Option Investor
Commentary

Very Tough Week

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It was a tough week for me rather than a tough week for the portfolio. Every tick higher in oil prices adds another pound to the weight I am carrying for not being fully invested in energy stocks. I know there has not been any fundamental support for the rising prices and no way to have foreseen the various afflictions currently hampering the oil patch. Still it ticks me off to see prices moving higher and not be fully invested in oil.

Looking back every weekend seemed to be a new peak in prices with inventories rising not falling. Why would anyone want to buy the top ahead of a potentially weak period in the cycle? I can't imagine a more risky play. However, each week something new appears to push prices higher. In just the last four weeks oil has risen from $58 to $68 at a time when demand should be falling. Typically February and March is the lowest demand of the year and the time when refineries shutdown for extended periods for maintenance, upgrades and to shift production from heating oil to gasoline. Oil demand during this period drops substantially with many refineries offline for weeks at a time. Sometimes you can do exactly the right thing for the right reasons and end up on the wrong side of the market. That is what I feel today. I could not in good conscience recommend new energy plays ahead of this demand drop. The demand is slowing as expected but the prices are soaring instead due to geopolitical issues. Who knew?

I explained all about Iran and the oil card in this weekend's Option Investor commentary so I will not repeat it here. Other factors pushing prices higher are outages in the North Sea of more than 350,000 bpd due to six platforms being shut for various problems from fires, damage, emergencies and weather. Nigeria, an exporter of light sweet crude has lost over 200,000 bpd due to increased rioting and attacks by rebels. The situation is not expected to get better any time soon. There is still more than 400,000 bpd offline in the Gulf of Mexico and 225,000 bpd are not expected to return to production before the 2006 hurricane season arrives. There seems to be no end to problems in the oil patch with South America political tensions rising almost daily.

Goldman Sachs said prices could hit $70 by summer and CIBC World Markets said $100 was not out of range for 2006. CIBC went as far as to claim Peak Oil for conventional oil production had arrived in 2004. They categorized deepwater drilling as "non-conventional" and that took a substantial amount of current production out of conventional, which backdated the Peak for conventional. This application of terms is just additional confusion for the Peak Oil conversation but the bottom line is still the same. Regardless of how you categorize different types of production the total production number is still the same. While almost nobody expects the global peak in 2006 there is strong evidence it could come in 2007. But, that is another story.

Today we have to make a decision on adding additional oil positions. Each day that oil rises and the leading oil stocks hit new highs my indigestion level rises. However, we can't let these issues force us into an emotional decision. According to several oil analysts I follow at least $10 of the current price of oil is related to those geopolitical concerns listed above. Should tensions ease the price of oil could hit $58 very quickly.

While the Iran problem is not going away any time soon it is also not going to come to a head for several months. Once the news fades we could see reduced pressures on oil prices until it heats up again in the fall. It could take months to make it to the security council and Russia and China both have a veto that could remove it from consideration. I can't justify investing on oil at an all time high based solely on Iran.

The North Sea problems will be resolved shortly and production restored. That is the easiest of the problems to bet on. It is a sure bet that production will be restored soon. The problems in Nigeria may not go away but they can't get much worse. Of the 350,000 bpd that could be impacted due to a total shutdown of Shell's operation more than 200,000 are already offline. The odds of much more being taken out are slim. There may be some small amounts but it would be nearly impossible to shut them down completely. Production in the Gulf of Mexico is slowly returning. 175,000 bpd is expected to come back online over the next 30-60 days. Nothing should interfere with that process.

Increased oil prices are producing higher gasoline and diesel prices and that should keep a lid on demand during Feb/March. That will help inventories build and take the pressure off oil prices.

All of this is simply conventional wisdom based on the theory that no new disruptions appear. Problems will be resolved and demand will slow over the next two months. Prices should revert back to the 50-day average between now and the summer demand cycle. "Should, could, might and probably" are the key words in the preceding paragraphs. Nothing guarantees oil prices will go down.

However, that puts me right back between the same rock and hard place that I have been in for the last four weeks. To buy the potential top or wait for a retracement. Despite my extreme consternation about the missed profits I refuse to buy the top. Friday's close at $68.55 was a four-month high. The post hurricane high on the now current March contract was $70.95. I would like to believe that $70 is a sentiment top that will hold. The term double top comes quickly to mind. Yes, hope springs eternal.

Right now support at $64 looks like a bargain but stronger support at $58 would be a much nicer retracement. No, I am not on drugs but living on hope. We all know how fast oil corrects when traders take profits and we have seen many $5-$6 drops that occurred in just 3-4 days over the past several months. Eventually we will get a drop like that. You may remember the last one from $63.45 to $58.10 that occurred between Dec-13th to Dec-21st. That was the one that stopped us out of our last batch of oil plays with the selling climax on the 27th.

Of course there is always the question of the demand slump. Given the time of year it is always possible we could get a retracement all the way back to $58. Wishful thinking maybe but a danger to us if we take an entry in the $62-$64 range I am expecting. It means we need to plan on spending the extra bucks for insurance once triggered.

Natural gas plays are history unless a new ice age arrives soon. Warmer weather continues to allow inventories to remain well over the 5-year average and the clock is rapidly expiring on winter. CHK is struggling to break resistance at $34 and without some cold weather it may be a futile attempt.

Our non-energy plays are doing well, especially Overstock.com. The transportation plays were on the right track until the Thursday short squeeze tacked on a +78 points to the transports. The trend has resumed but we have to sweat out the recapture of those points while we wait for a lower low.

Krispy Kreme is begging the NYSE for an extension to avoid being delisted on Jan-30th. So far the NYSE has not granted it since it would be only one more in a long line of extensions. KKD has not filed financials since 2004. If they do grant the 90 day extension I will exit the play. The original idea was to be short when the delisting occurred to capitalize on the fund flush just before being kicked off the exchange. Many funds cannot own stocks not listed on a major exchange. KKD dropped about -20% on the news over the last week.

The drop in housing numbers last week accelerated the drop in LEND and MTG and gave us a margin of safety in each of those plays.

I am adding some plays to the watch list this week in hopes an oil retracement is near. With the February crude contract expiring on Friday it is always possible the end of week buying was fueled by expiration reasons rather than by political ones. I have illustrated the expiration gyrations on contracts in the past and I want to be ready if lightning strikes again.


Dow Transports Chart - Daily

Natural Gas Chart - Daily

Crude Oil futures Chart - Daily

 

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