3SOF

I have turned short-term bearish on Oil as mentioned in the NLG.TO thread last weekend and consequently sold all my energy stocks (except ESI.TO)

To try to predict the direction of crude oil is two steps away from alchemy and to bet against a commodity with such a strong chart is a bit crazy but I am willing to take the risk - so here we go:

The recent run up in oil prices even before Katrina defines logic and to refer to our previous discussions is an example of a bubble where people use irrational arguments to justify price increases.

Katrina affects the oil market in three ways. First of all some of the production in the Gulf of Mexico has been interrupted. In some of the reports you almost get a feeling US has been cut off from the oil market but in fact the Gulf of Mexico is only accounting for 1.5% of world production and even though the damage has still not been fully assessed it seems like most of this production will be brought back in the coming weeks.

But Katrina also affects the refinery capacity of US and as the Ludwig von Mises Institute writes:

QuoteSome analysts have tried to explain how reductions of crude demand by refineries can push crude prices up! (Wall Street Journal, August 12, 2005) Proving that even corporate economists don't always remember basic economics, one of them explained that "logic and the market are barely on speaking terms these days," as if the market was anything else than a way to reconcile the participants' subjective valuations

For me that defy logic. How can the fact that refineries might not be able to process all the crude oil that the market need cause the price of crude to go up? If the crude oil can't be processed crude oil everything else equal would drop like a stone. But as David would say this is a bubble so......

And finally Katrina disrupted the import of oil into US but again that seems more bearish than bullish (It will hardly cause the price to increase if you can't sell the crude to US).

There are other indications that we are looking at inflated oil prices. The world strategic reserves are close to an all time high (even after the latest releases) and there are concern about the growth of the Chinese economy which has been driving the rise in demand (BTW I do not support this!)

The chart below shows Oil prices in Constant 2005 US$ since the seventies. The red line representing the increase up to Katrina. Oil has increased from $45 to $70 within the last 6 months and I am pretty sure that the effect on the demand by fare outstrip the minimal long term effect of Katrina (that is if there is a long term effect at all)



As can be seen this is not the first bubble we have had in fact it is probably the 6th in the last 30 years. Neither is it the worst bubble. (that was the Iranian revolution in the start of the eighties when the priced almost hit $100).

Most of the bubbles has been introduced by politics and wars. If spikes caused by geopolitical events was excluded, real oil prices have followed a downward trend from the mid-1970s until the late 1990s. This is the first bubble that actually has its outset in real long-term demand and supply and I do therefore not see the oil price collapse.

That the market is ready for a reversal is confirmed by the chart (IMO):



This is a very strong chart but there are however several technical indicators that point towards a drop in price:

1) There is a divergence between the RSI and the actual price development of oil
2) MACD will most likely turn negative in the coming days
3) ADX shows a weakening trend

I have looked at number of other indicators and most of them indicate a reversal within the coming days.

Using the long-term chart I believe the demand and supply can justify an oil price in the low to middle fifties. The Oil price might therefore drop between 20% and 30%. Oil stock will most likely react more violently (not to mention alternative energy!) I think there will be a risk premium due to the tight supply situation and terror risk in the middle east. My call is therefore an oil price in the high fifties to low sixties.



I have been wrong before and will be wrong again but this is my take on the situation and I have decided to adjust my portfolio accordingly.

Hi Michael,

Great analysis!

I have sold NLG (thanks again for bringing it to us) and CHAR.OB, take a nice profit on both.

The only oil stock that I have right now is EGY, looking at it to significantly boost its production in the coming quarters.

I bought two NG companies (KCS and CHK) last Monday. I think the natural gas situation is different from oil:

- We are coming to an end of the driving season, but starting the heating season shortly, in October.
- Oil price went from $45 to $70, but NG price went from $5-$11, but it's not reflected in stock price yet
- There is no reserve in NG, where there is for oil, which the governemnts are releasing right now
- KCS and CHK are both in-land productions, so that they are no affected by Katrina
- Specular growths for both companies recently, still more to come in the coming quarters
- Very low PEs on both companies
- In the case of CHK, insider buying are crazy (>$10M), in the $28-$29 range, where the stock is $31.78

I share some near term uncertainy with your concern with oil stocks. I am bullish on NG stocks till the peak of winter.


-Louis

p.s. still looking at SVA this weekend, did you buy?

My biggest gainer on the oil stock was RER.TO, 70%+ gain and sold 2 weeks ago after I believe it was fair valued. 

