Peaking Bond Markets: The Reversal of a 30 Year Trend

Is the three decade long bull market in bonds over?  It certainly seems that way.  Bonds have been retreating across-the-board since early November.  QE 2, which was supposed to bring rates down, simply isn't enough -- even in the targeted middle range of the yield curve.

So what happened in early November?  I don't know. Maybe it was the announcement of QE 2.  Look at Vanguards Total Market ETF: BND.




Consider:

• Treasuries are in an downtrend across the spectrum:  See the 2 year here, the 5 year here, the 10 year here, and the 30 year here.  All show declines after early November peaks. The benchmark 10 year in particular shows an alarming drop.
• Municipals suddenly collapsed  and show no sign of recovery.  PCK, a leveraged California Closed End Municipal fund is down almost 20% since November 7.
• Corporates (LQD) mirror the declines.  Surprisingly, junk bonds (JNK) have held up somewhat better.
• Emerging Markets (EMB) are not immune.

Pundits have long touted the debasement of the U.S. dollar but now the unease is spreading.   Perhaps last month's precipitous drop in munis was a wake-up call.  It will take a lot to change the public's view of bonds as a "safe" investment, but that may now be starting.

The Fed seems to be losing control.  Former Fed Reserve Chairman Alan Greenspan warns that on going deficits will lead to a bond crisis.   Mr Bernanke is between a rock and a hard place.  Tightening may crash markets.  But . . . QE contributes to the perception (reality?) of dollar debasement -- driving interest rates up anyway.  To make matters worse, QE's newly printed dollars flee U.S. shores, contributing to overseas inflation which may precipitate currency wars.

All fixed income instruments will follow treasuries down if rates rise.  You may find a possible haven in convertible bonds.  Blue-chip, dividend paying, stocks may be your best bet for a "safe" investment from here on out. Do your own due diligence.

The bond market is huge ($91 trillion worldwide) -- more than twice the size of equity markets.  If prices continue to decline, some this money will flow into equities and commodities, pushing up inflation.  Commodities are arguably in a bubble while blue-chips are probably not (yet).  Once inflation gets started, it is very difficult to stop. You can argue over what is inflation but precise definitions of inflation are meaningless to most people.  If the price of fuel goes up . . . it is inflation to them -- even if wages are stagnant or falling.

Keep an eye on the Fed.  It seems QE is needed on a ongoing basis to prop up the economy.  At the slightest sign of tightening (such as the pending expiration of the Build America Bond program) markets head south fast.  Bernanke says he is not going to allow deflation, yet the Fed has to pump harder and harder just to stay even.

The ground world economies are standing on is getting steadily narrower, sooner or later we will fall either into the pit of deflation or the excesses of inflation.  Either way it won't be fun.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours

Are Municipal Bonds Cracking?

Look at last week's price action in PIMCO's Municipal Income Fund ETF (PML).  Municipal bond markets plunged.  Not surprisingly, the California ETF (PCK) shows the most precipitous drop.

It might be argued that muni markets are merely reflecting similar declines in treasuries (TLT).  Fair enough. Bond holders, though, are probably are more interested in the fact that their bonds have declined rather than why they are declining.

Warren Buffet warned back in June on the Muni Bond market. Defalt, so far, have been rare but local and State municipalities are struggling to meet their obligations.

There was a time -- before the 2008 crash -- when triple AAA rated, insured munis were seen as the safest of safe investments.  Times have changed.  Only Assured Guarantee (AGO) still insures municipals but the company has been recently downgraded from AAA to AA.  Ambac (AMBK) is  in bankruptcy. MBIA (MBI) is entangled in litigation and no longer writes new policies.  The financial guarantee business today is but a shadow of its past.

Even though defaults in the muni markets have been rare so far the Feds zero interest rate policy has thrown a cloud of uncertainty over all bond markets.  Declining tax revenues, rating downgrades, loss of insurance, rumors of bailouts, all contribute to uncertainity and suspicion that all is not as well as claimed.

It may be wise lighten up on all medium to long term bonds at this juncture.  Greece, Ireland and Portugal may not be as far removed from New York, Illinois, and California as we might wish.

QE2 or the Titanic?

Someone has awaken the band, found the girls, and broken out the drinks!  Thanks to Ben Bernanke's Quantitive Easing 2 (QE2) November 3rd announcement the risk asset party is in full swing again.

The Fed's planned purchase of $600 billion in Treasuries and QE1 rollovers over the next 8 months already has it fleeing into equities, commodities, and emerging markets -- before the QE even starts!
The elections put Congress out of the stimulus business.   Not to worry . . . .  The Fed's QE2 ship, captained by Mr. Bernanke, is launched and steaming off into dark, uncharted waters -- with or without congressional support.
Since the U.S. dollar is the world's reserve currency, you might say Mr. Bernanke is Captain of the World.  Worldwide FOREX, bond, equity and commodity markets all soar or fall on the slightest nuances from him.  To argue if it right for one man to have so much power is, at this point, moot.  He simply has it.
Who wins with QE?

• Banks:  They get liquidity and more time to repair their balance sheets.  The interest free money is reinvested where it earns more (rate arbitration -- profits come from the spread).  Why risk loans to the private sector when you get a risk free return from Uncle Sam?  According to Shahien Nasirpour in the Huffington Post U.S. banks own $1.6 trillion in taxpayer-backed assets such as Treasuries and Fannie and Freddie debt.
• Some of the public:  Rising markets benefit those who have the foresight be invested in them.  The hope, of course, is that inflating asset values will eventually spread to the increasingly desperate real estate sector.  No sign of that happening yet though.
• Corporations:  They are floating bond issues while interest rates are low -- get while the getting is good.  The stock market recognizes this and is rising.  High unemployment allows corporations to keep wages low and employees working on over drive.

