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Week Commencing June 16, 2014

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This week we look at the following topics:* The impact of Iraq on oil markets What happens in Iraq matters very much to the flow of global oil supply, unlike Syria.* The depression in mining won’t last foreverBear market in coal in steel equal the losses of the biggest bear markets of the last century.* Australian listed energy producerThere aren’t too many attractive ways to play the rise in energy prices, this is an exception.* S&P500 looks like a good short Trading opportunity here on a risk to reward basis, despite the trend.

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The impact of Iraq on oil markets

We’ve been writing about the supply constraints and geopolitical events in oil for most of this year.

Two weeks ago in Invast Insights Issue 36 we said “The only major growth potential in OPEC is Iraq and with the recent elections expected to return in incumbent to power, the country is now at the highest risk of civil war than any other time after the exit of US and coalition troops. Iraq now produces at just over 3 million barrels of oil – similar to levels during the period of Saddam Hussein. The country has barely increased its total production rates. The common view in the market is that near perfect conditions – which are very unlikely for at least the next five to ten years – could see oil production reaching a daily run rate in the order of 6 million barrels of oil.

But one of the main points out of Iraq is neither market nor the government itself does not really have a good handle on depletion rates. Decades of under investment and near anarchy at times have brought Iraq’s oil production industry to its knees. Even recent post war efforts to kick start production have brought with them legal issues – the Kurdish autonomous region constantly fighting for status and revenue flows with the central government in Iraq.” If you haven’t read the full report or somehow missed it we suggest you completely re-read what we wrote. You can download the link here.

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Iraq is not the largest producer of oil in the Middle East and the chance of another civil war is no real surprise. The country has been in some form of a war now for the past two decades. But unlike the situation in Syria – which at the time we published our views in Invast Insights that the Syrian situation was unlikely to play on oil markets, despite press reports – the situation in Iraq has the real prospect of disrupting the market, for the following reasons:

1) The failure of the Iraqi government to stop the flood of militants from Syria into Iraq’s second largest city, Mosul, signals the inability of the government to withstand civil unrest and this will could see coalition troops increasing their deployment into Iraq. The return of US and UK troops in Iraq is not something either country wants to see, but with Russia agitating Western Europe, it might be an opportune time for the West to reassert its position in the Middle East militarily.

2) The deployment of troops will cause further tensions between Iran and Saudi Arabia who are the key swing producers in the Middle East and very significant to global supply. Not only will the civil war – which now looks almost certain – disrupt Iraq’s plans to increase capacity from around 3 to 6 billion but any disruption to the Saudi and Iranian status quo would see major disruption to the flow of oil in the Hormiz Straight - a major transit way of global seaborne oil.

3) The third point is the most important and probably the most extreme and unlikely but if it occurs it will have a huge impact on energy markets. The Islamic State of Iraq and Syria (ISIS) and associated militant groups have largely been funded by Saudi Arabia in order to curb Iran’s influence in the region. But the groups have shown an ability to evolve and merge themselves into their own autonomous functioning parts. There is the remote possibility that the success of these groups might bring a direct threat to the Saudi Royal Family who still commands the vast amount of oil wealth in the country. Should the militancy groups succeed in disrupting Iraq, they could work their way further south into the most volatile and extreme oil producing regions in the world. This would no doubt send oil prices sky rocketing.

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The image below highlights the sphere of geographic influence that ISIS and associated groups have so far commanded. As you can see, the shift and growth has been southward.

Image: Militant groups expanding into oil regions, via The Wall St Journal

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We don’t know that the possibility or probability of ISIS and associated groups moving in on Saudi Arabia actually is. It might be completely remote and unlikely. But should it occur, the oil market will completely move into a phase of panic. We have already stipulated in prior reports the other threats to global oil supply and the common misconnection in markets that the United States is becoming dependent on oil, which is completely false. The United States is becoming more energy dependent, but this is largely due to the growth in gas as an alternate energy source. The United States is nowhere near becoming completely independent in terms of its supply of oil.

