Key Importance Of Oil And Energy

As we leave 2011 it should be clear to almost everyone that oil has regained its perch as the most significant commodity (not that it ever really lost it). Clearly, oil by a wide margin is the most widely traded commodity in the world -- and also by a wide margin, arguably the most important.

But coming to the end of this year we find that despite the near record output by OPEC (some would characterize it as ?maximum output? by OPEC), and slowing world-wide growth, oil prices are once again up to 3-digit levels.

Oil and more generally energy have once again become critical issues. It seems very unlikely that our economy, even though there have been some signs of strengthening over the past month or so, is any position to survive a big upturn in oil prices. We?ve pointed out on many occasions that once the year-over-year change in the price of oil reaches 80% or more, the economy is under severe duress.

Everything else being equal, this kind of analysis is based on oil and its use as a feed-stock in so many materials and essentials of our economy. Probably nothing is more important in this respect as gasoline, and on this score it probably would not take an increase of 80% in oil prices to drive the economy into something of a tizzy. Indeed, with the recent closing of refineries on the East coast it is likely that, come this summer, gas is going to be considerably higher relative to oil prices than it has before. It?s even likely that $4 a gallon could end up being a bottom for gas prices rather than a top, and that would assume that oil is somewhere near where it is today. If oil continues to climb toward $130 or $140 a barrel, it?s not impossible to see $5 per gallon gasoline.

More broadly, this in just one reason why energy remains a very, very big deal. And hopes of nonconventional energy filling the gap are, to date, just that ? hopes. At best they may fill a very small portion of the gap.

There are many implications. Beyond the evident shortage of oil the one we must stress is the fundamental question of how are we going to solve the energy problem. Obviously, alternative energies, whether they involve non-conventional oil or renewable energies, or any other form of energy, will have to be tried. But in order to use renewable energies, so-called smart grids and many more power carrying cables are required -- not only in the U.S. but across the world.

This is a good point to segue to China for a moment. China no doubt ended the year on a soft note. But despite slowdowns in manufacturing and the real estate sector, that economy appears to be growing at a reasonable rate. The big rap against China, besides the supposed overbuilding of infrastructure, is the lack of consumer spending to sustain an economy that is moving into a consumer economy. Most of the pessimists cite that currently China only generates 35% of its economic activity from consumer spending.

But we think these numbers are dramatically understated. If you look at the import data from China, you?ll see that imports there have risen dramatically in recent years, even quicker than the exports. It?s almost impossible to rationalize such an import data increase with anything as low as the 35% figure for the consumer sector of the China?s economy.

Furthermore, if China is in such trouble, why aren?t they lowering interest rates? Why are they simply focusing on very targeted measures, including an increase in the value of the Yuan (which, incidentally, recently hit a 17-year high).

A rising Yuan, of course, will make all commodities ? and imports -- cheaper for China. This obviously will further boost the consumer sector, and make very dear commodities, such as oil, cheaper for Chinese consumers.

Looking at how China uses various commodities, what stands out is that while commodities such as steel and cement find most of their uses in infrastructure and in construction of houses and commercial buildings, one commodity stands apart. It?s the one commodity in China for which energy-related usages are by far the largest share of total usages: copper.

Nearly 40% of the copper China uses goes directly to the power sector. There?s a good reason for that: again we touch on the subject of smart grids, which is part of the whole process of extending electricity throughout China ? and perhaps more important, preparing for the next energy revolution in that country.

There?s no way that you?re going to have an economy that?s running on a wide mixture of different energy sources without having a smart grid, and without using massive amounts of copper. China has already begun this massive undertaking. Indeed a big chunk of their proposed $2.5 trillion investment over the next 5 years will probably be devoted to smart grids and other related energy projects. In this regard it?s interesting to note that despite the fact that many commodities have been relatively weak, even copper for that matter, other commodities, such as coal, at least in terms of price have held their own very well.

One of the predictions we would make for 2012, although we must admit that we might have to wait for 2013 to see it fulfilled, is that copper is going to become regarded as a very scarce commodity. There?s only so much of it in the world and, as most people know, copper grades have been declining steadily.

And all this is taking place in the context where most of the world remains stuck in a grid that just will not serve it in the 21st century. China is an exception, in that it has already begun to create its grid, but even China still has a long way to go in terms of grid development. In any event, the need for copper is going to accelerate markedly not only in China, but throughout the world.

China clearly has the edge on us: their mines in Afghanistan, and their mines and infrastructure in Africa virtually assure that any copper mined in those locations, whether by Barrick or by a Chinese company, is going to find its way to China.

Where could copper go in terms of its ultimate price? We can?t say. We can remind you that less than 15 years ago oil still traded in single digits. That is not a projection that copper could go to $100, but bear in mind that in today?s world things are a lot faster, and the amount of growth you can get is a lot stronger, even if growth is not accelerating as fast. One percent growth today takes a lot more copper than one percent growth took 50 years ago; one percent growth today takes a lot more copper than one percent growth took oil 50 years ago.

