OPEC to the Rescue?

9/11/2007

Today's "surprise" OPEC decision to increase crude production by 500,000 bbl/day above ACTUAL current OPEC production is one more instance of a situation where there is far less than meets the eye.

The first question which comes to mind: why increase above actual production and not above the current quota? The answer to this question provides useful insight into the actual workings of the OPEC member states. Current OPEC production is well above the official quota because virtually all the non-Saudi members CHEAT. In fact, they are pumping flat out within the constraints imposed by actual production problems. Moreover, this phenomenon of de facto ignoring of quotas and pumping as much as possible is par for the course at OPEC.

Consequently, as we have argued in an earlier analysis, OPEC decisions and OPEC quotas are irrelevant to the global supply/demand balance for crude. It is Saudi Arabia alone which counts. Indeed, the Kingdom is crucial. Only the Kingdom possesses a real surplus which it could pump should it so choose. Of course, no one besides the inner circle of the Saudi royal diwan actually knows what this spare capacity is. As we have noted before, it is in the self-interest of the Saudis to allow the world to believe that it is larger than it may actually be.

"OPEC" decisions in turn mean nothing to the Saudis. They have ignored OPEC "decisions" and quotas in the past, whenever it has suited them to do so.

Saudi oil policy is a cleverly crafted instrument designed to optimize -- though not, in the short term, to maximize -- Saudi revenue. Traditionally, the Saudis have sought to negotiate between the Scylla of overproducing, with serious negative consequences for oil prices and the revenue the Kingdom needs/seeks, and the Charybdis of keeping crude prices too high and thereby creating a sustaining economic basis for massive investment in alternative energy sources. During earlier periods of global economic weakness, oil overproduction, and crashing oil prices, the Saudis were pressed into an unpleasant situation, having to bail out various white elephant projects, royal rake-offs, and meet mounting demands for services and financial aid from their growing population.

The tripling of oil prices over the past half decade has relieved most of these stresses. The Saudis, consequently, have more room for maneuver. There are, however, ominous geopolitical threats, of which the Saudis are well aware. It is by no means clear that the Saudis will seek to reduce Iran's capabilities by allowing oil prices to fall, thereby reducing the revenue available to the mullahs in Tehran. There are undoubtedly voices arguing in favor of appeasing the Iranians within the royal family. Moreover, the ever-growing financial demands of the Saudi populace, fear that fundamentalists may turn against the regime, and sheer greed -- fed by the sense that the major consumers can adjust quite nicely to steep oil prices-- are acting against any impulse in Riyadh to provide relief to major consuming countries.

The Saudis know that the fundamentals of the market have shifted profoundly, with the emergence of voracious oil consumers in eastern and south Asia. The high costs, undesirable environmental side effects, and economic consequences of many bruited about alternative energy schemes are well known to the Saudis.

Today's quota increase will do little to change the supply/demand equation, barring a serious US recession and/or a financial collapse in China. The Saudis' oil policy currently mimics that of the FED: do as little as possible while claiming to be taking timely action.

Interest Rate Prognosis

The decline in market rates, and the accompanying rise in the price of long-dated Treasury bonds, must rank as the MOST MISSED OPPORTUNITY of recent months। Since cresting in June, the yield on the 10-year Treasury Note has dropped nearly 100 basis points (1 full point), from a peak of 5.31 to today's 4.33. The yield on the 30-year Treasury Bond has fallen from 5.41 to 4.76 currently, a decline of 67 basis points. Since Treasury prices move inversely to yields, this has translated into a very impressive double digit gain on the 30-year bond.

Of potentially greater significance for fixed-income investors, buyers of these Treasury securities at their June yield highs has enabled investors to lock in the high rates for periods of 10 to 30 years, depending upon the maturity date of the bonds पुर्चासेद.

The key question is: will this trend continue? Or, to put the matter in a wider analytical perspective: has the 25-year bull market in Treasury bonds (and the accompanying DECLINE in yields) come to an end, despite the short-term bond rally?