Who loses with QE?

• Savers and other frugal people:  Interest rates are at record lows.  I didn't even bother listing the $2 interest income I made last year from a savings account.  The Fed is forcing us into risk assets and anyone who holds cash in U.S. dollars or cash equivalents such as treasuries loses.  If bond markets crack and interest rates skyrocket (as they will if inflation picks up) anyone holding fixed income denominated in U.S. dollars takes big losses.
• The U.S.:  Dollar devaluation sparks up commodity prices and exports inflation world-wide.  The recession stricken U.S., however, does not have the room to increase wages to compensate increasing fuel and food prices.  You already see the signs -- more people walking or bicycling (that may actually be good), more gardens, more roadside produce stands, empty malls, shuttered businesses, large numbers of homeless, etc.  The bottom line: One way or another, the U.S. standard of living is declining.

Other QE risks.

• Currency war:  QE in the U.S. raises all kinds of red flags abroad.  Both European and Japanese Central Banks may be forced to intervene (retaliate?), precipitating a "currency race to the bottom".  No wonder precious metals seem to be rising nonstop --  a certainty in a world of uncertainty.
• Capital outflows from the U.S.:   It flees to friendlier shores.  Badly needed domestic investment shrivels and the U.S. economy languishes.
• Never enough QE:  The $1.6 trillion QE1 did not revive the U.S. economy, so how will QE2's $600 billion?  Additional QEs will probably be implemented.  The Fed is independent and can buy whatever it wants, mortgage backed securities, bonds of all types, equities, you name it.  Eventually the U.S. will be forced to give up these futile attempts at stimulus; rates will go up and markets down as reality is faced.  The unfortunate fact is that QE has never worked in the long run.  Maybe this time will be different but don't bet on it.

Investment ramifications.

• Real assets:  Maybe stay with ETFs to avoid single issue risk. Precious metals (GLTR), agriculture (DBA), and energy companies (VDE) are but a few.  Click on the ETF tab on the Seeking Alpha website for additional ideas.
• Minimize fixed income investments (bonds): Upside risk is limited while the downside risk is infinite.  If you have safe treasury bonds and the incomes covers a fixed rate mortgage . . . maybe keep those -- some hedging is always a good strategy in times of uncertainity.
• Go with the trend:  As long as the Fed keeps its Zero Interest Rate Policy -- ZIRP-- you might consider some high dividend REITS such as Annaly Capital Management (NLY) and Chimera Investment (CIM) which benefit from ZIRP.  This is a risky area though as things can change quickly.
• Protection: You can protect yourself from rising interest rates with TBF and TBT but be aware of daily rebalancing erosion .

As always, do your own due diligence in picking investments.  Everyone's investment strategy and needs are different.  Only you can decide what is best for you.  This article only presents my thoughts on macro trends and is not a recomendation to buy or sell.   But, whatever you do, watch the bond market and Mr. Bernanke closely in the coming months and year.

Disclosure: Small positions in CIM and TBT

7 Speculative Chinese Small Caps

Looking for investments outside the U.S.?  You are not alone. With the dollar plummeting almost daily money seems to be fleeing U.S. shores faster than the Fed can print it.

Check out the Wild West . . .  err, I mean Wild East of stocks. East as in China, the elephant of emerging markets.  Now look at small-caps.  Scared yet?  After the Tuesday's action you should be!  Some Chinese small-caps fell 9-10%.  But wait . . . Yes, you can  find value and growth in Chinese small-caps.

Consider China Sky One Medical (CSKI) -- PE under 4, no debt, yoy revenue growth of 27%, and a Price/Sales ratio of 1.  Look at Duoyuan Printing (DYP) with its PE ratio of 1.4.  Then there is  Fuqi International (FUQI) which you can buy for only slightly more than its $6.27cash per share.  Both sell for less than 70% of annual sales and have P/E ratios less than 4.  Similar Chinese  small-cap values exist in CELM, CSR, LLEN, and UTA.

With those numbers how can you not like these stocks? . . .  I know!  I know!  Mr Market can be quite ingenious at finding ways of torpedoing the most obvious "buys".  But, like I said, this is the Wild East and anything can happen.  What goes down fast can go up just as fast.

Risks?  Where do we start?  Jim Chanos says China is the next Enron.  Sudden currency changes, an unpredictable government (I hesitate to use the word communist), and accounting irregularities are but a few of the potential negatives.   Volatility is frightening -- the smallest rumors can rocket up or torpedo prices.

Wealth management firms such as Northern Trust (NTRS), burned by the 2008 crash, play it conservative. They will never recommend these Chinese small-caps for their clients -- it would violate their fiduciary responsibility.  Individuals can, however -- if played right --, tap into some of the fastest growth markets in the world with these stocks at what by most standards are currently bargain prices.

Do you own due diligence -- small cap stocks are volatile everywhere, especially so in China.  My approach is to take small positions in several companies, sell those that fall 10% or so, but let the winners run.  Who knows?  You may tap into a Chinese superstar.

Think positive to avoid the Chinese market's Dr. Loveless like twists and turns.  James West and Artemus Gordon protected and won the day for the U.S. Maybe you can't protect the U.S. but you may be able to protect and enhance your portfolio with these stocks.

Trashed Real Estate, Soaring Gold

The prop wash from Ben Bernanke's helicopters has yet to spread dollars on the struggling U.S. real estate market.  Gold, though, up over 30% in the last year, is a major beneficiary,

Three years ago a typical Florida house (Tampa area) sold for $240,000 and gold was around $450/oz.  Now the house value has been cut in half to $120,000 while Gold has tripled and is closing in on $1,350/oz.   It took 535 ounces of gold to buy the house in 2006, today it only takes 90 ounces.  Why such a large about face?

