Oil Price Ready to Bounce?

Markets were all over the shop again last night. By the end of trading though, stocks were only down slightly, thanks largely to more ‘Fed speak’. Regional governor James Bullard said the Fed should continue buying assets beyond October. What a surprise!

Thankfully, this guy is a non-voting member, and apart from a few trigger happy traders, most people will ignore him. If the Fed turned around now and said they’re going to start QE again, just as soon as they finished it, they’d become a laughing stock.

Remember, this whole game is one massive con. It’s about making everyone (or nearly everyone) believe that the Fed knows what it’s doing. It doesn’t; it has no idea. But the market still believes that it does.

These next few months will go a long way in telling you whether the market’s perception of the Fed remains intact, or whether there is an increasing awareness of the con game. This means the Fed will need to handle the end of QE with extreme caution.

Turning on the liquidity taps almost as soon as QE ends would be a bad move in terms of maintaining confidence. With government bond yields already extremely low, how much more would QE really help ‘to lower interest rates and encourage borrowing’? Not much at all.

No, if they pulled the QE card out again, it would become blindingly obvious to everyone that the Fed’s only strategy is to inject liquidity to make the market go up, in the vain hope that a rising market will drag the economy with it.

Clearly, this is a dumb strategy, and people would start to see through it. (Why they haven’t already is beyond me, but the mainstream press reports so earnestly about the Fed’s attempts to ‘revive’ the economy that it seems to have hoodwinked everyone.)

So don’t expect anything more than words just yet. It’s all the Fed really has. More than likely, they’ll put it up with further market falls before they entertain QE IV.

While global markets are trying to stabilise around here, oil continues to sell off. In the chart below you can see the performance of Brent crude over the past six months. The price dropped dramatically in the past few trading sessions as volumes (which you can see at the bottom of the chart) jumped higher.

This suggests a bit of capitulation selling, where traders try to get out at any price. Also note that the ‘relative strength index’ at the top of the chart is deeply oversold. This tells you the short term selling pressure is extreme.

It’s also telling you to prepare for a bounce over the next week or so. Should this happen, you’re going to see plenty of oil stocks rally sharply, given that many have suffered steep falls in recent months.

Oil — due for a bounce?

In a case of exquisite timing, my colleague over at Diggers and Drillers, Jason Stevenson, is just about to release some research on some ‘wildcat’ Australian oil plays.

Get the timing right and you could make some big gains when the bounce in the oil price comes. But this sort of investment is not for the faint-hearted; it’s high risk, high reward stuff. If you’re interested, Jason’s new research will hit your inbox tomorrow. Keep your eye out for it.

While oil is very close to a short-term bottom, what about iron ore?

Earlier this week, the Fairfax business paper Business Day proclaimed (on its front page) the bottom was in for iron ore. They based the claim on sharp share price gains from the iron ore miners the previous day and some bullish comments from prominent market commentators.

Fair enough…but here’s a tip for you. Whenever a mainstream business publication splashes a headline saying the bottom is in, you can bet that it isn’t anywhere near it. The bottom for iron ore will be in when the financial dailies are handwringing about how low prices can go…when the juniors have gone bust and when Fortescue doesn’t have a market capitalisation of $10.5 billion.

We’re nowhere near that point.

Yesterday, Fortescue [ASX:FMG] announced third quarter production. Like Rio and BHP, they’re also ramping up production. In the three months to September, FMG produced at an annual rate of 166 million tonnes. That’s a 60% increase on last year.

The problem is, Fortescue are only just keeping their head above water. While the benchmark average iron ore price for the quarter was US$90/tonne, FMG only received an average of $71/tonne for their product. That’s because their ore is lower quality than the benchmark. But still, a 21% discount is massive.

Given the benchmark price is well below the US$90/tonne average achieved for the September quarter, the pressure continues on FMG. They expect the discount they receive for their ore to narrow in the future, but with BHP and Rio churning out additional volumes of high quality product, they may be disappointed.

If the iron ore price falls into the low $70/tonne region, and the Aussie dollar hovers around or just under US$0.90, then FMG will struggle to break even. When you’ve got net debt of US$6.9 billion, that’s not a pleasant development.

Keep in mind that despite the sharp decline in FMG’s share price this year, the market still values it at around $10.5 billion. If the iron ore price decline continues into 2015, which I expect it will, and FMG starts bleeding cash, the share price has much further to fall.

Yet, when I look at Thomson/Reuters consensus analyst estimates, out of 23 analysts covering the stock, there is only one sell recommendation and three underperforms. Meanwhile, there are still four buy recommendations and seven outperforms!

In other words, there are still plenty of people out there punting that this is the bottom. From a short term perspective, that may be worth a bet. But lasting bottoms don’t form when the majority of people are thinking the same thing.

They form when no one cares anymore. With memories of the 2008 to 2013 price boom still fresh, there are plenty who still care about iron ore.

Which is why gold looks pretty interesting here. No one seems to care about it anymore. And Business Day or the Financial Review certainly didn’t declare a bottom last week when gold bounced for the third time off its lows.

So keep an eye on it…it might just continue to go up from here.

Have a great weekend…


Greg Canavan+
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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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