Caterpillar Inc , down 2.5 percent, was among the top drags after the maker of bulldozers, excavators and other products said worldwide August sales of machinery to dealerships fell.

Crude oil futures shed 3.5 percent to $69.48 a barrel and spot gold prices dropped below $1,000 an ounce. The S&P materials <.GSPM> index fell nearly 2 percent.

Shares of Exxon Mobil Corp declined 1 percent to $69.26, while gold miner Newmont Mining Corp shed 3.1 percent to $43.55.

The Dow Jones industrial average <.DJI> lost 55.85 points, or 0.57 percent, to 9,764.35. The Standard & Poor’s 500 Index <.SPX> declined 6.64 points, or 0.62 percent, to 1,061.66. The Nasdaq Composite Index <.IXIC> dipped 6.77 points, or 0.32 percent, to 2,126.09.

The Nasdaq’s losses were curbed by a rise in shares of biotechnology companies after a brokerage raised its rating on Celgene Corp , up 3.6 percent at $54.46.

Through Friday, the benchmark S&P 500 <.SPX> had risen 58 percent since hitting a 12-year closing low in early March, partly because of strong second-quarter earnings and optimism that an economic recovery is gaining traction.

That optimism is beginning to come under some strain, however, as investors seek more clarity about the 2010 profit outlook and await hints of how strong results will be for the rest of this year.

Computer maker Dell Inc announced a $3.9 billion proposed takeover of Perot Systems Corp . Perot Systems shares jumped 65.4 percent to $29.64, while Dell shares dipped 3.2 percent to $16.15.

Any benefit from that announcement, however, was tempered by the rising U.S. dollar. The dollar index, which measures the greenback against a basket of major currencies, rose 0.7 percent.

“No rally can be sustained with yields and P/Es so poorly valued,” says underground investor Chris Weber, writing for DailyWealth. Chris is a very special kind of investor. When he was 16 years old, he turned just $650 (saved from his paper route) into $1.8 million through a series of remarkably insightful investments. So naturally we’re all ears when Chris gives his opinion on the direction of the market.

Chris is bearish on US stocks. (He’s mainly in cash and precious metals.) Why? Because there’s no value in the US stock market.

As of the end of July, the dividend yield on the S&P 500 has fallen to only 2.13%. When the rally began in March, the yield was over 3.5%. That is a huge fall in a short time.

Then, as stock prices have soared, earnings of companies have just not kept pace. In many cases, they are down sharply. This imbalance in price to earnings is shown in the weird spike in the P/E ratio on the S&P 500. It is now up to 127 times annual earnings, up from less than 20 times earnings at the rally’s start in March.

In other words, the dividend yield and the P/Es were not what you see at real bottoms. In really low markets, investors are shaken so much that years are required for them to regain bullishness.

Instead, I think what we’ve been seeing are the types of violent rallies within bear markets we saw throughout both the 1930s and the 60s-early 70s.

So once again, I’m just watching the stock markets. My position is that if the Dow Industrials and Transports can both better their previous record highs that they reached back in the second half of 2007, then I’ll be interested and ready to say that we are really off to the races again.

What I think is more likely is a repeat of the period of 1966 to 1975, where we’ll see a series of rallies within a bear market. In other words, this will be an easy time to lose money, and a hard time to make it.

Porter Stansberry has another take on stocks. He reckons we’re in the early stages of a “massive inflation.” Porter’s argument is simple. As long as the government keeps printing up trillions of dollars a year and holding short-term rates at nearly 0%, financial stocks are going to rise… And as long as financial stocks rise, the rest of market will follow.

Financial stocks are on a roll, as you can plainly see from the nearby chart of the financial sector ETF (XLF). Now, ask yourself a very simple question: Are investors buying financials because of their strong balance sheets and smart management or are they buying because they know that the government intends to keep pumping money into these boated behemoths?

Say what you like, US stocks are rising. All we know is we don’t like it one little bit. And we wouldn’t touch stocks knowing what we do about the market. As Chris Weber says, “This will be an easy time to lose money, and a hard time to make it.” Amen to that.

So today we turn away from the markets and focus on something more important: basic investment principles. As Alexander Green, investment director of The Oxford Club, puts it over at InvestmentU.com, “It’s not uncommon to run into investors who are knee deep in option trading, currencies, short selling, or sophisticated arbitrage strategies without mastering – or even understanding – basic investment principles.”

Here’s what Alex believes are the six factors that determine the value of your portfolio’s. Only one of these six factors is beyond your control: your assets’ annual compounded return. That means it only makes sense to focus on the other five.

