Option Investor

Support Forming?

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Crude prices spent a week over $62 and under $70 and it appears a bottom is trying to form. Without forced liquidation by funds the price of oil actually took a break from daily declines.

I am actually starting to turn a little bullish on oil prices although I am not sure the selling is over. We saw funds clear the decks over the last two weeks and then produce a textbook window dressing rally going into their year-end on Friday. My concern is that they could come back as sellers next week in anticipation of some bad economics and potential election problems.

I am confident enough that we may have seen a bottom for oil that I am putting another ETF play in this weekend using DIG. That is the Proshares Ultra 2:1 oil ETF. It has declined from $131 to form a solid bottom at $24. Obviously buying calls on a $35 ETF that could run to $70 or $80 over the next six months is something anybody would like to do.

I heard an interesting statistic last week. Charles Biderman, a noted analyst who tracks money flows, said the commodity boom was created by a switch to commodities by hedge funds starting in 2004. From 2004 through 2007 over $250 billion in new money was going into commodity funds. It doubled the size of the commodity sector to $1.9 trillion of which hedge funds controlled $945 billion. This created a massive bull market in commodities just as the global economy led by China and India was exploding. In 2008 the retail investor finally caught on when oil prices started making the news every day and another $250 billion was redirected to commodities. Most of the money moving into commodity funds came from real estate sales according to Biderman. These windfall profits from homes escalating 25% a year were fattening the wallets of investors and they needed someplace to park their money. The new commodity bull market was sucking up all the loose change in the investor community.

Because those funds were highly leveraged in the futures market every ten dollars invested controlled $100 in commodities or more and sometimes a lot more. Over 500 million barrels of oil were trading each day even though only 86 million were bring consumed. It was a fascinating money trail including the collapse. Once the July top was reached those highly leveraged hedge funds could not exit fast enough. The falling commodity prices on one side were being accelerated by investor redemptions on the money side. It was a nightmare on Wall Street and the funds may take a long time to recover. Actually many commodity funds have shut down for the rest of 2008 and will not reopen until 2009. They want the smoke to clear and then pick their entries for the next run.

Jim Rogers, noted commodity investor over the last 30 years and co founder of the Quantum Fund with George Soros in 1970, is buying commodities again. He was interviewed last week and he gave the tired speech about buying things when nobody else wanted them but it is still the truth. It just takes a lot of money and patience. He argued that despite the recent commodity boom and bust most people still don't have a clue about investing in the sector. He claims only about 100 of the world's 70,000 mutual funds are commodity funds. Rogers thinks the current commodity cycle will run another 10 years or longer and the current recessionary environment would eventually fade and the commodity boom would return. He quoted statistics about usage in China and India and why there will not be enough to meet demand in the years to come. He said three billion people in Asia want to live like we do and that would continue to constrain supplies for the next decade.

I believe oil and copper are going to be key commodities. The only true copper ETF (COPA) only trades on the London Exchange. The Power Shares Base metal ETF (DBB) has 1/3 copper, 1/3 aluminum and 1/3 Zinc and it is optionable. I am considering a position on it once we know what is going to happen with the global recession. Over the short-term I am going to add a steel play to capitalize from the extreme oversold conditions.

I loaded up the watch list again as many energy stocks appear to have found a bottom and may be preparing for a new move higher. I added several small cap plays that were low volatility and flying under the radar. If we do get a broad market rally I am hoping the fund managers will try to do the same in looking for 2009 positions.

Jim Brown

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