Chapter 13
Getting Slick and Slimy: Understanding Energy Futures
In This Chapter
Understanding the connection between energy (oil) and bond markets
Exploring the effects of peak oil and long-term bull markets in energy markets
Balancing energy supplies with demand
Timing the cyclical nature of the energy markets
Coming to grips with markets for crude oil, gasoline, heating oil, and natural gas
Measuring the effects of sentiment on the energy markets
I never realized that I was going to become an expert in energy until I wrote a book entitled Successful Energy Sector Investing (Prima-Random House, 2002). I also never thought that crude oil would touch $100 per barrel in my lifetime either. But on January 2, 2008, it did — briefly — and by February 7, 2008, the price had moved to $105. Anything is possible. No one can ever predict what any market will eventually do with any certainty. But you can do a lot to prepare yourself as a trader, especially in the energy sector.
I can’t tell you everything I know about oil in one chapter. Here I provide you with a good summary of the way professionals think about and execute their trades in the energy markets, and the way I make recommendations on energy stocks and exchange-traded mutual funds (ETFs, see Chapter 5), as well as covering and analyzing important stories regarding the oil markets on my Web site (www.joe-duarte.com).
The emphasis in this chapter is on the entire energy complex from a speculator’s standpoint, concentrating on the practical. The goal is to understand how you can use a combination of three factors — supply and demand, geopolitics, and technical analysis — to reach sensible decisions about making good energy market trades.
Some Easy Background Info
Trading in energy futures began in 1979, and it’s centralized at the New York Mercantile Exchange (NYMEX), the world’s largest physical commodity futures exchange. The 132-year-old NYMEX trades futures and options contracts for crude oil, natural gas, heating oil, gasoline, coal, electricity, and propane. The NYMEX also is home to trading in metals (see Chapter 14).
Trading is conducted on the NYMEX in two divisions:
The NYMEX division, which trades energy, platinum, and palladium
The COMEX division, which trades the rest of the metals
For smaller traders, NYMEX offers e-mini contracts for oil and natural gas that also trade on the Globex network of the Chicago Mercantile Exchange (CME).
The NYMEX Web site, www.nymex.com, offers a good deal of information and is worth a visit. The calendars and margin requirements, which are listed individually for each contract, are especially useful to traders.
Next to interest rates, energy — especially oil — is the center of the universe not only for industry but also for the financial markets.
Completing the Circle of Life: Oil and the Bond Market
Much of what happens in the world — from your mortgage rate to how easily you find a job — depends on what I like to call the Circle of Life formed by energy prices and interest rates. For the sake of simplicity, I use the term oil interchangeably with the term energy in the rest of this chapter unless I note otherwise.
This relationship is important because it ties together the two most important aspects of the global economy: energy (the fuel for growth) and interest rates (the catalyst that powers borrowed money to do things). Sometimes the price of oil leads to a rise in interest rates, both in the bond market and through the actions of central banks, and at other times the opposite happens. In this chapter, the term interest rates means both types unless I specify one or the other. The relationship depends on where the economic cycle of supply and demand and the political current happen to be at the time. After September 11, 2001, traditional relationships changed somewhat but not completely.
Here are two examples. In mid-2005, one of the major reasons for the Fed to continue to raise interest rates, according to speeches made by Fed governors and Fed Chief Alan Greenspan, was that the rise in oil prices was creating inflation. At the same time, the bond market was struggling with the possibility that high-energy prices were increasing the chances of a recession.
As a result, the Fed kept raising interest rates, and the bond market was stuck in a trading range with rates slowly creeping higher.
If you fast forward to 2008, the economy of the United States was slowing, as a result of the credit crisis created by the subprime mortgage crisis. Yet oil prices kept moving higher. In this instance, the markets were struggling with the potential for supply shortages of crude oil, along with geopolitical issues, as the Middle East conflict was heating up, and demand for oil from China remained stable.
The Federal Reserve kept lowering interest rates in this latter instance, because they were more concerned about the slowing in the economy than the potential inflationary pressures of higher oil prices.
Here’s the basic concept. If oil prices rise high enough, one of two scenarios happens: The Fed starts worrying about either inflation or an economic slowdown because oil prices are so high that people can’t buy enough of other items.
If inflation is the dominant theory at the Fed, the central bank will raise interest rates. If a slowing economy is more likely, the Fed will start lowering interest rates. The bond market eventually will catch up with whatever the Fed does, and sometimes leads the action of the Fed.
Watching the bond market
You’re probably wondering how you can determine — or at least make an educated guess about — how the Fed will act. You can often find your best clue by monitoring the bond market. If bond-market interest rates begin to rise along with oil prices, it’s a sign that the bond market is growing concerned about high oil prices triggering inflation. If bond-market rates rise high enough, the Fed is likely to increase bank interest rates. If rates start falling in the bond market, then bond traders are expecting a slowing of the economy, and the Fed is likely to reduce interest rates. As I note in the preceding section, though, the Fed sometimes makes the first move by raising interest rates, and the bond market follows.