1. The amount of money you save. To put it bluntly you have to start by maximizing your income, minimizing your outgoing and paying yourself first. Why? Because expenses always rise to meet the income available. As soon as you get a raise or a higher paying job, you’ll find that you need a new car, a bigger house, better furniture and a new set of Callaway irons. But you have to draw the line somewhere. You can’t save a pittance and expect your portfolio to perform miracles each year.

2. The length of time your money compounds. The sooner you start investing the better. And the longer you leave it alone the better. If you start too late – or raid your portfolio to redo the kitchen or take the kids to Disney – you’re going to have a lot of catching up to do down the road. The old chestnut is true: Don’t touch your capital. It’s like eating your seed corn.

3. Your asset allocation. Studies consistently show that how you divide your portfolio among non-correlated assets – stocks, bonds, real estate investment trusts, precious metals, etc. – determines 90% of your portfolio’s long-term return. (The rest is due to security selection.) If you’re too conservative – or too aggressive to stick with your program – you simply won’t meet your goals.

4. Your assets’ annual return. This, of course, is the great unknown. Not even Warren Buffett or Ben Bernanke can say what their portfolio will return each year. But the better your security selection and asset allocation decisions, the higher your annual compounded returns.

5. What you pay in expenses. Don’t be oblivious to what all those financial intermediaries are charging you. You can sacrifice far too much in commissions, bid/ask spreads, wrap fees, management expenses and other costs. All things being equal, the lower your expenses the higher your net returns.

6. How much you pay in taxes. Too many investors are oblivious to the tax ramifications of their investment moves. When possible, put your high-yielding investments in your tax-deferred accounts and your tax-efficient funds and individual stocks in your non-retirement accounts. (I call this your asset location strategy.) Hold positions 12 months or more to qualify for the lower long-term capital gains tax rate. Offset your capital gains with capital losses if possible.

You see what most investors don’t understand (and probably never will) is that market timing and stock picking make up only a small part of serious wealth building. It’s a secret the “ultra wealthy” have known for a long time. And they spend a lot of time and money making sure these six factors are right (and others, too, that would be too complicated to explain here). It’s how they hold onto their wealth for generations.

It’s actually what we’ve been working on while here in France. Along with my dad and your Notes co-editor, Chris Hunter, we’ve been researching these wealth preservation secrets. And we’ve discovered that wealthy families nearly always have something called a “family office.”

Most of these require massive amounts of cash to join. (One group in London my dad went to talk to was looking for a $200 million minimum!) So that’s why we decided to set up Bonner & Partners Family Office. It puts all of the money management secrets of the ultra wealthy to work… without the massive price tag.

Partners will enjoy the following benefits:

Access to what my family is doing with its money. Over the years we’ve spent literally hundreds of thousands of dollars on high-level wealth management advice. It’s been distilled into our family portfolio, which partners will have full access to.

Twice-daily market advice from full-time money manager Simon Mellon. The family has spent a lot of money, and considerable time, finding the right investment director for the family office. Simon has a resume as long as your arm. And his insight into the market is the kind that comes only with years in the trenches in New York and London.

Full-time tax planning advice from Raife Nueman. Raife went to university with your editor at St John’s College. And he’s one of the brightest attorneys we ever come across. (He has been elbow deep in the US tax code over the past two months, and he’s identified a way to drastically reduce your tax spend – to as much as 0% in some cases.)

Access to all of Agora trading advice and investment research. Family office partners will have full access to the entire daily output of Agora, the family publishing company. This amounts to 34 trading and investment research services. (A total of over $97,000 worth of subscription services a year.)

We will be sending out an invitation to join us as a family office partner this week. As a Notes reader, you can join the invitation list early by sending an email to info@contrarianprofits.com. Just make sure to put “Family Office” in the subject line so our staff will be able to quickly add you to the list before the invitation goes out…

The market awaited U.S. Energy Information Administration (EIA) data due at 1430 GMT to see if they would confirm the trend from Tuesday’s American Petroleum Institute (API) figures.

U.S. crude oil for September delivery was down 90 cents at $64.71 a barrel by 1407 GMT, having fallen to a low of $63.76. London Brent crude for September lost 50 cents to $66.37.

The fall followed five days of rises that had pushed U.S. crude oil futures up more than 10 percent in just a week.

“The market has exhausted itself and needs to pause,” VTB Capital analyst Andrey Kryuchenkov said in a research note. “Today, all attention will be on the weekly U.S. fuel inventories.”

U.S. crude oil stockpiles rose unexpectedly last week as domestic refining activity slumped, the API said on Tuesday.

