Commodity ETF Alert February 2009 Issue

Oil’s known by these and probably another hundred names.  Only recently has oil been thrust center stage.  Oil prices hardly budged for almost a decade.  During the tech boom, nobody cared about oil.

Then, in the matter of a year or two, that all changed.

In 2006, oil prices started rising.  In January of 2007, oil was trading around $50 a barrel.  A year later, prices had doubled to $100 a barrel.

Then the real excitement started…

Oil started doing the impossible.  It skyrocketed month after month after month.  At mid-year, oil had spiked to over $147 a barrel.

Everyone was feeling the pinch.

From delivery truck drivers to soccer moms.  It was painful to fill up at the pump. Gallows humor was shared every time someone stopped at the gas station.  Gasoline, which is made from oil, topped $4.00 a gallon.

With prices that high, people just stopped driving.

According to the Federal Highway Administration, Americans cut their driving by an eye-popping 30 billion miles in a few months time.  The pain couldn’t last much longer. Demand was falling like a lead balloon.

Then just as quickly as they rose, oil prices started falling.  The relief was immediate and apparent.  Oil fell to $125, then $100.  By October 2008, it had traded below $75 a barrel.  By December 2008, it was below $50.

Our pleasure was someone else’s pain.

Oil producing nations had grown accustomed to high oil prices.  As revenue from oil sales plummeted, their economies started struggling.  Countries like Venezuela, Russia, and Saudi Arabia started feeling the pinch of lower prices.

They started to take action.

OPEC called an emergency meeting.  Remember OPEC?  They’re the Organization of Petroleum Exporting Countries.  It’s a big consortium of countries with huge oil reserves.  They decide how much to sell oil for.  Some would call it price fixing… I think they call it price management.

OPEC’s reaction to falling prices was predictable… they cut supply.  As supply falls, oil prices rise.  It’s simple supply and demand.

Their first meeting was in October of 2008.  They immediately cut production by 1.5 million barrels per day.  Then they met again in December.  This time they announced production cuts of 4.2 million barrels.

Now, if this cut doesn’t seem dramatic, consider this.  According to one source, the 4.2 million barrels represents almost 12% of OPEC capacity!

The Iranian Oil Minister (an OPEC member country) boasted he wanted to “restore oil prices to $90 per barrel”.  Aggressive, don’t you think?

OPEC isn’t alone in these cuts.

Consider Russia.  At the same time OPEC was cutting production, Russia chimed in and announced they too were cutting production.  Russian Deputy Premier Igor Sechin said, “Russian oil companies have already made a decision to cut deliveries to the market… approximately equivalent to 350,000 barrels per day.”

But, that’s not all.

According to World Oil Journal, oil production in the US was falling as well.  Total production declined some 17%.  Partially because of hurricanes, but also because of falling demand and price.

Despite the supply cuts, oil prices continued falling.

Until now.

An interesting trend is developing in the oil markets.

Production cuts were largely ignored at first.  But, that’s starting to change.  The easy cutbacks in consumption have been made.  Demand is still falling, but at a much slower pace.  At the same time, the production cuts from months ago are finally impacting the market.

Supply is tightening, and demand is stabilizing.  It’s a perfect recipe for higher prices.
In a nutshell, I see oil prices moving higher over the next few months.  Just wait for the first news of demand increasing.  Oil will pop!  Adding new production is much tougher than cutting it.  This will help drive prices higher.  Not to mention the quickly approaching summer driving season.

The net effect is higher prices.  And I don’t think $70 a barrel for oil is overly aggressive.

So how do we profit from the coming move in oil?

ABOUT OIL

There’s a bunch of different ways to play oil.  For this commodity trade, I want to use the iPath S&P GSCI Crude Oil ETF (OIL).  It used to be called the Goldman Sachs Crude Index.

Basically, the ETF manager buys futures contracts for West Texas Intermediate Crude.  These futures contracts are actively traded on the New York Mercantile Exchange (NYMEX).  When you buy an ETF, you’re buying a piece of the contracts owned by the ETF.

Now, you’ll note right now oil’s trading around $46 a barrel.  Our ETF trades for about $18.76.  So the ETF isn’t tied dollar for dollar to the price of oil.  However, it should move in similar percentage increments.  So I’d expect a 5% move in oil to result in a 5% change in the price of the ETF.

Remember, due to tracking errors and expenses, the actual change in the ETF value might be slightly different than the commodity.  It’s not a cause for concern, but worth pointing out.