This explanation isn’t infallible, but it holds true a fair amount of the time. In 2004 and 2005, then-Federal Reserve Chairman Alan Greenspan called persistently low bond-market interest rates combined with the Fed’s continuously high interest rates a “conundrum.”
Nevertheless, when oil prices rise along with bond yields and/or interest rates from the Fed, you must look for an inflection point, such as where bond yields and overall interest rates have gone high enough to lead to a break in the price of oil, because traders have started factoring in the fact that oil prices have risen to a point where they’re becoming a hindrance to economic growth.
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Looking for classic signs as oil prices rise
The overall markets are likely to project certain signs as oil prices rise and traders start gauging the effect of the increases on the economy, including
Decreasing traffic in stores and malls (and on the highways, for that matter): By August 2005, as oil prices were reaching all-time record highs, retailers began blaming a slowing of sales on high gasoline prices. Also look for how many people are actually buying products, as opposed to window shopping or just hanging around the mall.
Decreasing consumer confidence: By August 2005, consumer confidence was skidding. Plenty of reasons could be cited for falling consumer confidence and rising gasoline prices. Hurricane Katrina did significant amounts of damage to the Gulf of Mexico’s coastline in the United States and rendered the city of New Orleans nearly useless. The port of New Orleans, a major import hub for oil and export hub for agricultural products, closed for days. And the oil and gas production and refining infrastructure of the area, which accounts for 20 percent of the gasoline and natural gas used in the United States, shut down and took several months to get back on line.
Crazy headlines: Look for increasing emphasis on oil prices on the evening news and in the media that don’t normally cater to business news. A perfect example was the call from Congress for a windfall profit tax on oil companies and repeated calls for hearings on price gouging by gas stations and fuel retailers.
These scenarios can take a long time to develop. You have to be very patient and let the charts guide your trading. In this case of the U.S. economic slowdown, nothing really hit the skids until the subprime mortgage crisis became evident in 2007; by late in the year more and more people were losing their jobs. More interesting is that even when all these negative things in the economy became obvious, at least as of March 2008, oil prices were still acting fairly well, with West Texas Light Sweet Crude oil trading at $105 per barrel.
Check out Figure 13-1 (later in this chapter), which shows the relationship between interest rates in the bond market and oil prices. In a classic sense, this is the way things are supposed to work:
Oil prices and interest rates generally move in the same direction when viewed over long periods of time. Keep in mind that this relationship involves a wide band of movement and that I’m discussing only the very big picture, in the classic sense. The important point to remember is that rising oil prices can lead to inflation, and inflation eventually will lead to higher interest rates, both in the bond market and from the central banks. See Chapters 2, 6, and 10 for more about bonds, inflation, and the economy.
At some point, if classic (historical) relationships hold up in the future, oil prices and interest rates will rise enough so that the economy also begins to slow. A slowing economy then tends to dampen demand for oil and prices retreat.
The preceding describes a classic relationship that was well established before the emergence of China, India, and other emerging markets as major consumers of oil. As China’s economy continued to grow in the post 9/11 world, the relationship between supply and demand in the world markets was distorted. Prior to China’s accelerated expansion, the United States and Europe were the major oil consumption regions of the world, with little competition. Thus, when those economies slowed down, oil prices would eventually fall. The future is less certain, as it’s unclear whether the demand from China and the emerging markets will be enough to make the classic relationship between oil and interest rates a moot point. My guess is that the relationship will not become useless, but that it could take a lot longer before the endpoint, where high interest rates lead to falling oil prices, is reached.
Note that oil prices made a new high in March 2005, but interest rates in the bond market didn’t. At that point in time, you needed to be thinking that a top in oil prices was possible because interest rates in the bond market didn’t make a new high along with oil prices. Even though you may not have been right, you nevertheless needed to think about it.
Examining the Peak Oil Concept
Peak oil is the concept that the world’s oil production has peaked or will peak, and that after it does production levels will never again be as high.
The peak oil idea is controversial, but it’s increasingly plausible given the state of the global oil industry. The most important factors affecting this theory are as follows:
Countries such as Venezuela, Iran, and Nigeria, all of which are OPEC members, aren’t necessarily friendly to the United States and other industrialized nations. Turbulent political situations can reduce oil production in these and other countries, as can any potential production problems having to do with how much oil is available for extraction at any one point.
Poor maintenance of key facilities and equipment and questionable reserve data, in essence lies about how much oil is really in the ground, are reportedly rampant throughout OPEC nations; Indonesia’s production has already been in decline for years. Indonesia is a net importer of oil, despite being an oil-producing nation. Another example is Venezuela where thousands of oil wells, with potential extractable reserves in the ground, are in such states of disrepair that they are no longer usable.
Traditional non-OPEC sources of oil, such as the North Sea and Mexico, are also showing signs of declining production. The eventual loss of production from key fields in Mexico will likely affect the U.S. economy at some point. This is because many of these fields have been producing for decades and have just run out of the easy-to-extract reserves.