Since both houses and gold are "real", non-printable assets one might conclude either houses are extremely undervalued and/or gold is extremely overvalued.  Is it just a matter of time before the pendulum swings back and the gold/house ratio rises again?

Gold is very much a global commodity, of course, while houses are the quintessential local asset.  You can easily move a pound of gold or more around around the world.  The real estate goes nowhere.

U.S. real estate has very low liquidity right now.  Loans are difficult to get.  Anyone can buy gold in vaious amounts easily, either through ETFs such as GLD or SLV.  Physical gold is available in the form of bullion or coins at the local coin store or numerous web sites (Be careful)!  In 2006 all you needed was a pulse to get a real estate loan while precious metal ETFs were just coming on the scene.

Years ago I went to a real estate seminar.  One of the things we learned was how to value houses using the income approach.  The "rule of thumb": A good middle class 3 bedroom/2 bath/2 car garage house in a good (not great) neighborhood is a buy if it sells for less than 100 times the monthly rent.  For example, if the house rents for $800/month a price of $80,000 (or better) makes it a good buy.

So, with that in mind, how do things look today?  The above central Florida house, renting for $800/month, can again be had -- with some negotiation -- for about $80,000 or less.   In 2006 the house was valued at about $160,000 -- way above the "rule of thumb" above -- an obvious red flag to those who paid attention.

I believe real estate is now in the process of bottoming and will eventually follow gold higher.  Inflation, as evidenced by increasing commodity prices, now seems to be edging out deflation.  Real Estate appreciation will follow.  However, it will be slow due to liquidity issues and the poor U.S. economic recovery.

Disclosure: I own real estate, no positions in ETFs mentioned

America's National Parks and the U.S. Dollar

"No one is speaking English" whispered my companion. as we hiked through the Bryce National Park last week. We encountered a surprising stream of hikers on the back country trails.

Young (take it with some perspective, I'm 61), fit, and friendly, the trekkers seemed everywhere. Germans, Dutch, Asians, Australians, and people from I have no idea where, all cheerfully waving as they strode by. Americans that actually live in the USA?  Well, I'm sure some were around, but if so, they made themselves scarce -- perhaps whiling away the time in nearby Las Vegas.

The torch of leadership in the world is changing.  The U.S. still has its natural wonders  and a flood of visitors  is eager to see the unrivaled beauty of the American West.  The allure of the wild west draws back which fled over seas.

Consider:  It is hard to believe you could mail a letter in the U.S. with a 1 cent stamp at one time. Now it takes 44 cents (with rumors of more to come).  At least National Parks haven't devalued like stamps and other paper assets such as the U.S. dollar.
The U.S. still has its natural wonders.  A flood of overseas visitors  is eager to see the unrivaled beauty of the American West.  The Wild West entralled Europeans 150 years ago.  Now, the rest of the world has joined them.
However, the torch of leadership in the world is changing.  The U.S. dollar has lost 10% of its value just since last June. Our leaders seem hell bent on devaluing it even more as they try to perpetrate the illusion that we can have $30/hour manufacturing jobs and compete with people who work for $3.00/hour or less.

We are a deeply indebted nation and Asians (remember the "starving Chinese" your mother told you about) are calling the shots.  Fortunately, we grow,  most of our own food, so no need starvie.  Yet selling food overseas may soon become more profitable.

You got this crazy scheme:  The U.S. government prints money and then lends it to banks at zero percent interest (ostensibly to "stimulate" the economy).  The banks take the cheap money, buy longer dated treasuries (who else would buy them?) for risk free profits on the spread as they try to repair their balance sheets.  With the possible exception of "Cash for Clunkers" very little ends up in the hands of the American public.  The longer this charade goes on, the more impoverished America becomes.

We simply cannot afford social security, national healthcare, high minimum wages, highly paid government employees anymore but our leaders don't seem to get it.  The dollar is strong only when European crisis erupts -- they have similiar, possibly worse problems.

Even more disturbing a weakening dollar robs Americans of their savings by stealth. The bank statement may look good but the dollars buy less and less.  Forget about traveling overseas.  Cash and treasuries are a loosing game to everyone but the banks.  Most of us just aren't aware of it yet.
As the U.S. continues to sink into a recessionary quagmire you might consider investing in international blue chips, commodities, and emerging market ETFs, assets which have more than paper backing them.

Nervous about picking foreign stocks?  Use ETFs!  Since ETFs invest in multiple companies, most practically eliminate corporate risk by investing in dozens if not hundreds of companies.  You may wish to consider EEM (ishares MSCI Emerging Markets Index), GMF (SPDR S&P Emerging Asia Pacific), BKF (ishares MSCI BRIC Index), or DGS (WisdomTree Emerging Mkts SmallCap Div).

Its a little riskier but TBF and TBT provide protection and profit opportunities against the inevitable rise in U.S. interest rates as reality sets in.  And the flood of overseas tourists visiting the U.S?  Thank them!  They are returning some of the vast amount of dollars that have fled to foreign shores in recent years.


Disclosure: Long BKF, DGS, TBT

An ETF Portfolio for Both Yield and Safety

How can you find yield and safety in today's Zero Interest Rate Environment?  That is the question retirees and many others are asking?  Conventional wisdom says "You can't . . . the only safety is in cash or treasuries." Historically that has indeed been the case.

