Option Investor

Weekly Newsletter, Saturday, 05/31/2008

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Table of Contents

  1. Commentary
  2. Changes in Portfolio
  3. Portfolio Listing & Top Picks
  4. New Plays
  5. Existing Plays
  6. Watch List

Leaps Trader Commentary

Not Nice To Fool The CFTC

Bulls were unable to capitalize on the monster drop in crude inventories on fears that the CFTC was about to change the rules on futures trading. The weekly crude inventory report showed that crude levels fell by -8.9 million barrels for the week ended May-23rd. Gasoline inventories fell by -3.3 million barrels. On any other week that would probably have been worth a $5 move higher in crude prices. There was a $4 spike but it was immediately sold when the CFTC announcement hit the wires.

Oil Inventory Table

The CFTC announced on Thursday it launched an investigation in December into possible price manipulation of the crude futures markets. The CFTC said it was probing a wide range of activities including storage, transportations and trading of crude oil and related derivatives. Speculative pressure has been blamed for adding as much as $20-$30 to the price of oil.

The CFTC said it was taking steps to improve the transparency of the complex energy futures market. The crude futures market is huge but it is nowhere near as large as the stock market. On April 22nd the total value of all open interest in crude futures for all months and strikes was $174 billion. That is up by a factor of 10 from the $17 billion in April 2003. Is it realistic to think that the value of open contracts increased 1000% in only five years? To start with crude was only $25 in April 2003 and there were approximately 500,000 open contracts. At today's $125 level that is a 400% increase in the price of crude alone. A 400% increase in the contract value would only be $85 billion if the number of contracts stayed the same. Today there are nearly 400,000 contracts in the July contract alone.

How easy would it be to manipulate the price of the July contract? With open interest of 370,883 contracts and initial margin of $8,525 per contract that would equate to only $3.2 billion in margin for all open contracts. Obviously there are plenty of individuals, institutions, pension funds and sovereign funds that could easily manipulate the price. They would not need anything near the $3 billion since they only need to juice the market not own it. Volume on Friday was only 287,382 contracts. Yes, you read correctly. 77% of the entire open interest changed hands on Friday. Since there is a position limit of 20,000 contracts it would take several players to really jack up the price.

Here is the key to the puzzle. Not only do we have hundreds of major players all wanting to juice the market on their own but the really big players can get around the position limits through swaps. What we have is a monster game of poker here that runs continuously 24/7 five days a week. Everybody is placing bets, raising, calling and folding all day long with very little oversight.

The CFTC announcement suddenly had the impact of Matt Dillon (James Arness) walking up to a crooked poker game in Miss Kitty's saloon. Suddenly all the players with something to hide decided to take a break. With everyone leaving at the same time the value of the pot took a sharp dive. Those gamblers have not left the bar but continue to circulate on the fringes while they wait on the new rules.

The CFTC said their already vigorous surveillance activity would be enhanced immediately. They announced an agreement with the FSA in Europe to increase surveillance on the ICE Europe exchange where 25% of the U.S. crude futures are traded. The FSA agreed to expand information sharing to provide the CFTC with daily large trader position reports in the UK WTI contract. They are also going to provide large trader position data for all contract months not just the current month. They are going to provide more detailed information on the identification of traders. ICE also agreed to notify the CFTC whenever traders exceed position accountability levels. Previously the FSA provided a weekly summary and daily information only in expiration weeks.

The CFTC also said it was going to require more information on trader identification in the U.S. markets. They are going to require index funds to report their trading so the CFTC can determine their impact on the markets. They are going to require more identification from swaps dealers and index traders. They will decide if index traders are adversely impacting the market and decide if classifications should be changed and position limits should be imposed.

All of these rules together may have put a crimp in the gunslinger style of enough large traders to burst the oil bubble at least temporarily.