In summary, this week’s news in Iraq is the most sensitive and threatening development in oil markets for some time. It is much more significant to the developments in Libya, Egypt and Syria in recent years and probably most important than either of the two gulf wars in that both Saudi Arabia and Iran stood to benefit from both wars and so had their own motivations for passively sitting back and watching coalition troops roll through. We expect ISIS and other militant groups to consolidate their gains in Mosul, possible face large losses as Iraq’s central government attempts to thwart the expansion south towards Baghdad. We don’t think Baghdad will fall, but even if ISIS is successful in causing the government to fall and drawing in coalition troops, the impact on moral will encourage further expansion south towards the Persian Gulf and Saudi oil fields. These groups might be funded by Saudi Arabia but the system of government in Saudi Arabia is fragile enough to become a threat.

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The chart below shows the breakout in Brent crude as quoted by Invast’s MT4 platform on the hourly timeframe.

Image: Brent crude hourly chart via Invast MT4 platform

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The depression in mining won’t last forever

If as we expect energy prices continue to rise for the reasons mentioned above, the flow on impact on the mining space will mean higher production costs and tighter margins. Many global mining companies are already struggling with lower commodity prices which they think are low enough to see them closing down mines and shutting down operations. Mining is very energy intensive and so the impact of higher fuel costs cannot be ignored. Closing mines and deferrals of future spending will eventually have a large impact on global commodity supply, in turn reversing commodity prices.

This is s thesis that we true do believe in. it’s hard to be bullish on material and mining stocks today because of the huge value destruction which many mining companies have caused for their shareholders. As we write, copper prices are barely able to stay above US$3.00/lb. which is nowhere near the price many producers require to justify returns on their investment, yet alone expansion plans.

The biggest losers have been the coal and steel industry over the past year or so, not just in Australia and Canada. Share prices for large US coal miners recently traded 90% below their 2008 highs and US steel makers are down almost as much. Market declines of such magnitude usually discount the worst and can be good investments without an obvious improvement in fundamentals.

In Australia, BHP Billiton advised last week that it will close down more coal operations in Queensland, giving notice to its mining contractor Downer EDI. Downer shares slumped more than 10% on the day of the announcement and have continued to slide since. The stock was trading at $4.50 as of the time of writing compared with $5.25 prior to the announcement. The deal was worth around $360 in total revenue to Downer.

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These are the type of reactions we look for from the major miners when trying to assess the impact of long term supply. You start to get headlines like this on the front page of newspapers when the market is at rock bottom. It’s always hard to catch a falling knife, we have been talking about a recover in the Australian materials space for some time and it hasn’t come. But that doesn’t mean it won’t come, it’s all about managing your exposure and downside risk while maintaining a certain degree of patience.

The outlook for iron ore and coal is still bleak, make no mistake about that. Iron ore prices have fallen from as high as US$150 to US$90 or thereabouts over the past two years. This is Australia’s large export commodity. Prices for power plan coal have fallen 11 out of the first 13 weeks of this calendar year in the United States, down 13% year to date. US steel production and capacity utilization continues to slide in the United States by around 5-10% depending on which estimates are used. China is the key market for these commodities but the jury is still out on what exactly is occurring in that economy and so at times like these, US statistics become a lot more meaningful to compare.

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We continue to believe in the Chinese growth story and next week we will start to talk about the Chinese stock market having possibly bottomed but the key risk to us for China is the ongoing government driven slowdown with fears that pollution could spark a huge social backlash on the central government. China’s President has labeled air pollution as Beijing’s ‘most prominent’ challenge. The government is attempting to change incentives to shutter more steel plans.

New programs limit access to credit for highly polluting operations and call for tiered electric pricing to force inefficient production to close. This will have an impact on economic growth in the very short term, as we have seen through recent numbers.

Despite all the negative reasons outlined, we think that the market has completely priced in the worst case scenario and eventually – we don’t know exactly when – mining stocks will start to reverse from their deep losses. The main beneficiary from this will be the ASX200 index and AUD and CAD which are largely seen as a commodity currency. We’re looking for a bottom in Australian listed iron ore stocks – AGO, MGX, FMG, RIO and BHP and will update when we think the risk to reward ratio has moved in favour of an upside swing from such depressed levels.