Gathered steam after the events of September 11, 2001, and became well established in many corridors of trading during the mega bull market in oil that ensued and that remains in place well into early 2008.
Received support in July 2005 when Saudi Arabia told the world that in ten years, its production wouldn’t be able to keep up with global demand if demand continued to grow at rates that were prevalent at the time.
By 2008, some startling statistics were circulating. According to several key opinions, world oil production may, in essence, have either peaked already or will peak sometime in the next 10–20 years. If that’s true, the world as you know it will certainly change. In fact, according to a CIBC World markets report published in February 2008, it will take 4 million barrels per day of new oil to keep up with the oil demand of the next few years — and that’s if you take into account what’s already been lost in places such as Mexico, Indonesia, Venezuela, and the United States.
So if the report, and the work of Matthew Simmons in his book Twilight In The Desert: The Coming Saudi Oil Shock and the World Economy (Wiley, 2006), are right, peak oil may already be under way. Simmons did a literature review of hundreds of papers with relationship to Saudi Arabia’s oil supply and concluded that the Saudis don’t have near as much oil in the ground as they say they do, and that they have had shoddy maintenance of their existing fields that can still produce. If he is correct, that would mean that peak oil may be closer than the overall estimates, which seem to agree on 2010 or 2011 as the key dates.
The Post-9/11 Mega Bull Market in Energy
The world changed after September 11, 2001. The invasions of Afghanistan and Iraq were only a small part of what happened, at least in terms of the financial markets.
Just prior to September 11, 2001, the United States was scrambling to recover from the economic weakness caused by the bursting of the Internet bubble. However, the attacks on the World Trade Center derailed the fragile economic improvements and plunged the country into a deep psychological and logistical nightmare in which businesses closed their doors and job losses began to mount.
Here’s what happened:
The U.S. dollar went into a multiyear bear market. Money left the United States as the Fed lowered interest rates, making the dollar less attractive. Politically, the world also viewed the United States as unstable, unpredictable, and vulnerable because of the attacks. As with any bear market, there were periods after 2001 when the dollar rallied. But the rallies did not last. In February and March 2008, the U.S. dollar, as measured by the U.S. Dollar Index, made new all time lows.
Oil and natural gas entered once-in-a-lifetime secular bull markets. However, the natural gas bull lost steam much earlier than the bull in crude oil because new production sources, such as the Barnett Shale deposit near and under the city of Fort Worth, Texas, came online. A secular bull market is one that lasts years to decades. Traders almost immediately started bidding up the price of oil, initially because of the connection of the terrorists who attacked the United States to Saudi Arabia, the world’s largest oil producer. However, as time passed, a new dynamic developed as money began to flow into China.
In other words, as the United States appeared to be entering a period of uncertainty, traders began looking for places where economic growth wasn’t as affected by what happened on September 11, 2001. These traders found China, whose currency was pegged to the dollar.
As the dollar fell in value, the Chinese yuan remained weak, increasing the demand for Chinese products and revving up the Chinese economy, which relied heavily on exports to other countries, especially Europe and the United States. As more foreign money flowed into China for those exports, the Chinese economy became more and more able to produce goods and export them to the entire world. The upshot of all this economic rotation was a faster rate of increase in global oil demand, just at a time when production was starting to plateau.
Long-term interest rates entered a downward sloping and wide trading range. The yield on the U.S. ten-year Treasury note initially rose, because traders began to price in the likely collapse of the U.S. economy, and because China and oil-rich countries recycled their new found riches into U.S. Treasury bonds. Although by 2003 the U.S. economy wasn’t as strong as it would have been had September 11, 2001, not occurred, it clearly wasn’t going to collapse.
As the economy stabilized, interest rates began to rise. Note, though, that the dollar didn’t bottom out until 2005, a full two years after bond yields started to rise, and so did oil demand.
The key is not to be in a big hurry to see these events unfold, and not to be too rigid in our expectations or interpretations. That’s because these relationships can take significant amounts of time to reach points at which they become evident. Sometimes it takes a large number of interest-rate increases and a long period of rising bond yields to turn a major currency like the dollar around. Don’t forget that the politics and general stability of a country play big roles in how strong its currency will be. In the post-September 11, 2001, period, the markets weren’t immediately convinced that the United States would be able to survive the attack and remain a major world power.
As of 2008, those who bet against the United States in the immediate post-9/11 period as a military power were proved to be wrong. Despite large amounts of political controversy and conflict, the United States remained a major world power. The irony is that even though the 9/11 attacks did not destroy the United States and its economy, an internal attack on the U.S. economy in the form of fraud, greed, and bad policy did deliver a significant blow, as the subprime mortgage crisis unfolded. In essence, the ensuing credit crunch was a bloodless coup as U.S. unemployment began to rise, record numbers of home foreclosures developed, and the U.S. dollar continued to fall.
Understanding Supply and Demand
Wanna know a secret? Although most people think that demand is what makes prices change, supply rules in the energy markets. As the U.S. economy slowed during the months that followed the World Trade Center attack, the Chinese economy picked up steam, and its demand for oil increased.
