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Big squeeze potential in crude oil

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On April 27th in our 10:30 EST Update on PremierMarkets.com I pointed out that there looked to be a short-squeeze developing in stocks in the Gold/Silver Index (XAU.X) as a potential head and shoulders pattern was unraveling against the bears. Whether or not that is truly the reason for what we've seen in that sector since April 27th is anyone's guess, but now we could see "oil bears" get a lesson on what a short-squeeze can do to their account.

On Thursday, the Light Crude Oil Futures chart ($WTIC) from stockcharts.com gave a spread quadruple top buy signal at $29.25 and finished Friday's session at $29.91. What's could be setting up here and about to unravel is a short-squeeze in the commodity contract itself.

Light Crude Oil Futures - $0.25 box

The above chart of Light Crude Futures shows a nice little bear trap at $26.75, which was probably shorted by "uneducated money", but bought by "smart money" all the way up to $29. The decline back to $27.25 and immediate reversal higher now sets up the squeeze. With the current bullish price objective of $33.75 that can me very painful when dealing with commodity futures if you're on the wrong side of the trade. It can damaging to the speculator that simply trades commodity futures, but it can also cause an oil company's stock to suffer if they're selling production at lower prices than current market value.

Nuevo Energy

For investors that like to trade energy related stocks based on their fundamentals, then knowing how that company has hedged their future production can make the difference between having a tiger by the tail and a good investment, or riding a turtle down a lonely highway on a hot summer's day. The hot summer's day would represent a sector that has caught fire, but your investment just isn't moving. Every energy company can have its "quirks" depending on what type of commodity they produce, but for Nuevo Energy (NYSE:NEV) it had been a terrible hedge strategy that was partially responsible for this stocks underperformance. According to the company's latest 10-Q, NEV has entered into swap arrangements on 26,200 barrels of oil per day (BOPD) for the second quarter of 2001 at an average West Texas Intermediate price of $19.84 per barrel and for the third quarter on 20,000 BOPD at an average WTI price of $21.22. You can see from the above chart that the company has currently hedged a portion of its oil production significantly below current oil prices. That's what I call "a trade gone bad."

Nuevo Energy Chart - $0.50 & $1 box

On May 8th, the Board of Directors for NEV accepted the resignation of its President and CEO Douglas L. Foshee and appointed Phillip Gobe, the companies COO as interim President and CEO as the company looks for a permanent replacement. Sometimes a shakeup at the top can get a stock on track as shares of NEV have surged since May 8th's close of $17.20 to Friday's close of $21.30. CEO's of companies are often times the scapegoats for a companies underperformance, but if they're also the ones that approve certain strategies, the success or failure of those strategies often times dictates the length of employment.

Since Mr. Foshee's departure, shares of NEV have been on the move. Current risk/reward however is a bit unfavorable for a bullish trade as the bullish price objective indicates $25.50 and a pullback to the recent triple top buy signal at $19 would be a more favorable entry point. With a large portion of the companies oil reserves still hedged until 2002 at prices lower than current market trading, the catalyst for the stock to move higher might not necessarily be higher oil prices, but lower oil prices! At least that's what NEV must have been thinking.

Now think about this!

Remember that "hedge" trade we have currently profiled in shares of Barrick Gold (NYSE:ABX)? See how that trade has "underperformed" its true potential if we had not written that covered call and actually sold future potential in the stock? Also understand how that trade has still resulted in some upside for the position, even though it is hedged. The above analysis of Nuevo Energy is not to short the stock because they are currently on the wrong side of a hedge strategy, but to understand why the stock has been under performing other oil and gas stocks. Also understand the potential strength of NEV's hedge strategy as it relates to lower oil prices. If oil were selling at $15 per barrel today, NEV's stock price would probably be performing rather well compared to other energy stocks that had not been hedged at all.

The lesson here is simple and should be very meaningful.

It can always be prudent to hedge a position (the stock you own or the commodity you're producing), but what is most important is the monitoring of that hedge or what we call trade management. I'd say that when the supply/demand charts began giving multiple indications that the commodity was going higher, it may have been more prudent for NEV to cut their hedge strategy right then and there. For you the trader, think about the stocks you're trading and how any strategies (long, short or hedged) are performing and if you should be calling it quits. Otherwise, your account might also under perform that of your peers.

Before you apply for CEO

Before you apply for the open position at Nuevo Energy, I'd encourage you take a look at the companies latest 10-Q and management discussions. This would probably be one of the most exciting and challenging positions a CEO of an oil company could face. "Heavy Oil" as it's known in the industry, which NEV produces a lot of, is a very complex business indeed. Notice the predicaments that the CEO has to weigh when it comes to electricity, natural gas and heavy oil. It's simply fascinating. But upon review, this might show you just why a CEO's are so highly compensated and why many CEO's compensation is heavily based stock price performance with stock options. The decisions they make on a daily basis can be far reaching and may times their jobs depend on it. During my seven-year tenure with Mobil Oil I got to on many of the areas and projects that Nuevo now operates. The oil patch is fascinating and an exciting place to invest. Those that can take it to the next level and understand the underlying fundamentals and incorporate it with the technicals can have a very rewarding investment future.

Jeff Bailey
Senior Market Technician

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