Flash Alert: The Slow Drip Lower


The S&P 500 succumbed to another wave of selling pressure.

The S&P 500 managed to hold near the flat line for most of yesterday but succumbed to another wave of selling pressure in the final 90 minutes of trading. The selloff returned the broader market right back to a key support at 1,045 to 1,050—the index's February lows.

Credit market fundamentals show signs of improvement. I've written about the TED Spread—an indicator of health in the interbank lending market—several times over the past few weeks. That spread now stands at about 43 basis points, up marginally over the past two weeks.

The TED Spread is calculated by subtracting the yield on a three-month US government bond from the three-month London Interbank Offered Rate (LIBOR). When LIBOR rises, this indicates that banks are charging more money to lend to one another. In this case, however, LIBOR hasn't budged more than a few hundredths of a basis point since May 25. The entire rise in the TED Spread is due to panicked traders buying short-term US government bonds as a sort of cash proxy.

Although the interbank credit market seems to have stabilized, investors remain nervous about sovereign debt. The yield on Spanish government bonds, among other peripheral EU economies, remains elevated as do associated credit default swaps. Meanwhile, traders are piling into bunds—German government bonds—with reckless abandon. This flight to safety has also propped up German stocks; the Deutscher Aktien Index (DAX) is down less than 2 % this year, whereas the Euro Stoxx 50 Index is down 15%.

And the yield on French government bonds appears to be moving higher relative to bunds, suggesting that traders' risk aversion has grown.

But most of the economic news has been good. Manufacturing data in Germany was far better than analysts had expected. And although traders focused on last week's US non-farm payrolls report—a notoriously volatile series—other economic news from the US has been broadly positive.

The prevailing panic and risk aversion resembles typical behavior near key market lows. I still see the scope for a summer rally as valuations and fundamentals prompt traders to take on more risk. At the same time, it's tough to declare that the correction is over until the broader market mounts a meaningful advance.

I will regard any upside as an opportunity to short some of the stocks I outlined in last issue—names that will be negatively impacted by the Gulf drilling moratorium. Investors should continue to focus their attention on the "safe haven" energy groups I outlined until we get more concrete signs that the selloff is winding down.

Looking at energy specifically, crude oil continues to hold up reasonably well in a weak market and still hasn't challenged lows in the mid-$60s. Last week's inventory number from the Energy Information Administration (EIA) was bullish, showing a 1.9 million barrel drawdown in crude oil inventories—analysts had expected inventories to remain level. Gasoline inventories plummeted 2.65 million barrels against expectations for a 500,000 barrel drop. Although inventories remain elevated, this is a sign that the big recovery in US oil demand (up more than 8 % year over year) is starting to draw down inventories.

Macroeconomic concerns and the EU sovereign debt crisis have weighed on oil prices. As explained in the last issue of The Energy Strategist, the Macondo spill, the subsequent drilling moratorium and likely new regulations governing deepwater drilling in the US are all bullish for oil prices. In light of the spill, I suspect the EIA and International Energy Agency, among others, will need to lower their estimates for non-OPEC production growth, much of which was expected to come from deepwater. That means a higher call on OPEC and lower spare capacity—higher oil prices are inevitable.

Overnight, UK Energy Secretary Chris Huhne announced a step-up in inspections for rigs operating in UK waters. He also stated that the Macondo would transform the regulation of deepwater drilling worldwide. Although it's unlikely that other countries will go to the extremes that the US has—an outright moratorium that covers considerable shallow water production as well—you will probably see more requirements in terms of the age of rigs and equipment and more rigorous safety inspections.

This all raises the cost of drilling and the marginal cost of oil. It also heavily disadvantages contract drillers like Diamond Offshore (NYSE: DO), Transocean (NYSE: RIG) and even Noble (NYSE: NE) that have a significant fleet of older rigs. It's a marginal positive for Portfolio recommendation Seadrill (NYSE: SDRL).

While oil and stocks have tumbled, natural gas continues to rally and the 12-month strip is now trading at four-month highs. A number of factors support the rally: lower production from the Gulf; rising demand; predictions of a hot summer and strong hurricane season; and President Obama's favorable comments about natural gas. This has helped Portfolio recommendations Nabors Industries (NYSE: NBR) and Range Resources Corp (NYSE: RRC) broadly outperform over the past two weeks.

I expect the industry to step up onshore production to offset declining Gulf Coast output in the wake of a lengthy moratorium on deepwater drilling. Also, note that the moratorium covers wells in more than 500 feet of water—the traditional definition of deepwater is more than 1,000 feet. This means the ban includes shallow-water activity.

Portfolio holding EOG Resources (NYSE: EOG) suffered a blowout at one of its onshore wells in the Marcellus Shale of Appalachia.

The blowout released fracking fluid—primarily sand and water—and natural gas into the air. Soon after the accident EOG voluntarily halted all drilling in Pennsylvania, and the state imposed a seven-day ban on new EOG drilling and a 14-day ban on new fracking operations. No one was killed or seriously injured by the blowout.

Some pundits have made a big deal of this accident; however, it won't have a major, lasting impact on EOG or other natural gas stocks. The contrast between an on onshore blowout and a deepwater blowout is stark: EOG's well was under control and the leak entirely halted within 16 hours. The fracturing fluid is mainly harmless water and sand, but the company has already started to clean it up.

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