Option Investor

Perfect Storm

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Last weekend I titled this commentary the "Pause Before the Storm." I suggested we could see some increased volatility and while we never know what a change in tax year may bring I definitely did not expect the volume of selling we had this week. When the storm arrived it turned into the perfect storm where nobody wanted to step outside to pick up any bargains.

You should not have been surprised at the dip after my warning in the Dec-31st LEAPS Newsletter:

Remember I expect volatility in the week ahead so don't be alarmed if long-term support is tested again.

Oil prices fell -5.95 this week after a strong loss of -3.30 the last week of 2006. Evidently fund managers were holding their breath on their energy longs and waiting for the clock to run out on 2006. Once into 2007 it was a solid dump with volume 3-5 times normal on many issues and ETFs. Metals were also hammered with investors taking profits from the strong 2006 gains.

It was surprising to me that energy was hit so hard given the slow decline into Q4. It appeared most funds had already bailed during that big August/Sept decline but evidently not. It is also possible that others bought that dip to just over $60 and then found their money stagnant for the next three months. Exiting 2006 simply gave them another opportunity for a free portfolio adjustment.

Whatever the reason oil prices declined to $55 and rebounded right on cue when that level was hit. This is strong support dating back to March 2005 and is followed by stronger support at $50. Obviously we don't want to see $50 tested but I think we can expect $55 to be tested again next week. A successful test could provide a floor for the OPEC production cuts scheduled for Feb-1st and hopefully provide an incentive for OPEC to enforce the cuts called for as of Nov-1st.

Since we are not in control of oil prices we have to play the cards we are dealt. That means we took some big hits on some of our current positions. PetroChina for instance lost -$12 from last Friday's $142 high but that is only -$2 from the close the prior Friday. Those big gains we saw on PTR, SNP and FXI the last week of 2006 were erased by profit taking once 2007 arrived. I view this as a buying opportunity since growth in China has not slowed overnight.

Natural gas prices also collapsed going into year end but seem to have found a bottom at $6.00. I would not count on this bottom holding unless some cold weather arrives soon. The weather service said December was the warmest December in the US in 111 years. This left inventories of natural gas at near record levels and large supplies of heating oil. Late Friday afternoon there was a long term forecast that said the warm weather trend might break in mid January with 4-6 weeks of cold weather to follow. I would not trust this forecast any more than the hurricane forecast for 2006. Again, we will have to play the hand we are dealt regarding price pressures from lack of winter demand.

Conoco Phillips also added to the sector downdraft after warning that Q4 refining and marketing margins would fall significantly and that worldwide production would be unchanged from Q3. This is going to be a normal thing for the big integrated oils since they are essentially self-liquidating corporations. Every day they pump oil that they cannot replace at the same rate they produce it. Conoco, BP and Shell have all said they would not be able to replace reserves. This should be a clear sign to everyone that the end is rapidly approaching.

Last week's volatility triggered a couple of exits and both entries on the watch list. It also triggered entries into several insurance puts. I also closed several others due to new information and broker downgrades. Be sure to check the play notes for those positions you currently own.

Jim Brown

February Crude Chart - Daily

February Gas Futures Chart - Weekly


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