The easy trade is the dangerous trade

The easy trade these days appears to be in crude oil, and to a lesser degree, commodities.

My trading gut instinct says that the crude market may be a tad overextended at the moment, presumably due to geopolitical instability.

Modern historians should note that Iran and Iraq went through a decade-long war, yet the Persian Gulf still managed to export billions of dollars of crude.

The big shoe to drop is the answer to the question of “What happens in Saudi Arabia?” since they control a significant source of supply globally. That said, it is highly likely that the oil will still flow since whoever is left to control government will still want the cash cow – what will be significantly more disruptive is that the incumbent administration knows it will be kicked out, but has plenty of notice of its pending demise. In this scenario, they will likely use the “scorched earth” option, similar to what Saddam Hussein did in Kuwait prior to the first Iraq invasion.

Readers will likely note that their holdings in Canadian oil sands related companies have received a significant amount of appreciation over the past 6 months – partly related due to the market conditions and improving economy. Here is a chart of Cenovus (TSX: CVE), but you can pretty much fill this in with the usual suspects (Suncor, Canadian Natural, etc.):

The last spike up over the past month is a function of higher crude prices and geopolitical instability – I’d estimate of the $6 that it has gone up from $32 to $38, half of that is due to crude, and half of it is implied instability.

That said, it seems like an easy trade to pile in at the moment, so be very cautious – when others think alike, your risk/reward ratio becomes more adverse.

Difference between West Texas Intermediate and Brent Sea Crude

This article from the US Department of Energy is educational with respect to the price differential between Brent Sea crude oil and West Texas Intermediate.

It is clear that logistical issues with exporting Canadian oil sands crude will continue, especially if the Enbridge pipeline from Alberta to the Pacific Coast does not proceed. Oil sands production is steadily increasing so the supply pressure will continue to be apparent.

Although crude oil is being mined out, it is subject to cyclical patterns of supply-demand cycles. It should be noted that the last crude spike (in the middle of 2008) was so excessive that in conjunction with the economic crisis, pushed crude down 75% at its trough – producers still must produce supply but if demand lessens they must receive a lower price for the product.

In terms of cost accounting, there are situations where mining product is profitable from a marginal cost perspective, but when you fully burden in capital and other fixed costs, the project as a net becomes unprofitable – we are seeing this somewhat in the natural gas industry presently. Eventually the money-losing producers quit producing and/or demand will increase and you will see a price spike since bringing capacity online is not a speedy process.

Geopolitical concerns – Oil prices

The headlines making the news right now are focused around political unrest in the North Africa region – first Egypt, now Libya.

This has strategic implications with respect to crude oil pricing – Brent Sea crude has traded significantly higher than West Texas Intermediate, which would suggest that North American markets are somewhat more insulated from what is going on across the Atlantic Ocean.

In terms of market implications, it remains to be seen whether this geopolitical unrest is going to flare up into something bigger (and thus interfering with trade more than it has) or whether it will be a blip that will pass by – and the major indexes continue their seven-month uptrend without any significant correction.

Note that I will be taking a little break and will not be posting for the rest of the week.

The difference between ocean and land freight transportation

Apparently ocean freight rates for various commodities are tumbling simply because of the supply of vessels available to transport such goods.

I know very little about the ocean freight industry other than that internationally based companies, such as Dryships (Nasdaq: DRYS) have exhibited considerable volatility as the market has boomed and now crashed.

The big difference between ocean shipping and land shipping is that inexpensive freight transit can only be performed by railways, while oceans are only limited by the number of ships you can manufacture and port facilities. Trucking is not commercially competitive with rail freight (except for delivery to the “last mile”) and as energy prices continue to rise, rail will continue to be very relevant in the future.

The two large Canadian companies in this space are CN Rail (TSX: CNR) and CP Rail (TSX: CP), both of which are trading at healthy, but not ridiculously overpriced valuations.

Contrarian indications – Energy

I noticed the following was the headline on the Drudge Report, who is amazingly good at fueling public sentiment on various issues on his simple, yet amazingly addictive page of links:

Although a single headline does not make markets move, it is something to be cautious about. The price of gasoline has not reached the mania level that it did back in 2008; however, it may reach that again in 2011.

I noticed while reading the latest financial pornography, mainly the five or so Canadian-related websites that attempt to sell advertising that they are having a “top four” stock contest. While these are purely for fun and have no bearing on reality unless if people invest real money in their convictions, I do notice that oil-related companies are starting to become about as prevalent as investing than gold-related companies.

Although in the long run I believe that the easy oil is gone, oil is still a cyclical market and is still bound by the economic constraints of how the marketplace works – with high capital costs, there are times where each individual company would see it rational to produce product above marginal cost but below fully burdened costs, leading to a situation where you have the underlying commodity trading below the fully burdened cost.

You see this happening today in the North American natural gas marketplace.

The contrarian pick would be to long natural gas and short oil, but this seems too obvious and too soon. One of the most dangerous aspects of investing is knowing when to exit the party, and an early departure to the party at this point will likely lead to plenty of gains being abandoned in the name of safety. When everybody runs for the exits, it will not be pretty.

However, if you’ve survived with your capital, you will be sitting pretty to pick up the capital-hungry entities that will be left standing and will receive a good risk/reward ratio for your patience.

