Option Investor

Who Are They Kidding?

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OPEC met, announced a 1.5 million barrel and was promptly laughed out of Vienna. Despite making a point to say that everyone had agreed to honor their new quotas I don't think anyone believed them. The price of oil declined to $62.50 intraday and close off -3.69 at $64.60. I has not been a good quarter for crude.

With the prospect for continued OPEC cheating we could see a test of $60 soon. However, several analysts were calling Friday's low as a market bottom in crude. Since we have a bottom call almost every week I am not applying too much credibility today. The bearishness in crude options is at historic levels. There are 128,000 futures put contracts and only 4,000 call contracts in force on crude. When this reverses it could be dramatic.

The new OPEC quotas don't match up with current production. Angola would have to pump more to get their new reduced quota. I put these tables in the OptionInvestor market wrap this weekend but I am going to reprint them here for those who did not see the wrap.

The first table shows the old and new quotas for the 11 OPEC members who have quotas. The second table shows the amount each would have to cut from actual production to meet the new quotas. Notice the amounts are significantly different.

OPEC Quota Change Table
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OPEC Quota Change from Actual Production
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The odds of OPEC members actually cutting production by 1.822 mbpd or even 1.5 mbpd are extremely slim. Some analysts doubt they will even hit 1.0 mbpd in reduced production. The answer to the oil price question is clear. As long as they continue to over produce and demand continues to decline in a global recession the price of oil will decline.

The biggest plus to this decline is the drop in the cost of gasoline. Currently the U.S. average is $2.78 but in some states it is already under $2.25 with New Jersey at $2.15. Some analysts believe we could see gasoline under $2 soon.

$2 gasoline would be like $5 crack to a drug addict. Demand will return so fast it will be unbelievable. The high price of oil along with the financial crisis created the global recession and ultra cheap oil would help end it. High school drivers would start cruising again. SUVs would begin to sell like hotcakes again. Gas guzzlers would be pulled out of garages to replace the cramped compact cars for family excursions. It is a simple formula. Cheap gasoline equals greater mobility and higher demand. It won't be immediate but it will return. Cheap gasoline will also delay efforts to build economical cars and come up with new technology for transportation. It will change minds of a large number of people who had already planned on buying a hybrid as their next car. Why pay $10,000 more when gasoline is $2 a gallon.

I received several emails again this week suggesting that peak oil was dead. I can assure you nothing is further from the truth. This type of demand destruction cycle will delay it slightly but these cycles have been predicted as we near peak oil. Low prices increases demand, high prices reduce it.

The problem with low oil prices is lack of investment into new exploration. When oil was over $100 investors were rushing to pour money into exploration, development and infrastructure. With prices around $60 the risk reward ratio is not nearly as high and investors can find less risky places to put their cash. Cheap oil means new production will slow several years from now as the lag in exploration appears years later as a lag in production. When prices rise again we will see investment resume but there is always a 5-7 year lag time from exploration to production. It is a vicious circle of intertwined cycles and the result will always be the same.

The market is making me crazier than the decline in oil prices. We were stopped out of five more plays as the forced fund liquidation continued and we saw 500 point swings almost daily. I don't know how you successfully invest in this environment. Stops are impossible but the prospect of a position without stops is even worse. I refrained from adding any new watch list positions again this week. I hesitate to short anything because we are so oversold but I also hate to add to our longs with a global meltdown in progress. I hope everyone got the email in time to act on the Russell 2000 Call play on Thursday. If not the decline on Friday gave you another chance to enter for that $4 option price.

I had a couple readers email asking about other Ultra Long/Short ETFs. Basically they attempt to double the movement of the underlying index. Here are the most common ETFs. Some are optionable, some are not.

Proshares Ultra Long ETFs
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Proshares Ultra Short ETFs
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The current market crisis is being called a 100-year event. To me that sounds like an unparalleled buying opportunity but we have caught too many falling knives over the last few weeks. I think it best if we watch carefully until we get closer to November. October 31st is the fund year-end for 75% of investors. Hopefully this forced selling will be over by Nov-1st and we can rebuild a portfolio with positions that last more than a week.

Jim Brown

December 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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