Stocks Continue To Recover From Panic Bottoms

Stocks continue to recover from their panic bottoms of last November, many of them having doubled or more from then (case in point: General Electric).   All this seems very healthy to me given the lack of real world data indicating any sort of resumption in economic growth.  We get only data indicating a slowing in the rate of decline.  On top of that, we know there are more shocks to come:  huge default rates in loans on commercial real estate which lags the economy, the likely bankruptcy of both Chrysler and General Motors with the unknowable risks which bankruptcy entails, and an open ended risk of a global pandemic of Swine Flu.   Given those well know negatives facing us “down the pike”, recent market strength seems impressive.

Meanwhile some specific stocks are grabbing my interest.  Lynas (LYSCF), the Australian rare earth element mining company about which I’ve written several times has made some recent eye-popping advances including a nearly 50% move (to $0.35 per share) just today.  Trading has been halted in Australia pending news of a new financing - which is obviously seen by insiders as positive.  Lynas is one of those little companies that could represent a potential opportunity for many multiples of gain over the next year or three.  It should begin shipping product in Q1 or Q2 of 2010 from its world-class deposit.  Increasing numbers of analysts are noting the potential supply shortfall for rare earth metals given their use in many high-tech products - not least of which is batteries for hybrid cars.  I haven’t bet the ranch on Lynas but at this point I would be more inclined to be a buyer than a seller.  I started buying the stock around $0.50 a share and my positions have just today turned net profitable for the first time.

Another highly speculative stock (I’d say a good deal more speculative than Lynas) is Zenn Motors (ZNNMF), about which I’ve also written recently.   Zenn is a speculation on EEstor, a battery and ultracapacitor startup-stage company that recently announced that key metrics of their energy-storage product have been independently confirmed.  The product is in development and no working prototypes have been seen publicly.  The original announcement of permittivity certification was subsequently amplified to show that it works over a range of temperatures including very low temperatures.

The EEstor product could be a world class game changer on the order of atomic energy or the internet.  Zenn has some equity in EEstor and some rights to use their product for cars.   The only thing on which I can judge the risk/reward of owning Zenn stock is internet “chatter.”  My sense is that the recent product news has been impressive to people who seem to have a background to understand it.  There seem to be fewer attacks on EEstor as a “fraud” and “vaporware” purveyor.   Of course I’ve never had that fear because the company is funded by one of the most sophisticated and successful venture capital investors ever, Kleiner Perkins.   So the company’s business plan could fail, but if so, that won’t be be due to fraud.

The EEstor announcement - and some apparent leakage of it before it hit the public - pushed Zenn stock up by a factor of three.  Since the announcement it has retraced somewhat.   Is it worth buying here?  If I didn’t already own it, I’d want to have some.  How much is enough is an individual question - about which I am still noodling.

Meanwhile, the possibility of an EEstor revolution in energy storage is one reason why I’ve become a bit queasy about owning SQM, the Chilean fertilizer and lithium play that today reported excellent earnings for Q1.  If EEstor’s product is for real, the future use of lithium for car batteries could become much more questionable.  Some people have already raised questions about whether the lithium-ion battery is a realistic solution for hybrids, including analysts Jack Luftin and John Peterson.  Their arguments are too complex to repeat here but the links will give them to you.  Essentially they are technical opinions to the effect that lithium-ion batteries are inherently unsuitable to the task of powering a plug-in hybrid electric full size vehicle.

I’m not swayed as much my Luftin or Peterson as I am by the possibility of EEstor coming through with the sort of technology game changer that is needed for next generation cars to make economic sense.   I think EEstor has given ample warning that something big could well be in store for battery technology.  And if it’s not EEstor, perhaps there are others working on similar new technologies.   I would not want to wake up one morning and find that the primary reason for SQM’s 22 P/E has been blown up and the new P/E is 10.  So for whatever it’s worth to anyone, I have stepped back from SQM for now.  I no longer own it.

The Price of Oil

Last week I wrote that the $50 price of oil was a bit confounding to me because there is so much of a glut of oil right now both in storage and in excess capacity underground.  I said the high price in the face of a glut could be due to the highly contangoed futures market and thus to speculation.   A few right-wingnuts who apparently think that either speculation does not exist or that it is a God-given right and therefore should never be “attacked” wrote to tell me I was off base.   So I’ve been thinking about it some more.

For whatever it’s worth, here’s my conclusion.   First, it’s clear that the condition of contango or of backwardization is a function of speculation so there is almost always a fair degree of speculation in the futures market for oil.   Since oil swings from one condition to the other - contango or backwardation - regardless of the absolute level of the front month, there is clearly no explanation for why it swings other than speculation.  I don’t say that such speculation is good or bad, just that it is an important input to the futures curve.  The speculators are determining the shape of the curve based on their expectations for future market tightness and if the curve is steep enough, as is currently the case,  the far out months can impact current prices.

For confirmation that speculation is an important input to oil pricing I cite the recent statements of officials in numerous countries, both producers and consumers including the Saudi Oil Minister Ali al-Naimi.  They maintain that speculation has been an important input into oil pricing and they want to regulate markets to eliminate the ability of very large financial players to influence the price of oil.

The statement issued by the officials said that volatility in the market is harmful to both producers and consumers and that “financial markets have an impact on oil price formation,” according to Kyodo. It said officials, tackling the issue of supervision of over-the-counter markets and transparency, called for “further harmonized actions such as introduction of position limits.”

My conclusion, and the working hypothesis which I intend to use going forward as an investor unless better information changes my mind, is that the near term price of oil is a function of both fundamentals and speculative influences.  That’s not a radical idea.   It probably works for most markets, particularly stock markets.   The trick is to figure out at any given time what the relative input of the fundamental and speculative elements are.

My guess is that when oil dipped below $40 the fundamentals were overwhelmingly driving the price.  At $50, speculation that future years will bring much higher oil prices (which is also my own view) is having an important supporting role for the near month price.   Were it not for such speculation, I do believe the spot price would be in the $35 - low-$40 range.  That’s just my opinion.   The more important judgement is whether that trend is likely to increase or diminish over the near future.   The tendency is to think it will stay the same, which usually is not the case.

My sense is that if the economy actually begins to turn around, bullish speculation in oil will increase for two reasons.  First, speculators will judge that fundamental demand for oil will increase.  Secondly, the dollar is likely to come under pressure, which makes oil more valuable as an asset class.  So, will the economy actually begin to improve any time soon?  I think it’s a little too early to expect that, especially with Swine Flu hanging over everything.  I think the downward momentum of the economy has some more to go.  Hopefully only a few months, but possibly a lot longer.

My bottom line, therefore on oil?  The price is probably not likely to move much very soon.  Oil stocks, however, could still continue to do quite well as they have since last November if the general level of stocks continues to rise.  That’s because a rising stock market is seen by investors as an early sign of an improving economy - which implies a higher oil price down the line for the two reasons mentioned above.   The expectation of higher future oil prices can support continued appreciation for oil equities.

Eventually the economy will in fact turn around and begin to grow again, which will clearly support the oil price more strongly.  So my sense is that even if oil equities underperform stocks as a class over the next 3 - 6 months, they are likely to do better than the average stock as the economic recovery begins to take shape.   The MLP’s in particular, such as PWE, since they pay good dividends, are therefore especially attractive at this point.

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