The increased Chinese demand, however, wasn’t enough to boost oil prices immediately. That boost didn’t become noticeable for several months. Instead, the markets correctly began to price in the possibility of attacks on the oil-producing infrastructure and the increasing challenges of getting oil out of the Middle East. More important, the market again correctly factored the loss of Iraq’s oil supply into the markets as the United States attacked Iraq.
Now in 2008, the market faces a different set of dynamics. Iraqi oil is starting to flow back into the market, but it may not be enough to compensate for the loss of production in Mexico, Venezuela, the North Sea, and other areas that will likely crop up in the next few years.
The world runs on oil, and any threat to the oil supply leads to rising prices.
As an oil trader, your primary goal is to consider the effects of events on supply and to correlate those effects with your charts.
Demand fluctuates, but supply is finite. Weeks are necessary to ramp up supply or to turn it back down. Refineries are a bottleneck in the system. So even if plenty of oil is sitting in storage, if the refineries can’t turn it into gasoline or heating oil, the supply of those products is impaired.
Charting refinery capacity in the United States
The United States hasn’t built a new refinery since the 1970s. The combination of environmental concerns, red tape and paperwork, costs in the billions of dollars, and the multiyear time frame needed to finish a new refinery are prohibitive and have prevented any new oil-refining capacity from coming online. In essence, the United States is now in a position in which domestic refinery capacity can’t meet any increase in demand for oil or oil products. That means that now more than ever, the United States depends on foreign resources for its oil and refined products.
Damage to refining and shipping capabilities caused by Hurricanes Katrina and Rita brought the U.S. refinery issue to the forefront as gasoline prices skyrocketed. The markets and consumers also reacted as prices reached a level that was high enough to decrease consumption and lead to lower prices.
The net effect of the post-September 11, 2001, bull market in oil, though, was to reset fuel prices at a higher level than prior to that date. I don’t think gasoline prices will ever dip below $.50 again, barring some truly extraordinary event.
Playing the Sensible Market
The energy markets make sense, regardless of whether you believe in the concept of peak oil.
Real companies have huge trading desks with hundreds of traders all betting on the price of oil. Banks and brokers join oil, trucking, and airline companies in using the oil markets on a daily basis to hedge their future price risks and for pure speculation. Even Goldman Sachs and Merrill Lynch got into the oil storage and distribution business in the early part of the 21st century in the wake of September 11, 2001.
In other words, the oil market is about real people trying to figure out how much oil they’re going to need to run their businesses in the next few months to years, regardless of whether they’re suppliers or users.
Stock prices are built mostly on analysts’ drivel, such as price/earnings ratios and new paradigms, such as the nonsense that sank the Internet stocks. Oil, gasoline, heating oil, and natural gas prices, on the other hand, are based more on real-life circumstances and aren’t usually influenced by the kind of fiction spawned by slick Wall Street analysts penning negative e-mails about the stocks they push onto the public.
OPEC supplies 30 to 40 percent of the world’s oil. Russia, the next-biggest supplier, and other non-OPEC producers like Mexico, Norway, and the United Kingdom make up the rest of the world’s supply. The United States also is an oil and natural gas producer, with Alaska and the Gulf of Mexico being the largest affected areas. The United States ranks above Mexico and Canada in proven oil reserves. The total oil reserves in the United States are roughly one tenth of those in Saudi Arabia. Still, as time passes and exploration becomes more difficult for both geologic and political reasons, the dynamics of the oil market will change, and likely for the worse, with the potential for higher prices and supply disruptions rising.
From a practical standpoint, supply is made up of what comes out of the ground, what can be refined, and what can be delivered, both before it gets to the refinery and after it’s refined into gasoline, heating oil, diesel, and other fuels.
The potential for supply disruption can occur at any of several steps along the route from extraction through the point of sale, and each step has its own unique chance of causing price-increasing supply screw-ups.
Worker strikes, hurricanes and all other kinds of natural disasters, accidents, spills, sabotage, and even market manipulation by OPEC and other producers all end up affecting supply, not demand.
Oil without a doubt is a political tool. The Venezuelan government of Hugo Chavez didn’t like President George W. Bush, so it repeatedly threatened to cut shipments of oil to the United States during the Bush years in the White House. Sabotage of oil pipelines was a major weapon in Iraq in the early days of the U.S. invasion. It remains to see what will happen when a new U.S. president is elected and takes office in 2009 and how the war in Iraq will eventually evolve.
The one constant in supply, especially in the United States, is that not enough refinery capacity is available to keep up with any more than normal demand. That means when winters are extremely cold, refineries are a key bottleneck in the oil-delivery system.
Handling Seasonal Cycles
Energy demand, especially for heating oil, gasoline, and natural gas, is extremely seasonal in nature, and if you look at your own life, you can easily understand how these cycles work.
In winter, you heat your house. If you live on the East Coast of the United States, that means you use heating oil. Everywhere else you burn natural gas and sometimes coal. Some areas rely on nuclear energy. Likewise, during summer you drive your car or fly off somewhere to go on vacation.