However, the U.S. government is currently doing everything possible to keep rates low, and of course we all know you can't fight the Fed.  First the Fed drove down short term rates to zero.   Now, they are targeting longer maturities.  This is a war on savers!

So, are cash and treasuries truly safe?  Considering the U.S. debt situation the short answer is: "no."  Remember deflation and even stagflation is the fixed income investor's friend --  your dollar buys more.  If inflation or currency devaluation occur you do not want to be caught long bonds!  Governments almost always print their way out of a debt crisis, igniting inflation.   The portfolio below, however, provides inflation protection in addition to yield.

The portfolio consists of 7 ETFs and has a yield (equally weighted) of 5.67% and shows a 29.7% YTD gain. Compare this to SPY's 2% yield and 1% YTD gain.  Also, remember, since we are talking ETFs you greatly eliminate corporate or individual sovereign risk.

•  .EMB Emerging Market Bonds (4.7% yield, 15.5%YTD return)
•   LQD  Investment grade Corporate Bonds(4.7% yield, 8.6% YTD return)
•   JNK  High Yield Bonds -- aka junk bonds (9.7% yield, 37.7% YTD return)
•   DGS Small Cap Dividend Emerging Markets (4.8% yield, 83.2% YTD return)
  
•   PEY  High Yield Dividend Achievers (4.3% yield, 3.6% YTD return)
•   IFGL  International Reit (9.5% yield, -3.5% YTD return)
•   VPU  U.S. Utilities (3.8% yield, 11.3% YTD return)

Depending on your particular situation you could over or under weight individual ETFs.  Think a big crash is coming?  Maybe stay away from JNK.  Think Emerging markets will prosper?  Overweight DGS.  Already own substantial real estate?  You could stay from IFGL.  Talk to your financial adviser before investing.

A few comments:  JNK is probably the riskiest.  Yet, hi-yield bonds have strongly out performed the supposedly safer SPY over the last year.  DGS, PEY, IFGL, and VPU  have real assets and provide inflation protection and growth potential in addition to yield.  All but IFGL show positive growth over the past year,  prospering in today's dis-inflationary environment. Strong emerging market exposure minimizes risk to heavily indebted developed countries.

Sure, you can hide out in cash and treasuries but you miss the income and capital appreciation potential of the above portfolio plus you run a significant risk of currency devaluation or inflation.  Hiding in a fox hole may only get you buried some day, maybe some day soon.

Again, investors should do their own research and consult with their own financial adviser before acting on any thoughts expressed here.

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Hot Summer, Hot Bonds

Unrelenting summer heat has broiled most of the U.S. into a stupor.  Russia had extremes of heat and drought not seen in hundreds of years.  Global warming theories are again on the front burner.

The SP500 has wandered aimlessly all summer and now is about where it was in early June.  The U.S. dollar has mostly fallen, though firming recently.  Commodities, as show by the CRB Spot All Commodities Index, are strong and rising.  Equity volume is light, cash positions high.

Many "went away in May" and are sitting out this hot summer in cash or treasuries.  Is this a smart thing to do?  Well, the stash under your mattress may be safe as long as ex-spouses, burglars, mice and the federal government stay away.  I would be most worried about that last one.

But, wow!  Look at the bond markets!  In case you haven't noticed, everything is on a tear.  Treasury, corporate, sovereign, and municipal bonds, all are trending (in some cases rocketing) up.  U.S. 10 year treasuries as shown by IEF recently topped 98 with the yield dipping below 2.6%.

Even traditionally risky bonds are in a strong upswing.  Consider junk (aka hi-yield) issues.  JNK has risen signifigantly over the last 3 months -- no recession predicted here.

Emerging market bonds also continue to out-perform.

As an (perhaps unrelated) aside, note that Obama's economic advisers are jumping ship.   Peter Orszag, director of the Office and Management and Budget (OMB) resigned in late June while the ebullient Christina Romer, chair of the White House Council of Economic Advisers plans on stepping down in September.  Both Orszag and Romer say they are leaving for personal reasons, not job frustrations.  Well . . . draw your own conclusions.

So what to make of it all?  Do record low 10-yr yield indicate a flight to safety ahead of coming crash?  Or, do steadily rising hi-yield (junk) bonds, strong commodities and emerging market indexes indicate a recovering world economy and strengthening inflationary trends?

It may be a mistake to fight a strong trend but I would watch bond markets very carefully.  U.S. treasury upside potential is limited while downside risk is very high --  if bonds crash.  It may not be to early to take a position in TBF or TBT (short and ultra-short 20+ year U.S. treasuries ETFs). At the very least keep a close eye on this market.   Also, you may wish to consider ENY, the Canadian Energy Income Index, which has both yield (3.6%) and real assets of  Canadian oil and gas.  Gold (GLD)  will be strong with currency market disruptions.

With the U.S. government facing northward of $100 trillion dollar in debt obligations eventual massive money printing seems inevitable.  It just isn't here yet.  Things could end badly with high inflation or possible currency (U.S. dollar) devaluation.


The hot summer of 2010 will soon be a memory but if bonds go south a lot of other (unpleasant) things will heat up fast.  We will then long for the days when just the weather was hot.

The Thrill Ride Thats ATPG

Like roller-coasters?  Then you will love high-beta ATP Oil and Gas Corporation (ATPG). After bottoming around 2.5 in early 2009 it rocketed up to 23 by April of this year.  But, by mid May it was back below 8.3. Currently bouncing around in the 11 - 12 range.  Consider yourself warned!  This stock is not for the faint of heart.