Commercial oil inventories jumped 3.1 million barrels to 349.883 million barrels, reversing a stretch of weekly declines triggered by thin import levels and defying analyst expectations for a 2.1 million barrel drop.

A Reuters survey of 15 analysts forecast the EIA would report a drop in crude oil inventories as slow imports countered a decline in refining activity.

HIGH STOCKS

But refined products supplies were expected to have risen, despite the lower domestic refinery capacity use.

Global oil inventories are at historically high levels, equivalent to around 62 days of forward demand by the industrialised countries of the Organisation for Economic Cooperation and Development (OECD).

Robert Montefusco, broker at Sucden Financial in London, said oil came under additional pressure on Wednesday after disappointing results from U.S. bank Morgan Stanley .

Morgan Stanley reported its third consecutive quarterly loss on Wednesday, saddled with a charge related to repaying government loans and the accounting impact of improvement in its debt prices.

“We are not getting to much help from the stock market,” Montefusco said. “We’ve had some poor figures from Morgan Stanley so that has put pressure on stocks and oil too.”

But data showing apparent oil demand in the world’s second-largest energy user rose for the third month in a row offered some support.

China’s implied oil demand in June rose 1.8 percent over a year ago, Reuters calculations from official data showed on Wednesday.

July 22 (Reuters)

As I’ve mentioned in recent issues, oil had near-term targets of $70 in its sights. It hasn’t disappointed, shooting past the $73 mark late last week – a level not seen since the first week of November 2008.

On a technical basis, because oil has not only moved above, but also stayed above all the major moving averages (including the all-important 200-day average), it’s now got $80 in its sights. If any pullback is going to occur, which should happen after solid runs like this, the move down should hold at the $65 per barrel range.

On a fundamental note, we’ve got three reasons for the recent price rise…

1. Hedge funds seem to be pumping more money into the market again.
2. OPEC has decreased oil supply levels.
3. There seems to be some consensus that oil demand might be picking up from the slack levels seen over the past six months.

For now, the market looks strong and any pullbacks should be met with more buying. Here’s how you can play it…

How To Play Oil With Minimum Fuss

The chart below shows the daily movements of the front-month futures contract (July)…

The easiest way to play the broad oil market (either to the upside or downside) is to go for the very popular and highly liquid exchange traded fund, United States Oil (NYSE: USO). The fund mimics the moves of crude oil futures that trade on the NYMEX.

You can trade USO like a normal stock in a regular stock brokerage account and the ETF has options contracts available, too.

Since we first went bullish on oil, USO traded around $32. It’s now around $38.80 and is a very effective “cheaper” alternative to the high-priced arena of futures and futures options, while still profiting from the same moves as the underlying oil market.

Natural Gas Making Unnatural Moves

Having been stuck in the doldrums for ages, the natural gas market has really woken up recently.

Prices have coiled into a narrow trading range over the past two weeks, with volatile swings of 300-400 points over just a few days becoming the norm. At the moment, it looks like the $3.50 per MMB/tu level is the floor, while the market tries to decide which way it eventually wants to go.

Keep Tabs On The 20-Day Moving Average For Clues To The Next Move

With natural gas prices still sitting near multi-year lows, we continue to have a bullish longer-term perspective.

Also, I’ll reiterate a technical observation from my last issue: Because the 20-day moving average has crossed above the 50-day moving average for the first time since July 2008, this usually leads to a change in direction.

However, as volatile as natural gas is, the 20-day MA is flirting with crossing back underneath the 50-day MA, unless natural gas can muster a convincing move above the $4.000 per MMB/tu level.

We still like natural gas on the long side, but be patient here. This is a real, in-demand natural resource commodity, so it never has the worry factor of going out of business or bankrupt.

You can participate in this market by using the equivalent ETF for natural gas - United States Natural Gas(NYSE: UNG), which reacts just like the futures and futures options do. If you’re considering bullish strategies, UNG offers options contracts as well.

When Inflation Hits, You Want To Be Invested Here

The financials markets and investing can be a highly divisive subject… but most people agree on one thing:

Interest rates and inflation will rise eventually (in fact, rates have already started to rise), while the U.S. dollar will fall. This will be in response to the huge debt that the American government is getting itself into, due to the financial crisis and bailout programs.

Scenarios like this have always led to bullish moves into commodities, as they can buffer the effects just mentioned above. Witness the bullish moves in virtually every commodity sector that began in earnest a few months ago.

One of the best places to be in order to protect yourself from inflation is the metals markets. In fact, gold and silver have fared exceptionally well since the end of 2008 – and haven’t looked back since.