Traders anticipate the ebb and flow of these cycles and factor them into their bets. A good number of traders work for companies, energy and otherwise, that use the futures market either to have fuel delivered to them for resale or for their own use. Others use energy futures to hedge the cost of the energy they need to run their businesses. Still others are speculating and trying to make a buck.
Experience a lull in the spring months when refineries convert production from heating oil to gasoline. When that happens, the price of heating oil starts to fall, and gasoline prices firm up.
Swing up and down during the summer based on gasoline supplies. As the end of the summer nears, another pause occurs when refineries switch over from gasoline back to heating oil production.
This broad cycle became unreliable after September 11, 2001, because prices bucked the cyclical trends and pretty much went higher.
Preparing for the Weekly Cycle
A more useful cycle hinges on what happens on Wednesday mornings — or on Thursday mornings after three-day weekends. That’s when the American Petroleum Institute (API) and the U.S. Energy Information Agency (EIA) release their weekly supply data reports.
Analysts all pony up their estimates for the reports usually on Monday and Tuesday. They’re all focusing on supply, not demand, and they want to know whether inventories are building (increasing in supply) or drawing down (decreasing in supply).
The markets focus mainly on the report from the EIA because it’s a government agency that requires companies to provide their supply statistics. The API uses data supplied on a volunteer basis. Thus the API data tends to be less exact because of its information-gathering system.
A great time for a coffee break is at 10:30 a.m. eastern time on Wednesdays so you can watch for the energy supply data. Setting up some potential trades ahead of the release of the reports can help you get a jump on executing them based on the new supply data. Wednesdays can be the most profitable day of the week in the energy pits.
Checking other sources before Wednesday
On Monday and Tuesday, I start scanning news sources for analysts’ opinions about the oil market. Doing so gives me a good idea about what may happen if the market is priced wrong regarding current supply levels.
Some good stuff to read before the release of the reports include the commodities column at MarketWatch.com (www.marketwatch.com). It provides a good summary of expectations. Reuters (www.reuters.com) and Bloomberg (www.bloomberg.com) also provide good summaries of what the market is setting itself up for when the data comes out. If your broker gives you access to good news data, Dow Jones Newswires is about as good as any source to get the same data. Dow Jones Newswires is a subscription service accessible online, usually through brokers and financial-service institutions.
How to react to the report
Making trades based on the supply reports isn’t an exercise in being exact, because analysts usually are clueless about what’s coming up. What you want to look for are instances when they all agree one way or another. For example, if they’re all leaning toward a build (increased supply) of crude, be ready for the market to go higher if the report even hints of a supply shortage. The same is true for when the market gets set up for a drawdown (decreased supply) — be ready for the market to go lower if the report hints of more abundant supplies. Here are a couple of tips for trading the supply reports:
Be careful when the report comes out. Give the market some time before you jump in. The first few trades can be volatile. After a minute or two, your real-time chart should start to show you the way the market is headed.
Consider some option strategies. As with other reports, a straddle (see Chapter 4) is a good potential strategy to consider. Other hedging techniques, such as holding some long positions in blue-chip oil stocks and selling the futures, or buying puts on the futures, also may work.
You’re already out of the market. If you aren’t already in the market, you miss a chance to make some money. However, don’t go chasing prices trying to get into the market. You’ll end up being sorry.
You have an established position. You take advantage of the data being in your favor by ratcheting up your sell stops so you can take as much profit as possible if the market happens to turn on you. If you’re using a broker, hopefully you gave him instructions on what to do in this situation; otherwise, you’d better have his number on speed dial and hope you’re one of his favorite clients.
Your position gets stopped out. If you were in the market but were stopped out because you guessed wrong, be glad you’re out. Reassess your position and wait for a better opportunity. When you get stopped out, it means that the stop-loss order you placed to limit your losses was triggered as prices dropped to the level you specified.
Forecasting Oil Prices by Using Oil Stocks
One of the most reliable methods of forecasting futures prices is to use the action in oil stocks. John Murphy is one of the most prominent promoters of this dynamic, and I’ve found his approach a very useful starting point.
Changes in oil stocks tend to precede the moves in oil prices and should also confirm them. Sometimes oil stocks also will move along with or just after crude oil futures.
Although oil stock prices may sound unpredictable, as a new bull market in oil starts, oil stocks will normally start rising along with crude prices either before or right after crude oil futures start rising.
Much of the time, although not always, oil stocks will rise or fall before the price of crude oil rises or falls.
Similarly, as the falling trend line of a bear market in oil takes hold, oil stocks will either break sometime before, along with, or just after crude oil futures. Figure 13-1 provides a good example of the dynamic, using information from Exxon Mobil, the oil (XOI) and oil service (OSX) indexes, and December 2005 crude oil futures.
Take note of how
The price of Exxon Mobil stock (bottom-left chart) bottomed out before the XOI index (top-left chart) took off.
