Mike Panzner (via the Big Picture) comments on the strength of the agricultural commodities:

Over the past nine months, the Reuters/Jeffries CRB index has essentially gone sideways, and five out of six of its sub-sectors haven’t really moved one way or the other. However, one group stands out: the agriculture sector, with a 33% gain relative to the CRB index.

I noted the break out in DBA (DB agricultural commodity ETF) two weeks ago. Unfortunately, it promptly rolled out of bed and managed to hold the 50 DMA only two days ago. I will continue to monitor this ETF as I’m long term upbeat on this sector. The fantastic volatility should present some interesting trading opportunities.

Now staying with the theme and just to show you a chart that blew my mind, here’s TNH (Terra Nitrogen Co. LP). It’s in the fertilizer business that is enjoying a boom from ethanol and a general lift in the price of agricultural products. Its limited partnership structure probably also attracted yield-seeking investors. I let it go at $75 and $85 and certainly am not recommending buying now. But if you’ve had it for a while, big hat tip to you!

Staying with the energy theme, today’s focus is the mid-tier uranium miner – Denison Mining. It trades in Toronto but is also accessible via pink sheets (Yahoo symbol: DML.TO/DMLCF.PK). I wrote Uranium: The Big Picture a while back when uranium oxide (U₃O₈, aka “yellow cake”) was priced at $42 a pound. Its price has since mushroomed to $95 a pound with almost no pull back along the way.

Cameco (CCJ) is the 800lb gorilla in this space. As mention briefly here, the flooding in its Cigar Lake mine opened doors for many smaller competitors. The current Denison Mines is the product of a merger between the old Denison (DEN.TO) and International Uranium (IUC.TO) which operates a uranium tailings (recycling) facility in Utah in addition to exploration properties in Canada and Mongolia. Denison’s star asset is its 22.5% stake in the McLean Lake production joint venture but it also has other mines at the construction stage, as well as equity stakes in several junior uranium companies. There is a lot more info in their Jan 2007 company presentation (Power Point).

Technically Denison seems to have just broken out of a consolidation triangle which is normally a good entry point.

For more on buying Canadian stocks via pink sheets, read here. The company is said to be preparing for an AMEX listing which should gather it many more fans.

Disclosure: I own this stock. As always, do your own due diligence before making any financial decisions.

Frugal, I finished my taxes last week. Ha!

My post on oil generated some nice comments, including this one from Mike:

it’s $3.50 per gallon at the pump here in San Jose. anyone figured out yet if their profits made in oil related investments actually get eroded in the high prices paid at the pump? sheesh….

While the question itself may be a little facetious, it serves well as a launching pad for two points I want to make. Oh, btw, I drive about 12k miles a year. At 24 mpg and $2.50/gal for regular around here, it’s just over $100 a month. Even if you assume my wife’s car consumes twice that, it’s still more than covered by the nice dividends from my CanRoys.

Sector allocation
The first point I want to bring up is on asset allocation. When one is trying to cover living expenses with capital gains or more commonly dividend income from one’s portfolio, it makes sense to have the sectors match. In the example I gave, dividends from the oil/gas sector covers our actual energy expenses. The same guideline can be applied to utilities, food, etc. Consequently, the sector allocation is determined by one’s actual expenses and dividend rates rather than the sector weighting in some index which is what one gets by buying an index fund. This is an excellent way to hedge the inflation as experienced by each individual.

Crude/gasoline price disparity
The second thing I want to point out is the faster appreciation of gasoline ($GASO) over crude ($WTIC) in the last couple month, which can be seen from the following two charts. Specifically, $GASO has seen 10 consecutive weeks of increases. Obviously, it means the consumer’s pocket book is being hit a lot harder than the headline oil price is suggesting.

A while back, I wrote Sweet and Sour on different grades of crude and petroleum products. It was a primer written by a layman for laymen, if you will. In it, I mentioned the 3-2-1 crack spread which is a very rough approximation of an oil refiner’s profit margin. Basically, 3 barrels of crude is assumed to produce 2 barrels of gasoline and 1 barrel of heating oil. Below is a chart of the crack spread along with crude prices courtesy of Chris Puplava from Financial Sense. Obviously, the refiners are minting money lately. It’s too bad I didn’t pay attention to the names that I mentioned myself. Tesoro (TSO) especially, has gone from $53 to $100 in 6 months.

