The Real Oil Risk

I can see you all saying "what's he been drinking today", but I've been thinking long and hard about this and I believe the biggest risk to equity markets is an upside one, driven by a retreat in the oil price over the remainder of the year.

Oil prices usually make a seasonal peak as the US driving season ends, and then retreats as the refineries switch production at the margin to heating oil. This year's seasonal peak in prices is being exacerbated by production and refining outages caused by Hurricane Katrina, and by heavy hedge fund activity in the product markets and futures markets.

It is interesting that with the loss of 1.4 million barrels per day or 25% of total US production from Katrina's impact the oil price rose only 0.8% to $US69.47 still below the intra-day high of $US70.85. While the focus is on crude, the real move was in unleaded gasoline futures for October delivery, which rose 6.8%, clearly reflecting the lack of US refining capacity at present.

The American Petroleum Institute has reported that 12 refineries have cut run time and 8 have completely shut down, reducing total refining capacity by 17%. This has occurred at a time when US refineries last week ran at 96.4% capacity and have been averaging above 90% capacity for nearly 6 months, further exacerbating the problem. Interestingly, crude oil inventories have risen in the last few months above levels from last year, however gasoline inventories fell 1.7mb last week and are now at their lowest levels in 4 years.

There hasn't been, so much a shortage of oil in the US, rather there has been a shortage in refining capacity. We believe that the shortage in gasoline and distillates have significantly effected the crude oil price, in effect the "tail is wagging the dog". Considering the global lack of infrastructure spending and the long lead-time in building new capacity this will be a long-term problem.

Since Wednesday the US refiner margin has risen 24% and last night Lehman Bros raised their outlook for US oil refiners to outperform. The Singapore refiner margin has similarly responded to the events in the US rising 30% over the last 2 days to US$16.67.It is worth noting that the Singapore market is extremely volatile, however the average for the first half of this year has been only US$7.00 and clearly the events in the US will see the second half average significantly higher


BUT IS THE DOG SICK OF HAVING ITS TAIL WAGGED?

The point I am getting to is that we are at, or extremely close to, the seasonal peak in oil prices, yet we think refiner margins will remain strong. This year the upside physical oil has clearly been exacerbated by a number of factors, all of which will become less of an influence as the remainder of the year unfolds.

Energy stocks have led the Australian equity market for 18 months, and have dominated performance for the first two months of financial year 2006. Yet you can see with very few exceptions that the recent price action has looked tired, and the Australian energy sector is failing to respond in share price terms to the developments of the last week.

Energy share prices are a good discounter of the short-term future, and I think the lack of trading response from the Australian energy sector (ex Caltex for refiner margin reasons), is trying to tell you that the spot oil price is in the process of making a seasonal peak, and then retreating a notch.

The question is to what level do spot prices retreat, and I think the answer is actually $59. We only see spot oil prices retreating -15% from all-time highs, yet that will be enough to start a solid pro-cyclicality rally in global equity markets. It will be enough to ensure a solid bout of profit-taking in the energy sector, and it's fair to say there's plenty if "hot" and "leveraged" trading money playing the sector from the long side currently.

This is just a trading event, and for long-term energy sector investors a pull back in spot oil prices to levels way above consensus fy06 forecasts is not an event to get too concerned about. If the spot price pulls back to $59, the average for fy06 year-to-date will still be $62.00, and that's running at levels 20% above consensus forecast, and 10% above our own forecast.


PROFIT TAKING IS COMING IN ENERGY

I think you're going to see a hedge fund and trader driven sell-off in the Australian energy sector over the next six weeks, and remember it only takes a stalling of upward share price momentum to trigger widespread profit taking from short-termists and absolute return funds.

Hedge funds and traders are sitting on huge profits in the Australian energy sector, and domestic investors are also sitting on large out-performance, and the temptation is clearly to lock some of those profits and out-performance in.

We suspect we're on the cusp, short, sharp, 10% correction in the Australian energy sector, and there are clear short-term portfolio construction ramifications of this event.


US EQUITIES WILL RESPOND TO LOWER OIL PRICES

Any retreat in spot oil prices and the energy sector will have very large sectorial ramifications. The biggest ramification is that the US equity market will explode on the upside, as clearly the oil price has been holding back the US market over the summer. In simple terms, 10-15% correction in spot oil prices, will correlate with a 10-15% rally in the S&P500. This is when we will see the p/e premium that Australian equities command to the MSCI Index come in a fraction, as Australia's performance, as a net exporter of energy, won't match that of the largest net importer, the US.

I suspect the Australian equity market will match roughly 40% of any US equity market gains, but leadership of the domestic market will change rather dramatically. Lower oil prices will see bond yields rise, and that leaves 55% of the ASX200 in the doldrums.

ROTATION COMING

Materials, Media, Transport, Steel, Chemicals, Packaging, and selected global consumer discretionary stocks will be the beneficiaries of the correction in Energy, but the biggest winner will be materials as LME Metal prices will advance aggressively. The best way to play this in a short-term sense, is from Energy to Metals, including precious metals (Gold). The 2nd best is from oil producers, to refiners and consumers.

There's no doubt that we are entering the tradition Northern Hemisphere demand ramp up for metal demand, as the peak manufacturing season starts. If this period coincides with a period of oil price consolidation, the hedge funds and CTA's will all move at the margin from energy futures to metal futures, and we should see a tremendous rally in LME metal futures as inventories remain at critically low levels. Perhaps this even started last night, with Zinc up to 63.5clb, Nickel at $6.94lb, and Copper at $1.77lb. Under this scenario, you could add 20% to these spot prices.