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Richard Russell on Oil

Richard Russell
Dow Theory Letters
September 27th, 2005

I want to start with the chart below on oil. After its recent rise, oil has formed the potential "head-and-shoulders top" that you see on this chart. The odds are fairly good that oil will break support at around 62, and if it does break support I have no idea how low it may correct. I'm guessing that there should be some good support at the July 21 closing low (Oct. futures) at 58.

But that's not the point. The point is much bigger than a potential oil correction here. I've just finished four books about oil and energy. The book I read over the weekend is entitled, "Beyond Oil, the View From Hubbert's Peak" by Kenneth S. Deffeyes. Mr. Deffeyes is a professor emeritus at Princeton University; his previous book, published in 2001, was entitled, "Hubbert's Peak, the Impending World Oil Shortage."

The introduction to this book tells a lot of the oil story. It starts, "We are facing an unprecedented problem. World oil production has stopped growing; declines in production are about to begin. For the first time since the Industrial Revolution, the geological supply of an essential resource will not meet demand. . . Hubbert predicted that annual oil production would follow a bell-shaped curve; the curve became known as 'Hubbert's peak.' The more optimistic of his two estimates in 1969 placed the world's total oil endowment at 2.1 trillion barrels with peak production in the year 2000. My best current estimate puts the total oil at 2.013 trillion barrels peaking in 2005. Whichever of us is correct, or even if we are both wrong, we are not very wrong. Wherever the peak, the view is not good." He adds, "World oil production is going to decline slowly, at first, and the more rapidly."

Another seminal and widely-acclaimed book is entitled, "Twilight in the Desert, the Coming Saudi Oil Shock and the World Economy," by Matthew R. Simmons. In this book Simmons, for the first time and using original data, concludes that Saudi Arabia's oil has passed its peak of reserves. I'll quote just one sentence from the Simmon's book. "Once oil supply peaks and begins to decrease, the scarcity factor alone will force oil prices to far higher levels than today's perceived 'high prices'."

Stephan Leeb ("The Complete Investor" advisory) is a brilliant writer and analyst. He writes, "Your grandchildren will live in a world without oil. In the next one to four years, half the oil that the earth started with will be gone. And IF we kept using is the way we are, every drop would vanish by about 2029. It won't happen quite that way, of course. Long before 2029 oil quality will go from fair to terrible, the extraction costs will become crippling, and you will be paying $12 and $15 a gallon at the gas pump. Life will revolve around oil -- or the lack of it. .."

Yeah, I know. We've had a number of oil spikes and oil scares before. And each time the price of oil has come comfortably back down, and the whole oil problem is then put aside. Right, but this time something different has entered the picture.

The difference is the entrance of China and India and the rest of Asia into the global picture. These nations are thriving, making lots of money, and their populations want what we have -- cars, loads of cars, millions of cars. And that's going to be the difference this time. There's now a massive DEMAND side to the oil problem. The world battle for oil and oil reserves is on.

Question -- Russell, you keep saying that the US public isn't taking the oil situation seriously. Why do you say that?

Answer -- I say it because US auto dealers are still selling SUVs, trucks and gas-easters by the tens of thousands. Wife Faye subscribes to five auto magazines. All the mags write about is performance cars, luxury cars, cars that do zero to 60 in 3.5 seconds Check their cover pictures. C'mon, what I see and hear tells me that the US public believes this is "just another oil scare." But it isn''t.

The correction in oil that "could" be coming up will provide us with an opportunity to accumulate oil and energy stocks and preferably Exchange Traded Funds (ETFs). I've already mentioned -- namely, VDE, XEL and the closed-end fund, PEO. Then there's the D-J Energy Sector IYE. I'm suggesting these funds rather than picking individual oil or energy stocks. There's another ETF that I like as a long-term holding, it's the Goldman Sachs Natural Resources ETF -- symbol IGE.

The cycles of financials and tangibles (including commodities) tend to extend for many years. I believe that the cycle of financials started around 1980 and ended around 2000. I believe we're now in the early part of the cycle in tangibles, and also at the beginning of the decline in the cycle of financials.

The cycle of financials was built on an explosion of junk paper money. Once the world went completely off gold in 1971, the platform for the bull market in financials was laid. Twenty years of an increasing ocean of fiat paper followed.

But now we see gold moving up past all paper currencies. We see commodities (without agriculturals) surging higher. Oil has now joined the parade of rising tangibles. Diamond prices are through the roof, as are many collectibles (a Picasso just sold for over $100 million). The Sotheby's and Christy's auction catalogues are stuffed with collectibles at high prices. Real estate is going wild, particularly on the two coasts. Condo-mania rules, and one sector after another shows itself as the bull market in tangibles heats up.

You can live without a Picasso or a second home or a high-priced condo -- but oil, that's another matter. The Chinese and Indians may not be wild about Matisse paintings or million-dollar condos in Las Vegas, but they are most definitely interested in gasoline with which to run their fast-expanding population of cars. So today's oil story is very different from previous oil "crises." This time one third of the population of the world has entered the battle for oil. Therefore, today's rise in the price of oil is not just another speculative spike, it's the next higher zone or level for oil, just as 450 and above represents the next higher level for gold.

So say "Bye" to the age of paper money, and say "hello" to the new age of the real, the tangible, the solid. The Fed can create $30 billion of M-3 liquidity in a week, but they still can't make a quarter-carat diamond or an ounce of gold or a lousy pint of oil. So if oil or gold corrects here or if oil or energy ETF's sink a bit, don't complain. Treat such action as an opportunity.

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Richard Russell
Dow Theory Letters
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