Although I believe there is considerable political risk from a Democratic congress, I’m looking to increase exposure to refiners. Our energy needs depend on refining capacity as much as crude supply. As the supply of Arab light wanes (due to maturation of the Saudi Abqaiq and Berri fields), refiners geared towards processing heavier and sourer grades of crude will see their margins increase.

More about supply capacity
I cannot overemphasize the importance of refining capacity or petroleum extraction capacity in general. The Canadian oil sands which contain trillions of barrels of oil is being billed to be the savior of world’s energy problem. However, the mining and in situ extraction required are daunting tasks. The oil sand (bitumen) needs to be upgraded into a synthetic crude. The largest oil sands operator, Syncrude, has been expanding capacity in order to increase their production to 350,000 barrels per day (bpd) in 2007. According to this report (pdf, section 3.5) from the National Energy Board of Canada, even if all oil sand projects currently planned move forward, by 2010 total output will amount to little more than 3 MMbpd. Keep in mind that world energy needs are ~85 MMbpd currently and growth is projected to be 1.4-1.5 MMbpd for 2007-2008. Those number should put the promise of oil sands into perspective.

For now, the EIA is forecasting a world surplus production of 2 MMbpd. So even if you think it’s not consistent with the forecast of inventory reduction, there is no need to rush and get your own 1,000 gal tank. I showed that chart on declining Saudi production in the last post. It is entirely possible that they were shutting down wells voluntarily to rest those fields. For now, I’m still expecting oil prices to decline following detente of the Iranian situation coupled with normal seasonality effects. The real test for Saudi production will come this summer when demand picks up again.

The last time we looked at the oil chart was in a post about CanRoys. At the time, there were plenty of oil bears on CNBC predicting $20-30 oil, but I was pretty sure that $50 was going to hold. Fast forward two months, oil’s back up to $63 a barrel. The talking heads would again have you believe that geopolitical tension is the sole cause while completely glossing over the fact that the rebound started long before this latest Iranian incident.

Personally I cringe every time I hear geopolitical events being used as an excuse for price increases, be it oil or gold or anything else. What’s usually left unsaid is that the prices invariably fall as such events subside. Except that quite often the prices don’t fall as much as they rise… While Iran may have contributed a couple of dollars to the oil price, there are greater forces at work. I’ll show a couple quick charts and links and leave you to make your own conclusions.

The first is Saudi oil output in the past five years. The data from four different sources were averaged to produce the black line. Over 2006, Saudi production declined from 9.4 MM bpd to just above 8.5 MM bpd. The full article can be found at the OilDrum.

The next chart is the Baker Hughes oil rig count for Saudi Arabia. The data is only up to early 2006. The rig count increased drastically in 2005, with no apparent corresponding increase in output. So it would seem that the new wells replaced declining production elsewhere, or Saudi Aramco embarked on a massive exploration program, or both. Oil price peaked in July 06, but other than a small supply bump in the middle of the year, Saudi production was a straight line down in 2006.

Click to enlarge

Was the reduction in Saudi oil output by choice or due to production limitations? I leave you to ponder that question. By the way, if you haven’t read Matt Simmons’ Twilight in the desert, now would be an excellent time.

Caveat: This is a look at the long term supply of crude oil, not a short term call to buy oil or oil stocks. As a matter of fact, I think oil will likely move down in the short term to form the right shoulder of an inverse H&S formation. If concerns about world economic growth emerge then $WTIC may retest the lows at $50. It would be a grand buying opportunity if were to happen.

Disclosure: I’m long oil stocks.

Yesterday I wrote a post titled “Caution is warranted” that I didn’t post here because of scheduling and that it contains a link that I know Frugal frowns upon. Since it was posted last night, it wouldn’t have made much a difference anyway.

Nothing I’m going to say is going to alleviate you losses, I don’t even pretend it will limit your future losses. But I do need to talk about specific actions I took today, if only because I have written about those positions in this blog.