Why the huge drop since April?  Well, the BP spill disaster suddenly brought into question the feasibility of deep water drilling.  ATPG has invested heavily in deep water rigs such as its 7-story ATP Titan at its Telemark Hub.  Since the companies focus in the last few years has been deep water many investors apparently feel ATPG is in trouble

ATPG is also highly sensitive to oil prices, oil prices which are now considerably off  April's high of $87/barrel.  Now, throw in high debt invested in deep water rigs and you have a recipe for extreme uncertainty.   Since the company's main focus is in the Gulf of Mexico (they also have a North Sea presence) the shock waves of the disaster are severely rocking ATPG.

This perfect storm of a drilling moratorium, the almost certainty of increased regulations, lower oil prices, and high debt has combined to swamp ATPG's stock.  However, even perfect storms subside eventually and the U.S. really needs oil.  Any oil!  Deep water oil is one of the few oil frontiers left in North America, perhaps the world. The BP disaster gushes up to 60,000 barrels a day. The oil is spewing up under its own pressure, pressure so strong even the industry's best engineers can't tame it.  This has been going on for two months and looks like it will be going on for a considerable time yet.  We need this stuff.  Trouble is we need it in tankers, not the ocean.

Although ATPG had no part in the disaster it will surely be affected by drilling moratoriums and inevitable  increased regulations. Recently a 6 month moratorium was put on deep water drilling.  Louisiana wants it lifted sooner. Those who know how government operates say it will be a year or more before it is suspended. Markets hate uncertainty.

In a press release on June 4 (see release here in its entirety) ATPG provides an update on how the company is affected by the drilling moratorium.  Two wells at the Telemark Hub and one natural gas well at the Canyon Express Hub originally scheduled for 2010 will have completion and production pushed back to 2011.

The company sold $1.5 billion senior secured second lien notes in April.  Most was used to refinance debt with approximately $131 million to increase liquidity.  Capital Expenses of between 50 to 100 million will be saved due to the suspension of the three wells while moratorium costs are estimated at under $30 million.  ATPG has show resilience in managing debt in the past, having gotten through low oil and stock prices in early 2009.

Right now anti drilling fever is at a peak as oil executives are grilled by Congress on TV.  Oil prices are low due to dollar strength.  The anti drilling chorus will probably decrease over time, especially as Americans see increasing gasoline prices due to supply curtailment.  Considering the unaddressed deficit situation situation in the U.S. will probably drive the U.S. dollar considerably lower over time.  These longer term trends will work to the advantage of ATPG.

ATPG has done well.  In 2009 it replaced 376% of production with new reserves.  The company claims to have a 98% success rate in bring production from fields.  ATPG does not do exploring, rather they purchase properties with proven reserves, then bring them into production 

Oil prices appear to be heading up long term (but possibly down in the short term due to recessionary factors).  The moratorium on drilling will be removed eventually.  Uncertainty and risk?  Yes!  But the potential for large  price increases in ATPG stock while the downside is limited.  My advice wait for a big down day in the price of oil then buy!

The roller coaster ride isn't over.  If you want to buy I recommend the dips (big ones), then be prepared to bail at the peaks.  Its kind of like Six Flags and Las Vegas combined.

A Lot to Lose

The immensity of the unfolding disaster in the Gulf of Mexico is only now beginning to sink in.  Wildly varying estimates show as  much as 200,000 barrels of crude oil a day into the ocean.  We are in an early stage of an unprecedented environmental disaster.

The St. Petersburg Times' Headline of Sunday May 2 says it all: "A Lot to Lose".  Once the oil hits the Gulf Stream is will be dispersed from off the  Louisiana, Mississippi, and Alabama coasts to around Florida, up the U.S. east coast, then across the Atlantic toward Great Britain and Europe.  One can only speculate on the detromental effects on fish, shrimp, birds and shell fish.  We can only hope for the best.

Don't own BP stock? Think this doesn't affect you?  Think again!  Florida's pristine sand beaches, the price of seafood, the birds, the sea turtles will all suffer.  And then there is this: You better believe that everyone who drives will be paying more for gas because of this catastrophe.  Sarah Palin's "drill baby drill" image and Rush Limbaugh's "Eco-Nazi" rants are about to get a long over due dose of reality.

Suddenly the Gulf of Mexico (GOM), one of the two bright spots (the other is North Dakota) in U.S. oil production, has dimmed.  Oil production has been growing in the GOM recently.  Now, with new drilling temporarily halted, that trend may reverse.  New drilling is needed to replace depleting old fields. Caution and additional safety measures, which may or may not work to prevent this type of catastrophy, will drive costs up.

Since the U.S. absolutely needs oil economic considerations will eventually prevail and drilling will continue.  We will  pay for it not only at the pump but in diminished quality of fisheries and beaches.

Who to blame?  BP, who operated  the now sunken rig?  Transocean (RIG) who owns the rig? Cameron (CAM) who apparently made the malfunctioning blow out protectors?   Alan Von Altendorf, who is well versed in the field, forecasts costs to BP of $10 billion, RIG $1 billion. You can read his article here.  STO, and HAL are also impacted. You can bet legions of attorneys will be arguing this one for a long time.  They are all already dropping the ambulances and flocking to the Gulf coast billions of dollars beckon.

And this is how it always seems to play out doesn't it.  The road to peak oil is not a smooth slow upward trend.  Rather it goes in forward and back in jolts.  We are now seeing a jolt up, it is never a simple trend.  A full blown global crisis (markets are wildly down as I write this) may again drive oil prices dramatically down.  In the long run supply/demand issues and global fiat money printing will win out and drive oil prices much higher though.

Back in the 1960's we lived with the environmental illusions that as long as we picked up our litter, didn't carve initials in trees, followed Smokey the Bear's admonishments about disposing of cigarettes butts, and ate government recommended three square meals a day, all would be well forever.