Our technical levels have served us well, allowing us to spot the support areas for both metals – gold near the $880 per ounce level, while solid support for silver comes in at $12.000 per ounce. Both have bounced from those areas and have enjoyed strong moves.

Although both metals are currently seeing slight pullbacks, they should resume their upward marches toward $1,000 and $20 for gold and silver respectively.

You can trade gold and silver directly through the futures options that trade on the NYMEX. Or if you prefer regular stock and options-based plays, check out their respective ETFs – the SPDR Gold Shares (NYSE: GLD) and iShares Silver Trust (NYSE: SLV).

Source:Three Reasons Why Oil Prices Are Rising… And Where They’re Headed Next

While long-term commodity prospects are dictated by supply and demand, weather factors and long-term fundamentals, the short-term outlook is sprinkled with volatility. Some commodities have hit levels not seen in some time, reinforcing a new trend of late: The relationship between commodities and the general stock market.

It hasn’t always been the case that commodities and stocks moved in the same direction, but nothing is immune to a price shock these days. And when one domino moves, it can take many others with it.

We don’t foresee much change in this inter connected stocks-commodities relationship until all the recent government intervention takes a strong foothold.

So let’s turn to some commentary…

The Macroeconomic And Technical Outlook For Oil

Over the past three weeks, we’ve seen crude oil futures trade in a wide range between $47 and $54 per barrel.

Macroeconomically, we still have the issue of dwindling worldwide demand versus over-supply. The OPEC oil cartel has tried to arrest the latter by cutting supplies recently, but this trend could keep a lid on prices for the time being.

Although many market participants don’t give much credit to OPEC these days in terms of following through on their commitments, the psychological impact of better days ahead due to the U.S. government intervention can cause quick pops to the upside.

Technically, the oil market has support at the $47.75 area, right around the 50-day moving average. And if the price can break out above $55 convincingly, we could see some clear sailing for oil, possibly up to the $70 per barrel range.

For now, expect to see crude oil trade in a large range between $30 and $60.

As Natural Gas Drifts Lower, Our Optimism Rises Higher

The natural gas market keeps slowly eroding away to lower and lower levels.

Each week, we hear the Energy Administration Information report that that there’s an abundance of underground storage supplies of natural gas – and this, in combination with slack demand, is what’s keeping natgas heading south.

However, the lower this market gets, the greater the buying opportunity will be. We’ve been bullish on the natural gas market for a few months now, and although it’s moved against us recently, we continue to like it for the long-term – particularly with hurricane season around the corner.

I’ve consequently implemented a special options strategy in my Instant Money Trader service that enables investors to get into natural gas at even lower prices than current levels. For more information on how you can join in, click here to read a short guide on the service.

Gold And Silver Nail Our Support Levels… And Bounce Higher

In my column two weeks ago, I noted:

We don’t see the front-month gold futures (June contract) trading much below $870 an ounce after the current pull-back is over, and silver shouldn’t see anything much below $12 an ounce (May contract).

Right on cue, June gold futures tagged a low price of $865 an ounce last week and have since bounced off the very reliable 200-day moving average. The price jumped over $35 an ounce to hit $901 just this morning.

It’s a similar story in the silver market. The metal tagged support just above the $12 per ounce level and has rebounded almost a full dollar to its current level of $12.80 an ounce.

Now that the recent pullback seems to have ended right at those support levels, we have more reason to maintain our longer-term bullish stance on gold and silver. And the current area looks to be a great spot to dip into long positions.

Other than looking at limited-risk option strategies from the COMEX futures options market (where gold & silver futures options trade), you can buy outright shares of the gold and silver ETFs that track the price performance – the SPDR Gold Trust (NYSE: GLD) and iShares Silver Trust (NYSE: SLV) respectively.

Has This Hurricane-Hating Commodity Touched New Lows?

Lastly, we’re continuing to track the longer-term orange juice charts, as the price flirts with multi-year lows not seen since before hurricanes tacked on huge weather premiums to the price in 2004.

It looks like the market may have touched its near-term lows – and with a decent bullish move over the past two weeks, it could now be gearing up for the psychological and speculative fever that comes with the onset of hurricane season.

The best way to take advantage of this situation is through limited-risk bullish trades on orange juice futures options.

Source:  Prepare To Buy These Two Hurricane-Hating Commodities

U.S. crude fell $1.23 a barrel to $40.93 by 1500 GMT. London Brent crude was 25 cents down at $44.65 a barrel.