- TCK Sold at a small loss as it dropped below the 50 dma. I expect there to be a concern over global economic activity such that base metal stocks will likely be under pressure.
- ITA Sold at a small gain as momentum indicators are rolling over.
- BG Sold at a gain. Same reason as ITA, but even more extended.
- NAT It was already oversold going into today. It dropped in the morning but was unscathed in the bigger carnage in the afternoon. Adding back the $1 dividend it would have been at the 200 dma. Hold
- CanRoys Oil did ok for most of the day. The energy sector had (some) relative strength and I’m a long term believer. Hold

I day-traded EWM and QQQQ and made a little pocket change. At one point, I wanted to short EEM but no shares were available, so I settled on EWM instead. Overall, I believe the sell-off in China was just a trigger for a market on very loose footing. The durable goods number this morning, for example, was awful. This could be as bad as last May and the potential to be worse since the most recent experience taught everyone to hold through the downturn. In addition to IAI and the home builders, I’ll be looking for more shorting opportunities in the days ahead.

Although I have been bearish on the economy, I made no concrete bets as top-calling is reserved for the very bright and the very dim. I’m still in the accumulation stage of my investment life and I couldn’t afford to sit the market out. Now that I believe a top has been established, it’s time to get serious about protecting my assets. I cannot sell the asset allocation accounts easily, so I’ll be looking to offset them with put options or inverse ETFs.

What about gold?

Spot gold fared well during regular Nymex hours. It clawed back from down $11 to close down only $2. However, once the thinly traded Access market started, it was a one way trip down south. It bottomed just below $660. Around 3pm when the Dow was down over 500 points and many PM stocks were down double digits I actually scooped up a couple of names. The fear was so palpable and the bottom so brief that I couldn’t click my mouse fast enough. Still, I’m not sure if I made the right decisions, I may just trade these shares for a quick bounce. At the end of the day I also picked up some GDX puts for protection just in case. Overall, my faith in gold/silver is unshaken. Although I’m quite aware of the short term dangers, the strength of the metals during regular Nymex hours gave me some confidence.

In conclusion, my message is that I don’t expect this to be a one-day event and concrete defensive steps need to be taken. Stay tuned and best of luck.

If you don’t know what is an inflation spiral, read this news about corn. A higher oil price creates demand for alternative energy. Demand for alternative energy creates ethanol demand. Ethanol demand creates higher price for corns. Higher price for corns creates bigger acreage of corns and less acreage for anything else. Therefore, you end up getting not only higher prices in corns, but also higher prices in wheat, soybeans. Since higher prices in corn result in higher costs for meat producers (chicken, hogs, cows), eventually higher prices of meat must come, not to mention a higher transporation cost for all foods (meat & vegetables) due to higher oil price.

Which stage are we at? Higher prices of corns are already here. Meat producers will need to eat up the higher costs temporarily. If you can be in sync with the wave of inflation, you can maximize your profit potential. The best bets on this inflation front I believe is in agricultural producers. The worst bets will be in the agricultural consumers (probably including ethanol producing plants).

Therefore, I suggest long in Archer-Daniels-Midland (ADM) which is one of the largest agricultural producer. Doubling up your bets to make it stock market neutral, you could also short meat producers from Yahoo’s list. Do watch out for possible acquisition due to low valuation in this meat industry. The industry was plagued by Avian Flu, and all kinds of animal diseases (Mad Cow, etc). I invested in GKIS once due to the recommendation from my newsletter Capital & Crisis, but sold out in less than 2 months because I don’t want to be the shareholder/owner of an animal killing machine (I am a 1/3-vegetarian, hopefully eating fully vegan food one day). GKIS was acquired by PPC at ~40% premium, so if you will be shorting, pay attention to valuation.

P.S. For disclosure purpose, I have an existing tiny long position (< 1%) in ADM. Please do your own due diligence because I may increase or decrease my position without notice. By the way, agricultural industry is not a like high-tech. An above-average return is not going to be up 100% or even 50% in a year. Please have a reasonable expectation.