Now thick oil on our beaches, hardwood trees dying by the thousands across the U.S. Midwest from exotic insects and fungi,  and 62% of Americans overweight or obese shows us just how delusional we have been.

_______________________________________________________________________

BP is said to be in panic mode, turning to its competior Exxon for help.  Just what can you do when the shutoff valves a mile deep don't work and before your very eyes you watch.



Non peak oil people can point to the gushing oil and say: "See, we told you so" the oil is there we just need to harvest it correctly.  And of course they are right, all or the above.

But it just takes one error, one uncontrollable factor to threaten and potentially destroy so much as we are now finding out.

The good life goes on and on and then suddenly, it doesn't.


But yet once you drop the simple explanation you see no one ever gets it exactly right when it comes to the future.  Pollyannish claims of American ingenuity and omnipotence  keeping us happily . . . .  But this has already failed.  We continue

Revised uninsured liability forecast:
BP: $6 billion clean-up, $1 billion litigation, $3 billion compensation, $4 billion lost revenue
RIG: $500 million legal expense, $500 million lost revenue
CAM: $100 million legal expense
HAL: $300 million legal expense
STO: $2 billlion lost revenue Norwegian offshore drilling moratorium

With three miles of rock and a mile of ocean overlay extreme pressure can build in deep wateroil and gas deposits.  Blow-out protectors are supposed to control these high high pressure surges but all it takes is error either human or mechanical and a disaster can result as we are finding out.

Bang! Zoom! Straight to the Moon!

On hearing the latest jobs report Larry Summers told the Financial Times "we are now moving toward escape velocity."  The Great Recession is rapidly receding in the rear-view window.  Whether we reach the moon, fall out of orbit, or end up lost in space remains to be seen though.  "One of these Days America . . . " yes, we will find out.

After the bang of money creation we are zooming.  Stocks are up 70% in a year, gold, federal debt, interest rates, all seem to be nearing "escape velocity".  The boosters have ignited, the rockets are thundering, and off we go, pushing rapidly into the deep black depths (or is it debts) of space.

163,000 people found jobs last month, 48,000 of them as census counters.  Bill Bonner comments "If you could create wealth by having people count one another, perhaps we could create even more wealth by having them count the stars in the heavens." Put em to work in  Montana, no light pollution.

Alice never did get the ". . . Pow! Right in the Kisser!".  Let's hope Larry Summers is so kind.

Note: The "Bang! Zoom! . . .", "One of these days ...", and "Pow! Right in the Kisser!" phrases are paraphrased from "The Honeymooners", a 1955 TV sitcom starring Jackie Gleason as Ralph and Audrey Meadows as Alice.   I took the liberty of substituting "America" for "Alice".

The Coming Boom in Oil Service

With a deafening roar the greenish black gunk spewed 150 feet into the air, drenching men and machinery alike. Welcome to east Texas in 1901. The Spindletop oil discovery produced some 100,000 barrels/day (they expected 5), more oil than anyone knew what to do with at that time. The gusher heralded the start of the great east Texas oil boom. By 1903 the price of a barrel of oil was 3 cents.

But 1901 is so very long ago. Oil is now $80/barrel, gasoline $2.80/gallon, and both are heading up. A voracious, continually growing, worldwide fleet of 600 million plus vehicles, each suck up their quota every day with no end in sight. Oil companies drill through miles of rock and salt, often under thousands of feet of sea water, all doing so in a desperate attempt to find more of the elusive black stuff.

Now, in 2009, the easy pickings are mostly gone. Salt domes like Spindletop are tapped dry (Spindletop itself quit producing in the 1930's). Lots of hydrocarbons remain in the earth, but they are increasingly difficult to extract. Consider:

The U.S. (lower 48): Texas produces more oil than any other U.S. state but production peaked at 3.5 million barrels/day in the early 1970's. Now, Texas production is below 1 million barrels/day and steadily dropping. With the exception of North Dakota and the Gulf of Mexico, the same is true for the rest of the U.S.

Alaska: Prudhoe Bay, the largest oil field in North America, has produced some 13 billion barrels since 1977. BP plc estimated that as of August 2006 only some 2 billion barrels of recoverable oil was left in Prudhoe Bay.

Canada: Canada is the U.S.'s largest oil supplier. I covered Canadian oil production in a previous SA article. It covered the same scenario: conventional oil production is in decline. Potential exists in oil sands and shale, but environmental issues cloud the promise.

Mexico: The woes of Cantarell, one time the second fastest producing oil field in the world (behind Saudi Arabia's Ghawar), are legendary. Production peaked at 2.1 million barrels/day in 2003, and by 2009 it was at 774 thousand barrels/day and falling rapidly. Schlumberger (SLB) is now working with Pemex to slow the decline in Mexican production.
An interesting aside: It is thought that Cantarell exists only because of an asteroid strike some 65 million years ago (the same one that wiped out the dinosaurs). The strike created a large rubble field deep in the earth with good porosity in which oil collected.
The North Sea: North Sea oil production peaked in 1999 and A Wall Street Journal article on January 13, 2010, said about North Sea fields:

... oil and gas fields are in steep decline and nearing the end of their production lives.

The Middle East: The Middle East, especially Saudi Arabia, is somewhat of an unknown. The Saudis, currently pumping 8 million barrels per day, claim to have 4 million barrels per day of spare capacity. But, can you believe the notoriously secretive kingdom? Even assuming the Saudis are right, a worldwide economic resurgence could easily absorb this extra capacity. Ghawar, Saudi Arabia's, and the world's, largest oil field, needs increasingly large water injections to keep the oil flowing. Among other Middle Eastern states only Iraq may be able to ramp up production (and then only if it is able to keep the violence under control).

