With the end of the first quarter approaching, it is time to adjust the names in our Watch Lists. We will price all the new lists as of the close on Friday, March 30. Today we present our planned updates to the Small Cap Watch List (Track at Marketocracy).

Frankly, we were surprised at the amount of turnover in our screens. Only 9 of the original 29 names made the cut for the new list (which comes in at only 24 names.) Still, given the level of outperformance we saw in the first quarter (actually just two months) and the fact that much of those gains were achieved early, perhaps the turnover is warranted.

So without further ado, the names on the chopping block from the previous list are:

Silgan Holdings (SLGN - Annual Report); Steel Dynamics (STLD - Annual Report); NVR (NVR - Annual report); Middleby (MIDD); Vector Group (VCG); Sanderson Farms (SAFM); Downey Financial (DSL); Waddell & Reed (WDR); Wilshire Bancorp (WIBC); Harrington West (HWFG); Gamco Investors (GBL); Apria Healthcare (AHG); Papa John’s (PZZA); Cato Corporation (CTR); Meredith Corporation (MDP); CSG Systems (CSGS); Energy East (EAS); Dynamics Research (DRCO); Ingram Micro (IM); and Dade Behring (DADE).

The new watch list will be:

Barry Ritholtz recently expressed his dissatisfaction with the explanations being bandied about in the media as to why oil prices have fallen:

Here is a short list of the most common current explanations circulating in MSM:

1. More Supply coming online;
2. Reduction of global terror threat;
3. Cooling of hostilities between Israel and Lebanon
4. Seasonally weak demand, as Hurricaine season ends;
5. Iran cooling inflammatory rhetoric

I find these some of the mainstream explanations unsatisfying. At the risk of creating a strawman (only to knock it down), let me put forth my top 5 list:

1. Fast money rotating out of commodities and into tech;
2. Cooling economy consuming less energy;
3. No major supply disruption from weather or Middle East;
4. Psychology peaked earlier in year; (see Business Week Cover Story)
5. Stretched consumer shifts behavior;
6. And lastly, the Weak Strong US Dollar (Crude is priced in greenbacks)

We agree with Barry that each of these can pretty easily be explained away, as we do here:

1. Supply coming on line takes years. What new supply could have come on line that was not anticipated three months ago?
2. Just because they will let you take some of the liquids back on the plane now doesn’t mean the terror threat is any lower.
3. Israel and Lebanon don’t exactly have much oil - no oil supply was disrupted during their skirmish and it did not create any particularly unusual demand, so why would it have any effect on price (which was rising for years before the skirmish started?)
4. Seasonality is a valid point but certainly a very temporary one. It is long-term supply/demand balances that sent oil to $78, and those haven’t changed.
5. Iran? Isn’t this sort of the terror/Israel arguments tied together? Iran either wants to sell oil or it doesn’t. We’re betting on the former and think they are selling as much (or nearly so) as they can produce and that this won’t change any time soon.
6. Amaranth certainly suggests there was some speculation on the way up, but also suggests that (post their pop) there may be limited downside remaining.
7. The economy would have to cool to zero percent growth for the next five years for technology and substitution to offset the normal demand increase attributable to growth. If that is your forecast, fine (although I hope you are wrong.) Otherwise, your outlook for oil should be consistent with your economic outlook.
8. Psychology? Perhaps it had an impact on price, but it sure doesn’t affect supply or demand much. Unless you can quantify the impact on price, how do you know the current price is any more correct than last month’s?
9. Stretched consumer: See #6 above.
10. Dollar: Ditto.

So with the easy explanations as easily tossed aside, how about something with more meat? John Mauldin recently reposted a Charles Gave article on his site. Its basic tenet that oil prices will be brought back down due to substitution and new technology is beyond reproach. As far as the timing, however, we found it to be long on optimism and short on consistency. Consider:

1- The return of king coal: In WWII, the Germans (who were long coal and short oil) refined processes to make gasoline out of coal. This old process has been perfected and is now a source of energy in South Africa. Why is this important? Because there is more coal in North America or Australia than there is oil in the Middle East. The problems in using coal have historically been a) ecological issues (which can be solved with some money) and b) costs (using/moving coal is not as economic as low oil prices).

