It was a violent day for oil once again. Oil prices fell to near $36 a barrel on the NYMEX setting a new low point for 2008. Of course, many are still betting on a rebound in oil prices.

Goldman Sachs calls for $30 oil due to “weak underlying economic fundamentals”. Yet still says it expects oil to average $45 a barrel this year and close out 2009 at $65 a barrel. Merrill Lynch is expecting oil to average $50 a barrel and average $70 in 2010.

Everything from between $20 a barrel to $100 a barrel has been thrown out there lately. A lot of pundits cite the cost of production of a barrel of oil at $60 a barrel and anything less than that is “unsustainable” (we’ll take a look at why this propaganda gem is very misleading).

Oil is volatile and the volatility is causing a lot of uncertainty. But the question remains, how low can oil really go and how long can it stay there? As usual, it all comes down to fundamentals.

It’s Supply and Demand

On the demand side, the U.S. Energy Information Administration’s (EIA) latest Short-Term Energy Outlook stated U.S. oil consumption to fell 5.7% in 2008. The EIA went on to predict oil consumption will continue to fall in 2009 by 2.0% and expects a modest uptick of 0.8% in 2009 (view chart).

Those are pretty rosy predictions considering the EIA is expecting a 0.6% increase in GDP this year and3.0% in 2010.

It’s not just the U.S. though. The entire world is suffering through this downturn and oil demand is dropping by the month. The EIA lowered its 2009 forecast for global oil consumption to decline by 800,000 barrels per day (bpd) in 2009. That’s 400,000 bpd lower than its December estimate and shows this forecast could fall even further.

We all know the demand side of the equation will get pinched - global recession, financial crisis, etc. It’s the supply side which the market is reacting to now.

OPEC: Takes Credit Sometimes, Works None of the Time

As oil prices slide, we’d expect production to drop as well. Adam Smith’s “invisible hand” would naturally go to work, right?

It has, to a point. OPEC, has announced cutback of more than 4 million bpd. Despite OPEC’s relative ineffectiveness (combination of the OPEC cartel’s inability to move quickly and inability to prop prices up), Saudi Arabia has confirmed they cut production by 300,000 barrels a day. So far other members have stuck to the OPEC quotas – more or less.

Meanwhile, U.S. domestic oil production is increasing rapidly. In fact, domestic oil production will probably increase in 2009 for the first time since 1991. Domestic production is expected to increase 300,000 bpd to 5.25 million bpd - a 6% increase. Domestic oil production will likely increase again in 2009 by another 50,000 barrels.

All of this production coming on line is what has so many oil traders concerned. The groundwork for this growth was actually laid years ago.

Remember when Hurricane Katrina knocked out all of those oil rigs? Well, here we are two years later, and they’re coming back on line. For instance, BP’s (NYSE:BP) Thunder Horse platform is on line and started producing 200,000 bpd a few weeks ago. BP expects Thunder Horse to further increase its production in 2009.

It took a few years, but the oil industry is reaching the final stages of recovery from Katrina.

The Marginal Cost of Production

The final thing is the cost of production. After all, when the cost of production is below the market price for any commodity, it’s usually a good time to buy (i.e. uranium at $7 per pound in the 90’s while production costs were $15 to $20 a pound).

So if the cost of production of every new barrel of production is $65 a barrel, it would have to go up. Oil would be an easy win from here, right?

Not exactly. At the peak the world was consuming between 85 and 86 million bpd. That included the Canadian oil sands projects (whose cost of production is between $60 and $80 depending largely on natural gas prices) and marginal, deepwater offshore projects where the cost of finding and producing a barrel of oil can run as high as $60.

But hey, those are the marginal oil producers. They are needed for the 85 and 86 millionth bpd of oil. The costs are much, much lower to produce the 80 millionth bpd.

The costs of production for the two main sources of U.S. oil are still very, very low. As of 2006 the costs of production were about $25 per barrel of foreign oil (remember Saudi Arabia can still produce at around $2 to $3 a barrel) and just under $20 per barrel for U.S. onshore oil.

Remember when oil was down around $10 a barrel in the late 90’s? The world oil consumption was only about 75 million bpd and Exxon and the oil majors were still profitable at that time, although much less so.

Where to From Here

My take on oil remains the same as it was in “A Slippery Slope Ahead for Oil”:

I just can’t think of many good reasons to buy oil or oil stocks right now. Massive stockpiles are building up. The oil production projects made during the oil bubble are still in place. Oil demand continues to drop as, for the first time in decades, Japan, Europe, and North America will all be in a recession at the same time.

