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The End Of The Energy Cycle?

By Tobin Smith

This summer saw the most money going into energy, metals and commodities mutual funds -- 120% of ALL the money that went in during 2005. Yowser!

More energy and commodity mutual funds were formed in the first half of 2006 than in 2004 and 2005 combined.

I track this number religiously for one obvious reason: When the schoolteachers start shifting their 401(k) and 403(b) money to commodity and resource mutual funds, IT'S A TOP! When specialty ETFs and mutual funds that serve the masses trundle out in record numbers, they fuel the fire for awhile, then they are 100% invested and -- poof! -- the top is made.

Then forced selling on redemptions makes them sell out positions regardless of quality and valuation.

The same thing occurred in the '80s with oil and then stocks. It happened again with tech stocks in the '90s. And then it happened with residential homes in 2005.

We will get a dead-cat bounce off the huge oversold bottom in oil and energy services, but the energy trade is OVER for now, with some key exceptions of course.

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HOW WE GOT TO WHERE WE ARE TODAY

Remember the genesis of our bullishness on oil and natural gas?

First off, our good friend Hugo Chavez started the ball rolling in 2002 by losing 1 million barrels a day of oil production to his socialist economic plan. 3.25 million barrels a day of oil was cut to 1.8 million a day and it has stayed there (and looks to get worse).

Then in 2004 China and India reversed the supply/demand cushion for oil from 3 million barrels a day to less than 1 million by moving demand from 5 million to almost 9 million barrels a day.

Take out 500,000 barrels a day from Nigeria, 1 million barrels a day from Iraq and then add the impact of hurricanes Katrina and Rita, and the supply demand S-curve we look for in our investing was racing skyward.

Now fast-forward to today.

Chavez is still a chump, but oh my, you can see what $270 BILLION in exploration and development money spent in 2005 and $300 billion in 2006 can do for supply.

We have the new million-barrel-per-day fields in Azerbaijan now flowing through the Baku-to-Ceyhan pipeline.

We have 500,000 new barrels daily from Angola

And we have Russia actually INCREASING petroleum output -- for the first time.

The net result? 2.7 billion barrels of oil inventories worldwide and U.S. natural gas storage at full capacity.

On the demand side, we just saw the entire Shanghai government taken out to the woodshed by the Chinese Commies for allowing TOO MUCH growth -- and it's a lethal message to other cites in China.

And we saw a slowing rate of U.S. GDP growth that takes both China and India down a notch, JUST as new supply hits the market.

The key "tell" in the markets will be futures prices for oil and gas. Now February oil is trading around $63 … but natural gas is at $7.71 vs. $4-spot prices today.

If natural gas drops below $7 in 2007, watch out.

All in all, we can now make a case for 3 million to 4 million barrels of daily spare capacity for sweet crude in the oil markets -- up from less than 1 million just 12 months ago. Today's blended OPEC crude price (the basket of 11 different crudes) is $55, and just where I think sweet crude is headed.

If we overshoot by 10% or so -- like we humans tend to do -- $50 oil will CRUSH energy patch valuations as the last of the Mohicans jump ship.

There will be exceptions, for instance in oil tankers. (Check out the earnings from Nordic American Tanker or Frontline for Q3 -- wow!). More oil will be used and shipped longer distances. That's bullish for tankers in a world where single-hull tankers are being scrapped as quickly as new double-hulls come online.

Fast-growing Canadian tar sands projects will do well, too. They put out sweet crude once the heavy tar is converted to oil and they sell everything they have to the U.S.

But for now we kiss our energy cycle goodbye and gear up for HUGE profits in the information, communications and medical tech secular growth companies that will lead the market from here.

Toby

P.S. We are NOT returning to $35 oil unless we have a worldwide hard landing and the economies tank simultaneously. 2009 futures have oil at $70 as we speak, and the cost of offshore drilling and tar sands oil mandates $50+ per barrel crude. If exploration and development stocks get stupid cheap, we'll be back.

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Tobin Smith is the founder of ChangeWave Research, the editor of ChangeWave Investing and ChangeWave Microcap Investor and a contributing market analyst for Fox News Channel. His market commentary can be found twice weekly in the ChangeWave WaveWire and he provides more specific recommendations and advice through his ChangeWave Investing service. An army of 8,500 strategically positioned experts help you grow rich. Learn how the ChangeWave Alliance gives you a heads-up on opportunity and risk months ahead of the crowd. This is an opportunity not to be missed -- click here.