Over the last 5 years the number of commodity funds or index funds, ETFs, etc has expanded dramatically. The majority of these funds are long only funds. That means they never sell without rolling forward into the next month. As these funds grow in number and size the amount of contracts they control grow in number. With dozens of funds investing billions in the commodity boom there is a shortage of contracts. In order for a fund to buy 100 contracts somebody had to sell them short into the market to create that open interest. Since the funds never sell that means the person that opened the short eventually has to cover in an increasingly narrow market. As funds receive more money for investment the only way they can buy more contracts is by offering a higher price. Speculators decide the higher price makes the risk worth it and they sell short at what appears to be a high price at the time. This cycle is repeated daily and the constant shortage of contracts means the pressure on prices continues to build.

Now add in the news items like Venezuela, Nigeria, Iran, Mexico, Russia, OPEC, etc and there is plenty of fuel for the fire. As demand increases to a breakeven with supply the lack of enough oil to cover open contracts continues to escalate the situation.

The last several months have been like a huge Ponzi scheme. Commodity funds are receiving massive amounts of money from investors and their buying actually pushes the price higher and that attracts more investors. Eventually this is going to end badly. It will either come in the form of the arrival of peak oil and a real rather than artificial shortage pushing prices higher. Or it will end when some event or regulation changes the game and all the players rush to take profits all at once.

Because the underlying premise of peak oil will always return to push prices higher any commodity crash should be perceived as a buying opportunity for long-term holders. We are reaching a point where there will not be enough physical oil to go around. Based on the latest estimates of oil coming to market in late 2008 and 2009 the peak will probably be in 2010. That will make today's volatility events look like a Sunday picnic at a retirement home. There really will be a shortage of contracts and everything I described above will increase exponentially.

Until that happens we still need to be aware that the house of cards could collapse at any moment. The key event will be a reclassification of index traders by the CFTC as speculators rather than hedgers. The margin requirements will increase dramatically and position limits will apply. When this happens, and most analysts believe it is imminent, there will be a monster flush of positions. One analyst said it could be in 2-weeks or 2-months but when it happens it will be dramatic. The other change will be the identification and regulation of the swaps dealers. Swaps are normally treated as hedgers with lower margins and no position limits. If they are reclassified as speculators then margins go up and position limits come into being. That will make it a lot harder for the big money guys to move the market. It is estimated that 60% of the open interest is held by institutional investors.

The testimony of Michael Masters to the U.S. Senate on May 20th fueled the fires for the CFTC to take action. While many analysts disagree with some of his numbers almost all agree with the points he brought up in his testimony. Basically he spelled out in great detail the impact of index traders on the crude futures market. You can read it here: http://tinyurl.com/45l8r3

Obviously if we ever get that announcement by the CFTC there will be a monster flush in the crude markets. Our positions will be stopped out and we will need to start over at a lower level. Because I believe this will happen I am going to tighten the stops.

Sunday is the first day of hurricane season and the forecasters are predicting 8-9 major storms in 2008. They also predicted that in 2006 and 2007 and there were no major storms. Our luck is eventually going to run out and we are going to take another hit in the oil patch. As storms begin to form you can bet prices will rocket higher only to crater again if the storm misses the oil fields. The first named storm of the season appeared a day early. Arthur formed off the coast of Belize and should move into the Gulf by Monday. The current track takes it into Mexico, not the U.S. This is the fun time of year to be long energy with an expected exit date in late August. The CFTC changes could spoil the party but we will continue to play until they take away the punch bowl.

Jim Brown

July Crude Futures Chart - Daily

June Natural Gas Futures Chart - Daily

June Gasoline Futures Chart - RBOB Daily


Changes in Portfolio

New Energy Plays


New Non-Energy Plays


Dropped Plays


New Watch List Plays Triggered
VLO $50.84 Valero

Portfolio Listing & Top Picks

Top Picks

If you are looking to add another position these are my top picks for this week. The target prices listed would be the ideal entry points for these stocks today. There is no assurance any stock will ever return to these support levels and you will need to make your own decision about an entry point above these levels. I believe these stocks have the best potential this week. The list will change from week to week based on technicals, fundamentals, crude prices and market action. The list is not sorted in any particular order.


