Ming Lo Investing

Energy & Commodities: Gold Takes A Breather

Posted by admin on January 16, 2011  |  No Comments

Gold has taken a breather lately.  Recently, it’s had a tough time breaking 1420.  As of Friday, January 14, 2010, gold closed at $1,359:

It makes sense that gold would take a break.  If the market is doing well (and we all know that it is), it makes sense to put money into the market instead of gold.  Still, I think there is support for gold because our problems aren’t over, they’re just stepping back as the amazing rally in stocks takes center stage.  At some point, inflation is very likely to be a problem, and when that time comes, gold will again be in vogue.  At the moment, I think that would be sometime in the second half.

Many find gold confusing, and for a long time, I did as well.  I can’t say I’ve figured it out, but I have a working theory: gold is in vogue whenever there is a problem.  Trick is, many things fall under the category of “problem”, and what’s confusing is that many of those things seem to be on the opposite ends of the spectrum.  So for example, if GDP growth is too high, we get inflation, and if GDP is too low, we’re likely to get deflation.  Both of those qualify as “problems”.  We need to have GDP growth at just the right level – say between 2.0% and 4.0% in today’s environment (basically whatever numbers are “not too cold” and “not too hot” for the economy) for gold NOT to be popular.  Other factors that qualify as a “problem” include a falling dollar and fiscal irresponsibility.

Where will gold settle?  Hard to say, of course.  You’ll see on the chart that the uptrend (the diagonal line going bottom left to upper right under the prices) remains unbroken.  Somewhere around $1320 is the first downside target, $1250 would be the next.  I would look to pick up some gold in that range.  Currently, I do not own gold, nor do my clients.

Energy & Commodities: The Steel Trade at Year-End

Posted by admin on January 10, 2011  |  No Comments

Commodities can be a very tricky trade for the uninitiated.  On Friday, Steve Grasso of Fast Money’s Halftime Report said the following:

“The handbook is, you buy at the last week of November and you sell a the last week of December and if you want to go short, you go short in January.”

Joe Terranova, Grasso’s fellow commentator and Chief Market Strategist at Virtus Investment Partners, agreed with him.

Hmm… Could the trade really be that easy?  Well, the first thing I did was to take a look at a couple steel charts: US Steel (X) and Arcelor Mittal (MT).  Sure enough, we see a big kick in US Steel stock in December, and also bump in MT stock.

So you could have bought as Mr. Grasso said and done well.  But was it that obvious?  Not if you look at the media and statements from the steel companies at the time.  Take for example, this article in the Wall Street Journal on October 27, 2010, entitled, “Cold Steel: A Hard Winter Lies Ahead”:

“After a strong start to the year, the world’s biggest steelmakers lost ground in the third quarter and raised caution flags for the rest of the year, expecting to be hit by uneven demand, falling prices and high raw material costs.”

There were contrarian points of view.  A Goldman Sachs steel analyst summarizd the situation as follows in a note in early November:

“[The fourth quarter] is generally the weakest quarter due to a seasonal slowdown.  We do expect a recovery in 2011 but believe it will be very slow ith prices moving mostly in response to cost pressure.  The addition of new capacity should create more challenges for the industry.  In the near-term, we believe that steel prices are poised to move up, and that steel stocks are already starting to reflect this move.  Also, the steel sector has lagged significantly thereby prompting interest from investors.  As a result, we believe that even small positive data points could move stocks disproportionately.”

And Goldman turned out to be right.  In an article on Seeking Alpha entitled “Steel Prices on the Rise,” the author noted that “Steel prices also have soared, including multiple prices increases in recent months.  A very common grade of steel that not long ago sold for $520 a ton was price recently at $740, up 42 percent.”

For now, the floods in Australia have cut the supply of metallurgical coal (used in steel-making).  This will likely increase the cost of steel and it remains to be seen whether steel manufacturers will be able to pass on those costs to end-users.