The XOI index began to rally at a much steeper rate of rise than the December 2005 crude oil futures (CLZ5) contract. Some of the steeper rise results from the fact that the volume of trading in the December 2005 contracts didn’t pick up until 2003 and then really started booming in 2004. Nevertheless, oil stocks clearly began to rally before the futures.
Oil service stocks (OSX top right chart) kept pace with the XOI and Exxon.
Exxon stopped rallying in February 2005, and oil futures(bottom-right chart) and the rest of the oil stocks continued to move higher. Every time oil futures made a new high, Exxon didn’t confirm them — a classic technical divergence that requires confirmation. Figure 13-1 shows a classic double-top pattern in Exxon. A double top is when the market reaches a price that’s similar to a previous price and then rolls over. A double top is a sign of failing price momentum. Notice how the double top in Exxon was followed by a breakdown in the price of oil, which on November 1 dropped below $60.
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Figure 13-1: The relationship between Exxon Mobil, the XOI and OSX indexes, and December 2005 crude oil futures. Top row: Amex Oil Index (XOI, left), Philadelphia Oil Service Index (OSX, right). Bottom row: Exxon Mobil stock (XOM, left), crude oil futures (right). |
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Figure 13-2 is an enlarged version of Figure 13-1, and it shows in greater detail how the double top in Exxon coincided with the breakdown in the price of the December crude oil contract and how the break in the stock preceded the break in the futures. Be sure to check out these points in Figure 13-2:
Relative strength indicator (RSI) for Exxon and for CLZ5: Lower highs are present on both charts; however, the Exxon chart also shows clear overhead resistance on the stock’s price, a sign that sellers are waiting to unload as soon as Exxon nears $64 per share.
How the crude futures chart continues to make new highs: The RSI oscillator for crude futures also is cause for concern for the same reason — because it also fails to confirm the new high in crude, a sign of a momentum failure.
When the price of Exxon stock no longer confirms the new high in crude oil, you need to start being careful and monitoring the momentum and trend indicators so you can prepare to sell your crude futures position. In other words, Exxon, in this case, flashed a correct warning sign that oil prices were likely to fall.
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Figure 13-2: The relationship between Exxon Mobil (XOM) and December crude oil futures (CLZ5) from February to October 2005 (Exxon Mobil on the left, crude oil futures on the right) |
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As a futures trader, the situation shown in Figure 13-2 gave you little choice but to continue to trade crude futures on the long side. However, in this case, because Exxon was warning you and the RSI oscillator wasn’t confirming the rallies, you need to be very careful and use tight stop-loss points or consider trading only with options to curb your risk.
Burning the Midnight Oil
Crude oil trades around the world, but New York’s Mercantile Exchange (NYMEX) is considered the hub of global oil trading.
Light, sweet crude is high-grade, low-sulfur crude oil that’s more easily refined than thicker oils. It also yields better products. When it isn’t going by that name, it’s called West Texas Intermediate. High-sulfur crude, such as that which comes from Venezuela and certain Saudi Arabian wells, requires special refineries that process only the heavier crudes.
NYMEX also provides trading platforms for futures contracts based on the following:
Dubai crude oil. This contract is a futures contract for Dubai crude oil.
The differential between the light, sweet crude oil futures contract and Canadian Bow River crude at Hardisty, Alberta.
The differentials between the light, sweet crude oil futures contract and four domestic grades of crude oil, including Light Louisiana Sweet, West Texas Intermediate-Midland, West Texas Sour, and Mars Blend.
Brent North Sea crude oil.
Oil options.
Crude oil is the world’s most actively traded commodity, and the NYMEX contract for light, sweet crude is the most liquid of all crude oil contracts. The NYMEX Web site (www.nymex.com) is well worth a visit.
Here are the particulars of a crude oil contract:
Contract: Each crude oil contract contains 1,000 barrels of oil that will be delivered to Cushing, Oklahoma.
The e-mini contract trades on the CME Globex electronic platform are cleared at NYMEX and hold 500 barrels of light, sweet crude.
Valuation: A barrel of oil holds 42 gallons and trades in U.S. dollars per barrel worldwide. The minimum tick of $0.01 (1 cent) is equal to $10 per contract.
Trading: NYMEX offers both open-cry trading during regular hours and electronic, Web-based trading after hours. Open outcry trading hours are from 10 a.m. to 2:30 p.m. After-hours futures trading takes place on the NYMEX ACCESS, an Internet-based trading platform, starting at 3:15 p.m. Monday through Thursday and ending at 9:50 a.m. the following day. Sunday trading starts at 6 p.m.
Margins: The initial crude oil contract margin for nonmembers as of January 2008 was $7,088 (with the maintenance margin for customers at $5,250).
Settlement: Contract settlement is physical, and delivery takes place at Cushing, Oklahoma, or similar pipeline or transfer facilities.
You can find contract listings and termination dates at www.nymex.com.