New Plays

Most Recent Plays

New Watch List Plays Triggered

VLO $50.84 - Valero

Valero finally rallied enough to trigger our $51 breakout entry on Friday. If oil prices are about to decline then refiners should do well again. We all know gasoline prices never return to prior levels and refiners tend to do well in a declining crude market.

Company Info:

Valero Energy Corporation is a Fortune 500 company based in San Antonio, Texas, and incorporated in Delaware. Valero's common stock is listed for trading on the New York Stock Exchange under the symbol "VLO." The company has approximately 22,000 employees and assets valued at $38 billion.

The largest refiner in North America, Valero has an extensive refining system with a throughput capacity of approximately 3.1 million barrels per day. The company's geographically diverse refining network stretches from Canada to the U.S. Gulf Coast and West Coast to the Caribbean.

Valero has a mid-stream logistics system that supports Valero's refining and marketing operations.

A marketing leader, Valero has approximately 5,800 retail and wholesale stores in the United States, Canada and the Caribbean under various brand names including Valero, Diamond Shamrock, Shamrock, Ultramar, and Beacon. The company markets on a retail and wholesale basis through a bulk and rack marketing network in 44 U.S. states, Canada, Latin America and the Caribbean.

Breakout trigger: $51 hit 5/19
Position: 2010 $60 LEAP YPY-AL @ $7.20


Play Updates

Existing Plays

Energy Play Updates

PDE $43.94 -0.99 Pride International

Pride announced on Tuesday the completion of the $66 million sale of its platform rig fleet to Blake International LLC.

Zacks recently reiterated a buy rating on PDE on Friday based on their $9.4 billion backlog and their emergence as a pure play deepwater driller. They have sold off their non-core assets to leverage the deepwater play. The market is still valuing them as a shallow water jackup play and they are no longer in that sector. They are a strong takeover target given their small size and sector.

Position: Jan 2009 $50 Call PDE-AJ @ $3.70

I went with a Jan call instead of a LEAP because an acquisition would limit LEAP appreciation. I wanted to be close to the current price with a cheap option.


FWLT $76.17 +1.87 Foster Wheeler

Nice rebound after a -$5 loss the prior week. Lots of news on FWLT but nothing specific on the investment front.

Breakout trigger: $71 Hit 5/13

Position: 2010 $80 LEAP Call LWM-AP @ $16.80


CRR $47.69 -0.31 - Carbo Ceramics

Carbo had no news and no movement. It appears to have hit a plateau and nothing is happening. I will give it another week. I hate holding a stock that is doing nothing in a volatile market.

Breakout trigger: $48 Hit 5/12

Position: Dec $50 Call CRR-LJ @ $5.80


JEC $94.78 +3.13 Jacobs Engineering

Excellent rebound led by Fluor. At this point I don't care who caused it but just thankful it happened.

Breakout trigger: $90 Hit May 5th

Position: 2010 $100 LEAP Call WEU-AT @ $16


PBR $70.50 -1.88 Petrobras

I am surprised Petrobras declined any this week. There was so much positive news it should have been up +10. PBR expects to be a net exporter by year-end. On Wednesday PBR confirmed plans to build a 4th new refinery similar to a planned 600,000 bpd plant. The initial refinery is expected to be completed by 2014. When all plants are complete Petrobras will nearly double its refining capacity to 3.6 mbpd from its current 1.9 mbpd.

** See portfolio listing for any stop loss **

Breakout trigger: $125.50 hit 4/28

Position: 2010 $150 LEAP Call YMO-AV @ $22.10


NE $63.14 +.27 - Noble Corp

Noble has also gone dormant just above support at $62. It is as though traders don't know what to do with all the prosperity in the sector. There are no available rigs and those under contract are busy for years to come. Noble will present at the RBC Energy Conference on June 3rd. Hopefully the service/drilling sector will take flight from all the good news presented there.

Noble recently won a $4 billion contract to drill for Petrobras off the coast of Brazil. This is a monster payday and just one area of exploration for Noble.

