Jesse's Café Américain

For you players out there, its important to understand that the long term correlation of the SP 500 with the dominant financial sector is now weakening as Big Oil becomes a more dominant portion of the sector, with outsized earnings growth.

You can't play it to the short or long side unless you understand the makeup of what you are playing. This is one reason why we have switched more to sector plays recently as opposed to broader index ETF positions.

As an aside, these fellows fail the other sector that is turning in outsized gains with similar production cost problems and that is the basic materials and commodities sectors.

Oil Producers Mask Decade's Worst S&P 500 Profit Drop
By Michael Tsang and Darren Boey

May 19 (Bloomberg) -- Take away Exxon Mobil Corp., Chevron Corp. and ConocoPhillips and profits at U.S. companies are the worst in at least a decade.

Without the $70 billion that oil producers earned in the last two quarters, profits at companies in the Standard & Poor's 500 Index tumbled 26 percent and 30.2 percent, the biggest decreases for any quarter since Bloomberg started compiling data in 1998. Energy companies made up almost half the income growth reported by S&P 500 companies in the first three months of 2008 as oil prices surged past $100 per barrel, the data show.

The results leave the benchmark for American equities vulnerable to declines as oil companies' costs balloon and production slips, according to Bank of America Corp., Charles Schwab Corp. and Allianz Global Investors. The industry is getting less profit from a barrel of oil than at any time since 2005, just as the rest of the U.S. economy is sputtering. Still, energy shares posted the S&P 500's steepest gains in the past year, bloating their representation to 15 percent of the index.

''It's kind of a Catch-22,'' said Joseph Quinlan, 49, New York-based chief market strategist for the investment management unit at Bank of America, which oversees $643 billion in client assets. ''The better energy does, the weaker the rest of the S&P. It masks some of the weakness.''

Earnings Disparity

Energy companies in the S&P 500 reported an average 25.9 percent gain in first-quarter profit, the biggest of the index's 10 industry groups, data compiled by Bloomberg show. For the broader market, earnings declined by 18.3 percent, based on the 441 companies in the S&P 500 that already announced results.

The drop increases by 7.7 percentage points when profits for energy producers are stripped out, according to Bloomberg data, making the contribution of oil companies the biggest in at least 10 years. Even after taking out financial firms and consumer companies that reported lower earnings, oil profits accounted for almost half of the overall gain of 11.02 percent for the S&P 500, Bloomberg data show.

June futures on the S&P 500 retreated 0.2 percent to 1,423.50 at 10 a.m. in London.

The divergence in the earnings of oil companies from the rest of corporate America indicates that the S&P 500's two-month, 12 percent rally may not be sustainable, according to Neil Dwane, who oversees about $139 billion as chief investment officer for Europe at Allianz Global Investors' RCM unit in Frankfurt.

U.S. economic growth ground to a halt in the second quarter, according to economists' estimates compiled by Bloomberg. The last time the U.S. gross domestic product didn't increase was in 2001, during the last recession.

'Saved The Market'

''The oil sector saved the market,'' said Dwane. ''Ex-oil, the numbers show falling earnings and with data highlighting a U.S. recession, we can expect more earnings downgrades.''

Energy companies globally are spending a record $369 billion on exploration and production in 2008, Lehman Brothers Holdings Inc. estimates. The cost to find and develop a barrel of oil quadrupled to $18 last year from $4 in 2000.

Even so, output from outside the 13 members of the Organization of Petroleum Exporting Countries will meet only about 20 percent of the growth in world demand in the next four years, according to the International Energy Agency in Paris.

Earnings at energy producers are lagging behind the rise in oil prices as a result. Analysts estimate that oil companies in the S&P 500 will earn an adjusted $55.67 per share, or 44 percent of a barrel of oil that closed at a record $126.29 last week.

That's the smallest margin since September 2005 and about half the profit U.S. energy producers extracted from crude when it traded below $50 a barrel in January 2007.

Falling Production

Exxon, Chevron and ConocoPhillips, the three largest U.S. producers, all produced less oil in the first quarter. Chevron, whose reserves fell to the lowest in almost a decade last year, will spend more than $400 million a week this year to find reserves and tap discoveries.

Exxon, located in Irving, Texas, has climbed 12 percent since the S&P 500's low on March 10. San Ramon, California-based Chevron has gained 18 percent, while ConocoPhillips, located in Houston, had advanced 19 percent.

Threadneedle Asset Management Ltd.'s Dominic Rossi says that betting against energy stocks is a losing proposition because oil prices will stay above $100 a barrel.

Oil will rise to between $150 and $200 per barrel in two years as supply increases fail to keep pace with demand from developing countries, Arjun N. Murti, an analyst at Goldman Sachs Group Inc. in New York, wrote in a report May 5. The analyst first wrote of a ''super spike'' in oil prices on March 30, 2005, when oil closed at $53.99 a barrel. At the time, Murti predicted crude may climb as high as $105 in the next several years.

Target Surpassed

Murti was proven correct as oil prices touched $100 for the first time in January. Investors who failed to take heed missed out on a more than doubling of oil prices and a 97 percent climb in energy stocks in the S&P 500.

''We can't see oil falling below $100 from here,'' said Rossi, who manages the $756 million Threadneedle Global Equity Fund in London. ''It's time investors accepted triple-digit oil and started positioning portfolios accordingly.''

For Liz Ann Sonders, chief investment strategist at Charles Schwab, the ''real'' price of oil should be closer to $80 a barrel. The San Francisco-based firm, which oversees $1.4 trillion for clients, is ''underweight'' energy shares on expectations that oil prices will retreat.

More Sway

A 37 percent decline in crude oil to $80 would have a bigger impact on the S&P 500's performance than five years ago, when oil and natural-gas companies only accounted for 5.8 percent of the index's value, according to Bloomberg data.

Half of the world's 10 biggest companies by market capitalization -- Exxon, Beijing-based PetroChina Co., Moscow- based OAO Gazprom, Rio de Janeiro-based Petroleo Brasileiro SA, and Royal Dutch Shell Plc, located in The Hague -- are now energy companies, at a time when the marginal cost of producing a barrel of oil is climbing.

''A lot of that margin which dropped to the bottom line, that's gone,'' Bank of America's Quinlan said. ''The easy money is behind us, for both the oil companies and investors.''