The only real reason to go “all in” on oil stocks now is if you expect a sudden rebound in the global economy or expect Wall Street to take the long-term view. I wouldn’t bet on either happening anytime soon.

In the past few months we watched OPEC cut its production faster than any other time in history, Russia engage Ukraine in the latest round of “Gas Wars”, a cold December in the Northeastern U.S., and Israel take a hard line offensive against Hamas. Despite it all, oil prices fell by more than 20%.

The chances of a “V” forming in the oil price chart ahead are very slim. And with every mortgage which falls “under water”, each mall shop that shuts its doors, every Chinese factory which closes down, and each dollar that is taken away from a profitable business to give to a hopelessly unprofitable, the odds get lower and lower.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

It seems like it’s been years since CNN Money opined, “Who needs Google and Apple? Agriculture companies are the new ‘it’ stocks.” But it was just six months ago.

Since then agriculture stocks turned shooting stars to exploding supernovas. Leading the way down has been fertilizer stocks. Shares of former Wall Street and momentum chasing hedge fund darlings Potash Corp (POT:NYSE), Mosaic (MOS:NYSE), CF Industries (NYSE:CF), and Agrium (AGU:NYSE) have led the way down. And practically all of them have cut their production for 2009.

The sell-off has come from deleveraging hedge funds, mutual funds selling to meet redemptions, and the market realizing not all fertilizer companies are created equal. Meanwhile, the long-term outlook for fertilizer hasn’t changed much at all. Global demand for food will rise again, we’ve hit Peak Soil and most of the world’s arable is already utilized, and global soil qualities are in decline. Basically, farmers have to produce more from less and the only near-term solution is fertilizer.

So with the waters calming down a bit, fertilizer stocks are looking pretty good once again.

The Bottom Up

From a bottom up perspective, fertilizer stocks have remained very cheap relative to earnings. The forward P/E ratios are in single-digits across the board in fertilizer stocks. The worst is mostly priced in, although probably not completely.

A couple of weeks ago, a negative report on fertilizer from Goldman Sachs sent fertilizer stocks plummeting. Goldman’s Robert court stated, “U.S. farmers may plant 85 million acres of corn next year, down 2 million acres from this year and 5 million less than Goldman’s previousestimate.”

Just a week before that though, Merrill Lynch raised its rating on all the major fertilizer stocks to “buy.” Merrill cited solid long-term fundamentals and “attractive acquisition opportunities.”

One says buy, the other says sell…no help there (as usual). We can glean from the conflicting opinions, however, that fertilizer stocks are priced for an OK year. Sentiment is split. Some are expecting bad, others good. So we have to ask will it really be an OK year for fertilizer?

Well…if we look at fertilizer prices from a top down perspective, we’ve got some very solid potential for some and much less so for others.

The Top Down

When choosing fertilizer stocks though, you’ve got to look at each individual type of fertilizer. They all have different product mixes. The mix can make a big difference in the bottom line. For instance, nitrogen and phosphate prices have fallen off a cliff just like most other commodities. Meanwhile, potash prices have held up very well.

Nitrogen – Corn production requires a lot of nitrogen. Nearly 45% of all nitrogen fertilizer is used for corn. As a result, nitrogen prices are highly correlated to corn prices and demand for nitrogen moves in lockstep with corn plantings. So when corn demand for food, livestock feed, and ethanol is on the downswing, nitrogen demand will go right down with it.

A recent article in the Grant Tribune Sentinel (out of Grant, Nebraska – I find the local papers in the corn belt to be far superior to the big Wall Street researchers when it comes to fertilizer) says it best, “Demand for ethanol has declined with the drastically decreased crude oil and gas prices. Late harvest, high prices and wet soils limited corn belt nitrogen application this fall to about 50 percent of normal.”

That’s why nitrogen prices have tumbled and why the shares of nitrogen fertilizer producers have tumbled. The same paper goes on to say, “Barge traffic up the Mississippi is closed for winter, storage is full, and there are tanker ships sitting off Tampa full of ammonia that is being offered for less than $200 [per tonne], but there are no buyers and no place to move it.”

Prices down, no buyers at any price, tanker ships full of the stuff just waiting? Sounds like when oil prices were setting new lows. Of course, all this is a sign nitrogen prices are bottoming out.

Phosphorus – Phosphate prices have collapsed as well. They’ve fallen faster than nitrogen and global production continues to get cut back.

Last summer, when phosphate prices went parabolic, China started taxing all exports to keep as much of it in the country as possible. Last month, China dropped the export tax. That leads me to believe they have plenty of supply…probably too much.