U.S. unemployment rose to a record peak in mid-January, while new orders for long-lasting manufactured goods fell for the fifth month in a row.

The feeble state of the U.S. economy was already illustrated by a larger-than-expected 6.2 million barrel rise in crude oil stocks last week, according to government data on Wednesday.

Stocks at Cushing, Oklahoma, the delivery point for U.S. crude oil futures, rose a further 300,000 barrels.

“U.S. crude has weakened against Brent again. The 300,000 barrel stock build in Cushing and the general crude stock build has caused this,” said Christopher Bellew, a broker at Bache Commodities in London.

“Run cuts and OPEC production cuts may offer some support,” he said.

OPEC Secretary General Abdullah al-Badri, speaking at the World Economic Forum in Davos, Switzerland, said OPEC would not hesitate to act again if the oil price remained low.

The Organization of the Petroleum Exporting Countries has pledged to cut supply by 4.2 million barrels per day since September last year to try to support oil prices, which have dropped more than $100 a barrel since July.

Badri said on Wednesday OPEC was expected to have delivered fully on its pledged supply curbs by the end of this month, but a weak economy would continue to erode demand for fuel.

OPEC next meets on March 15 to decide output policy.

Martin King, analyst with FirstEnergy Capital Corp, said OPEC had done a much better job of cutting supplies from the market than many had expected, setting the stage for a gradual price rebound in the second half of 2009.

“We see the crude market on the cusp of achieving real signs of stability, driven in part by tighter supplies out of OPEC.”

LONDON, Jan 29 (Reuters)

Oil fell more than $2 towards $34 a barrel on Monday after Russia and Ukraine signed a 10-year gas deal clearing the way for the resumption of supplies to a freezing Europe.

Implementation of a ceasefire between Israel and Hamas in Gaza also eased supply concerns as the market remained under pressure from expectations that the weakening global economy would erode oil demand.

“Right now the economy is dominating,” said Harry Tchilinguirian, analyst at BNP Paribas. “The market is very volatile and the signs are that demand is weakening.”

U.S. crude oil futures for February delivery dipped to a low of $33.89, down $2.62, before recovering to trade at $34.53 by 1800 GMT.

Traders said the February U.S. crude oil futures contract, which expires on Tuesday, also fell because of very high stocks at the delivery point for the U.S. futures contract.

Only just over 3,100 lots were traded on the February U.S. crude contract. The March contract was much more active as more than 31,000 lots changed hands.

London Brent crude for March fell to a low of $43.80, down $2.77, before edging back up to around $44.50.

GAS FLOWS

The agreement between Russia and Ukraine, which set a final price for 2009 supplies, is expected to lead to the restart of flows of Russian natural gas to Europe via Ukraine within the next 36 hours.

Also easing concern about energy supplies, Israeli forces began to pull out of the Gaza Strip following a tentative truce with Hamas after the three-week war, easing tension in a region which pumps about a third of the world’s oil.

Prices came under pressure on Friday after the International Energy Agency, an adviser to industrialised countries, predicted a fall in world oil demand in 2009.

OPEC, the oil exporters’ group, has cut production three times since September to try to stem falling prices. It might consider reducing output again, Algeria’s oil minister Chakib Khelil said on Saturday.

Oil has collapsed by more than $110 a barrel since reaching a record high of $147.27 a barrel in the summer as the global economic slowdown has eroded demand and consumer spending.

Still, some in the oil market think there is little room for prices to fall much further.

“It looks as if Brent will hold in the current $40-$50 range,” said Christopher Bellew, a broker at Bache Commodities. “I do not anticipate new lows.”

LONDON, Jan 19 (Reuters)

My little brother dropped in to visit last weekend. It was his first trip to Northern Nevada, so I gave him the full Monty. To balance out the downtown Reno blackjack-and-greasy spoon experience, we had Sunday brunch at the Lone Eagle Grill.

The Lone Eagle is a chalet-inspired lodge and restaurant on the north shore of Lake Tahoe. (I used to be a two-minute drive from the place; now it’s about 25 minutes.) Everything in the Lone Eagle is pine and cedar and crystal, with giant stone fireplaces and exposed wooden beams in the 20-foot high ceilings. One might call it rustic opulence.

On this day, Lake Tahoe was particularly gorgeous, in full view from the floor-to-ceiling windows on our right. The boats were out, sails unfurled; the water was a deep serene blue as far as the eye could see. An outline of the distant Sierra Nevadas completed the picture, the last of the winter snow pack still visible above the tree line.