2- The exploitation of tar sands or bituminous coals in Canada, the US, and yes, Venezuela. Here, once again, the technology exists and the extraction costs are roughly US$30/bl. The production build-time is roughly around three to four years. The big hang-up is the shortage of technicians. Such shortage problems can however be solved after a few years (time of schooling/training) or, by enticing retired technicians to come back.

The company that converts South Africa’s coal into fuel is Sasol (SSL) and is on our Watch List. During the last few months they have not opened vast new capacity, nor even announced plans to start building vast new capacity. In fact, the recent decline in oil prices has hit Sasol and the tar sands producers harder than it hit traditional suppliers because these processes are only profitable when oil prices are as high as they have been recently. Given the long lead times for building the plants and extracting these resources, companies naturally want some degree of comfort that the price will not fall significantly below current levels for some time. The recent price decline reminded them why they did not start building these plants five years ago, and is unlikely to encourage them to start building them now.

The article continues:

3- The emergence of new technologies to recover more oil out of old and decaying oil fields. With the price of oil where it is, it makes a lot of sense to invest substantially to try and optimize the output from any individual well. In the past 25 years, we have seen the average extraction at existing wells climb, thanks to technology, from 25% of known reserves to 40% of reserves. Norway has set a target of 65% to 70% recovery for a good part of its reserves and is already achieving that in some fields. Where do the improvements come from? Technological progress!

Once again, technological progress that has not occurred overnight. If it took 25 years to increase extraction to 40% it is likely to take as long for it to reach 65%.

4- The possibility to produce oil/ethanol out of agricultural products. On this very topic, the best summary we have read of the issues at hand was produced recently by our friend Mark Anderson, the editor of the SNS newsletter. We lift his work below shamelessly: “Ethanol is a liquid fuel, currently produced from corn… Now here’s the rub: there is a debate about whether it actually takes more energy to create a gallon of ethanol than the energy contained in a gallon of ethanol. According to Report No. 814 from the Office of the Chief Economist of the U.S. Department of Agriculture, corn ethanol contains 1.34 times the energy required to manufacture it….

There are longer-term solutions. In a period of about five years, we could be producing ethanol in quantity from cellulose. Cellulose is found in a variety of plant material, including the stalks of the corn plant. The process for production of ethanol from cellulose does not require large amounts of hydrocarbons and is, therefore, much less expensive. If the federal government continues to provide large subsidies for corn-derived ethanol, however, we are in effect providing a disincentive to make capital investment in cellulose technology. The corn lobby will fight tooth and nail, but in the end, democracy, just like the free market, has a way of doing what is right and sensible (usually, after trying out all other options). In this case, that would see cellulose derived ethanol become widely available in the marketplace.

Well, call us in five years when the cellulose plants are up and running. In the meantime, with a 1.34 energy output/input ratio the best ethanol can do is cut fuel consumption 34% - and that is assuming there is that much excess corn produced, that the plants can be built, that the increased demand for corn doesn’t make it even less profitable, and so on.

6- Prices & Substitution

High energy costs are not impacting just oil. We have witnessed a stupendous rise in the price of all forms of energy through the substitution effect. And here technology is also making huge leaps. Let us, again, go through a few examples:

* Nuclear power. There are two main problems with nuclear plants. The first is that building a plant takes a long time (though the Chinese are definitely not wasting any time on that issue). The second issue is the disposal of the nuclear waste. But this is where the exciting news lies: we have recently read reports highlighting that the volume of the waste in the new French reactors is a tenth of what it was in the old reactors. This implies that the amount of space needed to store the waste is much smaller, and the arguments of the anti-nuclear green lobby further reduced.

* Production of energy at the individual and local levels: everywhere we go, especially in Europe (where the price of energy, on top of being very high, is also heavily taxed), we find new and interesting forms of energy production: in Scandinavia geothermal energy (one drills in the rocks, and gets the heat coming from below); in France, a massive movement towards heating pumps (exchanging heat between a source of water and the atmosphere - in fact, after a brutally hot summer in Provence, I am biting the bullet and having such a system installed in my Avignon house); in Denmark, there are quite a lot of wind turbines; in Spain, you can see solar panels on a growing number of roofs. All these systems enjoy huge tax breaks, and, once they are put in, they are here to stay; markets lost for oil, for ever.

