Option Investor

Correction In Progress

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"I love it when a plan comes together" was a famous quote from Hannibal Smith (George Peppard) on the 80s TV show the "A Team." It works just as well today as it did then. We planned our exits weeks in advance. We planned for oil to top out around the first week of August. We entered our puts just as that energy top appeared. Now oil is finally starting to crack and the correction in the energy sector has pushed our put profits over 100% each and pushing those energy stocks closer to our new entry points for fall. I love it when a plan comes together.

Multiple factors are lining up to give us the decline we expected. OPEC said they still believe there is plenty of oil and no shortage and they believe oil is fairly valued at $65. This put pressure on prices although supply and demand did not change.

Secondly, refiner utilization rose +2.0% for the week to 93.6% and the highest level since the week before Hurricane Katrina. Oil supplies fell sharply but it was due to the increased refinery runs and the timing of some imports. Because refinery utilization is up and driving season is almost over the price of gasoline for September delivery has fallen to just over $2 and a break of that support could have us back to $1.75 in a week. This was also pressuring oil prices.

Lastly the hurricane predictors cut their predictions for hurricanes for this season because weather patterns have not been conducive to their formation. The peak of the season is around Sept-10th so there is plenty of time for a storm or two to appear but so far none have shown. All the pent up anticipation of hurricane related gasoline price spikes has dissipated and traders are taking profits and moving on to other investments.

Just because oil may return to $65 this fall does not mean oil is no longer a good investment. It is very cyclical with routine rises and dips. We just need to be patient and buy the dip to capitalize on the future move higher. Nothing has changed in the demand fundamentals and based on recent estimates we could actually see peak oil in 2008. Depletion continues to subtract -3% from our annual production and new production coming online is being delayed for months and sometimes years by technical and geopolitical issues. Meanwhile demand is expected to grow by 2.2% for the rest of 2007 and again in 2008. Demand is growing by 1.87 mbpd and supply is falling by -2.55 mbpd. Do the math and we need to add 4.42 mbpd of production each year just to stay even. It is not happening and this will be more evident as we head into 2008.

I am adding a couple more plays to the watch list with what may seem like ridiculous entry points but we have plenty of time to wait and oil at $65 will be murder on stock prices. The only bug in this plan would be the sudden appearance of a hurricane headed for the Gulf. That would jack up crude prices and halt the current decline in energy stocks. If that happens I will adjust the targets for the next entry cycle in October.

I am also adding Bear Stearns as a non-energy play. I think BSC has been beaten so badly there is a good chance of a takeover play and $100 is strong support. Let your conscience be your guide on entering that position.

Jim Brown

September Crude Futures Chart - Daily

September Natural Gas Futures Chart - Daily

September Gasoline Futures Chart - RBOB Daily


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