Price of crude

It is an important benchmark to see that the price of crude oil is at an all-time high, at least in nominal US dollar terms, since the economic crisis:

Every day when I look around me, I see people in their automobiles, and I see trucks on the road, and airplanes flying in the sky. While the sample of one is statistically insignificant, when you start to think about world-wide demand for concentrated portable energy (which is what crude oil represents), coupled with the increasingly high costs to mine supply, leads one to suspect that hedging their energy consumption in the form of owning energy assets would be a prudent portfolio decision.

This isn’t new – I have been discussing this for the past couple years. I believe in crude much more than gold in terms of hedging your purchasing power.

Large-cap oil sand companies like Suncor (TSX: SU) and Cenovus (TSX: CVE) are highly correlated to the price of crude oil. They also have significant bitumen reserves which become increasingly valuable as the price of crude rises. Due to the nature of the financial structure of these companies, they are not going to double overnight, but they will retain their value as long as you believe in the stability of the Canadian and Alberta governments.

Companies with oil assets outside “safe” jurisdictions (e.g. Venezuela) involve much more risk, hence you will find them cheaper.

There are also some other smaller cap companies in the oil sands space that are worthy of consideration, and they contain a bit more financial leverage which would result in potentially larger gains.

A very brief primer on Canada-US petroleum trade

The US Department of Energy releases a weekly bulletin on energy, and this week they chose to look at the Canadian energy exports to the USA, and the impact of a pipeline blockage.

The oil sands is a huge strategic advantage, especially as fossil fuel mining becomes progressively more difficult. In particular, transport fuels are going to face huge demand pressures as China and India continue their very high economic growth.

Technical analysis of gold

Here is a chart of spot gold prices over the past 6 months. I have added in three “trendlines” to the chart, which was a rough hack job:

For technical analysis fans, here are some questions:

1. Is it a foregone conclusion that gold will continue rising, or at least no lower than $1260, plus a few dollars each day?
2. If so, what is the proper trendline to use?

Technical analysis also suggests that if the trendline “breaks” that you can no longer assume the trendline exists, and that there is some other trend that is occurring. How do you figure this stuff out without using the chart as a retrospective explanation?

The only reason why I look at charts is a measure of sentiment over time, rather than trying to derive future prices from chart movement.

The Canadian Dollar see-saw

Attached is a chart of the last six months of trading of the Canadian dollar, relative to the US dollar:

One issue I have with technical trading is that in retrospect it is obvious there are “trends” and “momentum” factors as participants try to load up (or dump) the product in question, but when does the party end? Today? Tomorrow? Next week? How will you know the party ends? Right now, “sell at 98, buy at 95” seems to be the optimal algorithm. We will see if that’s the case or not.

Even though I’ve got exposure to both currencies, I will only be watching this from a distance. It’s very difficult to know whether the Canadian dollar is “fairly” valued or not – how do you even begin to construct a fundamental model? This is why a lot of currency traders are primarily technical – hop on the bandwagon, and hope others are still keeping the cart going before you dump your trade.

Potash – Corporate takeover bid

Many years ago, the first time I heard the word Potash, I thought somebody was referring to a narcotic. I quickly educated myself (Wikipedia is a good primer) and nodded, and didn’t think about it otherwise. Potassium compounds aren’t exactly rare, nor are they terribly exciting – you can use potassium chloride instead of sodium chloride to replace your table salt, and more importantly, its usage as a fertilizer.

Canada apparently has the majority of potash reserves, and the major corporation is Potash Corp (TSE: POT). Never in my wildest imagination did I think back then that it would result in a triple over the past 5 years, but apparently agricultural fertilizer is in such demand that companies with potash reserves have been bidded through the roof.

Yesterday, Potash Corp received a hostile takeover bid for US$130/share, while the day before the takeover trading closed at US$112. After the takeover was announced, trading closed at US$143/share, which likely means that the takeover bid will fail at the present price.

Potash has about 297M shares outstanding (304M diluted), which implies that the price paid is around CAD$40 billion for the equity, plus CAD$4 billion in debt for a total price of around CAD$44 billion. The balance sheet has about $6.5 billion in equity, so there is a takeover premium of about $38 billion over book value. Presumably this is because of the embedded value of their resource reserves, but I skimmed their annual report and couldn’t find any clean quantitative data – it has to exist somewhere, but I couldn’t find it when wading through the many pages for a minute.

Apparently 2008 was a banner year for the company, where high prices allowed the company to mint about 11 dollars per share in earnings. 2009 was a more moderate year, with $3.25/share of earnings. The first two quarters of 2010 have an EPS of $3.02/share, so strictly from a backward looking P/E ratio, it looks expensive. Even if you assume every year is like 2008 from here on in, the CAD$44 billion valuation (roughly CAD$145/share) appears to be “average”.

Because of my investment laziness, combined with a lack of knowledge of the dynamics of the potash industry, I wouldn’t make a firm statement on the valuation of the merger. I don’t plan on touching this stock without doing a lot more research (which I am not going to do). Just strictly looking at the financial statements, it looks like the party willing to pay $44 billion for the company is over-paying, while the board of directors that are recommending the rejection of the takeover are likely playing for more money from their potential suitor.

Still, the general lesson here is that when you learn about some obscure compound or mineral, it might pay to look a little more carefully at it and see if it is plausible whether it will be an in-demand commodity in the future. Everybody knows about petroleum and potash, but what is next? Uranium already had its hype period in 2007, while “rare earths” and lithium are making the headlines currently – what’s next? Antimatter?