By themselves, none of the above factors is sufficient. And the rate of substitution from oil to these new sources of energy is excruciatingly slow. For example, if one had the bad luck of installing an oil boiler in one’s house three years ago, one is not going to change now. The capital costs are simply too high. But taken together they are significant and will change for ever the demand for oil or natural gas used to heat or cool houses, factories, or office buildings.

This is indeed the meat of the article, but there is nothing to say that this can happen any time soon. With a ten-year lead time to build nuclear plants, we just don’t see it making a sizable dent any time soon. Then, apart from the environmental issues, Gave offers the reason why it may not help even then:

Our 19th century world was dominated by coal. Our 20th century was dominated by oil. It is our firm belief that the 21st century will not be dominated by oil. It will be dominated by electricity; and oil will become a marginal energy. This simple truth might help explain why, since 2001, uranium has not had a single down month, and since 2003, uranium has never traded down for even a single day, regardless of what was happening to oil prices.

With uranium prices rising so much, why even bother? It sounds like it won’t do much to make energy cheaper, which is after all the point. In fact, there may not even be enough uranium out there to support much additional demand. As far as substitution consider that the median age of vehicles in the US is 9 years. If you assume that hybrids improve fuel efficiency by 50% over their gas-only counterparts, even if 100% of new car sales were hybrids it would take 18 years to fully replace the vehicle fleet and reduce fuel consumption by 50% overall (assuming demand doesn’t continue to rise.) Based on a more realistic (but still wildly agressive relative to today’s sales levels) assumption that 10% of new vehicle sales will be hybrids, the annual demand reduction is less than 0.3%. Color us unimpressed.

With that off our chest, some stories affecting individual companies recently:

Statoil STO) strikes gas at Barents Sea Well

Pension and endowment funds aren’t giving up on commodities yet.

ConocoPhillips Confirms North Sea Discovery - Oil and Gas Online

Helix names new CEO

Disclosure: Author owns shares of United States Oil Fund (USO).

William Trent currently has a short position in put options related to Office Depot (ODP).

Along with other commodities, the basic materials have taken something of a beating recently. The durable goods report suggest that it could be more than just a technical move as shipments, orders and backlog for primary metals all slowed while inventory growth accelerated. It is worth noting that the fundamentals aren’t bad, they are just not quite as good as they were a month ago. Most industries wish they had 15% growth in orders and 25% growth in shipments, and with both growing at a faster rate than inventories it is hard to argue there is a glut. Still, it will be interesting to watch whether the deterioration continues.

Fabricated metal products, which were never as strong as the primary metals to begin with, also show a slowing trend. Here, the fact that inventory growth was faster than order growth and nearly as fast as shipments suggests a higher degree of caution is warranted. Further, with these firms building inventory they are likely to need less of the primary inputs in future months.

Larry Kudlow sees falling commodity prices and bond yields as cause to worry about deflation.

Copper
According to a Bloomberg article, Chinese copper demand is slowing as well.

Copper demand growth in China, the world’s biggest consumer of the metal, may slow to 5.6 percent this year, as record prices prompt makers of cables, wires and air conditioners to switch to cheaper substitutes.

Consumption may be 3.8 million metric tons, Yang Changhua, senior analyst at Beijing Antaike Information Development Co., which advises the government on industry policies, said today at a conference in Nanjing in eastern China. The estimate is lower than his March prediction of consumption of 3.86 million tons and last year’s growth of 9 percent.

Meanwhile, Zambia keeps digging up more of the stuff:

Chamber of Mines of Zambia general manager Fred Bantubonse has said Zambia’s copper production for this year was likely to be at around 600,000 metric tonnes.

In an interview, Bantubonse said this year’s copper production was higher than last year’s which was pegged at 466,000 metric tonnes. “Future prospects of copper production for the year 2009 are likely to about 800,000 metric tonnes all things being equal,” he added.

Nickel
Inco has the right idea: produce less metal but earn more income.

Gold
South African gold production plummeted by 6.1 percent over the three months ended July from the previous three months, according to Statistics SA.

Newmont Sees Lower Gold Production Until 2008

Russia’s gold production down 0.4% in 8 mthsRumors of massive central bank gold selling are still just rumors.

Chemicals
In their latest Investment Survey, Value Line noted significant improvement in ranking for specialty chemicals makers such as Watch List member Sasol (SSL).

