Option Investor

Serious Volatility

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Everything was going so well until Thursday morning. The bottom fell out at the open on Thursday on what I am going to call the Refco drop. Energy futures gapped down on the open and hardly even slowed when the inventory reports showed a decline in all refined products and a slowing build of natural gas reserves. For some unknown reason the bottom fell out of energy stocks far in excess of the dips recorded in the energy futures. There have been many reports by analysts that the sudden drop could have been the unwinding of energy positions by Refco and by Refco customers fleeing to cash. Whether this is just a wild guess or reality we will never know.

Unfortunately it knocked us out of all but one position less than a week after we reloaded the portfolio from scratch. The extreme volatility did trigger all the watch list plays so there is a little good with the bad.

I was hoping to see the portfolio post some gains before the energy earnings begin in earnest the week of the 24th. After Thursday's drop I am not holding out hope for that possibility. I wanted to get well above our entry points before any negative earnings surprises shook the sector. Now we are faced with some positions that are underwater only two days into them. Not a pleasing scenario.

I was pleased to see the end of day rebound on the oil and gas futures on Friday and hopeful they will continue on Monday. September turned out to be the fourth warmest on record so natural gas reserves continued to build although at a lower than normal rate. The average for last week is a build of +54 bcf and they only rose by +44 bcf due to the production problems in the Gulf. With cold weather starting to appear I am hoping for an even smaller build when reported on Thursday. Oil imports are down -7.9% below last years level and U.S. production is -18.5% below the same period in 2004. These facts do not paint a picture that justifies lower oil prices. We are also hearing that at least 3 bcf of daily gas will be offline until March and 750,000 bpd of oil will be offline until at least January. 10% of our refining capacity is also offline for another 60-90 days. This suggests the remaining refiners will be running at 100% IF they could get enough oil to process. With imports and production both down the picture is not rosy. It is a known fact that production, import and pipeline capacity is insufficient to support winter consumption. Each year 2.0-2.5 TCF must be added to storage before the winter heating season begins. With lost production nearing 300 billion CF in the Gulf these injection efforts are running behind. Currently there is 2.987 BCF in storage and the target is 3.200 BCF. This would require an injection of more than 99 BCF in each of the next two weeks to bring the levels up to the requirement before the Nov-1st deadline. Fortunately the deadline can shift several weeks later if the weather remains warm. A colder than normal Halloween could get us off on a bad start and have supplies playing catch up from the start of the season.

How that impacts oil and gas prices and more specifically how it impacts energy stocks is still unknown. We have seen demand numbers fall -2 to -3% for refined products but it is unsure how much is related to price and/or the lack of a functioning economy in the Gulf disaster areas. This is likely to remain a confusing picture for at least another month.

November 1st is typically the start of the winter heating season and the beginning of strong demand for natural gas and heating oil. Forecasters are calling for a colder than normal winter and that could produce stronger than normal demand. It boils down to a lot of "ifs" and no real evidence of any trend for prices.

Oil futures are actually in a downtrend since the Katrina spike with resistance at $65 and support at $60. The futures have been clinging to the 100-day average at just over $62 although there has been strong bouts of volatility in both directions. What we are missing is a resumption of the bullish trend in prices despite what could be called an energy disaster. This causes me to question the validity of adding any further energy stocks until that trend resumes.

We also have the problem of energy earnings the week of Oct-24th. Many companies have exposure to hurricane damage and loss of production in the Gulf. In this weekend's OIN commentary I mentioned the sudden appearance of TV ads for Conoco Phillips ahead of their earnings. With the stock only $9 below a new high I fear they are trying to reassure investors ahead of their earnings and a potential negative surprise. Their website provides a detailed list of "problems" that might impact their earnings performance including damage, lost production and refinery outages. I would say the odds are good many companies will take hurricane related charges. How that will impact prices is unknown given the high price of oil offsetting the cost of repairs and lost production. It is a toss up but one that should be avoided.

I am going to reinstate two of the plays from last week that were stopped out, CHK and UPL. Neither have exposure to the Gulf and both are primarily natural gas producers who will benefit from colder weather and higher prices. We should only see positive surprises from both unless they hedged large amounts of gas at less than current rates. Many producers thought $7 to $8 gas back in June and July was a top in the market and presold production at those rates thereby limiting upside. Hopefully neither CHK nor UPL capped their income substantially.

Of the watch list plays triggered EOG, ECA and DVN are gas producers. EOG has reportedly NOT hedged the majority of its gas and should report record profits. TSO is a west coast refiner and has no hurricane exposure but should also report record profits due to the high prices of gasoline. NOV is an oil field equipment provider and business should be booming considering all the damage to offshore facilities. NOV had a $1.2 billion backlog of orders as of August 5th and that backlog should have grown substantially in the last 60 days. Earnings are scheduled for Oct-28th.

After many months of above average returns we were bound to hit a rough patch eventually. I am looking to keep the portfolio skinny until after earnings and then add to it only if a new uptrend in prices appears. We will be a lot pickier about adding positions with an eye towards a decline in energy prices after January. March is typically a good period for entering long-term positions ahead of the summer demand cycle. There will always be plenty of opportunity but every market has cycles that must be respected.

On Friday afternoon gas prices shot up from $12.80 to close at $13.24 without any specific news. If the end of week drop was due to Refco positions being unwound then hopefully the closing spike was the all-clear signal. Up until that spike there was a bearish head and shoulders pattern forming on the daily chart. That pattern has not been erased but the spike at least offers hope that it will fail.

Natural Gas Chart - 5 min

Natural Gas Chart - Daily

Oil prices are right in the middle of a down trend in place since the Katrina spike. The 100-day average at $62.50 is acting as support but the pattern is currently bearish until a break of $65 to the upside with a break over $68 as confirmation. I do not expect that until demand recovers and all refiners are back online. This negates any plays strictly related to the price of oil until a new uptrend develops. We saw the same uptick in oil at Friday's close but other factors suggest caution.

Crude Oil futures Chart - Daily

Crude Oil Futures Chart - 5 min


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