The first quarter of 2005 was one to forget. The S&P 500 was down 2.59% with the Energy component of the index advancing by more than 17% making it by far the best performing sector outpacing Utilities, the second best performing sector, by more than 12 %. The first quarter was characterized by a one way direction in Energy while other sectors were unchanged at best or down as much as seven or eight percentage points. On the down side, Telecommunication services Information Technology, and Financials led the way down by 8.6%, 7.5%, and 7%, respectively. The first quarter was almost an identical snapshot of sector performances in 2004 overall. Energy and Utilities led the pack while Information Technology and Healthcare were the very worst. What’s notable about first quarter sector performances is the performance of Utilities. After gaining better than 11% in the fourth quarter of 2004, they added 4.4 % in the face of rising interest rates.

Oil Prices made a new yearly high this quarter and there is rampant speculation that oil will continue on a meteoric rise as some analysts are predicting. To us this seems highly unlikely based on simple economic fundamentals and other assumptions that are unlikely to hold, mainly:

-         Oil bulls assume that oil demand is inelastic and will continue to grow regardless of price and they cite (and pound the table) strong demand from China. It’s important to note that demand growth rates are rooted in estimates based on oil prices at $30 and $40. There is no concrete evidence of what demand will be at $60 oil or higher as we are entering: a) new uncharted price territory (in recent years that is) and b) it is assumed that higher oil prices will have no negative effects on the Chinese economy or the world economy for that matter.

-         It is also assumed that the US dollar will continue to decline or at least stay at its current levels. The size of the oil price increase that is attributable to the dollar decline in 2004 is debatable but what is almost certain is the fact that dollar weakness did play a role in the increase in oil prices. Whereas the dollar may continue to weaken, recent economic data (February’s core (PCE) price index and March’s Chicago PMI index) suggest a strong economy with tame inflation all the while with interest rates creeping up slowly. All these factors support a stronger, rather than weaker dollar.

-         The U.S. Strategic Petroleum Reserve or (SPR) is expected to finally reach full capacity of 700 million barrels sometime in May or June of 2005. This would mean that mandatory government purchases will dramatically decline. Although this might be a small number (government purchases amounted to an estimated 1.3% of total US imports) it will nevertheless have a psychological impact on the market as well as a real impact on inventories which seem to be slowly creeping up in the last few weeks.

We are not necessarily calling a top for oil prices at these speculative levels but we believe that the above factors along with the fact that almost everybody seems  to be calling for higher oil prices is an indication that we are more likely to see lower oil prices later this year rather than higher prices.