Crude Could Explode in Either Direction

By Chris Marasco - August 9, 2012 | Tickers: BP, CHK, XOM, OIL, USO | 0 Comments

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At the tail-end of June I wrote an article titled OIL: The Buy of 2012.  I asserted that oil futures were at mid-term lows and were due for a drastic bounce.  I also went long iPath Crude Oil ETN (NYSEMKT: OIL) in the low-19 range.

Now my sentiment has changed.  Here’s why.

Oil still has tremendous upside, and it could get back up above 100 and close to 110 like we saw in February and March of this year.  But it could also break back down into the 80s and 70s like we saw earlier this summer.  And I chose to not take my chances – I decided to fully close the position instead of scaling out.

Here are a few reasons to be wary of price movement in the price of crude.

Why Oil Ran Up

Oil got a boost from the European Central Bank, which claimed that it would not allow the euro to fail.  This is an important point because the European Union accounts for a full 16% of all oil consumption.  A thriving Europe means that citizens and companies will use fuel consistently.

Also, Oil got a boost because supply recently fell by 5.4 million barrels, far more than the 300,000 forecast by analysts.  Lower supply pushes prices upward.

Tropical Storm Ernesto also caused crude to jump, as the storm passed through Jamaica and headed for Honduras, Belize, and Mexico.  Mexico’s Bay of Campeche contains two production centers, and if knocked out, would drive down oil stocks even further.

Danger Ahead!

While these fundamental factors have influenced the rise of crude instruments like OIL and the United States Oil Fund (NYSEMKT: USO), there are other factors that cause me to be wary.

First, the S&P 500 rests just above 1,400.  Typically I avoid the talking heads, but this trader presents a good bit of advice, urging long-term investors to be cautious about the market rise, especially on such little volume – meaning that the big funds aren’t the cause of the market’s upward push.

This is troublesome because crude is often highly correlated to the S&P.  So unless Mr. Bernanke & Co. decide to roll out another round of the dreaded quantitative easing (which escalates asset prices in the short-term but causes huge inflation damage in the long-term), we could see crude tank right along with the broad market.

Also, Tropical Storm Ernesto moved the market once – and it could very well do it again.  If the storm hits the Mexican refineries, then oil jumps.  If not, oil sinks.  This is the type of situation that calls for a short strangle options play rather than a long stock position.

Finally, recall that oil is run by a cartel.  The leaders want crude to be neither too high nor too low.  They will manipulate the price to their liking.  The Saudis may not have short-term control of oil, but they do have pricing power in the long-term.  Sad but true. 

So how can investors still get exposure to oil right now, despite its high price?  Stocks do the trick.

Exxon Mobil (NYSE: XOM), British Petroleum (NYSE: BP), and Chesapeake Energy (NYSE: CHK) all have significant exposure to the price of crude.  Exxon and BP are known more for their crude businesses, and Chesapeake has a thriving natural gas practice and is also a top-15 produces of crude – making it a better hedge in case crude heads south for the winter.

Exxon has a forward P/E of 11.1 and a 2.6% dividend yield while BP’s forward P/E is a mere 6.6 with a dividend yield of 4.7%.  Chesapeake’s P/E sits at 14.0 and pays a 2.0% dividend – but the stock is also far more volatile.

If either of the two oil ETFs contain too much exposure, you can pare that exposure with one of these three correlated stocks while still staying in the market.

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