Option Investor
Commentary

Buy the Dips

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I continue to get emails from readers who are new to this newsletter or for one reason or another failed to enter the positions when initially profiled. The number one question is "should I enter them at this level?" That is followed closely by "when should I add to my positions?" and "should I take profits?"

The answers may be obvious to some who have been reading my commentary for the last eight years but not so obvious to others. I try to continue the thought process in my market wraps with a running commentary on the future of oil. I continually suggest buying the dips. Ideally we would like to see crude pullback to the 100-day average for a safer entry. That has only happened a couple times over the last year so waiting could be a lonely proposition.

This puts traders in an emotional bind. When to buy? When we are on an up-cycle everyone feels like they are buying the top. When we are on a down-cycle we are afraid to buy the dip. Nobody is immune to those feelings. Thursday night I loaded my charts and looked at crude at $56 and the 100-day at $54.50. The severity of the three-day drop was a cause for concern and I toyed with the idea of buying the dip at $56. Option premiums had deflated and an entry would have been ideal.

However, the greed factor took hold and I decided to wait for a touch of the 100-day at $54.50. I did notice a bid on the QM futures overnight and decided to buy some just in case. After all it was just one day until the weekend and my complete review of all the oil stocks on my radar screen. I knew I was not going to be available at Friday's open so I set my stop and went to bed about 1:30am. When I did get to the computer mid-morning on Friday oil was up +1.25 and volume was slowing. While I closed the QM position for a nice profit I kicked myself the rest of the day for not adding to my long-term oil positions instead. To add insult to injury the futures continued to climb to end the day up +2.25. Option premiums are inflated again and I am back in the same boat as everyone else wondering when to make my next entry.

The moral to this story should be clear. Nobody and I mean nobody, will ever know exactly when to enter or add to the oil positions profiled here. We just need to have faith and continue to buy the dips. There is safety in that faith because I have not found any credible evidence that the oil crisis is not real. As I mentioned in my weekend wrap the world consumes 30 billion barrels of oil per year and there have been no major discoveries since 1970. Every drop we use is irreplaceable. Every barrel pumped out of the ground is one barrel closer to a dry hole. Those dry holes will start to appear much faster as we begin to slide down the depletion slope.

Boone Pickens is predicting Q4 demand at 86-87 million bbls per day. Current maximum global production is only 85-85 million bbls per day. Right now we are in the lull period where demand is lighter and any meager excess production is being put into storage for use late in Q3 when demand begins to increase. We are already seeing shortages in heating oil and we are not even close to heating oil season. Once that current summer production cushion evaporates all hell is going to break loose.

We need to buy every dip between now and the end of Q3 in order to profit from the Q4 prices. I know it is easy to say and tough to do to just buy every bounce. I know I am like everyone else who thinks the bottom will fall out on the next dip and we hate to pull that entry trigger. For those who can watch the market every day it is easier to watch for a rebound forming and jump in when resistance levels fail. That would have been at $57.65 on Friday.

August Crude Oil Chart

There is no magic answer to when to buy or when to add to positions. Everyone needs to be comfortable with the premise of a pending oil crisis and the bullish future for oil prices.

Oil demand is seasonal and I plan on closing positions late this year and reentering in the spring as the drop in heating oil demand provides a breather for prices. While buying and forgetting is still an option for many I see no reason to watch profits bleed away along with the time premium. However, with 2007 generally regarded as the end point for oil production as we know it I do expect to hold any 2006 positions until they mature. Given the uncertainty of global supply and demand that peak could come in 2006 or 2008. If we knew exactly you could sell the information for billions. The only certainty we know is that it is coming and the world, as we know it will change forever. If that gives you more confidence to "buy the top" over the next several months it shouldn't. Even raging bull markets in any stock or commodity will eventually pause for profit taking. Just be patient and buy the dips. I know that is easy to say and hard to do but if it was easy the profits would be much smaller.

The only real challenges in our current portfolio are CVX and XOM. Chevron continues to hover just outside of profitable due to concern about the UCL bid. Once that hurdle is past (August 10th) I believe Chevron will be bought quickly as undervalued relative to its pears.

XOM continues to hover just underwater as funds appear to have liquidated large positions as the quarter ended. XOM has seen some heavy selling which could have come on fear they will use their $30 billion in cash to overpay for another company. Every dollar oil moves higher will eventually be translated directly into profits for XOM but I am starting to believe our money would be put to better use elsewhere. If XOM does not move higher by next weekend I will replace it. I am trying to prevent adding additional positions as I want to limit the portfolio to only 10-12 of the best available.

After last week's dip I have raised the stops on several positions to just under the new support levels.
 

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