Energy & Commodities: Thoughts on Gold

Posted by admin on September 26, 2010  |  No Comments

I find gold a bit puzzling.  It’s not always clear what drives it – supply/demand; fear, aka risk-off; inflation, aka risk-on; or weakness in other currencies (the gold as a currency argument).  It’s interesting to see that I’m alone.  Whenever I watch Fast Money, there’s invariably a debate about what drives gold, and continuous cry, “gold doesn’t make sense”.  Guy Adami, one of the traders on the desk, is always confounded, because gold seems to go up in every scenario, but no one seems to be able to articulate why, or when gold will go down.  I’ve avoided gold for similar reasons – you find arguments that seem contradictory, but they argue that gold should go up.  For example, inflationistas say buy gold when there’s inflation.  Deflationistas also say the same, because gold will be a better currency.  So gold goes up either way?  We’re back to Guy Adami’s dilemma – when, and why, does gold go down?

I like to break things down, and I can’t say I have a definitive answer yet, but I’m building a hypothesis.  So I thought it would be a good time to jot down some notes.  Let’s first look at history.  Here’s a chart of gold, and you’ll notice that the S&P (light blue line) and the dollar (orange line) are drawn in as well for comparison.

(1) We see on this chart that from May 2006 to August 2007, gold was flat (period set off by vertical lines).  Here, we had the bull market and the beginning of trouble in the markets.  It makes sense here that gold shouldn’t go up, because the market was rolling and peaked.  So investors would put money into equities rather than gold.  Perhaps the question here is why gold didn’t go down?  Perhaps the market saw trouble coming on the horizon.  The dollar is also fading, so that may have helped keep gold prices up.

(2) From August 2007 to March 2008 (again set off by vertical lines), we see a rise in gold, a fall in the market and a fall in the dollar.  In this period, banks are in trouble and the Fed is cutting interest rates.  Gold rises for a combination of reasons: fear, as the economy weakens (proven by the decline in the market); and weaker dollar, as lower interest rates and a weakening economy weaken the dollar in international markets.

(3) From March 2008 to November 2008, gold falls as the market falls and the dollar rises.  This runs counter to the previous period, where gold rose as the market fell.  But here the dollar rises, so that may be the stronger correlation.  This is also a period where the market needs cash, so that may be a factor too.  Investors may have been pulling out of gold to raise cash.

(4) From November 2008 to March 2009, gold rises as the market falls to it’s lowest levels.  The market bottoms in March 2009.  Meanwhile, the dollar is stays essentially flat.

(5) From March 2009 to September 2009, gold dips from time to time, but essentially stays flat.  Meanwhile, the market is recovering, and the dollar is declining, likely because of fiscal expansion.  Normally in a declining dollar environment you would expect commodities and hard assets to rise.  So here, the more important factor is the recovering market, which makes equities a better place to be than gold.

(6) From September 2009 to late November 2009, gold takes off.   The market continues to rise, while the dollar continues to fall.  In this period, the more important correlation seems to be to the dollar.  Gold rises, even while the market is rising, perhaps because investors have begun to question the rally in the market.  I also remember this period as a time when most asset classes were not yielding much.

(7) Gold dips and then rises, essentially staying flat from December 2009 to late April 2010. The market and the dollar rise as the rally continues to the year high.  So gold pulls back largely because equities are doing well and market confidence is high.

(8)  Gold takes off again from May 2010 through the present (September 2010), as fears of the double dip arise, are temporarily assuaged, but a return to quantitative easing is expected.

As we can see from this little exercise, there’s no simple correlation of gold to the traditional factors, how well the market is doing and the direction of the dollar.  We also have to remember there’s other factors that we haven’t considered here, such as quantitative easing, and the relative attractiveness of other investments (such as bonds, etc.).  Still, we do see some basic ideas confirmed, though not all the time.

Before we finish, let’s summarize the basic and most common theses regarding gold:

- Gold rises when there is fear or when markets are weak.  We can see from our little exercise above that this is generally true, but there are exceptions, such as the March 2008 – November 2008 period.  Perhaps the need for cash caused the decline in gold here.