There is always the risk of geopolitical issues flaring up in the Middle East. Currently, things are relatively calm, and we have $80/barrel oil. Iranian Shiites have aspirations on Sunni oil, Al Qaeda is still around, and Israeli/Arab issues go unresolved. If any of the above flare up you can say goodbye to $80 oil - I don't need to tell you which direction it will go.

Elsewhere: Brazil, Russia, Africa, Indonesia, Venezuela are all large oil producers. All, except Brazil, have plateauing or declining production and/or exports. Several large off shore fields have been discovered in Brazil recently, but they are miles deep in the ocean, under salt and rock.

Throw a worldwide money printing binge into the mix, as governments try to inflate away their debts, and it seems certain the dollar denominated assets such as oil must rise.

This article is not meant to prove or even argue peak oil. Rather, the point is no matter what or who is right about peak oil, it will take more and more effort (read oil service) to keep oil flowing.

The oil services sector supplies the expertise that supports the massive worldwide infrastructure continually turning raw petroleum into useful products, such as the gasoline you put into your car. Whether it be horizontal shale, deep sea basins, getting more out of older fields, transportation or refining, none of it would happen without the oil services sector.

Oil Service Companies
Schlumberger (SLB) is a dominant player, and with a market capitalization of over $75 billion, it dwarfs competitors such as Haliburton (HAL) and Baker Hughes (BHI). Schlumberger is a quality leader in almost all aspects of the oil service industry. Recent acquisitions of Smith International (SII) and Nexus Geosciences enhance expertise in drilling and seismic services. If you were to pick just one, Schlumberger would probably be the best choice.
Transocean (RIG) and Diamond Offshore (DO) specialize in offshore contract drilling, while National Oilwell Varco (NOV) is more a "nuts and bolts" type company, designing, manufacturing and selling products used for the production and transportation of petrochemicals.
Exchange Traded Funds (ETFs)

If you wish to avoid corporate risk consider oil service ETFs. Three of the larger ones are: iShares Dow Jones US Oil Equipment Index ETF (IEZ), Oil Services HOLDRs (OIH), SPDR S&P Oil and Gas Equipment Services ETF (XES).

iShares Dow Jones US Oil Equipment Index ETF

IEZ has holdings in over 40 companies and is market-cap weighted. The three largest holdings: Schlumberger, Haliburton, and National Oilwell Varco comprise almost 40% of capitalization.
Since holdings are weighed by market capitalization, IEZ keeps most of your investment in the the larger, high quality companies, yet still gives some exposure to the smaller ones.
IEZ has a market cap. of $407 million and an expense ratio of .47%.
Oil Services HOLDRs

Like IEZ, OIH is concentrated in the larger oil service area. Transocean is the top holding at 15%. There are only 16 securities in this ETF. The three largest: Transocean, Schlumberger and Haliburton total around 35% of holdings. If you are considering investing in OIH you should be aware of the unusual features of the HOLDR Merrill Lynch products. Here is a good article on how they differ from most ETFs. Since you can only invest in round lots of OIH, you will need a minimum of $12,100 more or less at current prices to invest.
OIH has a market cap. of $2.28 billion and an expense ratio of .06%. The expense ratio is low because of the unique way that it is calculated (see the above article link for an explanation).
SPDR S&P Oil and Gas Equipment Services ETF

This oil and gas equipment and services ETF holds 24 securities, but no one security comprises more than 5-6% of holdings. Smith International is currently the largest holding. Although XES has many of the same companies as IEZ and OIH, there is a greater weighting of smaller to midsize companies in XES.

XES has a market cap. of $342 million and an expense ratio of .35%.

A Cautionary Note:

If you believe a double dip recession, crash, or even signifigant market decline are on the horizon, you may wish to stay away from this volatile sector. The sector shows even more volatility than oil prices do.

Disclosure: Author long XES

On Canadian Black Gold

"A New Saudi Arabia of Oil" scream the headlines. You've seen the hype. But, how do you separate truth from headline?  Well, we do know there are staggering amounts of hydrocarbons in the western sedimentary basins of North America.  It is no coincidence that the U.S. imports more oil from Canada than any other country.  While Saudi Arabia has 264 billion barrels of oil reserves, Alberta's Athabasca oil sands alone total some 1.7 trillion barrels of hydrocarbons.

Canada's oil and gas are vital for the U.S. The quiet rolling western prairies are safe, peaceful and close. One doesn't deal with egomaniacs like Venezuela's Chavez (though some might nominate Alberta's premier Ed Stelmach), Nigeria's violent saboteurs, or bomb-toting Middle Eastern jihadists. With that in mind, let's take a closer look at the Canadian portion of these "staggering" North American reserves.

Canadian oil originates from three sources: Conventional oil, oil sands, and newly recoverable oil from "tight" strata. "tight" refers to oil (or gas) locked in low porosity/permeability formations of shale, siltstone, or sandstone.  Historically, conventional oil production has predominated.  Now, by necessity, that is changing.

Conventional Oil and Gas

Mobil Oil discovered Pembina, Canada's super-giant oil field, in 1953.  Located in the Cardium Formation, some 100 kilometers southwest of Edmonton, Alberta, Pembina still produces more conventional oil than all other Canadian fields combined, it has given up over 1.2 billion barrels of oil in its 50 year history.

Canadian conventional oil, about half of all Canadian production, is a desirable light to medium grade.  Only 17% of Pembina's conventional oil has been recovered, yet production has been declining since the 1970's. It's there, you just have to crank harder and harder to get it.

