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Oil Markets Approaching the Fiscal Cliff

by | published November 9th, 2012

Markets declined significantly again yesterday.

In two days, the S&P has shed almost 3.6%.

On Wednesday (November 7), both crude oil and gasoline futures declined significantly. Yesterday (November 8), while the overall market slid, oil and gas began to rebound.

Now the undergirding of the energy sector in general – and oil in particular – is poised for a major move up. As I am writing this, six of the nine elements I regularly monitor to determine oil price direction are pointing north. The relationship between refinery margins (the difference between what it costs to produce oil products and the price that can be charged at the wholesale level – where the refiners make their profit) and inventory in gasoline are also indicating an oversold market, even without factoring in the East Coast double whammy of Hurricane Sandy and a Nor’easter.

The underlying dynamics, therefore, haven’t changed. If left to its own devices, oil should be moving up (and our profits right along with it).

So why the dip?

The first issue is short-term.

The aftermath of an election usually produces a downward pressure, regardless of who wins. The market bought into the election moving up smartly. It came out of the election moving in the other direction.

Nothing unusual there. The markets opened Wednesday morning with the election as history. That always occasions misgivings about what is coming next.

Yet cross currents over demand projections will be giving way to a more robust energy sector. This is not going to be a straight upward movement in prices. But those levels are currently depressed because of outside questions about overall economic prospects.

The oil market itself (and the energy sector as a whole will move essentially in the direction that its dominant component moves) has underlying dynamics that would dictate a crude price higher by about 15% at current levels. But the outside “distractions” need to be weeded out first.

Especially this time around.

There are two major elements preventing the energy sector from moving up.

I discussed both of these with my Energy Advantage and Energy Inner Circle subscribers yesterday, along with the way in which we have positioned both Portfolios to profit from the current situation.

Here is the summary of what I told them. Two matters remain foremost in the mix, assuring that the next two months will be marked by considerable gyrations.

First, the clock is ticking in Washington on the “Fiscal Cliff.” Second, Mario Draghi, the head of the European Central Bank (ECB), has prompted new concerns over the Eurozone.

[Editor’s Note: If you want to know the full story and how to play the Fiscal Cliff and European problems, click here now. You’ll find out how the oil markets really work, and what stocks Kent is recommending right now.]

The massive spending cuts and tax hikes obliged by the “cliff” would certainly push the U.S. economy over the brink into a deep and prolonged recession. However, despite the low regard given to politicians in Washington, there are already indications they will reach an agreement before the end of this year.

This will not be an ultimate solution. Yes, Congress and the White House will compromise to kick the can down the street one more time. But that will be sufficient for our purposes. Expect a rally in energy when the central powers begin to telegraph the compromise.

The second problem – Europe – was actually the major reason why the markets tanked on Wednesday. Draghi said publically what a number of folks had been saying privately. European economies are slowing, with that slowing now beginning to hit the continental engine – Germany.

Draghi subsequently made additional comments on Thursday that tempered the impact somewhat. Yet, new riots in the streets of Athens following the controversial passage by parliament of an austerity package have once again put a visual on the situation. A truly incredible admission by the Greek government of an almost 25% official unemployment rate simply intensified the concern.

Well, here is what will happen with the ECB. The mechanisms are in place allowing the central bank to buy distressed paper, although there are still some domestic decisions that have to be made by EU governments. It also remains unclear when Spain will formally request a bailout.

These details will finalize.

The European capitals have no other option, despite the political unpleasantness of the requirements. Even then, the most important decision (setting up the structure to buy cross-border commercial bank paper) has already been made.

Europe will not regain its financial footing without a lender of last resort. The ECB has now assumed that position. Despite the disagreements resulting, the path is laid out to ease the situation.

Once again, as with the financial cliff in the states, we will experience a stop-gap measure, not an ultimate solution.

The market has been trading on emotional reading of headlines for some time. We have undergone two downward slides in oil prices that went well beyond anything the actual market justified, followed by recoveries just as quickly.

All in the last few months.

This will remain a volatile situation in both directions. The objective in developing and balancing an energy investment portfolio in such an environment is two-fold.

