We are in the early stages of what may be the most significant revision in energy investments to occur in a decade (or more), and for me, that has meant yet another day full of meetings. As we just adjourned for lunch, I took the opportunity to fill you in on what’s been going on here.
The situation remains fluid, although the financing involved is quite large and likely to come in stages.
As this unfolds, I will advise you of what is about to happen, and how to play it. You will also be receiving a “heads up” as soon as the strategy has been settled.
Now, that may not happen until next week. For now, suffice to say that huge worldwide sources of funding are about to start investing globally – and especially in the U.S. – in what will be much more than just another merger and acquisition cycle.
But until I have concrete indicators to pass along, let’s today consider a more immediate concern: how to best play oil prices that keep bouncing up and down within a “range,” as they have this week.
It’s actually quite simple…
Oil is Up 4% One Day, and Down 4% the Next
Here’s what I mean. Crude oil prices in New York dropped 4.4% yesterday after a 4.6% rise on Tuesday. This morning the price was rising again by some 2%.
Welcome to our latest period of “range-bound” oil.
On June 23 WTI (West Texas Intermediate, the oil grade used in setting futures contract prices on the NYMEX) eked past $50 a barrel. Yet since then the price has declined 10.7% through close yesterday.
Now some observers had initially suggested there would be a rather straight line from $50 to the low $60s. After all, just about everybody (including myself) believe that is the level the market will realize in the fourth quarter of this year or the first of 2017.
However, I had suggested that we would approach $50 and then find some significant resistance there. My take was not that we would be then collapsing back to the $30s.
Rather, this rise in price is going to be gradual and, as I have put it a number of times before, “ratcheted” going forward (i.e., the overall move up will be accentuated by occasional reversals).
In short, the crude oil situation is stabilizing but in a very different environment than we have experienced in the past. With the massive extractable oil largess unfolding in several places, principally because of massive unconventional (shale and tight) oil in the U.S., the supply side of the supply-demand balance is driving restraint.
Of course, the volume must actually be extracted at the wellhead before it has a genuine impact on market price, as I explained on Tuesday. Nonetheless, traders who actually determine the daily prices via WTI and Dated Brent (the London equivalent) as the yardsticks for setting futures contracts tend to react ahead of the curve.
Traders Tend to Accelerate Oil Price Movements
On any given trading day, there are many more futures contracts (“paper” barrels) than actual consignments of oil (“wet” barrels) circulating in the market. A trader makes money by arbitraging between these two.
As we have discussed before, traders need to estimate ranges of implied volatility upon which to determine options as “insurance policies” on the futures contracts. Futures require that one buy a commodity at a stated price and time. Options provide the right but not the obligation to do so.
Traders are almost never interested in owning the actual commodity – instead, their focus is on making a profit off of it. The options provide the leverage to sell the futures contract prior to expiration (by effectively cancelling out the contract).
Traders try to gauge prices by estimating where the market will go. In stable times, they will peg their contracts on the expected cost of the next available barrel of oil. When oil prices are going up, that will translate into the expected most expensive barrel; when they are declining, it will translate into the least expensive.
That means traders will push the market in the direction it’s already heading more aggressively than the actual underlying dynamics justify.
When that happens, your best bet is simply to “jump on the bandwagon” and do whatever the traders are doing.
Unfortunately, that won’t work when oil prices are “range-bound” – bouncing between two prices – as they are now, as things will move to fast for regular investors.
And even if you stayed glued to your computer screen, you’re most likely not involved in the futures contract trade (nor should you be), which is what the traders use.
But as luck would have it, there’s a simple way to trade “range-bound” oil…
How You Can Best Play “Range-Bound” Oil
The tool I recommend you use are select exchange traded funds (ETFs) or parallel exchange traded notes (ETNs). These allow you to play an entire market segment without having to invest in the underlying commodities themselves, or in a multitude of individual companies.
In fact, ETFs and ETNs should be a part of your portfolio in any event. But they are even more important in the “bounded” trading environment we have in oil today.
When it comes to oil, there are two kinds of ETFs and ETNs to consider.
First are ones dealing with oil itself, as well as the direction of oil’s price. There are also “bear” and “bull” funds, that magnify the movement of the oil price up to three times (in reverse, for “bear” funds).
As you’d expect, such funds are also subject to high volatility.
Second are a number of funds that provide exposure to a wide group of companies – according to function (for example, producers, oil field services, distributors, midstream pipelines and storage, equipment, refining), global range (broad global to region-specific), and size (small caps, blue-chip).
A rule of thumb when using ETFs and ETNs in the present range-bound environment is this: it makes sense to stay away from funds that focus on small companies, given the acute debt crisis among operators underway in the U.S. market.
Broad exposure is preferable, with funds that have sufficient trading liquidity and low management fees.
Among the many currently available funds, the best straight exposure to oil is United States Oil Fund LP (USO), while a good exposure to the broadest range of producers is provided by SPDR S&P Oil & Gas Exploration & Production ETF (XOP).
If instead you’re most interested in oil field services – the market segment that is likely to experience improvement first, before oil producers themselves – the fund to look at would be VanEck Vectors Oil Services ETF (OIH).
Now, with oil prices stuck in their current range, timing will be everything.
P.S. Stay tuned for next week, when I’ll have more from my finance meetings. It’s going to be big…
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