The line between sufficient copper and severe copper scarcity could be a very thin one indeed ? and we fear it?s likely by the time we wake up to this situation, and to the fact that China?s efforts to secure massive copper supplies (or as much copper as they can possibly acquire), it might even be too late for the U.S.

Clearly, if a scarcity that is so overt and so potentially serious in terms of rare earths has not moved our Congress to consider strategic stockpiles of those metals, it?s going to take a lot ? and likely, happen too late ? for us to consider building such stockpiles of copper.

You don?t have to take my word for it. Look at how Germany, for example, has started to stockpile strategic metals ? rare earths and others, which we think also includes copper.

We begin our non-precious metal commodity portfolio with copper at its core, and probably the highest weighted metal. Clearly one lesson of 2011, and a scary one, is that any portfolio has to include the hard metals as well as the miners; as miners become harder pressed to increase production, accessibility and ore grade decline and costs to mine, transport and deliver product, etc. are rising, which means ever declining margins.

But in the case of copper we think there are at least several miners who are extremely well-positioned. Our two favorites: Freeport-McMoRan Copper & Gold (FCX), which, along with Southern Copper Corp. (SCCO), are the two largest dedicated copper producers in the world. We prefer Freeport because it has demonstrated that its goal is to serve shareholders ? all its shareholders. Southern Copper is a different story; by most metrics it may actually be cheaper than Freeport, but it?s controlled by a Mexican conglomerate whose decisions sometimes appear to favor the controlling group rather than the shareholders at large. That?s why we?re sticking with Freeport as our core holding in this area.

A smaller holding is the stock of a Kazakhstan?s largest copper producer, Kazakhmys Plc (KAZAY.PK). By virtue of its geographic location in Kazakhstan it has dedicated supply routes to China, and also supplies power. The stock is dirt cheap, trading below book value, with a P/E in mid-single digits (which is also the case, incidentally, with Freeport). This is obviously a more speculative play, as, for example, what?s to stop China from executing a ?take under? (in deal parlance, a situation where a company is sold at less than its market value). Yet the company is simply too tasty to pass up in terms of its fundamentals and captive market.

Among larger companies that have stakes in copper, we would focus on Barrick Gold Corp. (ABX) which has announced plans to continue to acquire copper assets. Their large purchase earlier in the year in Africa should pay big dividends for them, again with China a captive audience. We particularly appreciate the courage its CEO showed on two occasions: when he removed the hedges on gold upon assuming his position at the company, a move that was subsequently rewarded, and also when he bought a copper mine at a time when copper was widely perceived as having far inferior long-term valuation metrics compared with gold. We don?t necessarily believe this is going to be the case.

Gold, too, is a very scarce commodity. But its industrial uses are not primary, so you could say that however much gold there is now, we can live with. But that?s not the case with copper.

The other company we would single out is Rio Tinto PLC (RIO). Why we would favor Rio over BHP Billiton Ltd (BHP) is because it mines more copper as a percentage of its total operations than BHP, and it also appears to have a larger stake in some of the precious metals, such as silver. (Silver as we have written before is also very scarce and likely to become even more so.)

Finally a few words on gold, which is clearly ending the year on an extremely sour note. We continue to view the action in gold as very much like that of a rubber band. Gold?s weakness now is simply a reflection of how strong it has been. It?s sort of last resort liquidity, especially for German and other European banks which have had a lot of trouble getting dollars.

Gold may continue to be weak into the New Year. As we have pointed out before, if the correction in gold is comparable to what we saw in 2008, the price could go as low as $1,330 ? 1,340. This will not reflect a better world (unfortunately), but a world desperate for liquidity.

As to whether the Fed will engage in a QE3: yes, we still view that as extremely likely, not only because of the weakness in Europe, but also because we expect the recent signs of strength in the U.S. to prove merely ephemeral.

Ironically, gold?s weakness will be more a sign of the need for QE3 than the end of a bull market in gold. And need we remind you, as in 2008, once the printing presses start running again gold?s uptrend is likely to be chaotically strong.

As far as gold goes, our message to our subscribers is that you may have to gut it out a while longer, but in the end, this last quarter of 2011 and perhaps the first quarter of 2012 or so will just be a small bump along a spectacular and very steep upward road.

Disclosure: Leeb Group, its officers, directors, shareholders, employees and affiliated entities and/or clients of such affiliated entities may currently maintain direct or indirect ownership positions in financial instruments (i.e., stocks, bonds, options, warrants, etc.) of companies or entities whose underlying exposure is in the companies mentioned in this article.

Source: http://seekingalpha.com/article/316376-key-importance-of-oil-and-energy?source=feed

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