The problem with phosphates is that extra supply isn’t going to get soaked up by the rest of the world either. Phosphate producers in Europe and North America have all announced sharp cuts in output.

Potash – From an investor’s perspective, potash is a much safer bet than phosphate and nitrogen. Potash is protected by a virtual monopoly. Canpotex (a consortium owned by Agrium, Potash Corp, and Mosaic) and BPC (Belarusian Potash and Uralkaly (URALY.PK)) together control 70% of the world’s potash exports. That’s a big reason why potash prices have held up. The latest reported price from November was $872.50 per tonne in Vancouver.

The other reason is the capital costs and time required to start a potash mine. It costs between $1.5 and $2.5 billion (heavily dependent on commodity prices) and 5-7 years to open a new potash mine. That’s why no new potash mines have gone into production despite the tripling of potash prices over the past few years.

That’s also why potash prices aren’t nearly as volatile and fertilizer producers which produce potash offer an added layer of safety.

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At the end of the day it comes down to valuation, right now, we’re at the lower end of the range for fertilizer stocks.

As I said before, fertilizer stocks are priced for an “OK” year. And with fertilizer prices so low, less than stellar expectations are justified. The potash fertilizer producers, however, will likely have another “better than OK” year and that’s why I recommend sticking to them.

Barring a global depression, shares of potash producers (i.e. Potash Corp, Intrepid, Mosaic)will be some of the top performing stocks over the next five years or so until new potash production comes on line. The “reset” button has been pressed on the agriculture boom and the next year or two should provide plenty of opportunities to buy when expectations are low and the valuations are cheap. Right now, expectations are pretty low.

China’s worst fears are starting to be realized. The manufacturing jobs which have brought opportunity to 150 million migrant workers are disappearing very quickly. And riots (or “mass incidents” as Chinese authorities have termed them) are starting to become more common.

Over the past couple of weeks, the frequency of reported riots has increased. A month ago, government officials would arrive at factories with suitcases full of cash and pass it out to workers after the workers were told the factory will be shutting down.

In Guangdong 2,000 workers surrounded government buildings to demand severance pay from the government after the factories they worked at had been shut down.

In Zhongtan 19 arrests were made as 500 protesting workers destroyed five police cars while looting and vandalizing their former places of work. Meanwhile, 1,500 onlookers (passive supporters) who also lost their jobs simply watched the bedlam.

There are dozens more similar riots and Chinese authorities are starting to see how bad China’s manufacturing sector is going to get hit.

As we’ve been watching for a while, China’s manufacturing crisis is continuing to worsen. A month ago, Cao Jianhai, a researcher at the Chinese Academy of Social Sciences, stated, “By the year's end more than 100,000 plants will have closed”.

But now conditions are deteriorating more quickly than expected. About 65,000 toy factories have been shut down so far during this downturn. That’s just toys. Once you add in all the other factory shutdowns, China is already at or near the previous expected closings of 100,000 factories.

It’s Going to Get Worse before it Gets Better

Most of the downturn has already been priced into Chinese shares. The market is down about 70% from its highs of a year and a half ago, but it’s getting worse.

A few hours ago, China released the latest reading of its Purchasing Managers Index. The index, which tracks manufacturing activity, plummeted to 38.8. That’s down from a previous low of 44.6 in October. Since a reading below 50 means manufacturing is contracting, China’s manufacturing has contracted for four straight months.

Despite it all, China’s economy still grew at a 9% clip in Q3. That’s quickly starting to change. China’s economy, which really needs 6%-7% growth to sustain its “built for growth” economy, is watching growth decline quickly.

J.P. Morgan recently stated it expects China’s GDP growth could drop to a 4% annualized rate in the fourth quarter of this year. That’s not just going to keep China’s economy growing to its still adolescent economy which requires a lot of capital spending to grow.

The Bigger Picture

In the latest issue of the Prosperity Dispatch we took a hard look at the structure of China’s economy. We determined:

About 39% of China’s GDP is capital spending. That means a huge portion of China’s economy is building new factories, steel mills, mines, etc.

With the economy slowing down, you really can’t justify building a new factory while 10 others are getting shut down. Economies just don’t work like that.

That’s the bigger risk here. China’s economy is built perfectly for booms, but it will face a lot of trouble as more and more factories get shut down. Exports are a big part of the economy, but building the factories necessary to produce more and the housing needed to house the workers is an even bigger part of the economy.

The implications of further meltdown in China will be felt in many sectors in the rest of the world, namely oil and other commodities used to build infrastructure and production capital.