The Specialty Chemical Industry is currently ranked 32 out of 97 for year-ahead performance. This is, as noted, in the top half of all industries covered by The Value Line Investment Survey, and a considerable improvement compared with our June report.

Most companies in the specialty chemical sector reported strong bottom-line advances during the June quarter. The earnings outlook for the sector remains relatively favorable for the second half of 2006, as well. Moreover, much of the strength will probably continue into the first half of 2007. This is a disparate group, however, and prospects vary considerably by the product line and market position of each participant. We urge investors to carefully review each stock before making specific investment decisions.

Disclosure: Author is long the Streettracks Gold ETF (GLD)

Disclosure: Author is long STREETTRACKS GOLD (GLD) at time of publication.

Oil was down yesterday on stronger-than-expected gasoline inventories, and let’s face it, the strong price run for energy and energy stocks over the last several years has many predicting (for the umpteenth time) there will be a correction (eventually they will be right.) Business Week outlines the case for $50 oil. CNNMoney.com agrees, saying:

Most analysts don’t expect oil to fall too much further in the short term, as demand remains strong and uncertainty surrounds supplies from Iran, Nigeria and Venezuela.

But the recent record-high prices have fueled a boom in exploration. And as that boom begins to yield more oil, the industry will gain a greater ability to ramp up production in one place in order to make up for any shortfall elsewhere.

And according to the latest Value Line Investment Survey:

The Oilfield Services/Equipment sector continues to be among the top-performing industries in the Value Line universe. The sector holds a Timeliness ranking of 4 out of a total of 97 industries. Many oilfield services companies are generating record results, thanks to a very tight drilling market. The robust operating environment is being driven by increased energy demand worldwide, combined with high oil and natural gas prices. This, in turn, has prompted major energy firms and independent exploration and production (E&P) companies alike to boost their capital spending on oilfield services and related drilling activity in order to pump more fossil fuels out of the ground.

Many stocks, however, have appreciated so sharply over the past few years (despite a recent retreat) that we question their attractiveness for capital gains potential out to 2009-2011. Nonetheless, we are in the midst of an extended up-cycle in drilling activity that has shown few, if any, signs of slowing. We believe the progress will continue at least through yearend, and probably well into 2007. Investors should have in mind, though, the historically volatile nature of the industry and its direct tie-in to the direction of oil and natural gas prices.

I have seen several people say “everyone is expecting oil to keep going up, so it probably will go down.” Somehow, the above quotes don’t look to me like everyone jumping on the oil bandwagon. Meanwhile, we think the knee-jerk reaction to yesterday’s inventory data was short-sighted for several reasons:

1. The higher-than-expected increase in stocks applied mainly to gasoline. Not petroleum products as a whole. The nature of refining could cause more or less of any given product to be produced any given week.
2. Part of the reason for the increase was that refining capacity utilization was higher than expected. Higher refining throughput should mean less crude oil and more refined products at the end of the week. So? It’s not like it all isn’t going to be refined eventually. Besides, the utilization rate of about 92 percent is quite high - what’s going to happen to prices if we use up the remaining capacity? Given how long it takes to approve and build new refineries that seems like a distinct possibility.
3. Who cares about what the estimate was anyway? Who is making the estimate and has anyone looked at how accurate these estimates have been in the past? The market supply/demand balance and the trend in that balance is far more important than what a bunch of prognosticators think the ending inventory will be in any given week.
4. And finally, that balance isn’t looking so hot. By our preferred measure of total petroleum product supplied relative to non-strategic reserve inventories, stocks are tight and getting tighter. As the accompanying chart demonstrates, this week’s reading of 49.5 days of inventory is down sharply from 50.2 days last week and appears to be confirming the long-term trendline of ever-declining days supply of inventory.

Although our Watch List underweights the energy sector vs. the S&P 500, this is partly due to the fact that our methodology tends to favor stocks with smaller market capitalizations. Furthermore, although only 5% of the Watch List is classified as being in the energy sector, another 2% are energy-intensive names in other sectors (Sasol, a chemical company, produces fuel from coal and conglomerate Norsk Hydro derives much of its revenue from oil.) This brings the total weight closer to the S%P’s 9%.

It also brings up another important point, which is that energy stocks are not the only way to gain exposure to energy prices. There are of course exchange-traded funds such as the OIH, as well as many funds specializing in emerging markets that have high exposure to energy.

