Option Investor
Commentary

Are We There Yet\?

HAVING TROUBLE PRINTING?
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How many more days are we going to have to endure this irrational pessimism? If the IMF warning on Saturday is any indication there is more trouble ahead. However, there is a full court press underway by the Treasury, Fed and top finance ministers for the entire G20. The G7 statement on Friday was so worthless and without any details that a cry went up on Saturday for all the major countries to act together to solve the problem before Monday. I am hopeful that there will be an announcement before the open on Monday that calms global tensions.

The current fund liquidations we have been discussing for the last three weeks have not slowed. Anything with value is being sold or shorted to raise cash to cover redemptions. Anything stock/sector that was in favor over the last 9 months is now being sold ruthlessly and buyers who jump in on the dips are getting run over by the stampeding bears.

Exxon and Chevron were both down over $20 at one point last week as the last blue chip ports in the storm were buried under the selling hysteria. Exxon has $38 billion in cash and earns $10 billion a quarter. There is no fundamental reason to dump Exxon in that volume. Exxon traded 113 million shares on Friday. That is nearly $8 billion in Exxon stock alone. Add in the same dump of all the other majors and minors in the sector and this was a cash raise of historic proportions.

Reporters blamed it on falling global demand as predicted by the IEA. On Friday the IEA said the world is on the breink of a global recession and cut their demand estimates by 360,000 bpd for OECD nations. For 2009 the OECD demand was expected to be 600,000 bpd less than in 2008. This may sound grim but the IEA is all about making headlines.

What reporters failed to pick up on was the overall picture. The IEA also raised demand estimates by 80,000 bpd for countries outside the OECD. Overall non-OECD demand for 2008 is still expected to rise by 1.5 mbpd over 2007 levels and rise again by 1.3 mbpd in 2009. There was ABSOLUTELY nothing in the IEA statement that suggested global oil demand was falling off a cliff other than the headline of the report "When Storms Collide." That referenced the hurricanes and the financial crisis.

The price drop in crude on Friday was purely a liquidity crisis. When the markets opened there was a large seller dumping huge numbers of contracts in the electronic markets for 20 minutes. Volume was 10 times normal for that 20 min period. The rest of the day was only less a liquidity raise but still concentrated selling by funds. The CFTC said open interest in crude futures was at a 2.5 year low.

OPEC announced an emergency meeting for Nov-18th to discuss cutting production. You can bet the decision has already been made and the meeting is simply to define whose quotas get cut the most.

The current price drop is very painful for producing nations that depend on oil for their survival. Hurt the most will be Hugo Chavez in Venezuela. Since his oil is heavy crude bordering on sludge it will sell at the lowest price in the market. Since he depends on oil revenue to remain in power this could be the straw that breaks his political back.

Russia is undergoing its own political and financial problems as well as falling oil production. The Russian markets were closed on Wednesday on fears of a collapse after their worst ever trading day on Monday. They reopened on Thursday. Russia is suffering from investor flight after its attacks on Georgia. Investors have pulled tens of billions out of its markets and cancelled numerous projects inside Russia. The country is seriously suffering from its military venture. Russian oil production has fallen for nine straight months as it goes into decline. This comes at a time when Russia needs every dollar from its oil revenue to cover shortages in other areas. Russia has announced more than $200 billion in loans and relief since the crisis began in September. Russia needs higher oil prices but can't afford to cut back on production to provide price support.

The sell off in the energy sector has hit big investors as well as small. The massive drop in stock prices has caused massive margin calls for even big name investors. The CEO of XTO was forced to sell over $100 million in stock due to margin calls. The CEO of Chesapeake and the third largest shareholder in CHK was forced to sell his entire 33.5 million share stake last week when he was hit with a margin call he could not meet. His stake was worth more than $2.35 billion four months ago and was worth only $500 million when he was closed out on Friday. That had to be some serious pain.

The drop in natural gas prices has collapsed the gas sector. The sudden boom in shale gas discoveries and production has increased gas supplies by 6-8% after three years of declining North American production. Gas closed at $6.50 on Friday.

The forced liquidation in the oil majors has created some major buying opportunities. Many are now selling for a PE that equals their dividend yield. This is extremely rare. It also does not mean that they cannot go lower until the forced liquidations end.


Stk PE - DIV  
COP 3.9 3.8%
BP  4.1 8.5%
CVX 5.1 4.3%
MRO 4.1 3.7%
XOM 6.6 2.6%

TrimTabs said equity funds saw outflows of $72 billion in September. That was a historic record. In the first week of October outflows were more than $50 billion with $7 billion of that coming out of bond funds. If the bear market does not let up soon we could see another record for outflows in October. Since normal funds are leveraged from 2-8 times and hedge funds sometimes over 20:1 this was a monster amount of buying power leaving the market.

The massive -18% drop in the markets last week was the worst week on record. I did not add any new plays last week so we were only stopped out on one position. Last week's drop saw our entire watch list of plays triggered with many falling well below our entry points. When stocks are falling $10-$20 a week it is hard to pick an entry point. However, I am happy with everything we bought and will be much happier if we could get an oversold bounce next week. I also added a couple of new plays in MOS and BAC. I believe both are bargains here but we do need the market to cooperate.

I hesitated to add plays last week and again this week but as investors we need to be ready to buy when stocks are cheapest for maximum returns later. I never expected all those watch list entries to be triggered. Some of the targets were $20-$40 below the prior week's close. While nobody could have predicted an 18% drop in the markets, -25% in the energy sector, in only a week that does create a lot of bargains. Eventually common sense will return to the markets and those with the guts to buy with blood in the streets will profit handsomely.

Remember it is not about valuations next week. It is about forced liquidations and global credit crisis. It is not about a sudden surplus of oil production or a 10% drop in demand. Oil has nothing to do with the current market decline. Energy stocks are a market causality and the market has to recover before the energy sector will recover. A helium balloon will always rise above the crowd. However, if that crowd is in a down elevator that balloon will sink as well.

This is the time to be good money managers. If you are scared of the market then wait on the sidelines. There is no harm in being late to a rally. There is more harm to being early to a decline. Unfortunately this is a weekly newsletter and every week I need to plan for a potential rally so those willing to take a chance will be amply rewarded when that rally comes. As an investor you should enter only those plays you are comfortable in risking your own money and whenever you think it is the right entry point.

Jim Brown

November Crude Futures Chart - Weekly
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November Natural Gas Futures Chart - Daily
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November Gasoline Chart - Weekly
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