2010 has continued to prove one of the most irritating years in my investment career. Still I am encouraged by the market going completely irrational. Such things never last forever. After a few weeks of contemplation I have come up with what I think will be a great trade idea for 2011.
Long Oil and Oil Service stocks/Short Steel Stocks.
Considering the run up the market has had I would never venture on a straight long position in Oil related stocks. Steel Stocks have extremely high beta and a plain short is not particularly appealing. Options 1 year or more out are incredibly expensive and not so alluring.
While the fringe lunatics like Illargi, Stoneleigh and Prechter see a complete collapse of our Ponzi scheme, I am a bit more sanguine. That said, I see the road that lies ahead of us as painful to say the least. The thing I am most certain about is that World Oil excess capacity is far, far less than World Steel production capacity. Currently even according to most optimists we have no more than 2-3 Million barrel/day of excess oil production capacity. My sense is that it is no more than 1.5 Million barrels/day. We are hence at 98% capacity or higher.
World Steel Production is currently running at around 74%. With all the new capacity scheduled to come online, we are looking at a drop to below 70% if demand stays constant. Even in the case of improving demand we will not see the giddy days of 80% plus simply because of China's huge investment in this space. China's Steel producing capacity is expanding and expanding quite rapidly. In case of a total China collapse (not my base scenario) oil demand could drop 3-6% for a year at worst, whereas Steel demand could drop 20-30 % and utilization capacity would go to the low 60's with significant pain for the Steel industry. Even in such a case oil stocks and specially oil service stocks should have good earnings at around $50/barrel.
Comparing the stocks in the 2 groups leads to a very interesting picture. Most oil and oil service stocks are trading at single digit multiples of earnings if oil remains above $80/barrel. At current prices almost all domestic Steel stocks will make significant losses in 2011. That is correct, almost none will make a profit. So you have oil stocks priced for 30% lower prices, and Steel stocks priced for 30% higher steel prices. Based on capacity utilization, the market is clearly wrong. I shorted some US Steel (X) with a equal long position in Energy Income Fund (ENI.UN..which trades at a nice 15% discount). I will be adding more positions in this over the coming month. I will pick a basket of stocks in the Steel industry as the Steel ETF (SLX) contains too many base metal producers to be a good proxy.
6 comments:
What effect will the drilling moratorium have on nat gas production?
GOM is going to be in decline with or without the moratorium. GOM represents a small portion of the Oil drillers revenues and the ban and much worse is priced in.
Drillers will likely stay weak into year end as they are one of few stocks which are actually losers in the S and P 500 and tax loss selling plus a general market pull back may put a lot of pressure on names like DO and NE.
Yes the GOM is in decline but will there be any significant effect on production because of the moratorium. How long before we would see the impact. If I am correct the GOM represents about 20% of nat gas production?
Will the increase in shale gas offset the loss of production from the GOM? I assume land based conventional gas is also in decline. got acouple nat gas contracts for sept maybe I should roll them a few more months out.
I added more shorts today as Steel stocks continued running higher.
My long side basket now has OIH, ZAR-Un.To, Diamond Offshore, ESI-UN.TO and RVT.
CM,
It would be a good idea to roll forward. Right now there is virtually zero cost of carry from Sept 2011 till May 2013.
Good time to roll.
Declines will still take some time. The problem is that only now we are seeing some serious cutbacks. The drilling moratorium accelerates existing declines but overall it is still 6 months out. Significant economic weakness could prevent a strong NG recovery.
That said, I would maintain some exposure as it is impossible the pick exact moment of turn.
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