Option Investor
Commentary

Ugly Week For Traders But Opportunity Ahead

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What a week for trading. Buy and hold investors ended up about where they started with oil prices making a round trip from $63.50 last Friday to $68 on Wednesday and back to $64 at Friday's close. If you were trading the bounce there were some strong moves in many stocks. But if you were holding the week was a draw. Several of our stocks outperformed the market but we lost a couple coal plays, MEE and CNX when oil prices began falling. The cost of natural gas eased and with it the need to replace expensive gas with coal. At least that was the theory this week. With natural gas likely to explode higher very soon the coal buyers will be back.

I spent so much time covering the hurricane and its impact on oil in the market wrap I hate to repeat it all here. Some readers don't subscribe to both newsletters so I do need to cover some of the same ground. If you read the market wrap you can skip the next several paragraphs.

As I write this on Friday night 28% of the refining capacity of the U.S. is offline due to the hurricanes. 23% in anticipation of Rita and 5% is still offline for the next couple months due to Katrina. This is a huge amount of refining capacity to be down for any period much less 7-10 days. 19 refineries in Texas closed in advance of Rita rather than ride out the storm and take the additional risk of more severe damage.

99.1% of all Gulf oil is shut in according to the Minerals Management Service and 72% of all gas production. More than 4500 workers have been evacuated from the Gulf and 1200 rigs/platforms in Rita's path have been taken offline. Several of the pipelines from the Gulf have closed with the Colonial and Explorer running at reduced capacity on a contingency basis. The Louisiana Offshore Oil Port was closed on Wednesday in preparation for the storm and that represents a loss of 1.5mbpd in imported oil. So far the MMS estimates more than 50 million bbls of oil production has been lost from the combined impact of Katrina and Rita with more losses to come.

When Katrina veered east of New Orleans it took aim at about 50% of the more than 4000 rigs and platforms in the Gulf. When Rita veered east at the last minute and headed for Beaumont and Port Arthur it took direct aim at the other 50% not hit by Katrina. B/PA is also know as Petroleumville USA due to the high concentration of oil and chemical facilities. As of late Friday Rita is heading straight for that area.

RigLogix estimates that the same percentages of rigs will sustain severe to moderate damage as seen with Katrina and that represents 20+ rigs. Platform loss and damage could exceed 200+ locations of the 1200 in Rita's path.

RigLogix.com Rig Map with Hurricane Tracking

The downgrade of Rita to ONLY a Cat-3 hurricane seemed to produce relief in the investing community despite the fact that a Cat-3 storm still has sustained winds of 125-135mph. That is a far cry from Rita's original 175 mph with gusts to 212mph but still very damaging. A storm surge of 15 ft is expected and waves of 22ft are being tracked. 37ft of water and 135mph winds can move mountains as the Corp of Engineers are seeing in New Orleans. The levees broke again and New Orleans is again flooded. This will delay the recovery of the three refineries still offline there.

If you remember oil prices fell in advance of Katrina as it was downgraded just before going ashore. Somehow a downgrade appears to be a get-out-of-the-storm-free card for nervous investors. Those same investors may be jumping back in on Monday if damage is severe.

Either way there will be very serious gasoline shortages due to 28% of refining capacity being offline for 7-10 days. Most refineries in Texas went offline on Thursday and may not be back online until late next week. If they do not receive any damage they may still be at risk of no electricity. We know how fragile the electric grid can be during these storms. Since it has been 21 years since a material storm in Texas and 40+ years since a major storm there could be plenty of electric problems that have accumulated.

The Nymex has taken the unprecedented step of opening a special Sunday session this weekend to trade energy futures. The session opens at 10:AM on Sunday. This will allow traders to act on the earliest damage reports as they see fit. Unfortunately it means Monday will be a definite gap day. If you are holding options today you are hostage to the Monday gap and after a full day of futures trading the odds are very good we will either gap up strongly or down strongly depending on the damage. Odds are minimal we will open flat.

I am going to tighten the stops on the remaining plays but it is likely to do much good on a strong gap. We are at the mercy of Rita tonight. Since I am writing this on Friday you will already know the outcome by the time the newsletter is delivered on Sunday.

Also because of the strong possibility of a gap open I am not going to add a bunch of new plays to the watch list other than a couple with breakdown triggers just in case the gap is down. I definitely do not want to buy the top at this time in the cycle.

Oil prices are likely to decline regardless of any gap direction on Monday. Unless the western oil patch is wiped out the key is still refining capacity. With our capacity limited we are likely to see oil backup in the system until refiners catch up with supply. This should benefit companies like VLO, TSO, COP and SUN as refining profits will surge again on cheaper oil and more expensive gasoline. As long as gasoline, diesel, jet fuel and heating oil demand exceeds supply the end price will remain high even if oil prices decline. Oil has support at $63.50 but that would be easily broken on any good news from the Gulf on Sunday. Real support is still the 100-day average at $60. I would look to enter new positions at that level if possible. Once any post Rita volatility evaporates we will likely see a range bound market until heating oil supplies begin to dwindle then stock prices will begin to rise again. Gas stocks, ECA, CHK and UPL should continue to do well once the original hurricane volatility passes. Try to add to positions on any dip.

I would try to add to your BTU position on any weakness. Once nat. gas starts climbing coal will be right behind it.

Companies likely to benefit from any damage are HAL, SLB, NOV and BR.

This will be a week for traders more than investors so make sure you have a game plan in mind before the market opens on Monday.

Crude Oil Chart - Daily

Natural Gas Chart - Daily

I am also changing some of the chart views to a 30-min view from a daily. The energy stocks are so far above the daily averages they serve no practical purpose. I am going to show the charts with my personal averages of the 100/130 ema (avg high/low). Most of the energy stocks seem to respect these averages very well and I use them in my personal trading very profitably. The image below shows the setup in Qcharts.

Qcharts Average Setup

 

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