- Gold rises as the dollar falls / when the Fed is expansionary (i.e., quantitative easing) / when the Fed is inflationary.  This is also roughly true, but there are periods when gold can be flat while the dollar is falling (such as (5) above, March 2009 to September 2009).

- Gold rises when there is deflation.  Many claim this, but it’s less proven.  I’m also less certain of this.  I would say that gold definitely rises when there is deflation and the Fed is expansionary to combat the deflation.

- Gold falls or is flat in good economies, or when there is fiscal responsibility.  We can see from recent history that when markets are doing well, gold can fall or be flat.

What’s interesting about this exercise is that we can simplify the above to a binary conculsion:  gold falls or stays flat when markets are good, or when we have fiscal responsibility (only really possible when markets are good); gold rises when the economy is bad, and the Fed has to be expansionary (and a falling dollar as well as a declining equity market correlate with weak markets).

So, that’s my current hypothesis.  We’ll have to see if it can stand the test of time.

Energy & Commodities: Deutschebank Analyst Paul Sankey on Oil

Posted by admin on June 4, 2010  |  No Comments

Paul Sankey, a very  good oil analyst, was on Fast Money today:

• BP does not want to give up the dividend, will be seen as a failure in the company.  Asset sales are more likely (discussion of sale of Alaskan assets is already rumored)

• Shallow water drilling.  To clarify rumors, Mining and Minerals Management Service (MMS), is not banning shallow water drilling, there’s a 2-3 day delay to look things over.

• Gulf has huge implications for global oil supply.  Fastest growing area in oil supply was deepwater drilling, fastest area within that was the Gulf of Mexico.  In the short term, excess supply of oil, but long-term, huge supply problem.

• Canadian Tar Sands even more important.

• Exxon (XOM) looks smart because they had problems in deep water drilling in the Gulf and stayed away; decided to favor shallow water drilling. Exxon also bought XTO.  Chevron has problem, is long super deep water – 7-8,000 feet, going to 28,000 feet drilling.  So long Exxon (XOM), short Chevron (CVX).

Energy & Commodities: Oil Service Stocks Oversold?

Posted by admin on June 3, 2010  |  No Comments

On Wednesday, June 2, 2010, Collin Gerry of Raymond James upgraded the shallow water drillers.  Here’s some of his thinking:

• Shallow water drilling.  Upgrades on Rowan (RDC) and Hercules (HERO) because shallow water drilling is now permitted as of June 2, only days after  a ban on ALL drilling was imposed.  Still oversold because of BP disaster.  Longer term, capital may be allocated to shallow water market from deep water market.  HERO is 100% shallow water drilling.  However, HERO is very low priced ($2.92 per share as of June 3, 2010) and very volatile.

• Transocean.  Hold on to Transocean (RIG) because Transocean covered by insurance and largely indemnified by contract with BP.  Business will take on deepwater side, estimates will be recalibrated, but selling overdone.  Guy Adami also notes that the stock was + $90 back in April, but has fallen to ~ $50.  RIG is at the low established a low of about $42 in December 2008, when oil was at $37 per barrel.  That was a high volume capitulation day, and today, RIG is also at a low with high volume trading, indicating possible capitulation.  But Tim Seymour remains cautious because many companies might use force majeure in break their contracts with oil service companies like RIG.

• Diversified, Larger Cap Oil Service Names. Best growth prospects are in larger cap, diversified names like Schlumberger (SLB), Halliburton (HAL), Weatherford (WFT).  Also have a lot of exposure to international land operations, which tend to be driven by oil fundamentals more than natural gas fundamental.  Collin Gerry is more bullish on oil than on natural gas.

