Oil is Not Looking So Hot

I received another one of those scratchy cell phone calls from my friend in the West Texas oil patch. You could almost feel the dust coming through the ether. He said that while Ben Bernanke his committed to buying $40 billion a month of mortgage-backed securities as part of QE3, he has not promised to buy a single barrel of oil. This is bad for oil.

That means Texas Tea has to take the full brunt of collapsing demand caused by economies in free-fall like Europe, China, and Japan. There are no bailouts here. On top of that, Saudi Arabia wants to whip some discipline into its fellow OPEC members.

Saudi Arabia does this by permitting its own production to surge, dropping prices, and inflicting pain on recalcitrant cartel members, especially Iran. Around $80 a barrel is thought to be a price they would be happy with, some $15 a barrel lower than today’s price.

Last week rumors were rife of a “fat finger” trade that drew in high frequency traders and triggered an almost instantaneous $4 plunge in the price of oil. But notice how it has failed to bounce back. This generated chart sell alerts more than you can count.

The break of the 50-day moving average on the charts is thought to be particularly significant, reversing an uptrend that has been in place since June. Notice that the “fat fingers” always seem to hit the “Sell” button and are oblivious to the location of the “Buy” button … maybe they don’t have one.

On top of all this is the never ending threat of a Strategic Petroleum Reserve release by the administration that would cause prices to immediately gap down. It is safe to say that energy is not Obama’s favorite industry. He is essentially sailing “Buy those $100 calls on oil at your peril, because I will render them worthless.” That is what he did with his jawboning campaign in the spring when crude threatened $107. Substantially tougher margin trading requirements for many commodities by the main exchanges quickly followed.

One factor that no one appears to be watching is the dramatic ramp up in Iraqi oil production. In recent years, we have gone from zero to 3 million barrels a day, and appear to be headed toward 5 million barrels a day by 2015. That is half of Saudi Arabia’s total annual output. Norway and Canada are also increasing production.

Back in the US, conservation is making a dent on the consumption side in a thousand different ways that are impossible to quantify in the aggregate. Every time someone trades in a gas guzzler for a hybrid or electric vehicle they are cutting US consumption by 24 barrels of oil a year. Toyota will sell 2 million hybrids in the US this year, about half in California. That works out to a total oil savings of 48 million barrels a year, 132,000 barrels a day, or 1.3% of our total imports.

Energy savings are going on every day in a myriad of ways, from better building design, to industrial recycling of heat, and conversion of light bulbs from incandescent to fluorescent. It has become a major cost-cutting issue for US corporations. I just checked the specs on my new 80 inch 3D flat screen TV and it uses a quarter of the power of its cathode ray tube predecessor now headed towards the recycling center (notice how all the actors have suddenly aged 10 years). I have always said that this will be the big sleeper on the American energy front.

The final argument is that in the wake of QE3, there is a sudden death of “Risk Off” positions to trade against. Oil is almost one of the only ones out there. So an oil short will partially hedge out downside risk in the substantial “Risk On” positions we have built up in (GLD), (AAPL), and (GOOG).

The extra turbocharger on this trade is that the hedge fund community is still hugely long oil, betting an attack on Iran by Israel that never came. As we move into yearend, the pressure on them to dump their losers will be overwhelming. So I am quite happy to buy the United States Oil Fund (USO) December $32.50-$35 put spread at $1.07 or best.

The (USO) in particular is a great instrument to play from the short side because it has one of the worst tracking errors to the underlying in the entire (ETF) universe. (Only the natural gas ETF (UNG) is worse). Notice how it always goes down faster that it goes up. This is because of the enormous contango in the oil futures market, whereby far month futures trade at gigantic premiums to the front months. The (USO) has to take the hit on the rollovers; hence, its terrible track record.

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