Option Investor

Rough Week For Energy Stocks

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For the second time in two months we were stopped out of all our positions on a massive three-day drop. The good news is that we exited all of them before significant damage was done and most of our profits were protected. Hindsight is always 20:20 and I always feel the stops should have been tighter after an unplanned exit. However, as a weekly newsletter it is just as frustrating to have a good position stopped out by some temporary dip only to rocket higher for monster gains later. It is a balance I have to maintain in print but the reader is free to modify to his choosing. I am sure many of you exited earlier as the volume of email I have been receiving over the weeks just prior to the dip were from those taking profits early or asking about when to get out due to nervousness about risking large profits.

Of course there were also the few who did not put in their stops and are now suffering the pangs of regret with some stocks moving well below our stop levels. Just remember the capitulation point for the market is one tick after I finally exit those positions for a giant loss.

Here is a table of the exits for all the positions. I don't claim anybody got these exact results but had you followed the instructions exactly you would have been very close depending on your broker. The optional short-term positions are listed as well as the leaps for reference only.

Exit table for week of October 2nd.

The only positions we took a loss on were the last three entered simply because they had not yet aged sufficiently. Still the damage was minimal. The biggest damage was to profits as several positions fell several dollars in value before being stopped. The gap down open on Thursday was the most damaging since options did not open for some until well after the stock began trading. We took a big hit on those but still ended with a profit in most cases. Hopefully the majority of readers had already seen the disaster approaching and exited gracefully.

Last week VLO was on the watch list with an entry at $110 and an additional entry at $108 with a stop at $106. The velocity of the drop should have scared you off from making those entries. Had you taken the entries as planned it would have cost you $9.00 for the first entry and $7.00 for the second one for an average price of $8. Ironically the stop was hit just a few minutes later but the option price had risen to $7.60 so your loss would have only been -40 cents. This would have been scary in progress but a quick exit out the fire escape at $106 would have been cheap. I have never put a stop on a watch list item before but VLO looked very precarious just over $105 and I wanted to avoid a bloodbath. Turns out it was a lucky move on the surface but then VLO closed at $108 on Friday.

I sent out a midweek update on Wednesday with some suggestions for buying the dip. The gap down open on Thursday gave those interested a much better entry point but given the magnitude of the energy gap I would have hesitated taking the entries. All of the suggestions closed on Friday below the prices listed on Wednesday night except for COP and VLO. All the stocks closed higher Friday than their gap down prices on Thursday except for SWN. Had you taken the suggestions you would be profitable today. I appreciate the emails I received thanking me for the update and the suggestions.

Now, the next problem is what to do next? We only have one position in the portfolio, Questar (STR). I did not put a stop on it as a watch list entry and we were triggered at the beginning of the drop at $86. It hit a low of $77.90 but recovered to close at $82.99 on Friday. Despite being underwater I still like the position.

We came into the weekend with a blank slate and about six-eight weeks remaining in this demand cycle. Once we get into December traders will start looking towards spring and without some kind of energy crisis the prices will begin to soften.

Over the next six weeks I do expect natural gas and oil to rise again. The press is full of comments about falling demand but in reality it is mostly due to the hurricane fall out. Over a million people are not driving back and forth to work every day and that leaves a lot of gasoline unburned. Current estimates claim that more than 350,000 cars, trucks, etc were destroyed by the hurricanes. How much gas did that save? The high prices also impact driving habits but in most cases for only a few weeks. Once consumers get used to seeing the $3 number it will be just another hardship to bear and driving will resume again.

The refinery outages will keep oil prices soft with 14% of our total capacity offline for up to two more months. U.S. crude oil production was 3.81 mbpd in the week ended 9/30. That was the lowest recorded number since 1949. As of 10/5 there were still 3,114,700 bbls per day of refining capacity still offline. Those running only managed to operate at 70% of capacity due to lingering problems and lack of oil supply. This was the lowest level of capacity utilization since March 6th, 1987. Refineries saw inputs of crude oil of only 11.715 mbpd last week. That was the lowest volume of crude refined since March 13th 1987. Crude oil imports fell -1.574 mbpd to 8.119 mbpd due to ports or facilities still closed for Rita. This is the lowest level imported since March 7th, 2003. Gasoline will remain high but oil prices should drift until the refineries come back online.

The biggest obstacle ahead is natural gas. There is no strategic reserve. Pipelines and gas processing plants are still not back online. Mexico said it had lost 220 bcf of gas imports from the U.S. due to the hurricanes. They also said they would have to import another 275 mcf per day from other U.S. sources to cover shortages until Gulf production came back online. Once those Gulf gas fields restart production there are going to be a lot of empty pipelines battling for any available production. Last Wednesday the gas inventories saw a build of 44bcf and slightly less than expected. Considering that 68% of Gulf production is still offline. I believe that pipelines and gas processing facilities still offline from the storms are hindering dispersion of gas for use and allowing it to build up in underground storage. Mexico said 220 bcf of imports from the U.S. had been lost over the last 30 days due to hurricane damage. If that gas is being produced somewhere other than the Gulf they have to be storing it until the lines to Mexico open again. They said they would have to increase imports by 275mcf per day from other U.S. sources to insure critical needs until the Gulf came back online.

The CEO of LNG was on CNBC this week and he said that gas production and imports for 2005 and the future, regardless of hurricane disruptions, would be flat to declining for the foreseeable future. In other words despite our best efforts we cannot produce or import any more gas. New LNG hubs will only act to replace declining production elsewhere.

With the winter weather hitting the middle of the country this weekend the winter demand cycle for gas consumption should get its first test. I personally believe that gas numbers for next Thursday will show a decline but I am not qualified to offer an expert opinion. Time will tell.

Given the oil and gas scenario I have laid out above I have decided to recommend only a few new positions this weekend. The oil demand picture will remain cloudy until the refineries come back online. The gas demand cycle will also remain cloudy and a hotbed of confusion until the winter demand begins to appear. until then we could see prices on both wander unless something appears to push them in a particular direction. Personally I believe that direction will be up.

The new plays I am going to recommend this weekend are cautionary at best. I am skeptical of any oil company with exposure to the Gulf. With the majority of energy earnings due out in two weeks I do not want to load the boat only to have it sunk by a rash of earnings charges due to hurricane damage. Until the refineries come back online oil will be plentiful regardless of how slow the Gulf production resumes. I believe the only rational plays ahead of earnings are gas plays. The potential for a gas squeeze this winter is huge.

Coal is another sector where prices should rise. As long as gas remains in the $12-$13 range or even higher the utility companies will burn more coal. The Senate version of the Barton bill should contain language about coal gasification and liquefaction into gasoline and diesel. Despite that being a long way from reality on any major scale it should provide another incentive to own coal.

I am going to keep the portfolio light especially since the Friday rebound was lackluster. I am also going to avoid the refiners due to the low capacity utilization for those actually running. This could impact earnings regardless of those with damage.

I am picking BTU (coal), UPL, SWN, BR and CHK (gas) and KMG as a wildcard after BP sold its chemical business. KMG is also going to spin off its chemicals business sometime in Q4 and this is a very good time to do it. I wanted to add EOG and ECA to the list but their rebound was weak. Maybe next week.

All these plays will be short-term calls, not LEAPS. I expect to be out of them well before year-end.

Turn up your thermostat and lets get that demand cycle moving!

Crude Oil Chart - Daily

Natural Gas Chart - Daily


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