Look at the following charts from stockcharts.com:

The first chart is the CRB, which was a more pronounced bull market in the USA. The bottom chart with $CRB divided by $USD (US dollar index) shows that commodity markets were ranged bound in the last two years priced in US dollar index (or a bucket of international currencies), and seem to have a bottom at about 3.30 for the last two years. Both charts have fallen under 200 days MA however. I believe determining whether the international commodity market has broken down is very important. If the commodity market priced internationally is not broken down, then it should be positive for BOTH stock and commodity markets towards 2009.

Obviously, using $USD index is still somewhat faulty since it doesn’t take the currency values of the major commodity consumers into account. The best chart would be constructed from all currencies, weighted by the amount of commodities that each country consumes. But this is the best that I can chart. You will need to combine both $CRB and $CRB:$USD in a weighted fashion to account for US contribution. Of course, China/India are still missing in the combined pictures. Here is the contribution for each currency in USD index.

The bull market in the past has been more pronounced priced in $US. But nevertheless, it has been a bull market in all currencies until the recent “breakdown”. Let’s see if $CRB:$USD will turn up in the next couple of months.

For those people who know USO, it’s directly related to crude oil prices. Instead of investing oil stocks, investing in commodity itself usually gives you less volatility. However, after watching how USO behaves over the last year and half, I finally realized that this thing is either a scam itself, or being scammed by futures market manipulation.

Look at the two charts below (click to see the details). The first one is the actual crude oil spot price. The second one is USO.

Supposedly, USO should track crude oil spot price. However, since USO does so via futures contract, it is subjected to contango (future price higher than immediate delivery price, which will be UNfavorable to rolling over the contract) or backwardation (future price lower than immediate delivery, which will be favorable to rolling over the contract). You would expect that rolling these contract over would not be such a big deal. But apparently, market manipulation near the futures expiration dates have made USO a costly investment. If you calculate the price gap between USO and crude oil spot, you will discover that from 2004 to March of 2006, the gap of USO – $WTIC is about $4 (ranges from $2.56 to $5.5, but mostly near $4). However, something happened in 2006. The peak in $WTIC was almost $80, while USO was just $74.6, going from being higher than $4 to being lower than $5. And the story doesn’t end there. The gap kept getting worse. On Jan 8th, the gap has grown to negative $8.

I checked the NAV from the home page of USO, just to make sure that what I’m seeing is not due to stock symbol trading at a discount to NAV.
From USO home page, the current NAV or net asset value was 47.70 on Jan 8th 2007.

Even when I factor the management fee / expense ratio of 0.50% for this recent underperforming 1 year, that will only take out $0.37 from USO if I use their peak price of $74 to calculate the fee.

How do you account for this difference of $12 going from +4 to -8 gap to $WTIC? That is a huge 24% loss (using $50) coming from nowhere. I believe that the answers probably lie in the technicalities of rolling the futures contracts. In general, if you don’t take physical delivery of your commodity, you are subjected to market manipulation near the expiration dates. And I think that is what had happened to USO. Obviously, the managers at USO had no choices but to simply rolling over their contracts whenever they see fit or being forced to do so. They don’t have tanks to store these crude oils. I supposed that their hands were forced. Actually, I recall reading an article on financialsense that talks about crude being down $2+ on the date of expiration, while the next closest contract is still some $2+ higher (can’t find it, but it was in Nov or Dec rollover). Usually it would be the most cost-effective to roll over contracts on the last day so that you don’t incur extra time costs. But in the case that I just mentioned, USO would take up an immediate $2 loss on such rollover.

Crude oil is definitely the most political and the more manipulated market. It goes to show you again that taking your gold & silver bars home is probably the best bets. Counting on that the shorts in gold/silver market don’t go bankrupt may be too big of an assumption. Actually, they probably won’t go bankrupt, since they’ve got Bernanke behind their back. They probably just won’t have gold & silver for you, even when the futures contract states that they are obligated to deliver you such.

Do NOT buy USO! Any commodity funds that you buy better be backed by actual physical commodities. Paying storage fee is far better than being at the mercy of market manipulators.

Today I’ll go a bit off the beaten path and venture a bit into the exciting world of, Canadian politics?!