Russia’s rapid economic growth has been fueled by record high world prices for the nation’s booming oil exports.

Finally, as oil prices remain high, interest continues to rise in alternative energy sources.

In Upington, a town in the arid, ironed-flat expanse of the Northern Cape, the extreme and persistent heat may cause some to become hot and bothered, but to Eskom it’s good news - because this is where the utility is considering building its electricity-from-the-sun project. (In fact, the Northern Cape every year records some of the highest aggregates of sunny days a year worldwide.)

If Eskom takes the decision to go ahead with the project, it will be the first major solar-energy project in Africa, especially where the electricity generated will be directed into the main power grid of a country.

Plus, Watch List member Sasol Ltd, the world’s biggest producer of motor fuel from coal, is in talks with Iran’s government over the construction of a gas-to-liquid fuel plant, South Africa’s foreign minister said.

However, even alternative energy is subject to red tape, NIMBYism and environmental concerns.

The first utility-grade wind farm proposed in Virginia is hailed by its supporters as clean energy that can help stem global warming and rising fuel prices. But mountaintop residents near the Highland County site worry about what the blades of 18 towers taller than the Statue of Liberty would do to their environment.

That would include rare or endangered birds, bats and a few other species, as well as a wild trout stream.

Eleven state agencies have reviewed the Highland New Wind Development proposal and come up with a lengthy list of suggested studies, including an analysis of the cumulative impact of wind farms on the four-state Allegheny Mountain region.

The State Corporation Commission, which has final say, will conduct a public hearing Oct. 30 in Richmond on the proposal by retired poultry processor Henry McBride of Harrisonburg. His attorney, John Flora, hopes the project can benefit from a federal tax credit that expires in 2007.

Year after year we have pundits telling us that oil prices will fall once the premium related to Prudhoe Bay/Iraq/Hurricanes/Whatever dissipates. We say oil will keep rising until long-term supply exceeds demand. Watch List member Helix Energy (HELX) just bought some facilities idled by last year’s hurricanes, and doesn’t expect them to come back on line until 2008.

Furthermore, increased exploration is no guarantee that projects will come on line. Another Watch List member, Statoil (STO) proved some resources way back in 1989, but doesn’t expect them to become profitable until 2010.

The company said it and the other license holders aim to send the plan for development and operation to the Ministry of Petroleum and Energy during the autumn. A final cost estimate will also be available by then, it said. The Gjoa field is located 70 km north of the Troll field and some 45 km off the coast of western Norway.

Located in blocks 35/9 and 36/7, Gjoa was proven in 1989 but Statoil said making the project profitable has been demanding.

So let the pundits pundit. Our bets are on continued supply shortfalls.

Basic Materials stocks continue to appear well positioned. According to the latest Value Line Investment Survey:

The Chemical/Diversified Industry continues to fare relatively well, with most companies on track to generate higher earnings in 2006. Economic conditions remain largely favorable, with the industrial sector extending its record of expansion. One common trait shared by most of these companies is that they continue to battle the headwinds of higher raw material and energy costs.

Manufacturers have made every effort to pass increased expenses onto their customers by raising selling prices, but commodity price changes continue to outpace their efforts. As a result, although most of the companies here will report margin improvement in 2006, they largely remain below their best levels of prior years.

Still, the stocks continue to show improving relative price and earnings performance, with the group’s Timeliness rank moving up a few notches into the top half of the Value Line universe. Readers will find a number of issues here that offer attractive price growth potential, both for the coming six to 12 months and out to 2009-2011.

Our Watch List exposure to the chemical industry is through South Africa’s Sasol. Their technology to convert coal into oil was recently written up in the Charleston Gazette.

For decades, scientists have known how to convert coal into a liquid that can be refined into gasoline or diesel fuel. But everyone thought the process was too expensive to be practical.

The exception was South Africa, a one-time pariah state that had huge reserves of coal and, thanks to anti-apartheid sanctions, limited access to foreign oil. Sasol Ltd., a partly state-owned company, built several coal-to-liquids plants, including the ones at Secunda, and became the world’s leading purveyor of coal-to-liquids technology.

Now, oil prices are above $70 a barrel, and Sasol has emerged as the key player in the world’s latest alternative-energy boom.