Many have argued that this, in fact, is the case. We are now in a long-term bear market for Treasuries, equating to a long-term uptrend in rates, according to this school of thought.
We will confess to a strong skepticism on this point। The crucial factor is the future rate of inflation. Neither the current rate nor "inflation expectations" offer much help in assessing what the future rate of inflation is likely to be.

The seeming pervasiveness of the popular view that inflation is bound to rise is, in and of itself, a contrary indicator, we think।

More to the point are the likely continuation of factors which have created a global environment tilted in a disinflationary direction। Intense global competition, the lid on the price of labor in consequence of the contining and prospective entry of large numers of workers moving from the rural to the urban sector in "emerging" economies, the probability of the locus of low cost labor shifting from China to still more impoverished, overpopulated, and underdeveloped countries, the accumulation of excess capital in Asia and the Middle East,the increasingly pervasive reliance on the internet -- a tool which exerts downward pressure on prices across the board by imposing transparency on comparative prices offered for the same product by competing producers -- will likely remain operative in the future।

The periodic puncturing of asset bubbles, whose recurrence is virtually assured by the ample global liquidity and the global desperation for higher returns in a low interest rate environment, constitutes a deflationary factor of considerable proportions।

The decisive component in the equation remains, of course, the money creation policies of the key central banks। Inflation, after all, is a monetary phenomenon. Whatever the fundamental price trends, decisive action by the key central banks can negate them. On this score, long-term Treasury bond investors can feel reassured by the seeming unshakability of the persisting inflation-phobia of the Federal Reserve, the European Central Bank, and the Bank of Japan. The policymaking echelon of these banks is overwhelmingly populated by individuals who have a profound dread of inflation, coupled with a near-blind determination to crush it, whatever the cost. While countervailing pressures from politicians and financial markets during periods of crisis -- such as the current one -- may force these monetary policymakers to temporarily suspend their crusade against inflation, we doubt that they will adopt a less hostile view of the hated enemy.

The bottom line is that the major central banks are inclined, over the long term, to remain very tight with money creation, thereby assuring the persistence of the disinflationary trend long into the future। It would take a massive replacement of the current group of monetary policymakers, a drastic change in the mindset of the economics profession, or a catastrophic global deflation to alter the orientation of the major central banks.

For these reasons, and in the absence of countervailing evidence, we believe that the long-term bull market in Treasuries, and the secular decline in interest rates, are more likely to continue than not.

Seasonal Stock Plays

The most essential prerequisite for sound analysis is the ability to separate underlying trends out from the enormous cacophony of useless and often misleading background "noise." In the stock market, this requirement translates into the crucial importance of blocking out all market predictions. Oceans of ink are spilled daily by the intellectually and analytically incompetent in the ceaseless efforts to file copy and sell newspapers by grabbing the attention of the reader/investor via prognostications of forthcoming market "moves." In fact, as no less a sagacious investor than Warren Buffet himself has so aptly noted, the market is unpredictable.

In fact, we think there is a direct correlation between the amount of ink spilled and the inherent unpredictability of that which is "predicted।" Overall market predictions -- and especially short-term predictions -- are a complete waste of time, we think, save for those who earn an income by making them.

What then is "predictable?" How is one to make money in stocks?

To pose the question is to answer it , we believe। You succeed as a stock investor by carefully analyzing individual stocks and investing in those that you judge to possess the most favorable risk/reward ratio at any moment in time. One essential component of this approach is to RIGOROUSLY EXCLUDE all predictions/expectations of what the "market" will be doing.

In today's blog we wish to focus on the seasonal factor। For whatever reason, it is a very well-established historical fact that technology and biotek stocks produce most -- if not all -- of their gains in the autumn. Thus, while September is statistically the worst month of the year, it is frequently a very good month for tek stocks. Despite sometime extreme market volatility in October, October too is frequently a good month for these sectors. Finally, the November-January period ususally constitutes the prime season for these stock groups.

We do not believe that tek and biotek stocks will deviate much from the norm this year. Consequently, we think these groups are odds-on favorites to perform well over the next 4-6 months. Coincidentally, in the current season, valuations in these sectors are a good deal lower than usual, and earnings prospects are decent.