Reuters reported on Dec. 14:

The chances of a quick election in Canada rose on Thursday when both the main opposition parties said they would not back the minority Conservative government in crucial votes early next year.

First, a little background on Canadian politics: Canada has a multi party, parliamentary system where the House of Commons holds much of the power. About one year ago, the Conservatives won a plurality (128/304) of seats in a general election and their leader, Stephen Harper, became the Prime Minister. Since the Conservatives are short of an absolute majority, they have what’s called a “minority government” which makes it difficult to pass legislation.

In December, the Liberals, the main opposition party, elected a new leader, Stéphane Dion. Dion wasted no time in voicing his opposition to the budget proposed by the government which led to the Reuters report above.

The investment angle (of course there is one) in all this again came from the Canadian Royalty Income Trusts (CANROYs). You’ll remember that a proposed change to tax the CANROYs by Finance Minister Flaherty resulted in a loss of ~$26B in the market cap of these trusts. The irate Canadian investors have dubbed it the “Halloween Massacre” base on the timing of the announcement.

The sad thing was that one of the promises by the Harper campaign was to leave the income trusts alone, not to mention that the Conservatives enjoyed wide support in the oil producing province of Alberta. It swept all 28 seats there on their way to victory.

So what if there is an early election? All politicians pander to voters when it’s crunch time and it’s no different in Canada. Retirees were badly hurt from this tax rule change and retirees vote if nothing else. So some relaxing of the rules seems likely. Ideas such as lengthening the waiting period form 4 years to 10 years, or providing a grandfather clause for existing oil/gas trusts have been floated around. Whatever actually happens, I think the worst news is out for CANROYs.

Of course the price of crude is a wild card. While I really enjoyed the gorgeous weather here in the Northeast last weekend, slackening demand and the prospect of a recession has really put a damper on energy prices. Crude (basis western Texas intermediate) has broken down a long term trend line and looking to test low 50’s in the near term. But crude is the most political commodity, I don’t think OPEC/Russia will standby to watch the price drop. I think Wall Street’s doubts in OPEC countries’ discipline to stick to production quotas were based on the previous cycles. Even if half of what Matt Simmons (of Twilight in the desert fame) says is true, we won’t see $40 oil again.

Here’s a small list of CANROYs. Many are poised to re-test the November reaction lows, some have already dropped below (of course, they’ve been paying dividends along the way). I’m steering my portfolio towards more dividend paying names this year, so I’ve been taking positions with the intention to hold. If the changing political winds in Canada provide something more immediate, all the better.

Click to enlarge

Two other blogs on this topic
Specious Argument: for the tax change
Senator Larry Campbell’s blog: check out the comments. Here’s a hint: retirees are not happy.

I’m thrilled of having James West to agree to be a regular guest writer on my site. For those who are not familiar with his work, he regularly watches and reports on the COT (Commitment of Trader) Reports at various futures/option exchange market. What is futures? Here is from investopedia:

A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. If you buy a futures contract, you are basically agreeing to buy something that a seller has not yet produced for a set price. But participating in the futures market does not necessarily mean that you will be responsible for receiving or delivering large inventories of physical commodities….

James’ articles regularly appear at financialsense.com. His reporting on COT is important to put together pieces of puzzles in the stock & various other markets. When you go to casino and play black-jack with dealers, assume that you can count dealers’ cards accurately, won’t you have a much higher long term success due to additional information on calculating the odds of having a bigger (or smaller) number card?

Likewise, it is the same with futures market. Most of the time, people only look at the stock market, stock options market, but forgetting that there is also a futures market. The major brokerage companies are the House in this case. And if you don’t look at the futures market, you are not counting all the cards (or even majority of the cards). Maybe by the outstanding open positions in the option market, you would conclude that market would more likely rise. But you may not be looking at the futures market, where more House money has been betted for a market fall.

By having James reporting on the COT data, I hope readers at 1stMillionAt33.com can be better informed of the futures market.

Let’s hope that James West will continue to make his articles available on an indefinite basis for everyone here. Please welcome James West, and be sure to visit his own site too.

Frugal