So far the oil markets have been propped up by hopes of a fairly quick recovery in emerging markets. Copper, cement, iron ore, and plenty of other commodities have experienced fairly significant price drops as well, but there’s a very real risk they could go down even further.

We’ve watched a few mining stocks revert back to 2002 prices in “Mining Stocks: How Low Can They Go” back in October. As the hopes of a quick recovery or a greater degree of immunity from the global slowdown for China fade away, there could be a good bit more downside ahead for the oil and other commodity-related stocks which have held up well.

For the time being, the world is waiting to see the impact of the $585 billion spending plan announced last month and other expansionary monetary policy changes made in the past month. But if no positive effect starts to show up, there is a lot more room to fall.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

Full Disclosure: Author is currently long Ultrashort Xinhua/FTSE China 25 (NYSE:FXP) and Horizons Betapro S&P/TSX Global Mining Bear Plus ETF (TSX:HMD)

Almost every day, the U.S. government releases some new tidbit of economic data. It never fails there is always someone out there to question the validity of it. They say how manipulated or plain wrong the data may be. In most cases, the scrutiny is certainly justified.

There, however, seems to be no scrutiny of the occasional bit of economic data released from China. And the “next thing to go wrong” could very well be in China.

China’s $585 billion bailout sparked a renewed sense of confidence which will likely be short-lived. After all, that’s about 17% of China’s GDP (the equivalent in the U.S. would be more than a $2 trillion stimulus package).

The markets were quite excited with the spending plan (although not much different from what the world was expecting the country to do anyways). However, the excitement is probably not going to last.

China’s current economy is built for boom times. As a result, when times are good for the world, they’re great for China. When times are bad for the world, it’ll get downright ugly in China.

That’s why China has taken very drastic measures to ensure the economy keeps growing. Earlier today, the country announced its biggest interest rate cut in 11 years. The 1.08% cut was a big one, but it was the fourth interest rate cut in the past three months.

Remember back in February when the Fed slashed interest rates by 1.25% in about a month’s time? The impact was quite limited. It was too little, too late. Now, China is playing catch up. But aggressive rate cuts will probably end up being another case of too little, too late.

Of course, those are just short-term interest rates which take a while to work their way through the economy.

China, however, made an even more aggressive move today when it cut the reserve requirement for its banks. Before today, China’s reserve requirement for all banks was 16.5%. Starting December 5^th, the reserve requirement will be 15.5% for larger banks and 14.5% for smaller banks.

I consider this the most drastic move of all. The multiplier effect of reducing bank reserve requirements can have a truly massive impact on money supply. Just a simple 1% or 2% tweak will be multiplied many times over in new money created by a fractional reserve lending system.

Clearly, China is facing drastic times. So far though, they’re being met with drastic measures. But there’s a very real risk that these measures  might not be enough.

The cracks in China’s economic engine have already started to show. Massive amounts of factory shutdowns (and the accompanying rioting Chinese factory workers) are just the start. Unemployment is on the rise and the World Bank has lowered its estimates for China GDP growth to 9% and 7.5% in 2008 and 2009, respectively.

From a medium and long-term perspective, China stocks are as cheap as they have been in a long while. The country needs a lot of infrastructure (roads, bridges, water distribution systems, etc.)and has the money to spend. Most importantly though, it has a work force made up of people willing to work. That’s probably going to be the big difference-maker over the long run. Factory workers who can (and are willing) to make the move from making steel to build roads are key to a successful economy.

But there are potential structural issues that could easily spell more short-term pain for the economy that has been built to thrive off very high growth. Basically, China is highly leveraged to the world economy. It has a massive capital base of steel mills, mines, and factories. Those are all highly cyclical industries.

Also, 37% of China’s GDP is comes from exports which are already in decline. And 37% of China’s economy is used to build stuff to build more stuff. For instance, a big part of China’s economic growth came from building factories and machinery to build more things. That’s where the big problem lies. You can be building new toy factories while other ones are being shut down.

All that is why I there are still a lot of risks left in China most investors just haven’t considered yet. As unemployment continues to rise in the U.S. and the rest of the high-consumption, importing western world and consumers watch their dollars more closely, China’s economy will be going through a lot very rough patches.

So far, the Chinese government has been able to keep confidence high, but the country’s actions show the structural issues of the economy may be far bigger than most investors are expecting.

There are still a lot of reasons to like China. There are, however, a lot more reasons to be very skeptical of China’s near-term prospects.  That’s why it’s best to continue to take a very conservative investing approach when buying shares in Chinese companies and ensure you’re still in position to pick up more shares in the likely case these truly historic economic stimulation efforts don’t pan out as well as the market is currently expecting.

