Vince Farrell of Scotsman Capital-Verbatim

From: vince farrell
Sent: Wednesday, February 20, 2008 6:20 PM

Rich Bernstein is Merrill's chief strategist and thinks energy shares should be sold. He has a bunch of reasons. Among them are 1) sentiment towards the group is overly bullish and there is too much speculative froth in the prices, 2) the companies are reporting negative earnings surprises, 3) Merrill is forecasting lower oil prices for the year, 4) inflation is a lagging indicator and will come down as the year goes on , and commodity type plays will lose their attractiveness, and 5) oil is priced in dollars and the dollar looks to be bottoming.

All good points and I won't address each one since I don't know how you really measure bullish sentiment and speculative froth. I find that both bulls and bears use such terms to augment their positions. The companies have surprised on the earnings front but mostly because of weak refinery results which always occurs when the price of crude spikes. It is tough to pass such costs on in a timely manner. This is well known but hard to estimate the impact in any quarter, so the magnitude can be a surprise but not the direction.

Where I would disagree with Rich, and he is some smart guy and being on the other side of a debate form him is a cold and lonely place, is on the price of crude being down this year. For 2007, the average price of a barrel was $72. We got used towards the end of the year to talking about $100 oil, but for the full year it averaged $72. If it were to average less than that this year, than I'll be wrong and we should reduce our energy exposure. We are near the end of February and the average is in the mid to high $90's, so my guess is the average this year will be $80 plus, and it could be plus a lot. Also, as I mentioned in an earlier email, the consensus guess for this year is $79, so the stocks reflect a negative bias to the current price and surprises might come on the upside.

Inflation is a lagging indicator, and if inflation quiets, central banks will feel free to cut rates to stimulate growth and drive the demand for oil up. I feel there is a basic supply/demand imbalance in the oil world. 77% of the worlds reserves are held by governments or National Oil Companies (NOC's) and they tend not to like us and will squeeze every penny out of us they can. There have been no new major fields found in a long time and even the Saudi fields are in decline. The Saudis have never had more rigs working, yet their production is stable, not growing. In any year the price of crude can do whatever, but I think the trend is up. The companies themselves are trading as though the price of oil were around $55-$60. I say that because Exxon, the biggest, usually trades around a market multiple. For this current price to be equal to a market multiple, the price of crude would have to be $55-60 to generate the earnings for my little equation to work. Using current oil prices and current earnings, XOM is at a big discount to a market multiple.

We are staying long the energy stocks.