TECHNICALLY SPEAKING

Clearly, oil has been in a long term downtrend.  Looking at the ETF, The 50-day moving average is right around $23.  It looks like we’ve hit a support level around $18. I think we could see a nice move higher as oil bounces off support.

 

 WHAT TO DO NOW:

iPath S&P GSCI Crude Oil Total Return ETN (OIL) is trading at $18.76.
Buy OIL up to $20.25 per share.
Our Profit Target is $27.00.
Don’t forget your position sizing.

ENERGY COMMODITIES

The energy complex moved lower by 8.2% in January.  The year-end rally fizzled and most energy commodities tumbled lower.

The energy complex spent a good portion of January below the 20-day moving average.  Recently, prices have turned higher and crossed above this technical indicator.  I see this move as a positive sign a longer uptrend is on the horizon.

OPEC continues to strangle supply in an attempt to drive oil prices higher.  This month’s trade capitalizes on the anticipated trend higher in oil prices.  The futures market appears to agree with oil prices in “contango”.  Prices are higher in out-month futures contracts.  (Contango’s a fancy way of saying it’s cheaper to buy oil now than delay delivery a few months.)  This despite EIA data showing inventory is building.

Increasing seasonal demand (it is winter after all) has done little for heating oil or natural gas.  Both are down.  Despite a colder winter, big industrial users (like Dow Chemical, DuPont, and Alcoa) are slashing demand.  This is driving prices lower.

GRAIN COMMODITIES

After a strong move higher in December, Grains are slipping a bit.  January was tough in the Corn and Beans market.  The US government released new estimates showing demand is slipping while production is expected to increase.  The markets went “limit down” on the news.

It looks like the December lows may have put a bottom in for the market.  Spring planting is still a few months off.  That’s a time of increased risk.  You never know what crops will go in the ground… and a late freeze could be harmful.  We could see a good buying opportunity shortly.

INDUSTRIAL METALS

Industrial Metals were the big winner in December… and the big loser in January.  The index fell more than 11%.  A tough economic environment is crushing demand.

Despite the poor fundamental data, we’re seeing some positive movement in the price action.  The Industrial Metals complex moved above the 50-day moving average.  And we had a 5- and 20-day moving average crossover to the upside.  On a technical basis, both are very bullish signals.

However, I’d like to see the fundamental and technical data agree before taking a position.  I think the technical move is a kneejerk reaction to some of the mining companies announcing future production cuts.

Take the nickel market for example.  Nickel prices are still falling despite massive supply cuts by BHP Billiton (one of the largest producers).  BHP is closing its Ravensthorpe, Australia mine.  This removes another 14,000 tons of nickel from the market a year.  An unbelievable 60% of nickel production goes to the manufacture of stainless steel… which is in very low demand these days.

PRECIOUS METALS

The big winner this month is Precious Metals.  The entire Precious Metals complexmoved higher by over 8%.  Leading the charge was gold.  Silver didn’t do too badly either.

On a technical basis, the complex looks really strong.  We’re trading well above the 20-day and 50-day moving averages.  Both averages are in a nice uptrend and should provide strong support as we move higher.

Gold and silver will be bought as an inflation hedge over the next few months… driving prices higher.  Our IAU trade is already working out fabulously.  Our position peaked above $91 just a few days ago for a gain of more than 8%.  Hold tight.  I’m expecting this trend to continue.

SOFTS

This month Softs moved slightly higher, just over 1%.  The complex is still firmly trending upward.  We crossed above the 50-day moving average back in December. The 20-day moving average is providing strong support as the complex rides it higher.

Cocoa continues moving higher… recently trading at 20 year highs.  As one analyst noted, “Chocolate is relatively recession proof.”  You think?

Coffee is moving higher as well.  The commodity jumped above the 50-day moving average for the first time since September 2008.  News out of Brazil, the largest producer of Arabica beans, indicated a smaller than expected harvest.  I guess my morning java jolt is going to get more expensive!

LIVESTOCK

Livestock lost 4% in trading this month.  The down appears firmly entrenched.  Both the 50- and 20-day moving averages are trending lower.  Bad news for livestock producers, great news for summer BBQ season.  If prices continue falling, we’ll see some great deals on beef this summer.

The falling prices are appearing in the face of falling seasonal supply.  Winter is always a seasonally low time for livestock supply.  Declining supply and prices indicate demand is falling much more quickly.  The bad economy is clearly causing consumers to cut back on beef consumption.

• This month we’re adding OIL to the portfolio.  Buy up to $20.25.
• We moved IAU from a Buy to Hold.  We’re above the buy up to level.

Category: Commodity Trading