** See portfolio listing for any stop loss **

Breakdown trigger $56.00 hit 4/29

Position: 2010 $70 LEAP Call YVJ-AN @ $8.10


RIG $150.19 -1.82 - Transocean

I don't get the decline in these drillers. Business is so good they are printing money on a daily basis. RIG closed at the low for the week. RIG will present at the RBC Energy Conference on the 3rd at 10:50 AM. The webcast will be available here: http://www.deepwater.com

RIG is the premier deep-water driller and there is no scenario where they don't continue to make money.

** See portfolio listing for any stop loss **

Breakdown trigger: $150 Hit 4/29

Long 2010 $170 LEAP Call YDR-AN @ $24.00
Shrt 2010 $230 LEAP Call YDR-AW @ $8.50


NOV $83.32 +1.97 - National Oilwell Varco

For every dormant stock there is another stock making new highs. NOV is very close to a new high after a strong week. NOV is Cramers best pick (this week).

** See portfolio listing for any stop loss **

Breakdown trigger: $67 Hit 4/30

Position: NOV $80 Call NOV-KP @ $5.40


FLS $138.52 +8.41 - Flowserve

Absolutely outstanding! Flowserve continues to amaze and broke out to another new high. They declared a dividend of 25 cents on Friday to cap off a perfect week.

** See portfolio listing for any stop loss **

Breakout trigger: $110 Hit 4/16

Position: OCT $120 Call FLS-JD @ $10.40

Non-Energy Positions


Covered LEAP Calls

AAPL $188.75 +7.58 Apple Inc *** Covered LEAP Call ***

Apple is back on a roll again as the hype over the 3G iPhone continues to build. Steve Jobs is expected to unveil the 3G model on June 9th at the Apple Developers Conference in San Francisco. The iPhone has captured 19.2% of the U.S. market for smart phone sales in Q1 according to IDC. That was down from 26.7% in Q4. The BlackBerry captured 35.1% in Q4 and then surged to 44.5% in Q1.

No change. Over $150 we are at max profits.

Long: AAPL @ open of $177.52 (Jan-14th open)
Short: 2009 $150 LEAP Call VAA-AW (APV-AJ) @ $20.80
Breakeven: AAPL @ $136.12

Position changes:
Closed $200 LEAP Short @ $9.40 ($30.00 - 9.40 = gain +20.60)
Replaced with $150 LEAP short @ $20.80
AAPL cost basis $177.52 - $41.40 (20.60 + 20.80) = 136.12
Breakeven: AAPL @ $136.12


RIMM $138.87 +7.23 Research in Motion

The IDC news that RIMM captured 44% of the Q1 smart phone market compared to Apple's 19% failed to crimp Apple's stock and RIMM rebounded to resistance at $140 on the news.

No change. We are at max profits over $110.

If we continue holding the position until January and let it get called away your profit will be $34.80 when the stock is called away for $110.

Alert entry 11/12 @ $102.60

Covered LEAP Call:

LONG RIMM @ $102.60 (cost $102.60 -9.10 $150 LEAP = 93.50)
SHORT 2009 $110 LEAP Call VHO-AB @ $18.30 on 1/14/08

Closed: 1/14
SHORT 2009 $150 LEAP Call XTB-AJ @ $18.50, close $9.40 +9.10

Leaps Trader Watch List

Dropped Entries


New Watch List Entries
Sandridge Energy
BTU Peabody Energy

Current Watch List


Based on the recent announcements by BP it may be time to take another run at this stock. When Thunderhorse comes online in Q3 it should get a lot of press due to the high volume of oil they expect to produce. Maybe BP's troubles are over.