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Australian listed energy producer

Our main preference in the Australian listed energy space is Woodside Petroleum (WPL) but in recent weeks we have continue to watch with strong interest the prospects of AWE Limited (AWE). The more we dig into the business, the more we like. We think that AWE could eventually become one of the more preferred energy exposures in the mid-cap space as the LNG producers start to become expensive and WPL’s share price rises further.

The company was formed in 1997 to appraise oil and gas discoveries in its initial asset portfolio and to build a significant international petroleum exploration and development entity through further international asset acquisitions. AWE's focus is on exploration and appraisal-type assets, in regions of proven prospectivity and where there is a high chance of commercial success. This focus includes currently marginal fields, whose worth may be improved by innovative appraisal and development approaches.

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AWE currently has six main producing assets:

•Tui oil fields - offshore Taranaki basin, New Zealand (AWE 57.5% operator)•BassGas project - offshore Bass Strait, Tasmania (AWE 46.25%)•Cliff Head oil field - offshore Perth basin, Western Australia (AWE 57.5%)•Casino gas project - offshore Otway basin, Victoria (AWE 25%)•Onshore Perth Basin interests, Western Australia (AWE 33-100%)•Onshore US shale gas, Texas (AWE10%, net 7.5% after royalties)

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The big point here is that AWE is not only an explorer but an actually producer generating cash flow and still has a market capilisation below $1bn. Management has an ambitious goal to triple its existing operating cash flow over the next 3 to 5 years which would see the stock score big goals with the market. In the nine months to March, the group produced 4.3 million barrel of oil equivalents which was 17% higher than the prior corresponding period. Revenue increased by 21$ to $268m while operating earnings added 27% to $178m. The business had $72m in net cash – that’s right, NET CASH! – With undrawn debt available at around $300m. All this for a company which still has a market capilisation of around $980m as of the time of writing. Compound annual returns have averaged 15.5% per annum for the past three years compared to WPL at 5.4% and Origin Energy (ORG) at 0.3%. We feel that AWE is definitely going places and deserves to be on your watch list if you are looking for an energy exposure outside of trading the Brent crude prices directly.

Image: AWE two year share price chart via Invast Share Trading Platform

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S&P500 looks like a good short

It’s hard to take a position against what has been such an amazing upward trend in US markets but sometimes the risk to reward ratio is just not compelling. We don’t think US stocks are on the brink of collapse but we just feel that the market – in particular the S&P500 – has got a little ahead of itself and looks like a compelling short term sell at the moment. The trade feels similar to our call for shorting the Euro against the US Dollar when it was trading in the mid 1.38 level, it has seen come back towards more appropriate levels where it is finding some type of support. Our main issue with the S&P500 is the valuation – current trading at around 19x its trailing earnings. This is different to future earnings but even if we assume 10% earnings growth across the whole market – which is high compared to US GDP growth, the S&P500 would be trading on a forward multiple of around 17.1x which isn’t exactly over stretched but still vulnerable to shocks – like a large rise in the price of oil for example. We think the S&P500’s gains will probably cap out at 2000 in the short term and we would be happy to position our stop loss here.

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Most technical analysts would argue that the trend is still overwhelming positive but we feel that the momentum is about to change. Technical analysis is about the past, making money in markets is about the future. Technical analysis is a very powerful tool but not gospel and should not be relied upon completely. If technical analysis was perfect, every trader would have predicted the 2008-2009 market crash…which they didn’t.

Image: S&P500 daily index chart via Invast MT4 platform

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Our target is 1860 or thereabouts and our stop loss is around 70 points away from the current spot price, as of the time of writing, which makes our risk to reward ratio 1:1. There’s further downside scope if 1860 doesn’t hold, as illustrated by the very thing Ichimoku cloud formation.

Aussie Dollar Forecast Webinar – 24th June 2014 starting at 7pm

The Aussie Dollar has been rising from below 93 cents and recently popped its head above the 94 cent market, representing a steady short term uptrend in place. What will happen next to the great Aussie battler? Come join Peter Esho in his Aussie Dollar Forecast webinar where he will discuss the fundamentals that are driving the currency and what the impacts could be going forward.

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Go to www.invast.com.au/insights to get a complimentary 4 week trial and receive the latest insights as they are published to our live clients.

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