I still have some Canadian $ to go around and looking at a good buy. Why are you still keeping ESI.TO, if you are short term bearish on oil? The PE is > 20, which is a lot more than many US oil companies (including the refineries such as ALJ, VLO, TSO, and FTO, which is kind of hot right now)


-Louis

Actually, the one that is on the top of my list right now is TDG on TO, Trinidad Energy Services.

Very good price/volume increases in the recent years. It won't explode like VPHM or AOB, but a good safe play, plus it pays ~7% dividend yield.

Still, the question is buy now or wait till the oil price to pull back a bit. I am a bit inclined to wait a bit, as I share your concern on oil, but bullish on NG due to seasonaility.

Hi Louis,

This is a short-term prediction on crude oil. The energy sector is still bullish and long-term I believe that there are lots of good opportunities out there. I have however mainly been invested in "real oil stocks" and I think they are headed for a drop.

Natural Gas should still perform well (even though a drop in oil stocks might drag them down as well). NG shortage is a US phenomina so longer term I would be concerned about LNG (in fact the world is being overflowed with NG and the worst problem is to get rid of it!).

Other interesting opportunities are refineries and drilling companies (that is why I haven't sold ESI.TO).

great posting again Michael, applaud from the new godfather

Oil is down but NG is up (at least on Monday night EST)

http://www.nymex.com/index.aspx

Great post Michael !!
I must Applaud you ! 

I agree with you in most of your thoughts, and I too believe that a lot of oil stocks have already reached their highs, mainly the big caps and the leaders (not the same with the small caps)..

Another reason, is simply contrary opinion strategy...  I have contact with many average investors in Europe (the general public), on the past few days (after Katrina), every investor I know have asked me what Oil Big Cap should they buy ? Not to say, that who bought Crude Futures last week is already loosing money, but that could be just the market hurting the «buy the news» traders on the short term.

Usually is after a big event, in this case a tragic event, that we reach a market top (Oil Sector)... Where the smart money have the opportunity to sell large lots to the generall public...
Following the logic, there is the time for the small cap attack, which is the last group to be bought in large scale during a bubble, usually when the big caps are already below their highs...

best regards,

Hi Ramsburg

Thanks for the Applauds 

Oil for sure is an interesting play these days. I heard that Saudi Arabia and some of the other OPEC countries are going to lower the price. I am wondering how that is going to work.

I agree that there might be some lacking between a drop in oil price and oil stocks but the correlation between the two is quite strong.

Below is a comparison between the price of oil and AMEX oil index and DJ world index for emerging oil/gas companies.

I guess the trick is to find individual stocks with either hype around them or fundamentally undervalued.

As Louis rightly pointed out there might also be excellent picks in the NG and refinery sector unless they will fall in sympathy. Off course the premise of this discussion is that oil will fall significantly and that is still not a done deal!

For the sake of good order: I sold ESI.TO this morning.

http://biz.yahoo.com/ap/050906/oil_prices.html?.v=21

See the comments on natural gas. Both KCS and CHK went up today.

It certainly seems like the prediction about a drop in oil prices was correct. But the other side of the bet didn't work out as nice.

Oil stocks has basically been unaffected by the drop in oil prices. This can either be because the oil stocks are so undervalued that they are still catching up or because the retail investors are still on a buying spree while the institutional investors are moving out (as Ramsburg suggested).

I believe Ramsburg is right so I will stay on the side line. Oil stocks are undervalued but I am still not convinced that we will not see a short-term correction.

If I were buying in the sector I would be looking at NG and Refineries (as Louis suggested)

Mike

Hmmm..... Rita created a little spike but oil still looks bearish to me.

Oil stocks have kept up surprisingly well. It is very rare you see a double-digit fall in a commodity without the stock feeding on that commodity falling even more. I think the oil stocks resilience is due to partly the sector being undervalued partly retail investors' excitement. I would expect institutional investors to reduce their holdings.

Hi Michael,

I agree. I am out of oil stocks now for now, but continue to hold the two NG stocks till March, 2006

http://www.rednova.com/news/science/250249/natural_gas_shortage_feared/index.html?source=r_science

http://www.mywesttexas.com/site/news.cfm?newsid=15274619&BRD=2288&PAG=461&dept_id=474107&rfi=6


-Louis

Hi Louis

I think it is time to look into the energy sector again. We have certainly as expected been through a rough time but the heating season is approaching....

As usual this is a matter of timing and I am not sure the time is right yet but I will try to post when I buy.

Michael