An inspired scene such as this (complete with lobster, champagne and tiramisu) invites many thoughts. One wouldn’t, however, expect to be pondering the price of oil in such a place.

And yet that was the topic du jour for a well-to-do foursome seated near our table. All looked comfortably retired, with the casual air of Tahoe locals. With my brother off roaming in search of the dessert table, I couldn’t help overhearing their banter.

“It’s just crazy to think of oil over $100,” one snowy-haired gentleman said. “It will be interesting to see what happens when it goes to $150.”

“Yes,” the woman across from him agreed. “And my gosh, just think of what’s happening in the Middle East. With the presidential election coming up, there’s no telling what could happen next.”

They went on in that vein for another minute or two, which I found fascinating. Not so much for the content of the conversation, but rather the time, the place and the participants.

It’s long been the case that “normal” people don’t talk about this kind of thing. Big-picture thinking has always been something of a quirky pursuit. When someone brought up the gold standard in the poker room a few weeks ago, I thought it was a one-off… But if two data points make a trend, perhaps the public is waking up.

I had some further thoughts on the implications of $100 oil — what it means, where to look for profit, and so on — but Adam Lass beat me to the punch in his excellent piece below.

Adam does a great job pointing out the folly of the pundits who rejoice in oil’s short-term pullback (a topic we touched on recently, but which benefits from further exploration). Better still, Adam lays out the case for why $100 oil “changes everything.” Take a look.

Warm Regards,

JL

$100 Oil Still Changes Everything

by Adam Lass, Senior Editor, WaveStrength Options Weekly

“Oil is falling, oil is falling!”

So what?

Oh, it’s true enough by and of itself. Over the past few trading sessions, we have indeed seen crude oil futures fall some $11 off the all-time high of $135.09 a barrel set a fortnight back.

It’s almost comical how the all the Wall Street analysts and their talking-head stooges are tripping over each other to point out this new record low. Why, this is the lowest price since May 15!

Don’t Celebrate Just Yet…

But don’t break out that bottle of cold duck you’ve had stashed in the back of the company fridge just yet. Because in this case, “down” is definitely a relative concept. And the reasons for even this modest drop may be nothing to cheer about.

Two years back, if a pundit wanted to throw out a real bomb, he or she would predict $100 oil. Everyone would gasp at the sheer audacity or mere stupidity of such a claim. Didn’t they know that the price supply and price demand curves would prevent that from ever happening?

You see, there are several things that are supposed to happen when oil prices climb. First of all, the supply of oil magically increases.

Marginal Oil Goes Mainstream

In reality, it isn’t quite that simple. Much trumpeted “alternative” oil sources aren’t quite as magical as commonly assumed. Different crude oil sources have radically different prices associated with extracting them and making use of them.

When a fresh field is so ripe that the oil simply oozes up out of the ground, the cost to deliver to market is pretty darned cheap. Work that field’s reserves down for 20 years or so, and now you must (at great cost) pump in water and steam in order to get half of what you used to scoop up with a child’s sand bucket. And when those easy to find reserves are clapped out, you must look farther and farther afield to find ever more expensive fresh supplies.

Modern geophysical science can guide us to more raw oil then ever before. So after a fashion, the supply appears theoretically elastic (at least within our lifetimes). Marginal crude that would have been unprofitable to fetch out when the cost of crude was a mere $50 a barrel, becomes intriguing at $65 and damned attractive at $75.

Earlier this week, NYMEX crude oil futures, in un-lady like fashion, bolted to an intra-day high of US$127.27. It capped an exuberant dash which saw oil gain over 8% in six trading days, 30% since the beginning of the year, and 100% in the last twelve months. It’s just the sort of thing you’d expect from a ten-year old.

Here is an astonishing fact: on December 10th, 1998 the spot price for a barrel of West Texas Intermediate crude was exactly ten U.S. dollars and ninety eight U.S. cents. Nearly ten years and one thousand and sixty two percent later, it is time to ask some impolite questions about oil.

Impolite questions are not always obvious questions, though. The obvious question is to ask how high oil can go. Arjun Mutri and his team at Goldman Sachs have told us a disruption in supply could send oil to another “super spike” over US$200. Two years ago, the “super spike” was supposed top out at $100. Maybe it will be US$500 two years from now.

It is easy to keep raising the figure, but is probably more useful to ask a different question. The important investment question is not how high oil can go from here. The impolite but important investment question is where future global oil production will come from at all.

The answer, according to a new report from UBS, lies with just eight oil companies, one of which investors can’t even buy. Below, I’ll look at where future production may come from, who stands to profit the most, what investors can do now, and three “Black Swan” possibilities for the oil market that no one has prepared for.