It is no secret that worldwide conventional oil production is also in decline.  Saudi Arabia, which claimed two years ago it could produce 15 million barrels per day, has yet to even come close.  Saudi production has never exceeded 10 million barrels per day, even with the $120 plus/barrel environment of 2008.  Saudi Arabia's Ghawar, the largest oil field is the world, seems to be in decline (see here).  Saudi crude is rumored to be increasingly sour, with increasing sulfur and water content.

Even in decline, Canadian conventional oil production will continue to supply oil for U.S. and Canadian markets for quite some time.  Water and carbon dioxide flooding continue to push more oil out of Pembina.  Penn West Energy Trust (PWE) is a large producer of conventional oil and gas in the Pembina area.

Oil Sands

The extensive Athabasca oil sands and other smaller oil sand fields north of Edmonton are (as noted above) estimated to hold more than 1.7 trillion barrels of hydrocarbons -- the largest petroleum resource in the world.  The catch?  Oil sand hydrocarbons are bitumen, a thick, gooey, tar-like substance.  Bitumen lies in vast beds near the surface of north-central Alberta.  Huge shovels and trucks strip off the boreal forest vegetation and surface soil to get to it after which, capital intensive processing and refining are necessary to produce gasoline and other end products.  Often more BTU's must be input than are derived.

Oil sand development raises serious environment questions. The surface forest is destroyed, leaving a barren, moon-like landscape over thousands of acres. Greenhouse gas emissions are high. The Pembina Institute has taken the lead in monitoring oil sand environmental issues.  Some people question if it will be worth the environmental, ecological and financial cost.

Alberta's oil sands currently produce approximately half of Canadian Oil, most of it is exported to the U.S.  Despite the drawbacks, declining conventional oil production and rising prices have led to increasing oil sand production in recent years.  The trend is projected to continue, provided the environmental issues can be addressed.

Many companies, both domestic and foreign, have stakes in the Canadian oil sands. Suncor (SU) and Syncrude Canada (joint venture of several oil companies) are major participants. ConocoPhillips (COP) has big plans.  Imperial Oil (IMO), Canada's large integrated oil company, has a major presence.

Tight Oil Formations and Multi-stage Fracturing

Multi-stage fracturing (MSF) is where all the excitement is now.  MSF in horizontal bores has revolutionized North American gas production and may do the same with oil.

MSF has the potential to draw billions of barrels oil from previously inaccessible tight formations.  Tight formations often contain large quantities of oil and gas but, due to low porosity and permeability, have historically been hard to get at.  MSF creates flow paths in tight strata from which oil and gas can be harvested.  By creating fractures MSF makes accessable smaller, previously uneconomical, oil and gas collections . The hydrocarbons flow into the induced fractures while proppants, such as sand, ceramic, or other particles, prevent the fractures from closing.

Candian (and U.S.) tight oil often has a very desirable gravity (API 39-45), better than Pembina conventional oil (API 37), and comparable or better than WTL (API 39.6).  Since MSF technology has significantly reduced extraction costs it may be a game changer for western Canada.

Keep in mind that tight oil production rates often decline quickly and the water component rises over time.  For now, better technology is trumping this.  Here is an excellent 2008 article on U.S. Bakken tight oil economics.  Recent technological improvements continue to point toward ever better recovery rates, with up to 24 stage MSF improving productivity.

The success of MSF in the Pembina area will probably be duplicated in other fields, potentially drawing billions of addition barrels of previously inaccessable oil from tight formations.  MSF is now being tried in over 20 Canadian formations.

The Candaian company Petrobakken's (PBKEF.PK) website claims it is ". . . primarily a pure-play, southeast Saskatchewan, light oil-focused company with targeted 2009 exit production of more than 37,000 boepd, more than 95% light oil".  Petrobaken is now also moving into Cardium light oil with its proposed acquisitions of Berens and Result Energy.

One might also consider investing in Canadian Royalty Trusts (CANROYS).   Penn West , mentioned earlier for its conventional production, also has large tight oil lands as a bonus.  Enerplus (ERF) is another CANROY which pays high distributions and has large land holdings in tight oil areas.  Some of best land potential for MSF is on the flanks of convention oil fields such as Pembina.

CANROYS have special taxing considerations so consult your tax advisor.  Also, since distributions track the price of gas and oil they can change quickly.  Both Penn West and Enerplus plan to convert to corporations in the next few years as new taxes on CANROYS take effect.

Summary

MSF has revolutionized natural gas production in the U.S and, though unheralded, North America is now self sufficient in gas.  Can MSF do the same for oil?  Can MSF make up for declining conventional oil production?  Can it make  environmental sacrifices for oil sands unnessary?  It's a tall order but recent trends are encouraging.  MSF will, at a minimum, stem and help reverse the decline in North American oil production.  U.S. oil production, for the first time in 30 years, is now up (see my earlier article here).

Don't underestimate geopolitical considerations.  Declining exports from both Mexico and Venezuela make Canadian deposits even more valuable for the U.S.  Western Canada (and U.S.) are as safe an oil and gas investment as you can find now-a-days. A major flare up in the Middle East will send Canadian and U.S. oil and gas companies stocks soaring.

You have a choice of income paying CANROYs with large land holdings, established integrated companies such as Imperial Oil, or new exciting tight oil plays such as Petrobakken.

Thanks to "The Big Fat Greek Crisis" the US dollar is now strengthening against all risk currencies including the Canadian dollar.  This is driving commodity and natural resource company prices down so the coming weeks may present an excellent entry point into Canadian oil companies.  Do your own research.

Tags: SU, COP, IMO, PBKEF.PK, PWE, ERF