Good investing,

Andrew Mickey,
Chief Investment Strategist, Q1 Publishing

By now it’s clear a global recession at hand. China announced its plans to stay the course, the Obama rally has passed, and the U.S. consumer has decided to cut back. We’re in a bear market and the highly cyclical commodity stocks have led the way down.

Is there more downside to come in commodities? Have we finally hit rock bottom? These are a few questions I posted a few weeks ago in “How Low Can Mining Stocks Go?”

The answer at the time was pretty much summed up with:

“I realize most of these mining stocks are at the lowest prices they’ve been in a couple of years. But considering the overcapacity in the automotive industry, sharp fall-off of industrial production and the unknown impact of a global slowdown on base metal prices, there could be even more downside to come.”

Since then, the slide has continued. Even the worst case scenario (reversion to 2002 prices) has hit a few mining industry leaders. For instance, Teck Cominco (NYSE:TCK) shares have gotten absolutely pummeled thanks in large part to the economics of its leveraged buyout of Fording Canadian Coal (TSX:FDG-UN). Currently shares of the embattled mining company are below 2002 price levels.

Teck Cominco isn’t the only mining company that has paid a big price, Southern Copper (NYSE:PCU) has hit the “worst case scenario” price levels. As copper prices continue to slide (today down below $1.60 per pound), Southern Copper shares are sliding right down with it. Today shares fell another 12% down to just over $10 per share. This new low is actually lower than you could have bought shares for in 2002.

Considering it happened to these two major mining companies, there’s nothing stopping it from happening to others. For any investor that decided to just wait it out through commodities’ cyclical downturn, the risk of a lot more pain coming is very real as you can see in the chart below:

As you can see, many of the base metal mining companies’ shares have fared the worst. As aside from the two that have already fallen below 2002 prices, there are plenty that appear to be on their way.

Of course, it makes a lot more sense now. If the stock market can return to its 2002 lows, unemployment could go back to 2002 lows, and it’s looking like world GDP has a shot at falling back to its 2002 total, then everything else could too.

Oil and gold have managed to avoid a big part of the reversion. However, as the table points out, if the whole world is flashing back to 2002 price levels, there could be a lot more danger in holding stocks in the oil and gold sectors.

Mining companies are continuing to get prepared for 2002 base metal prices by closing up even more mines.

Preparing for the Worst

In the past two weeks, the flood of mines which will be closed for “care and maintenance” continued to increase.

Consolidated Minerals in Australia announced it will be closing its nickel mine and downsizing its chromite mine “due to deteriorating market conditions and the uncertain outlook for our product.” Chromite and nickel are primarily used in the manufacturing of stainless steel.

Also in Australia, CBH Resources (ASX:CBH) cited an “extremely difficult” 2008 as the primary reason for announcing it is one step away from putting its substantial zinc mine, Endeavour, on care and maintenance.

The problems aren’t just in Australian mines which were leading exporters to China and other quickly growing Asian countries. There are plenty of mines in North America headed for care and maintenance.

First Nickel (TSX:FNI) announced it will be shutting down its nickel mine in Sudbury, Ontario. Also, St. Andrew Goldfields stated it is

All these announcements came in just the past two weeks. And given the state of the commodity markets with high risk of more downside and limited near-term upside potential, we’re almost certain to see more mine shutdowns in the weeks and months ahead. The impact of mine closings can be disastrous to many of the smaller companies. Many of the share values of the companies mentioned about have fallen more than 90% from their highs.

The Risk/Reward of Mining Stocks Now

It still blows my mind how many people are expecting ongoing demand from China to keep base metals prices propped up. Yes, China is going to continue to build new infrastructure, buildings, sewage systems, etc. and will need a lot of base metals. China, however, is not going to be doing it fast enough to offset the decline in demand for base metals in other parts of the world.

With each passing day, it seems like we’re headed for a very long economic downturn. There is still a lot of oversupply and low-grade mining operations are going to be the first ones to get shut down. Mining companies are forced to survive and the major mining companies, although not in a great spot, are in a much better position to weather the storm. 

It’s a deflationary environment and there’s no reason to buy anything today…especially many of the base metal mining stocks. Even contrarians looking to buy at or near the bottom should buy using an extremely conservative investment strategy. But for me, it’s still too early. The risk/reward situation is getting better, but it’s still not that great considering we’re still in the down part of an economic cycle.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

Disclosure: I have no interest in any of the shares mentioned.