Why Are Oil Prices So High?

An obvious question on the lips of anyone who buys petrol is, “Why are oil prices so high?” Consumers trained in the ways of the free market—and used to cheap clothes and electronics made in China—are right to ask the question.

In a fully-functioning free market, rising demand tends to attract rising supply. The reason?
Profit.

When a market is imbalanced and demand exceeds supply, prices rise. At that point, opportunistic new producers tend to rush in and grab some of the profits by brining on new supply. Prices fall and, for awhile anyway, equilibrium is restored.

That’s how it works in textbooks. That is not how it’s been working in the real world. According to the International Energy Agency, world oil demand has increased in each of the last three years, from 84.9 million barrels per day in 2006, to 86mbbl/day in 2007, to this year’s rate of 87.2mbbl/day. The IEA’s most recent forecast calls for global demand of 87.8mbpd for the rest of this year.

In response to this increase in global demand, OPEC oil production promptly declined by 265kbpd in February (the latest period for which official figures are available) to around 32mpbd. Not exactly helpful. And latest survey from Platts predicts a March decline in production of 347kbpd from the February figure. This brings average OPEC production below 30mbpd for the month.

This past weekend, U.S. President George Bush travelled to the Kingdom of Saudi Arabia, politely requesting the Saudis increase oil production to bring down gas prices in America. The Saudis demurred, and told the President oil production was more than sufficient to meet global demand.

OPEC blames the oil price on the weak U.S. dollar, but admits prices could go higher still. OPEC President Chakib Khelil explained the situation to journalists in late May, saying:

The prices are high due to the fact of the recession in the United States and the economic crisis which has touched several countries, a situation which has an effect on the devaluation of the dollar, and therefore each time the dollar falls one percent, the price of the barrel rises by $4, and of course vice versa.

In other words, OPEC blames the oil price on the sliding U.S. dollar and not inadequate supply. Khelil added that, “If this (the dollar) strengthens by 10 percent, it is probable that (oil) prices will fall by 40 percent.” At today’s prices, that would put a barrel of crude at US$76.

Froth vs. Fundamentals

If you can say with assurance why oil prices are US$127, you are more assured than most. OPEC believes oil strength is really just U.S. dollar weakness. A stronger dollar means lower oil prices, and probably lower commodity prices in general. There are other theories that seek to explain the high oil price, including a “fear premium,” oil as an inflation hedge, and pure speculation by professional traders.

But there are three other possibilities to consider. Exploring them gives us a clue about where oil prices are headed and where future production might come from. These possibilities are:

1. OPEC won’t increase production because it doesn’t want to
2. OPEC can’t increase production
3. Non-OPEC countries cannot increase production enough to bring prices down

It is impossible to answer the first question. Oil producers, from OPEC to large multi-nationals, plan with long time horizons. They view oil markets as cyclical and do not base capital expenditure plans on pie-in-the-sky price forecasts. They are reluctant to recognise and respond to what your editor (among others) believes is a structural revaluation in global energy prices (not a cyclical bubble).

But this institutional skepticism about how long high oil prices can last does not account for the slump in this year’s production. OPEC’s production has fallen this year because of continued disruptions in Nigeria (see table below). Rebels in the Niger River Delta have reminded us all of how vulnerable the global energy system is to systematic sabotage. But excluding Nigeria, the rest of OPEC is running at near capacity.

The case for the target-price increase of 20% was very clear.

“The math is really simple here,” Fitz-Gerald said in an e-mail interview from China, where he was heading an investment-research tour. “We are burning through supplies at a rate that’s four times to five times faster than we’re discovering new reserves. Throw in a few [surprises] … perhaps a terrorist event …and add in the accelerating use of oil and gasoline in Third World countries, and we have the recipe for far higher prices. That’s already in the oven.”

Crude-oil futures jumped up over the $123 a barrel level yesterday (Wednesday) – closing at an all time record – as worries about worldwide oil supplies continued to sweep away any good news in the energy sector. In fact, prices have soared more than $11 a barrel – or 9.8 % – over the past four days alone, reaching back to last Thursday, MarketWatch.com reported.

But it wasn’t the price increases that prompted Fitz-Gerald to boost his oil-price target. In fact, he did that last week. In addition to the proprietary strategy he uses to project market prices, Fitz-Gerald said he relied on some of the observations he’s been making as part of the investor trip he’s leading through China.

In that country, all it takes is a stroll down the street to see that the demand for oil and gasoline is going to increase far faster than most analysts would ever believe.

