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Peak Oil

We've been wrongly bearish on oil over much of the past year. The practical consequences of this mistake have been largely mitigated by the fact that we've been bullish on natural gas and coal, but we certainly wouldn't have recommended any exposure to the beaten-down airline sector if our oil market analysis had been 'on the mark'.

As far as we can tell, the "Hubbert Peak Theory" of oil production is a good theory in that it meshes with historical evidence and makes predictions that are consistently borne out. However, while "Hubbert's Peak" underpins the oil market from a long-term perspective, we think it has very little to do with the huge run-up in the oil price over the past 12 months. Our view is that the currency market -- US$ weakness, to be specific -- has been the main driver of the oil-price surge that began in early 2007, with supply problems -- actual and perceived -- being the next most important driver. Note that the supply problems we are referring to aren't related to Hubbert's Peak, but are, instead, related to the uncomfortable reality that a lot of today's oil production comes from parts of the world that are politically unstable. It seems that if the supply of oil is not being threatened by the manic behaviour of Hugo Chavez in Venezuela it is being threatened by the actions of rebel forces in Nigeria, or bombings in Iraq, or the potential for another Arab-Israeli conflict.

Whatever the reasons for the price rise, the result is that oil is now very expensive relative to almost everything. The price of oil in US dollar terms or in terms of other paper currencies doesn't necessarily mean very much because these currencies are all headed towards zero at different speeds, but oil is presently very expensive relative to gold (the oil/gold ratio is near its all-time high), gasoline (oil is so expensive relative to gasoline that refinery operators are being financially crushed), natural gas (on an energy-equivalent basis natural gas currently trades at a 40% discount to oil), labour (the number of hours of work needed to buy a barrel of oil is higher now than it has ever been), and the stock market (with the exception of a short-lived spike following Iraq's invasion of Kuwait in 1990, at no time over the past 20 years has oil been as high as it is today relative to the S&P500 Index). We are therefore seriously considering the possibility that the oil price is now close to a secular peak in REAL terms, that is, relative to other 'things'.

If there's sufficient inflation (money-supply growth) then the nominal price of a barrel of oil could rise to $200 or even higher over the next few years, but if so then the percentage gains in other commodities -- most notably gold and natural gas -- would probably be much greater.

The Stock Market

Intermediate-Term Outlook

Has the stock market discounted the worst, as the bulls claim?

To answer this question, let's take a look at the market's valuation. The S&P500 Index currently has a price/earnings ratio of about 21, a dividend yield of about 2.1%, and a price/book ratio of 2.75. This combination of measures indicates that the US stock market's current valuation is amongst the highest in its history. In fact, the only time that the market's valuation was substantially higher than it is today was during the final phase of the mania that ended in March of 2000.

Today's high valuation for the overall market does not, in isolation, tell us anything about the market's likely performance over the coming 6-12 months because it is not uncommon for over-valued markets to trend upward for lengthy periods. What it tells us, in no uncertain terms, is that the market has NOT discounted major problems. In fact, the S&P500's current valuation tells us that the market expects the year ahead to be characterised by strong earnings growth, high profit margins, relatively low interest rates, and minimal currency depreciation. In other words, rather than having fully discounted major problems the market has fully discounted a rosy scenario. This means that the market will have a problem if anything other than a rosy scenario materialises.

One likely spoiler of the rosy scenario presently being discounted by the stock market is the resumption of the debt crisis. The market has come to the conclusion that almost all of the banking sector's woes are in the past, but this conclusion appears to be baseless given that the people running the banks don't even have a clear understanding of the ultimate extent of their companies' liabilities/write-offs. 

Another likely spoiler is the next 'shoe to drop' in the "global food crisis". The next shoe to drop will be sharp increases in the prices of beef, pork and chicken, potentially leading to more widespread awareness of the global inflation problem. Inflation expectations and price/earnings (P/E) ratios are inversely correlated, so P/E ratios are likely to be pressured lower WHEN -- not IF -- meat prices factor-in the large increases in the cost of producing meat that have occurred over the past 18 months.

A third potential spoiler is the on-going housing depression. House prices will probably remain in a downward trend until at least next year, leading to more write-downs on mortgage-backed securities and prompting the government to 'do something' to support prices. But the only thing the government can do to maintain prices at an artificially high level is to implement policies that have the effect of devaluing the currency, meaning that the official response to the bear market in residential property will likely create an even bigger inflation problem. Corporate earnings would probably be boosted under such circumstances, but we suspect that the positive influence on stock prices of higher earnings would be more than offset by a general decline in P/E ratios.

In conclusion, the market appears to be priced for good news, not bad, and whenever the market discounts a bright future it's appropriate to be more cautious than usual even if the future really does look bright. The reason is that at such times there is more scope for a negative surprise than a positive one.

Right now it is appropriate to be very cautious because the market appears to be discounting a rosy scenario even though the future does not look particularly bright. This creates considerable downside risk.

Current Market Situation

The following chart shows the Dow's recent upside breakout. How bullish was this breakout and what does it portend?

In our opinion, it's quite possible that the Dow's April-2008 upside breakout will prove to be as 'bullish' as its September-1973 breakout proved to be. As illustrated by the following chart, the Dow's upside breakout in September of 1973 was followed by a few weeks of modest additional gains and then a year-long decline that lopped about 40% off its market value. In other words, the recent breakout may not have bullish implications beyond the very short-term.

By the way, 'point A' on the following chart (early October of 1973) marks the end of a downward correction in the gold sector. That is, during 1973 the end of the Dow's upward correction followed the end of the gold sector's downward correction by about three weeks. This is partly why we think further evidence of a bottom in the gold sector would be a bearish omen for the broad stock market. As was the case during 1973, the broad stock market and the gold sector are inversely correlated at this time.

