Option Investor
Commentary

$70 Oil, Gulf Hurricane

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Just a couple years ago you could have seen that headline and immediately understand that oil had spiked to an unbelievable level of $70 as the result of a hurricane hitting the gulf oil fields and causing significant damage. Fast forward to 2007 and we find that even with a potentially damaging hurricane in the gulf, oil prices have fallen from the unbelievable level of $78.76 back to $70.10 in only two weeks. Times have definitely brought changes.

Hurricane Dean is currently a category 4 storm but is expected to become a category 5 as it nears the Yucatan Peninsula late Monday. Currently the majority of storm trackers are predicting an impact in northern Mexico and southern Texas but storms normally become erratic once they hit the Yucatan. The actual track is impacted by moving over the Yucatan land mass and away from the feeding influence of the warm water. There is also a high pressure area over the southern U.S. that is currently expected to keep pushing the storm south.

All of these predictions could change at any moment and that is what prompted a +$2 rebound in oil prices from Thursday's low. A hit on Mexico endangers 3.2 mbpd of oil production. 1.5 mbpd of that production is exported to the U.S. A slight move higher to hit Corpus Christi endangers three refineries and 5% of our total refining capacity. Just a little higher and Houston becomes a target with 9 refineries and 14% of our total refining capacity. With the current track predictions the majority of the gulf oil fields will escape any damage other than some evacuation related slowdowns. Any sudden shift northward and the oil fields could become a danger zone.

The final track will not be apparent until Tuesday morning at its present course and speed. That means oil prices should rise again on Monday as the news wires begin talking about the chances for any oil field impact and the storm hits cat-5 status. Once that final track is established prices should firm but not rise unless the oil field is in danger. By Tuesday night traders should have a good idea of the eventual outcome and prices will react accordingly. If the hurricane hits northern Mexico prices should drop sharply unless serious damage to Mexican oil installations is reported.

Gasoline demand has slowed considerably now that summer is nearly over and kids are going back to school. There will be a 30-45 day period where overall crude demand will slow before accelerating into the heating oil season. This slack demand period will see gasoline prices fall dragging down the price of oil.

If the hurricane misses the oil fields the price of oil could easily fall to $65 over the coming weeks. If the oil fields are hit then we could see $75 by the end of the week and even higher if the damage is severe.

Hurricane Dean Wind Forecast

Dean 5-day Track

On Thursday the price of oil fell -$4 from the Wednesday highs due mainly to the dumping of positions by hedge funds facing massive redemption requests. August 15th was the deadline for notices for redemptions by investors wanting to withdraw money from hedge funds potentially exposed to the debt wreck. Reportedly many funds were experiencing redemption requests of historic proportions.

Those funds were faced with the need to raise substantial amounts of cash and they were unable to sell many of their various debt positions. When you need cash fast you are forced to sell whatever you have that is liquid. In this case that means stocks and commodities. With many funds up strongly on their energy positions this was the perfect opportunity to take profits in those positions rather than close losing positions in a very thin market.

When I saw this happening on Thursday and oil prices firming at $70 I sent an email to everyone to exit our short positions in the XLE, TSO and CVX. While I think we will see lower lows in each of those stocks I did not want to get trapped by a sudden northward turn by Dean. We took our profits at almost the exact bottom of the drop and now we are ready to react to whatever Dean throws at us. I did add another XLE put to the watch list.

The dramatic market drop also gave us entry points on several of our watch list candidates. I believe the -$11 drop in NOV on Thursday was a gift. I just wish it had happened on a couple other stocks as well. I still believe we will see lower lows so we will probably get another chance at the rest of the list.

We received this reader email last week:

I find your articles and commentary to be very informative. However, I can't seem to get any trades. Is that because of the current environment? I would like to continue as a subscriber but I am not able to measure any terms of profitability without any trades.

This is NOT a trading newsletter. This is an investing newsletter with a primary focus on the energy sector. If you are looking for trades every week then you need to focus on the Option Investor or Premier Investor newsletters. They give new trades on a daily basis.

Because this newsletter primarily focuses on the energy sector there will be periods where there are no new trades. The energy sector is cyclical driven by supply and demand cycles. We attempt to capitalize on these cycles to produce profits. We have exited nearly 20 positions over the last couple months that we put on during the last cycle with most producing more than a 100% profit. A new energy cycle is almost upon us and we are mostly in cash today in order to take advantage of the seasonal buying opportunity over the next 6-8 weeks.

Readers over the last month should be aware that we exited our longs at almost the exact top in oil in late July. We entered three short positions at almost the exact top and closed them at $70 last week. The LEAPS newsletter capitalizes on these cycles rather than force a trade every week.

For any other free trial readers you can always check the LEAPS performance by reading the past newsletters on the website. Just click the weekly issues and look at either the portfolio graphic for that week or the "closed plays" section. I am going to produce a summary sheet over the next couple weeks of all the plays over the last year and then keep it updated for future reader reference.

Another email:

I would like to start writing short term call options against my Leaps, for extra income, I would appreciate if you could describe the ups and downs about this strategy. I read that I cannot write ITM or ATM short call options against my Leaps is this correct?

Writing covered calls against your LEAPS is a good way to capture extra income but it is also very dangerous to do on a regular basis. When you write a short call against the LEAP you always take the chance of having that short call exercised and your LEAP position closed to cover it. Normally this is a losing proposition for you. This may be why you read that writing ITM or ATM calls were not an option. You are almost guaranteed of having your LEAP position closed by writing ITM calls. If you are going to use this strategy it is best to write out of the money calls and setting OTM stop losses on those calls to avoid having your position exercised.

Volatility Ahead

With the current broad market pressures, hurricane Dean and the peak of hurricane season still ahead on Sept 10th the energy sector will be volatile for the next 4-6 weeks. We welcome this volatility as an opportunity to enter some strong positions at bargain prices. Readers should be prepared to enter multiple long-term positions during this high volatility period.


September Crude Futures Chart - Daily

September Natural Gas Futures Chart - Daily

September Gasoline Futures Chart - RBOB Daily

 

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