Turning to metals, despite Teck-Cominco dropping out of the race, there is still a two-way battle to acquire Inco. Depending on your perspective, the recent acquisition frenzy across the board in the materials and energy sectors represents either a market top or a signal that shares are undervalued.

Many experts believe gold will hold above $600 per ounce. If so, you may want to look at MineWeb’s list of the world’s top gold stocks. But what do the technicals say?

Plus, we learn that Dell’s battery recall may be positive news for zinc miners.

Disclosure: Author is long STREETTRACKS GOLD (GLD) at time of publication.

With its coal conversion technology suddenly in the limelight (and possibly requiring $ billions of investment) Watch List company Sasol (SSL) is looking to shed some weight (and raise some cash) in other parts of its portfolio.
Business Report - Sasol received bids for chemical unit

Bidding has started for the chemical unit of South African petrochemical group Sasol , with negotiations with short-listed bidders to be held in July and August, the group said on Tuesday. Sasol is selling most of its Olefins & Surfactants (O&S) chemical unit, although keeping the unit’s South African business. Early last month the group said 19 firms had received information to prepare their bids.

The sale will affect the overseas operations of the chemical unit it bought more than four years ago, most of which is concentrated in Germany, Italy and the United States. Last August, Merrill Lynch said the sale might fetch up to 900 million euros ($1.15 billion), and backed the sale, provided that oil prices do not crash below $15 per barrel. Sasol in 2001 bought the chemical business then known as Condea from Germany’s RWE Dea for 1.3 billion euros, and most of this business is held in Sasol O&S.Sasol says it wants to sell most of the O&S unit because it is not well-integrated in its plans, which include using its chemical division to provide feedstock for units such as the group’s gas-to-liquid (GTL) initiative. - Reuters

Although the sale doesn’t look to fetch as much as Sasol paid, focusing on the energy business makes sense these days.

Last week we took issue with the idea that higher absolute inventories of oil products in the US suggest oil prices should be lower, arguing that it was the number of days’ demand that the inventories could supply that was the more relevant number.

Jay Walker hit on the other major reason that US inventories should not have the predictive power they once might have: increased demand from India and China. He points to a New York Times article that makes the following points about China:

• Total miles of highway, now some 23,000, more than doubling what existed just six years ago;
• Year over year growth of car sales of 54%;
• Passenger cars on the road, now 20 million, compared to about 6 million in 2000;
• Government announced target of 56,000 miles of freeway by 2035 (the US has 46,000 miles of interstate highways);
• and by 2030 carbon dioxide emissions are projected to exceed those of the US.

Walker goes on to make his own point, with which we heartily agree:

Anyone who thinks that the demand for global fossil fuels will abate anytime soon, should also consider that the average American uses about 25 barrels of oil annually, versus 1.8 barrels in China and 0.8 in India. Those latter two figures are obviously going to move upwards at a rapid rate, considering those countries recent growth rates in the 7-10% range annually and the apparent embedding of the car culture in China particularly.

Which of course provides a long tailwind to investing in the fossil fuel industry.

And, of course, alternative energy sources. Last week we chuckled at calling coal an “alternative energy” but now we read that Watch List member Sasol (SSL), which has long converted coal into traditional liquid fuels, is going a step further and converting it into hydrogen for fuel cells. More »

The New York Times has a story on new techniques for converting coal into energy. Although we wonder how coal, which has been used for centuries, became an alternative energy source all of a sudden the search for new uses for coal benefits two of our Watch List companies - Sasol (SSL) is mentioned in the article as having been converting coal into fuel oil for decades and Headwaters (HW) develops catalyst technologies to convert coal and heavy oil into liquid fuels.

The article points out that coal reserves in the US are far greater (in terms of potential energy) than the oil reserves in Saudi Arabia. Given the enormous global demand for energy as China and India rapidly move into the developed world, in the short term any available energy sources are likely to be sought just to keep the lights on. However, the article notes coal’s dark side:

Producing fuels from coal generates far more carbon dioxide, which contributes to global warming, than producing vehicle fuel from oil or using ordinary natural gas. And the projects now moving forward have no incentive to capture carbon dioxide beyond the limited amount that they can sell for industrial use….

Unless the factory captures the carbon dioxide created during the process of turning coal into diesel fuel, the global warming impact of driving a mile would double. 

More »