“Nowhere is that more evident than China where I’m traveling now,” Fitz-Gerald said last week in an e-mail from Mainland China’s capital. “Beijing alone is adding 14,000 cars a day. Across China, the number is obviously higher. [The] same [is true] in India, but I don’t have the figures at my fingertips. Then there’s the other side … evidence suggests that OPEC reserve figures may be artificially high. Imagine what’s going to happen when people figure out that there really isn’t as much oil as everybody thinks. $225.21 is not out of the question … after we get to $187.”

Alternative energy is the only answer, Fitz-Gerald says. But some of that is years from being commercially viable – cheap and reliable enough to be affordable to, and used by, mainstream consumers.

“Barring the introduction of a truly [alternative] and inexpensive technology, this is going to get ugly … and very pricy before it gets better,” Fitz-Gerald wrote. Investors need to be “long energy, long commodities” for right now, and for the foreseeable future.

China is doing all it can to overcome the massive energy deficits that it faces. One such project is the massive Three Gorges Dam, which Fitz-Gerald had visited the day of his interview with Money Morning.

“It’s surreal how big this project really is,” he noted.

Fitz-Gerald sees oil-and-gasoline prices going higher – much higher. And four factors will be the key catalysts. They are:

• Obfuscation by OPEC: Members of the Organization of the Petroleum Exporting Countries have been misrepresenting their reserve capabilities for years. The key players have reported no new discoveries for decades.

• Terrorism Threats: The odds that a terrorist act will interrupt oil supplies – in the near term or the long term – are higher than most security experts would ever publicly confirm, Fitz-Gerald says. And this is especially problematic because of the double-whammy effect: Damage to a major pipeline or a strategic refinery could crimp supplies just as demand is continuing to escalate.

• The Dollar Doldrums: Oil is priced in dollars. And the dollar is in the dumper. Indeed, rising inflation and falling interest rates have put the greenback into a steep downward spiral. And if prices keep rising, and if Federal Reserve policymakers keep cutting short-term interest rates, the dollar will continue to lose altitude against other key global currencies. OPEC members will counter the greenback decline by marking up the price of crude, causing prices to increase still more in dollar-denominated terms.

• Cruising Goes Global: As an increasing number of households in China, India and other advancing overseas economies join the world’s middle class, they’ll start making such basic purchases as electronic goods, houses – and automobiles. The fact that China’s oil imports jumped 18% in one month is evidence enough that this is happening. And the fact that leading India automaker Tata Motors Ltd. (TTM) has unveiled a $2,500 car, the Nano, underscores that international carmakers are looking to recruit a whole new group of motorists. The fallout: For U.S. refiners, oil will first get lots more expensive, and then supplies will start to dry up as countries opt to halt exports and keep the precious black gold for themselves.

Oil Becomes a Strategic Asset

Oil prices have made a major move in the past five years – just as the emergence of China, Russia and several other key economies transformed crude-oil pricing into much more of a global game. High prices have sent cash pouring into the coffers of oil-producers in Asia and the Middle East. Many countries have used that capital to finance global investment initiatives, creating government-controlled “sovereign wealth funds” to do their bidding.

Little wonder crude oil has become a strategic asset – as well as an energy source.

“As oil and other fuels become a more and more precious resource, OPEC countries, China, Russia and others will begin holding back oil, instead of putting it into the market,” Fitz-Gerald says. “That’s going to be devastating in the short-run.”

Some big oil consumers such as the United States have lobbied OPEC to boost production in order to bring market prices down. But it’s done no good: Members of OPEC have said over and over that market supplies are adequate and that the surging prices are not something that they can control.

China – a growing consumer of oil – has embraced a different strategy: To create captive supplies of crude, China has demonstrated that it’s more than willing to endure controversy and cut deals with countries U.S. refiners either can’t or won’t deal with. China Petroleum & Chemical Corp. (SNP), and PetroChina Company Ltd. (PTR) – two of China’s biggest oil companies – have invested in such political hot spots as Africa and Iran.

The Chinese government, desperate to lock down supplies of such crucial natural resources as metal ores and crude oil, has sealed deals with Sudan, Chad and the Congo. African Business reports that trade between Africa and China has advanced at a rate of 40% a year since 2001. In 2006, bilateral trade between the two was $50 billion.

Already, 14% of China’s oil imports come from Angola. About 60% of Sudan’s oil goes to China.

To understand why you should heed Fitz-Gerald’s observations, it’s important to understand just how far ahead of the pack he’s been – and how far ahead he remains – when it comes to predicting long-term energy trends and investment opportunities.