The rise in global oil prices from $20 a barrel in 2001 to over $100 has largely been the result of worldwide supply/demand fundamentals. Demand has increased substantially, supply is lagging, and new supplies are becoming increasingly more difficult to find and extract.
But the most recent rally that has shot skyward like a Texas gusher has moved too far from the fundamentals of supply and demand. Billions of dollars in speculative funds have poured into the sector, fueling much of the recent rally.
Even OPEC is now signaling that oil is overbought. The Middle East oil cartel recently suggested they see a significant decrease in global oil demand growth this year. OPEC states, “This year's summer driving season is not likely to show its normal annual growth due to the anticipated weaker gasoline demand in the US.”
You see, the markets always work. As prices rise, people may complain, but they use less. Americans alone drive millions of marginal miles – to places they really don’t really need to go, when they don’t really have to be there. At over $3.90 a gallon – they’ll drive less. Already, the Financial Times reports that US demand is falling more than expected.”
The “oil is going up” trade has become very crowded. Combine that with lower demand and some of those speculative dollars seeking a new home, and we should see a healthy correction in the coming weeks.
There is still momentum behind crude. So we might see higher prices in the near term. But the higher probability trade is for a move to the downside. I expect oil prices to pull back to the $115 level… and possibly closer to $100. This kind of correction is perfectly normal, and it certainly wouldn’t break the long-term uptrend.
What to Do?
If you’ve made good profits in oil and energy stocks, consider ringing the cash register on any positions that are extended to the upside. At least, consider tightening your stops. If you’re looking to enter the market, I suggest waiting for a pullback.
If you want to take the other side of the trade, consider buying the ProShares UltraShort Oil & Gas (AMEX: DUG). DUG is an exchange traded fund (ETF) that goes up 2% for every 1% drop in the Dow Jones U.S. Oil & Gas Index. If the index falls 10%, DUG will gain 20%.
If you’re experienced with options and want additional leverage, consider buying call options on DUG. Remember, as oil goes down, DUG goes up. Call options would magnify this potential move.
Another consideration is buying the refiners. The profit margins for the refiners get squeezed when the price of oil (their input) rises faster than the price of gasoline (their output). For months, the refiners have been getting crushed. But it looks very much like they are hammering out a bottom.
You might consider Frontier Oil (FTO), Tesoro (TSO), and Valero (VLO) or call options on these companies. Should the price of oil fall, the margins for these companies should improve dramatically, and investors will bid up these shares in a hurry.
Over the long-term I believe oil is going higher… probably much higher. But not without a healthy correction to bring the fundamentals of supply and demand back into equilibrium.