A Contrarian Oil Play

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It was always assumed that when the resource wars began the shots would be fired by armies and or navies or air forces against one another, not by a government at its own private sector. But if you’re mobilising for a war over scarce resources and capital, maybe it makes sense that the first thing you do is nationalise the means of production and the resources within your own industrial base. That’s what we’re thinking today about Australia’s resource super profits tax (RSPT).

But before the big picture, what about the market? Even the most grizzled bear would have to be impressed if stock markets can rally right now. But is it possible? It IS possible. Our technical guru Murray Dawes says the U.S. action is poised on a key level. He believes that will determine what happens here in Australia.

It WOULD be impressive if stocks can hold the line now. It doesn’t get much more negative, at least in terms of events. Geopolitically, you have a low-level crisis on the Korean peninsula. Over in the Middle East, you have an escalating crisis off the coast of Israel. Whether those two problems amount to anything more, they’ve already contributed to a very nervous marketplace.

And then? And then you have the fact that stocks seem to have exhausted all the optimism and momentum they’ve built up since the lows of 2009. U.S. pundit Richard Russell are predicted a “major crash” if the Dow Jones took out its May 7th lows. It’s already done that. And now it’s knocking on the door of 10,000.

Is there something self-fulfilling about negative sentiment and the stock market? Well, of course. That’s why being a contrarian is fundamentally unnatural, or really difficult. In a 24/7 media market where everyone tries to digest what every piece of news means at every second, only a very courageous man would claim that the market efficiently prices every single security on a continuous basis.

Instead, we’d make the claim that more than ever the market is driven by marginal fear and marginal greed. Speculators in the futures markets and program traders can influence index levels dramatically. But what influences them? Hunches? Experience? Indigestion? Bad models? Bad shrimp?

Where are we going with this? It probably pays to force yourself to point yourself in the exact opposite direction of prevailing sentiment and spend a few minutes thinking of the other possibilities. Don’t be a lookie-loo! Or as Indiana Jones send to Marion when the Ark was opened by the Nazis, “Marion, don’t look at it. Shut your eyes Marion!”

For example, if stocks don’t break key levels from here—with such a heavy burden of bad news—you’d think it could lead to an explosive short-term rally. That’s a tradable event, and thus what we discussed with Murray this morning. That’s a possibility you want to consider. Mind you we remain fully convinced that the lows will be tested and taken out. But it may not be just yet.

Or take another slightly more complicated example; oil. In the recently published edition of the Australian Wealth Gameplan we speculated that the full consequences of the BP oil spill haven’t yet been factored into energy markets or oil stocks. Let’s assume that no public company with shareholders can run the legal risk of drilling off-shore after the BP affair.

Of course, we’re assuming BP will see a lot of shareholder value destroyed and will not survive in its present form. That’s a big assumption. But even so, what would happen to off-shore drilling and exploration if BP is socked with a multi-billion fine for its role in the explosion of the Deepwater Horizon drilling platform? What will happen to global oil supply?

This, by the way, has always been the core contention of the Peak Oilers. It’s not that the world is literally running out of oil. It’s that the cost of finding it and producing it is going up. That cost includes, now, the legal risk of operating an off-shore rig. We’d be willing to bet that for most public oil companies, that risk is now unacceptably high.

So what? The market has just begun to re-rate the oil companies based on the BP example. If publicly traded oil companies can’t or won’t expand reserves by exploring and drilling offshore, what then? You’re left with national oil companies who presumably bear a lot less legal risk, considering they are owned by the State. And there are still places in the world, like Africa, where you can imagine that governments are happy to sell off-shore drilling permits for the right price.

It’s conceivable, then, that oil stocks are not priced for the litigation risk they face in the future. But it’s also conceivable that the stocks are not priced for a world with lower oil production resulting from the death of off-shore drilling (if that’s what happens). Even if it doesn’t, it’s clear that drilling in the Gulf of Mexico is going to be an iffy proposition. That will affect some companies more than others.

But our main point is that every crisis has consequences. For starters, the Gulf crisis is an ecological disaster. It makes you wonder why we’re still burning oil as a transportation fuel instead of using it as a construction material. But from an investment perspective, there are short-term losers and long-term winners. We’d suggest taking that analytical perspective at times like this, and tuning out the noise on TV.

But what about this resource war we talked about at the start of today’s’ notes. Is it real? Well, it DOES sound a bit conspiratorial. The simplest explanation for the Rudd government’s resource tax proposal is that it has a budget deficit of its own making that it needs to turn into a surplus to win an election. The mining companies have big profits. It’s a logical place to look if you’re an acquisitive, grasping, and mildly panicked politician.

The miners, through a new report commissioned by the Minerals Council of Australia, are no claiming that the RSPT makes many new projects “unviable.” The main issue is the ability to get debt financing. This would, by the way, be complicated by that $5 trillion of other corporate debt that needs refinancing in the next 36 months. Good luck getting project finance in a market like that with an opaque law on top of you.

According to today’s Financial Review, “The KPMG report found that the resource tax would discourage financiers from backing new projects despite the government offer of tax refunds on 40 percent of past losses or capital investment. While all new mining projects would lose value from the tax, the impact was the greatest in gold, nickel, and copper where some projects would be economically unviable.”

Is the mining industry talking its own book? You bet. Is the government talking its own book? You bet. Which book are you buying? And which books are we buying? Well, if it helps, we can let you know that Diggers and Drillers editor Alex Cowie is getting ready to head over to Africa himself to research some opportunities first hand. We’ll keep you posted.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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5 Comments on "A Contrarian Oil Play"

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Tony Hansen
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‘…It’s a logical place to look if you’re an acquisitive, grasping, and mildly panicked politician’.
Just wondering what it might look like beyond the ‘mildly panicked’ stage (and what the next stage is called).

Stillgotshoeson
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Lack of oil may soon be a problem…

http://www.energybulletin.net/node/4856

Coffee Addict
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The Transocean, Deepwater Horizion catastrophe will reduce near to medium term drilling. This will put pressure on energy prices, which will inturn reduce economic activity to a point. I agree that POO will rise as a consequence although it may take a bit of time for the price rise to fully work its’ way through to market. All of this highlights the point that natural gas is a lower risk, lower cost alternative to very deep crude. Although the environmental damage caused by that similar (in nature) gas / condensate well rupture off WA was considerable, it was magnitudes less… Read more »
Ross
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Hang tough CA

mike
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…in the great lakes of north america, many industrial out and in-take pipes are continually clogged by the lowly zebra mussel making a home there…using this concept, could the bp oil gush be impeded by introducing a vast number of variously sized and shaped neodymium magnets into the drill hole?…

wpDiscuz
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