Getting the Lead Out with Gasoline
Gasoline has become a hugely important contract for several reasons. It’s the largest-selling refined product sold in the United States and accounts for almost half of the nation’s oil consumption. Two important factors that you need to know about the gasoline futures contract are that
Refinery capacity is limited. As the global economy continues to grow, the global demand for gasoline also is rising. As is true in the United States, the number of cars in China also is growing, contributing to this increased global demand. For many of the same reasons, environmental and otherwise, gasoline demand outpaced refinery capacity for a good portion of 2005.
International competition for oil and geopolitical problems in South America are on the rise. Although a bit more subtle, the importance of Venezuela as a major exporter of oil and gasoline to the United States is becoming a major global market factor. As rhetoric grew more intense between Venezuelan president Hugo Chavez and the United States in 2005, so did the risk of Venezuela cutting off exports.
The situation between the Chavez government and the United States is rather fluid. Much of it may be due to the personality conflict between Chavez and President Bush, who will leave office in 2009. So things can theoretically change.
Chavez, though, has pursued the development of alternative markets for Venezuela’s oil products, including having made deals with China and several countries in South America. Indeed, Chavez has made production, exploration, and refinery deals with Russia, Brazil, India, Iran, and Cuba. At some point, if Chavez is successful, the United States may indeed encounter supply problems. I’d expect that the United States can buy oil and gasoline from alternative sources. The key is that prices are likely to be higher because of the logistics involved.
Contract specifications
You needed a $7,425 initial margin per contract to trade a gasoline futures contract and $5,500 to trade gasoline futures in February 2008.
A contract gives you control of 1,000 barrels or 42,000 gallons of unleaded gasoline. A 25-cent move in the per-gallon price of gasoline is worth $10,500 per contract, and that amount is the limit move. Each tick of $0.0001 (1/100th cent) is worth $4.20 per contract. Delivery is physical to the New York harbor.
Trading strategies
Keep the following general tendencies in mind when trading gasoline contracts, but understand that they’re not guaranteed to occur or to follow any particular script.
Gasoline prices tend to move along with prices for crude oil; however, gasoline prices aren’t guaranteed to mirror crude prices, because they move according to their own supply and demand scenario.
Gasoline prices tend to be the highest during summer months when demand is highest. Prices tend to rally for the July, August, and September gasoline futures contracts during April and May. Figure 13-4 shows the start of the rally in the September contract at the beginning of May. The figure also exhibits choppiness in the market as expectations for less driving are incorporated into gasoline prices. This chart is particularly important, because it shows the consistency of the overall seasonal pattern. In 2005, gasoline supplies were below historical stockpiles because of an overall tightness in the market and problems experienced within the refinery industry.
You also need to take note within Figure 13-4 that although Hurricane Katrina pushed gasoline futures prices above $2, the seasonal pattern held. Aside from the usual decrease in demand caused by seasonal factors, in this case, the market was essentially flooded with gasoline imports from Europe, and President Bush also suspended the need for refining a multitude of different grades of gasoline that are normally produced to meet clean-air standards. The combination of these three individual variables led to the decline in gasoline prices.
Keeping the Chill Out with Heating Oil
The price of heating oil has a tendency to rise as the winter months approach. As is true with all energy commodities, supply is the key, and chart watching is as important as keeping up with supply when trading heating oil futures.
After gasoline, heating oil, which also is known as No. 2 fuel oil, makes up about 25 percent of the yield from a barrel of crude oil. Here are the particulars of trading heating oil futures:
Contract: Heating oil futures trade in the same units as gasoline: 1,000 barrels of 42 gallons each, or a total of 42,000 gallons. The contract is based on delivery to New York harbor, the principal cash-market trading center.
Margins: Margins for heating oil are quite high, and they’re based on a tiered structure designed to give a more precise assessment of risk. Each tier consists of at least one futures month, and all the months within a given tier are consecutive. In general, as of February 2008, the Group 1 margin for nonmembers was $6,750, with maintenance margins at $5,500.
If you trade nearby contracts, contracts that expire in months that are in close proximity to the current month, your margin will be higher, because the volatility and the chance for profit is higher, and you’re being charged a premium for that.
Valuation: The price relationship of each tick is identical to gasoline, with 1/100th of a cent equaling $4.20 per contract.
Figures 13-3 and 13-4 also show the general tendency of heating oil to rally with oil, gasoline, and natural gas prices. During the time frame depicted in the figures, the contract started to show some price compression in late August and had joined gasoline in diverging from crude oil prices, which suggested that a big move was coming.
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Figure 13 3: Gasoline and crude oil futures show the effect of Hurricane Katrina. |
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Figure 13-4: Heating oil and natural gas futures after Hurricane Katrina. |
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Getting Natural with Gas
Natural gas is an increasingly popular fuel. Its reputation for burning cleaner than crude oil and coal has made it the number-one choice of environmentalists and a commodity with a rising demand profile.
Russia has the world’s largest natural gas reserves. The United States has roughly a tenth of the reserves of Russia, and Iran has the second-largest natural gas reserves. Yet, domestic production in the United States has increased significantly since crude oil prices have been on the rise.
