Option Investor
Commentary

The Pain Continues

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The market implosion continued and energy stocks were hammered again despite oil prices holding in a narrow range between $68-$70.50. Gas prices were crushed on news of a stronger than expected build in the weekly inventory report. This knocked gas prices back to $5.85 and a new 52-week low. When gas prices fall it depresses coal stocks as well. Energy companies with both typed of generation capability will use gas when the BTU price is cheaper because of the cleaner emissions and the vastly easier burning process. Once gas begins to rise again so will the price of companies like Peabody. Gas is highly seasonal and this is the low season between winter heating and winter cooling demand. There is likely more pain ahead for gas and coal before that summer demand begins to decrease the inventory levels.

Oil prices remained above support at $68 despite some ugly markets. The Dow's -214 drop on Wednesday and the implosion in the metals could not push oil below $68. I view this has strongly positive and evidence funds were keeping their oil positions.

The June contract (CL06M) ended trading on Friday and the July contract (CL06N) becomes current as of Monday. June closed at $68.60 and July at $69.25. On the July contract $68.75 is the same support level as $68 on the June contract. I would like to think crude prices would rise on Monday as traders moved into the July positions but I am not convinced. OPEC was in the news on Friday saying that there would likely be no cuts in production quotas at the June meeting. I doubt it would make any difference since nobody is obeying them anyway. Iran did say it was going to slow deliveries to accommodate a temporary drop in refinery capacity.

Chavez continued to rile the US with his announcement that he was considering selling his oil in euros. I believe it was just a boastful bluff but you never know.

Japan said this week they are planning on increasing their strategic oil reserves. Unlike the US Japan stores the refined product rather than crude oil. They currently have 90 days of reserves, 13.5 billion gallons of gasoline, diesel, etc. That is roughly 325 million bbls. They are considering raising it to 18.5 billion gallons or 120 days supply, roughly 440 million bbls. China said last week they were going to add to their strategic reserves and create 2-3 more oil reserves of 36.5 million bbls each. Each would require the equivalent of 45 days of excess global production to fill. That is assuming they used heavy Saudi crude and I believe that is a faulty assumption. Japan needs mostly light crude and we currently don't have any extra to go around. If they filled them in the off peak cycles it could take them a couple years to accumulate the needed reserves in addition to the current 33 million bbl reserve they just completed but have yet to fill due to the high price of oil. They are currently constructing a total of 101.9 million bbls of storage with another 36.5 mb facility still without a firm site. When all are filled it will equate to 20 days of China's consumption. With China growing at the rate of 9-10% per year their economy will double by the end of 2011. They currently consume around 8 mbpd and consumption is growing at more than +7.5% per year. This is more than seven time faster than the US growth. China is expected to more than double the number of automobiles by 2010. That is 90 times its 1990 level. If China doubles its oil consumption by 2011 as expected that additional +8 mbpd is more than all the anticipated new production coming online worldwide through 2012. That does not take into consideration the current average annual decline of -5% in existing fields. Essentially we have to add +5% every year to stay even and that does not count any additional global consumption.

I spelled out the detail on China to emphasize that any decline in the price of oil will only be temporary. I did not even get into the India topic. They are only a couple years behind China on the growth curve and will also be a major global consumer by 2010. They only consume 2.9 mbpd now but that is increasing rapidly.

While the price of oil will eventually rise to $100 a barrel and higher and probably in the next couple of years that does not mean it will be a straight line. We will have setbacks as seasonal patterns produce ebbs and flows. Natural disasters will occur and the geopolitical landscape will get even more daunting. As prices rise due to tighter supplies it will promote conservation but any easing of demand will only be temporary. Just like any declines in prices will only be temporary.

Those temporary declines will be enough to knock us out of positions from time to time and sometimes with losses. It is a fact of life proving the need to be long-term investors. When we are knocked out we will bide our time and look for the beginning of the next wave to load up again. Dips should be seen as buying opportunities but that does not mean we should race into every dip. When dealing with seasonal patterns and long term geopolitical problems the dips can be measured in weeks if not months. However, the long-term trend will always be up and we will profit handsomely in the end.

With all that said I am sure everyone realizes this was an expensive week. There is ample evidence that several large hedge funds were forced to unwind their short bonds, long energy positions when bonds began to rally last week. Bonds had been selling off since mid January and it is now apparent that some of those shorted funds had found their way into commodities, primarily energy and metals. When those types of positions are unwound it is normally done quickly and that produces the types of declines we saw in metals and energy last week. Add in option and futures expiration and rampant Fed speculation and it became the perfect storm for commodities. This is the low point of the demand cycle as well. As gasoline demand increases over the next six weeks gasoline prices and crude prices should rise. Around the end of June we should get another dip, depending on hurricane activity, then a rise into the fall demand cycle. The charts below are for the same period in 2005 and 2006. Notice the extreme similarity. Hopefully the post May rebound which took oil prices in 2005 from support at $50 to $68.75 (December contract) will appear again this year. We have the same support only about +$20 higher as a starting point. ($69 on the July contract)

Comparison chart 2005-2006

I added two positions after the market plunge on Wednesday and sent everyone an update. Those positions were McDermott and Trinity Industries. We will be exiting some positions this week as weakness persists in the refining sector and some positions were hit pretty hard. Time to clear the deck for the next cycle. Obviously, had I know in advance about the carry trade about to be unwound in the bonds/commodities we would have exited much sooner. Unfortunately while we can discern long-term trends the individual potholes on our journey can be painful. It is hard not to be stopped out when we have -$20 moves in some stocks like PCU. It is even more frustrating that we were up +$12 in the PCU leap just last Sunday.

Stop losses are in place for disasters and you could easily call this a disaster. The following table is the positions we were stopped out of and the points and percentages for the drop over the last seven days. The average was -14.75 points each and nearly -20%. Most hit new highs the day after the Fed meeting and then imploded on profit taking and the drop in oil. It was painful but better times are ahead.

Post Fed Point Drop Table with Position P/L

Oil Service Index - Daily

June Crude Oil futures Chart - Daily

July Crude Futures - Daily

December Crude Oil Futures Chart - Daily

June Natural Gas Futures Chart - Daily

December Natural Gas Futures Chart - Daily

 

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