Option Investor

Corrections Happen

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Corrections happen in every market, sector and stock and most of the time without warning. One week everyone is talking about the new highs and a short time later there is nothing but devastation. Traders and analysts scramble to pin the blame on the cause but in doing so many turn themselves into donkeys. Assigning blame after the fact can take many directions and normally most are wrong. It was a correction, plain and simple. The rally simply became extended and the underlying fundamentals were no longer able to support the price. Profits were taken, stops were hit, panic appeared and the selling quickly became overdone.

The correction in oil last week was the worst on record. Crude prices fell from just below $147 on Tuesday to close just under $129 on Friday. From the commentary in the press you would have thought a 250 million U.S. consumers had suddenly traded in their cars for bicycles and there was going to be an instant glut of oil that our great grandkids would be forced to deal with.

It was a correction, not a global catastrophe. It was a 12% drop not 50%. I wish I had counted the number of talking heads on TV over the last week claiming we were headed back for $80 oil. Never have so many been so wrong about any one thing and rushed to the airwaves to proclaim their stupidity. Even Donald Trump got into the act and went on a several minute tirade about how much oil there was in the world. "We are awash in it, there are tankers floating around fully loaded with no place to go. There is so much oil ports are turning them away. I know this to be a fact because I keep up with these things. The press has covered up this glut because the big oil companies don't want us to know, etc, etc." Donald you are one of the biggest jackasses I know and you could not tell an oil tanker from the Queen Mary. Stick to your overpriced real estate and bad hair.

I could pick out a couple reasons for the price drop and write a few paragraphs but I believe it was just time for a correction and all the reasons were just excuses helping to speed it on its way. Oil profits are not profits until sold. I will list a few in what I consider the order of importance but that is just my view.

1. Cooling Iran tensions. The U.S. and five other nations are meeting with Iran this weekend in Geneva to discuss bribes to get Iran to quit enriching Uranium. It will be the first meeting with a U.S. envoy since the hostage crisis in 1979.
2. The U.S. even said it might be interested in opening a diplomatic mission in Tehran. (I couldn't believe it either)
3. Options on August Crude Futures expired on Thursday.
4. August crude futures expire next Tuesday.
5. Oil was overly extended from its +$57 gain since February. $147 appeared to be a double top failure after the Morgan Stanley $150 by July 4th prediction passed.
6. A +3 million barrel build in crude inventories on the weekly report. -31 mb over the last 8 weeks, +3 mb last week. I somehow doubt that was the cause of an $18 drop.
7. The API said oil demand for the first six months of 2008 fell -3% to the lowest level in five years. Gasoline demand was down -1.7%. It was the first significant decline in gasoline consumption 17 years.
8. MasterCard's Spending Pulse report for the week said gasoline demand fell more than 5% in the prior week. Mastercard said the normal post July 4th holiday uptick in driving had not appeared.
9. CIBC World Markets predicted there would be 10 million fewer cars on U.S. roads by 2012.
10. President Bush ended the executive order preventing offshore drilling on the continental shelf.

Pick your choice of reason but it won't ease the pain in our portfolio. We were stopped out on seven plays when stock prices imploded along with oil prices.

They say you should buy stocks when nobody wants them. Buy when there blood in the streets. For energy stocks that would be now. I am adding two of our stopped positions back into the portfolio today. I am putting two back on the watch list and I am adding a long play on the XLE as a sector play. I was going to add a USO long but the potential for a continued drop to $122 convinced me to put it on the watch list instead.

Personally I believe Iran was stalling at the weekend meeting because they feel they can get more concessions from the next U.S. president. They are just stalling for time until the election. Iran made it clear as they entered the meeting this weekend that suspension of enrichment was "out of the question." After the six hours of talks on Saturday meeting EU foreign Policy chief Javier Solana said Iran gave "no clear answer" to the U.N. proposal offering economic bribes in exchange for a suspension. U.S. State Dept spokesman Sean McCormack said Iran had two weeks to "give a clear answer" or face further sanctions. Evidently the term "clear answer" had a specific meaning to what was said in the meeting. Diplomats described the talks later as a "final attempt to persuade Iran that it must halt its nuclear program."

After the meeting another member of the Iranian delegation repeated the "no chance" of a suspension mantra. Other than that simple statement Iran was silent about the outcome of the meeting. That suggests the government is planning a big announcement by the Ayatollah or President Ahmadinejad and they want to grab the stage rather than have a lower level aide get the sound bite. There is always the possibility that the meeting participants told Iran specifically that some demand better be met ASAP or they were going to get slapped down hard. Iran may have decided it was better to be quiet and consider the options before making a speech.

There are actually some signs the U.S.-Iran cold war stance may be thawing but it is too soon to tell if it is just a delaying tactic by Iran or the sudden realization that time is running short with Bush and maybe they would be better off to do something now rather than wait. Either way there was no decisive agreement reached at the meeting and that could be neutral for oil prices on Monday. If Iran makes headlines between now and then that could change quickly.

On the storm front there is a strong tropical wave in the western Caribbean that has better than a 50% chance of storm formation. If this turns into a hurricane this weekend then oil prices will quickly rebound.

Hurricane Chart

I believe that oil is extremely oversold as a result of all the conditions I listed above and from the asset allocation swap back into equities. If the equity market begins to roll over we could quickly see oil come back into favor.

Jim Brown

Readers Write:

Jim, I have been a devoted reader of your columns for over 5 years. Now I find myself trying to understand the recent market movements as they relate to energy investments. I will use by example, my comfort stock, XTO, which I have owned for years.

Underestimating the potential for fat tails is a major risk for all investors. I have always planned for the day when XTO would fall 15% in two days as the momentum traders moved out. Your column correctly points out what is likely to be the proper destination for oil stocks, but uses stop losses along the journey.

Now the question: XTO fell by 30%, or double my expectation. My conclusion is that the heat was too great for the arbs that bought energy and sold the financials. The loss on the short financials position was so great, that dumping the matching energy trade at any price was a necessary act.

Is this explanation too simple? If not, would this mean we have a few more weeks/months before the trades are all unwound? LC


I think you may have hit the nail right on the head. Nearly every hedge fund worth its fee has been short financials and long commodities for the last six months. When the picture suddenly changed those same funds had to cover shorts instantly and pull money out of commodities. It makes perfect sense to me and the only question now is what will they do once the short squeeze is over. Go back into energy or stick with equities? If you figure out that part of the puzzle let me know and I will share it with the readers.

As far as XTO it was whacked because it is primarily a natural gas play and gas was crushed. XTO broke support at the 200-day on Thursday and fell to next level support at $55. I would be a buyer of XTO at this level. Maybe it is time to average into some more?


(I am going to try and make this a weekly feature. Send me your email questions and I will try to answer. Jim @ OptionInvestor.com)

August Crude Futures Chart - Daily

August Natural Gas Futures Chart - Daily

August Gasoline Futures Chart - RBOB Daily


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