Although stock market risk is increasing, we doubt that a rebound peak is already in place. This is mainly because sentiment indicators aren't yet revealing the amount of optimism that would normally be seen near the top of a bear-market rally.

Our guess is that the bulk of the market's upside was behind it when the S&P500 Index reached the 1420s early this month, but that marginally higher levels will be achieved over the next few weeks.

Gold and the Dollar

Gold

A daily chart of June gold futures is included herewith.

Gold hasn't yet done anything to indicate that a correction low is in place, so the prospect of a quick decline to around $800 remains very much alive. If such a decline materialises then anyone waiting for an opportunity to buy more gold should consider it a gift and buy aggressively.

Our short-term gold view will turn bullish following a drop below $820 or a daily close above $900, whichever happens first.

If gold drops to around $800 then silver will probably drop to around $15. An opportunity to buy silver near long-term support at $15 should also be considered a gift.

Gold Stocks

The bullish MACD crossover shown on the following chart is evidence that the HUI's correction bottomed on 1st May at around 385. However, this bullish signal will be negated unless the HUI soon resumes its advance.

Even if a correction low was put in place at the beginning of this month there is a decent chance that this low will be tested before a powerful upward trend gets going, but the test shouldn't occur yet (it shouldn't occur so soon after the low). In fact, if the HUI were to close below 400 within the next few days then we would assume that last week's bullish price action was a 'head fake' and that a quick drop to the mid-300s lay in store.

As previously advised, we think that a drop to the mid-300s would present a good opportunity to purchase some January-2009 GDX call options. In the mean time, we will continue to look for opportunities to accumulate our favourite junior gold/silver stocks.

Currency Market Update

The Dollar Index bottomed in mid March, but up until now its rebound has been unimpressive to say the least. If this rebound is part of a new intermediate-term advance (our view), as opposed to just a routine correction within an on-going intermediate-term decline, then at a minimum it should reach resistance at 75 before the next multi-week pullback commences.

If an intermediate-term US$ advance is underway then the top of the INITIAL phase of this advance will, we think, roughly coincide with the ultimate correction low for gold. This is what happened during 1973 and 2005.

Update on Stock Selections

(Note: To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question)

In the 5th May Weekly Update we presented a table of potential future TSI gold/silver stock selections, including the prices at which we would, or might, be interested in adding them. Below is an updated version of the same table.

     *TGB is a copper producer

    New stock selection: Western Goldfields (AMEX: WGW, TSX: WGI). Shares: 135M issued, 155M fully diluted. Recent price: US$2.17

We successfully traded WGW last year and are now returning it to the TSI Stocks List. As evident from the following chart, the stock is down by almost 50% from its 52-week high. Moreover, it has just dropped to the price area that we'd previously identified as a buy zone.

We are adding WGW to the Stocks List because the gold reserves and future gold production at its California-based Mesquite Mine are currently being valued by the stock market at only US$160/ounce and US$2500/ounce, respectively. This is a fairly low valuation for a gold-mining asset in a secure location that's close to commercial production. Having said that, there are two reasons why the decision to add WGW wasn't a straightforward one. First, the recent plunge in the stock price from the high-US$2 area to the low-US$2 area was primarily driven by the company's announcement that 2008-2009 production would be lower than expected and that production costs would be higher than previously estimated. Second, we don't like the fact that the company has forward sold about 45% of its first 6 years of production at $800/ounce.

This is what we wrote about WGW's forward selling plans back in April of 2007, when we first added it to the List and when it had the stock symbol WGDF:

"...In general, locking in the selling price of UP TO 12 months of commodity production will make sense when commodity prices are near multi-year highs. But WGDF's management is about to enter contracts to deliver gold at a pre-determined price as far out as 2014. The thing is, nobody has any idea where gold will be trading a few years from now. In our opinion it will be trading well above today's level, but the risk, for miners who commit their future production, is that major problems within the monetary system will cause it to move to an unimaginably high price. And if that happened then a gold mining company that had committed to sell 'only' 45% of its annual production at a price that looked reasonable in 2007 could end up with a large-enough mark-to-market loss on its hedge book to render the company insolvent; and who wants to own a gold mining company that has the potential to go 'belly up' in response to a large rise in the gold price?

In addition, committing to sell a significant chunk of production at what eventually proves to be a low price could become problematic even if the company's bankers are willing to ignore the huge mark-to-market loss. The risk is that operational or environmental issues force the mining company to halt its production for an extended period. If this were to happen then the company would have to buy gold at the current market price in order to fulfill the obligations under its hedging program.

WGDF's senior managers obviously believe they are doing the right thing by going down the debt/hedging route rather than diluting the stock via another equity financing. However, we think near-term dilution would have served long-term shareholders better than taking on the risk inherent in a combined 6-year debt package and hedging program. In our opinion, junior companies that need money to build mines should take-on the maximum amount of debt they are able to take-on WITHOUT having to lock-in the price on more than 12 months of future production."

Due to the hedging issue, when we added Western Goldfields to the TSI List last year it was as a trade rather than as a long-term investment/speculation. Our view at the time was that the company's hedge book disqualified it as a long-term position. We feel the same way now, and are therefore adding WGW as a trade with an expected holding period of up to 6 months.

We will set a protective stop for this trade after we see some evidence that the gold price has bottomed. In the mean time, a reasonable approach would be to take an initial position near the current price with the aim of scaling into a full position over the coming month.

Our upside target is US$3.00.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.futuresource.com/
http://bigcharts.marketwatch.com/