First, the stock selections need to reflect the tradeoffs in the sector itself. That is, not all reactions to market activity will move in the same direction. Second, there are ways to establish ceilings and floors on risk short of simply using puts and calls.

As we move through the current cycle of market instability, I’ll be providing some general suggestions in OEI on how to design such a portfolio.

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  1. Janna
    November 9th, 2012 at 21:15 | #1

    I am new to energy trading. I don’t know the intricacies of executing trades on my own. I have a Charlie Schwab account, and my background is in finance. I understand this as you provide thorough research, but don’t know anything about puts and calls, other than the definition. Thoughts?

  2. Ed Nichol
    November 10th, 2012 at 02:25 | #2

    The other marketplace still requires a mechanism to move money into the street. This includes pensions, welfare checks, crop subsidies, new bridges, teacher’s pay, doctor’s pay,and many other day to day items. Too many of these checks are in the hands of municipal and state offices. Most of these offices are bankrupt. So the Feds can kick the can waaay down the road but it will not reverse the chart line on the plight of the general public.

  3. enthusceptic
    November 10th, 2012 at 10:21 | #3

    You are so right about the 2 big issues that need to be dealt with, Dr. M! CNN made the same point. More than one confirming is a good thing.
    The effect on the stock market was felt as far away as filthy rich Norway. Regarding filthy rich, too much money gives you a different problem than not enough: I believe in redistribution. Governments need a reasonable amount of tax revenue, and we as individuals have a responsibility to spend excess cash wisely. Charities and NGOs one believes in are excellent targets for redistribution.
    Then there is deciding how much to reinvest and how many and how big diamond encrusted yachts to buy. Hard work, don’t you agree?

  4. November 13th, 2012 at 09:58 | #4

    …We have undergone two downward slides in oil prices that went well beyond anything the actual market justified…

    Say what?

    A more true statement would have been ” After years of manipulation by private enterprise, the oil bubble is popping and oil prices are headed toward a level sustainable by the general economy.”

    Oil is still over-valued by about $15 dollars and maybe as much as $25. Investors may not like hearing that and I am 100% certain that the gurus will curse me for saying it but facts are facts. Every time oil goes up the general economy contracts way more than the increase in wealth generated by the inflated oil.

    As oil prices go down we see an uptick in virtually all other aspects of consumer spending. I’ve been monitoring local businesses for two years now comparing their sales figures based on oil prices and I can usually estimate to within 100 dollars what they will make on any given day based on the price of oil. These stats have never been wrong in the two years I have been doing this research.

    What this indicates is that the resource holders who control oil are manipulating the general economy for private gain. Oil is not like pet rocks, DVDs, movie tickets, and clothing purchases…

    The engine of societies need fuel to run and without it our society would fall apart rapidly. Oil is a resource that should be nationalized as well as a Manhattan project started to create an alternative to oil that cannot be monopolized nor manipulated like oil has been for a hundred years.

    The general public would benefit from an inflation proof source of energy that is not controlled by the private sector.

    I dare any of you who disagree with me who believes that the general public’s need to prosper is of more importance is a greater need than private enterprise’s need to get filthy rich off the backs of everyone.

    Dependency upon oil prices is like a modern day slavery that our societies need to eliminate. I know its not going to make some people happy but no civil and economic rights legislation ever has!

  5. Leland Waterman
    November 20th, 2012 at 15:19 | #5

    Al Broadman, on Nov 13th, made comments that oil should be nationalized!! I think you better look at the situation in Venzeuela where several of our US oil firms were taken over by the Government. Oil production in this South American country is going to the DOGS!! If you think the Government stinks with handling what parts of the economy it has its hands on now, just wait until until they get hold of the oil industry. Governments know little about efficiency!!

  6. Ed Stein
    December 8th, 2012 at 13:31 | #6

    The predictions of much higher prices neglects some important factors. One is expanded drilling in the US and elsewhere. Another is increasing use of fuel efficient vehicles – particularly natural-gas burning trucks. A third is the use of biofuels – even in the military.

    Of course, the world’s populations are increasing and the use of motorized vehicles is increasing but the price is still dependent on daily supply and demand numbers and if supply exceeds demand, prices will drop. So there’s no guarantee of increased prices – only a hunch.

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