Energy & Commodities: Natural Gas Gets A Bump

Posted by admin on September 14, 2009  |  No Comments

Last week, natural gas got a bit of a bump. Much has been said lately about the massive oversupply of natural gas and how natural gas has tracked the cost of oil rather than reflecting fundamentals. In short, recent natural gas discoveries have led to an overabundance of the fuel in the last few years. Surprisingly, the price of natural gas has fallen, but not as much as expected given the oversupply. Instead, natural gas has followed the cost of oil. Analysts believe that if the price of gas falls far enough, producers will eventually be forced to stop production. The market estimates that natural gas will be in the $6-7 range next year, compared to the $2-3 range of recent weeks. If the market is right, then natural gas stocks should be a buy. A small decline in inventories last week created the bump in natural gas last week.

It makes sense that natural gas should bottom as storage reaches maximum capacity. Exactly when that will happen is unclear, and I won’t claim to know. As for investing in natural gas, I am, for the moment, just watching to see if how supply and demand actually works the way we think it does.

I am long XTO (a trade, as opposed to an investment).

Energy & Commodities: Thoughts on Commodities

Posted by admin on May 21, 2009  |  No Comments

The more I look at commodities, the more I think there is no fundamentalreason for oil to be rising. Consumer demand hasn’t changed significantly,and supply is ample. The only real thing that has happened in recent months is that suppliers have tried to manage the price of oil (for example) to drive up the price of oil (same case with other commodities).

So why is oil rising? Let’s incorporate the role of speculators in commodities. What I think has happened, in addition to suppliers curtailing production, is that speculators have seen a bottom in the pricing of oil. Because they can see a turn, they have decided that it’s an appropriate time to accumlulate oil, thus helping to drive up the price of oil. I don’t think anyone is consuming the oil. It is, as it did last year, sitting in tankers somewhere in the ocean.

The role of speculators also helps explain another thing that’s been bothering me. Demand is flat, and by themselves, producers can’t cut production enough to drive up the price of oil from $45 or so to $60. No one thinks that OPEC is an effective cartel and with Russians, Brazilians, Venezuelans and the like in the mix, there is no effective coordination of supply. The only explanation left is that speculators help limit supply and drive up the price of oil.

A similar example would be China stockpiling commodities. I never accepted the argument that a) China’s economy was excelling while the rest of world was in crisis; or b) that China could save us from recession. China is wayto export dependent for a) to be true, and China’s economy is not large enough to do b). So the stockpiling argument is the only one that made sense. So in effect, China is being a commodities speculator. Like the oil speculators buying oil and holding them off in tankers at sea, China is stockpiling needed commodities when they are cheap and holding them in storage. And you see the effect that it’s had on the markets; if speculation is large enough, it can drive up the price of commodities, the way China helped drive up the price of copper and coal.

Add one other factor to the mix: the price of the dollar. As the dollar weakens, as it did today, the speculators (traders and china both) will buy and stockpile more because the lower dollar drives down the price of these commodities for some of these players.

So what does it mean? First, in terms of a model for understanding what is happening with commmodities prices, that would mean we have to take intoaccount the following:

1) “true” demand – what people are actually consuming

2) supply – and this could be OPEC; other countries; and the US reserves,such as the petroleum reserve (the US could release oil and increase supplyto drive down prices); and supply disruptions (violence in Nigeria)

3) speculators – China, traders, as mentioned above

4) the price of the dollar (lower dollar = higher commodities)

5) inflation (which is actually related to 4)

And in terms of what this all means for investing, it means the following to me:

1) Commodities require caution because volatility will be higher and not based on fundamental demand.

2) if this explanation is correct, this means that we have to TRADE commodities rather than INVEST. Meaning we have to buy and look to sell and take profits when we think the speculators have stopped buying. For example, this means that the copper trade based on china’s buying cannot last forever. It might last because the dollar weakens or inflation hits, but not because china is in economic recovery.

3) and it means that we can’t assume the economy is recovering. Which I think is the more accurate picture. I think the recovery will be long and slow. That makes more sense to me than the idea that people will spend more and we’ll recover sooner.