy the land, it is pretty hard to build the factory.

But while traders have anticipated the slowing of economies around the world, the fundamentals, particularly for crude oil, remain intact. That's because a supply demand imbalance as little as two or three percent is enough to send prices skyrocketing again. Oil prices, which have been running up for the last several years have been going up in spite of the fact that supply has been growing at 2% a year because global demand has been growing even faster.

Figure 2: Oil Prices Falter - Could This Be a Buying Opportunity?

Source: First Asset Investment Management Inc.

And while there has been lots of talk of $35/barrel oil bandied about, the facts seem to suggest that they may be unrealistic. Saudi Arabia which is the only country that claims to be able to bring on any appreciable quantity of incremental oil supply quickly, is only able to do so economically at prices of $32.50/barrel or more. Chevron, which recently discovered an enormous oil field in the Gulf of Mexico, is unable to bring on production at that field in a price environment of less than $60/barrel. With fewer big fields globally and rapidly escalating development costs, the era of cheap oil seems to be over.

For natural gas, the story is one of weather. The key variable in determining the price of this commodity is weather, and in particular, the severity of the winter. Unlike crude oil, which is a truly global commodity, natural gas is a regional or North American commodity. If you believe in global warming, as the Economist magazine recently discussed, then we may be in for tepid winters for some time to come. This may be bad news for natural gas prices, which are reliant on a cold stretch of winter to deplete the natural gas in storage (inventory) and send prices spiraling higher again.

The stock market is, in reality, very short-term in its outlook. Commodities are a story that for many is long in the tooth. But as long-term investors, you need not worry about that. The upward price correction in many of these commodity oriented stocks, particularly energy stocks, may not come from the stock market itself, but rather from the big energy companies who are desperate to replace their declining reserves with reserves in politically secure parts of the world. To do that, they will need to acquire the reserves of some of the smaller more focused players in the energy world. This will occur through friendly mergers at substantial premiums to today's traded prices.

The likely targets? Canadian oil and gas companies with a focus on Alberta's oil sands. The Canadian oil sands represent the largest proven oil reserves in the world. Not only that, but escalating finding and development costs worldwide have made this resource base economically attractive.

Investors looking to outperform in the medium to long-term should take this pullback in commodity prices for what it is — a great buying opportunity. Investors looking to outperform should focus on commodity companies that have their resource base located in politically stable regions of the world.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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