Company Info:

BP p.l.c. (BP) is a holding company. The Company three business segments: Exploration and Production, Refining and Marketing and Gas, Power and Renewables. Exploration and Productions activities include oil and natural gas exploration, development and production (upstream activities), together with related pipeline, transportation and processing activities (midstream activities). The activities of Refining and Marketing include the supply and trading, refining, marketing and transportation of crude oil, petroleum and chemicals products. Gas, Power and Renewables activities included marketing and trading of gas and power, marketing of liquefied natural gas (LNG), natural gas liquids (NGLs) and low-carbon power generation through its Alternative Energy business. During the year ended December 31, 2007, BP acquired Chevrons Netherlands manufacturing company, Texaco Raffiniderij Pernis B.V. In April 2008, BP registered in Russia its subsidiary BP Exploration Services.

Breakdown trigger: $68. *** I am holding this level ***

Buy 2010 $70 LEAP Call WAO-AN


COP - ConocoPhillips

COP is still running and I am not going to chase them. I am going to raise the trigger slightly but just to support.

Company Info:

ConocoPhillips is an international, integrated energy company. It has six operating segments. Exploration and Production segment explores for, produces and markets crude oil, natural gas and natural gas liquids. Midstream segment gathers, processes and markets natural gas, and fractionates and markets natural gas liquids, primarily in the United States and Trinidad. Refining and Marketing segment purchases, refines, markets and transports crude oil and petroleum products. LUKOIL Investment segment consists of its equity investment in the ordinary shares of OAO LUKOIL. The Chemicals segment manufactures and markets petrochemicals and plastics on a worldwide basis. Emerging Businesses segment includes the development of new technologies and businesses outside the Companys normal scope of operations. In October 2007, American Electric Power Company, Inc. sold its 50% interest in the Sweeny Cogeneration plant in Texas to ConocoPhillips.

Breakdown trigger: $86 *** New trigger ***

BUY 2010 $90 LEAP Call YRO-AR


SD - Sandridge Energy

CEO Tom Ward, co-founder of Chesapeake with Aubry McClendon bought 230,000 of his own shares at $50 over the last week. This kind of confidence gave Sandridge a $5 bounce to a new high. SD announced the prior week that Williams had acquired certain assets for $285 million giving Sandridge additional cash for growth. This company appears to be in high growth mode and I want to own it on a pullback.

Company info:

SandRidge Energy, Inc. (SandRidge) is an independent natural gas and oil company with its principal focus on exploration, development and production activities. The Company also owns and operates drilling rigs and a related oil field services company operating under the name Lariat Services, Inc.; gas gathering, marketing and processing facilities, and, through its wholly owned subsidiary PetroSource Energy Company, carbon dioxide (CO2) treating and transportation facilities and tertiary oil recovery operations. The Company is focused on exploration and exploitation of its significant holdings in West Texas that it refers to as the West Texas Overthrust (WTO), a natural gas prone geological region that includes the Pinon Field, and its South Sabino and Big Canyon prospects. SandRidge operates in four segments: exploration and production, drilling and oil field services, midstream gas services and other.
Breakdown trigger: $52
Buy 2010 $60 LEAP LWE-AL


BTU - Peabody Energy

Joy Global said in an interview last week that there could be a coal shortage this year of 70-100 million tons. Tony Blair said China was building coal fired plants so rapidly that they would out number all the electric generation in Europe within a few years. Coal remains the cheapest alternative for electricity and demand will continue to grow for years to come.

Company Info:

Peabody Energy Corporation (Peabody) is a coal company. During the year ended December 31, 2007, the Company sold 237.8 million tons of coal. It sells coal to over 340 electricity generating and industrial plants in 19 countries. At December 31, 2007, the Company had 9.3 billion tons of proven and probable coal reserves. The Company owns majority interests in 31 coal operations located throughout all the United States coal producing regions and in Australia. In addition, it owns a minority interest in one Venezuelan mine, through a joint venture arrangement. Most of the production in the western United States is low-sulfur coal from the Powder River Basin. Peabody owns and operates six mines in Queensland, Australia, and five mines in New South Wales, Australia. During 2007, the Company generated 89% of its production from non-union mines. On October 31, 2007, Peabody spun-off portions of its Eastern United States Mining operations business segment to form Patriot Coal Corporation.

Breakdown Trigger: $70.00

Buy 2010 $80 LEAP Call LLW-AP


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