Natural gas supplies about 25 percent of the energy used in the United States and is increasingly important in generating electricity, especially during the summer months, because of air conditioning.
Natural gas contracts have nine margin tiers, with initial margin requirements differing and changing from time to time. Check out nymex.com for current figures when you’re considering trading. Tier 1 margins in February 2008 were $6,750 and $5,000, respectively, for initial and maintenance for retail customers.
A natural gas contract gives you control of 10,000 million British thermal units (mmBtu), and a $0.1-cent move is equal to $10 per contract.
Getting in Tune with Sentiment and the Energy Markets
Sentiment is an unclear concept. To some, it can mean sadness; to others, it means great joy. In the financial markets, it means greed and fear. Greed usually comes with market tops, and fear usually is the hallmark of market bottoms. These diverging concepts are, of course, what make up the contrarian thesis of investing. (For more information about contrarian thinking, see Chapter 9.)
In the summer of 2005, when oil prices had risen by roughly 50 percent from the previous summer, many attributed the huge rise in prices to a three-pronged combination of refinery problems, significant weather changes, and steady economic growth, compounded by event fear and fanned by the flames of the greatest extension of a bull market in oil that started after September 11, 2001. It was in this context that I started carefully tracking market sentiment.
When I appeared on CNBC on August 24, 2005, the first question I answered was, “How high can oil go?” My response was that $60 or $70 was possible, but that I wasn’t sure. I also said that the market had been going up for some time and that it was due for a pause.
When I returned to my office after the interview, the network pundits were talking to Professor Michael Economides, author of The Color of Oil (Round Oak Publishing, 2000), and he was predicting $100 oil, although he didn’t say by when. All day long on CNBC and elsewhere in the financial media, coverage of the oil markets was rather dramatic, and so were the perceptions of what was coming.
The next day oil prices fell more than a dollar, and the headline “SCREAMS AT THE PUMP” appeared on the Drudge Report a few days later, signifying that life in the oil markets was about to become even more interesting.
By August 26, 2005, the market was trying to decide what effect Hurricane Katrina was going to have. The market close on that Friday was inconclusive, but by Sunday, August 28, it became clear that Katrina was a major storm and that the oil infrastructure in New Orleans and the Gulf Coast area, which is responsible for a major portion of the energy supply and distribution of the United States, was in peril.
Although oil had traded above $70 per barrel as the storm was brewing overnight August 28, not enough data was available to support prices at that level. As the storm hit on the morning of August 29, damage reports began trickling in, and by August 30, oil finally burst above $70 per barrel during a regular trading session.
As the news of the storm trickled in, and the damage assessment became clear, the oil market took on an entirely new, extremely serious tone that was certain to suddenly make the American public keenly aware of daily price fluctuations.
By the end of trading August 30, crude oil futures for October closed at $69.85, just shy of $70, but nevertheless, still at an all-time record high.
On September 17, I appeared on the Financial Sense News Hour radio show with Jim Puplava, and Jim and I both agreed that oil prices were looking as if they were making a top. Few other analysts were on that side of the trade at the time. I submitted an article to Rigzone.com in which I reported the conversation Jim and I had, and I forwarded the article to CNBC, which was interested enough to call me back for an interview.
I was back on CNBC the week after I made the call on the Jim Puplava show, and told them that if oil fell below $56, it could go to $40. During the next several weeks, the oil market dropped from the $70 area to around $60 by November 1, when Republicans were agreeing with the Democrats in Congress and starting to discuss adding a windfall tax to oil companies for making too much money, another sign that prices could fall farther.
A second storm, Hurricane Rita, also hit the Gulf region just a few weeks after Katrina, but the damage, although significant, wasn’t as bad.
As history shows, the U.S. economy recovered, but the price of oil, after a brief fall, continued its bull market.
What was apparent in November 2005 was that at least 50 percent of the oil and natural gas production infrastructure in the Gulf of Mexico was off-line, although refinery capacity was steadily coming back online. The United States was running on imported gasoline from Europe, yet prices still were going lower and people were still calling for $100-per-barrel oil.
Some Final Thoughts about Oil
I’ll end this chapter with a list of some final thoughts to illustrate several points that you need to know about the oil markets in the winter of 2008:
The bull market in oil was nearly seven years old. If you count September 11, 2001, (or shortly thereafter) as its date of birth, that means the bull market was getting old, even by secular or long-term bull market standards, which are measured in years and sometimes decades. No one knows how long a bull market of this magnitude can last. But one thing is nearly certain, this one has been quite amazing, and theoretically has the potential to last several more years, although there are likely to be periods of significant declines along the way to higher prices.
The prevailing wisdom in August 2005 was that oil prices couldn’t go anywhere but up. The world, after all, was running out of oil, and the global economy could never slow down. At the start of 2008, the global economy was slowing, and demand was about to slow, so prices should have fallen. But they didn’t fall. In 2005, prices pulled back and the bull market resumed. In 2008, prices finally closed at new records, well above $100.