jaudio shorts

$90 Oil? Are you serious?

Yes I am. In fact, I jumped on the train selling oil short last week. More about the trades in a bit.

The dents in the armor of skyrocketing oil are already in place, and the stage is being set for oil to fall. Most players are on the opposite side, looking to ride oil past $200 and beyond. I not only view even higher oil prices unlikely, but $200 oil is next to impossible in the time frame being put forth.

My views are simple, based on economic principles that have been around since Cain traded vegetables with Abel.

1. Supply
2. Demand
3. Strength/Weakness of the Dollar

Most of us understand supply and demand. (All of you oil company conspiracy theorists can stop reading now). China wants more oil, the emerging markets are demanding more, and the USA isn't curbing its appetite for oil. We are using up oil as fast as it comes out of the ground. With more people demanding it, the price goes up, of course. Couple this with countries falling behind with total oil output, like Russia, and further price increases are expected. To make the perfect storm complete, oil is priced in US dollars, so as the US dollar weakens, oil creeps upward. Speculators are there to play the game, and they sometimes get caught up in the hysteria. It seems that oil is destined to continue its upward climb, with no end in sight.

If it were only that easy.

The simplified story of oil in the last 12 months that I just recounted above cannot and will not continue. Here's why:

Again, the supply story is a great one. We think of the recovery of oil as drilling a hole in the ground (or the ocean for all of you RIG owners), and then pumping out that dark liquid known as Black Gold. Naturally, oil is recovered in places where the technology allows us to get it, at a price that allows acceptable profit to the particular companies doing the work. As the price of oil increases, it becomes more cost effective to employ technologies that are more expensive than drilling into the ground. Oil Shale and Oil Sands hold a tremendous potential, with more than enough supply to satisfy demand--at the right price, that is. No one can nail down the magic price of oil that will open the floodgates permanently to oil shale and oil sands, but oil won't get to $200 per barrel (in 2008 dollars) before it is cost effective. There are always environmental concerns, bureaucratic red tape, and worries about dropping oil prices that impede this process, but it will eventually get done. Throw in the token clean energy technologies coming on line (although minuscule when compared to oil), and the supply will be satisfied. There is a short-term price ceiling here.

The demand story is probably the most misunderstood of all, with conspiracies, collusion, and myths of intentional sabotaging of technology (the 200 mph carburetor). There are a lot of people that believe no matter what price oil rises to, Americans and other people in the world will not change their habits. They think we will use the same amount of oil no matter what . . . after all, we all must drive to work and such, right? This is short-sighted thinking. We all have an individual mark that gasoline would hit before we change our habits. I can tell you, mine is much higher than most because I live so close to work, so $10.00 per gallon gasoline is probably my limit. I would then bike to work. Everyone has a breaking point, and as a people, collectively, we are setting the price. As the price climbs upward, people change their behavior, that is, they drive less. That includes not taking a vacation that requires driving hundreds of miles, and it means car pooling when going to Jimmy's birthday party. The car that gets better mileage is used a lot more, while the SUV sits in the garage. Whatever the case, behaviors do in fact change as the price climbs. Modification of behavior means less demand, and less demand will lead to price decreases given the supplies stay constant or rise. Rising gasoline prices made me figure out a way to break free of my own dependence on it, and due to my own lifestyle modifications, I now pay no attention to the price. I am an extreme case, but everyone has a breaking point. As the price goes higher, more people reach that point, making further price increases more difficult because of the slipping demand.

The weakening dollar is pretty easy to understand. A barrel of oil is priced in US dollars, and when the dollar gets weaker, the price rises. Likewise, when the dollar strengthens, the price of oil will slip, given the supply and demand factors stay constant in our make believe world in this example. The Wall Street Journal had a great article on the editorial page entitled The FED's Bender in Monday's paper showing the escalation of the price of oil and graphed its price in Euros and dollars. If you missed it, go back and read it. Though there are some stories about the price of oil pushing the dollar down, I don't buy them. A connection of a weak dollar and higher oil exists.

The wild card for the price of oil is how much the recession will cause it to decrease in price. We are at best in an economic slowdown and at worst a recession. This will eventually put downward pressure on oil due to a decrease in demand. We also have the possibility of the FED holding rates steady, which will help halt the slide of the dollar. Even if the FED cuts rates, the consensus will be that no more cuts will follow, so the dollar bears will cash out. Oil is traded globally and demanded globally, and any economic slowdowns overseas, particularly China, will certainly put downward pressure on oil. I'm not about to predict an impending China recession, but the free market doesn't put the rules on hold just because the Commies are at the helm. Oil has been on fire, and it's time to cool down.

So how have I been trading ahead of this situation? I have first held steady in my position of DUG, the Ultrashort Oil and Gas ETF. It is one of the safer ways I have played it, even though it is Ultrashort. DUG will move up and down a few percentage points, sometimes in tandem with the price of oil, and sometimes not. I only have a small percentage of money in DUG at this time, mostly because I am looking for juicier returns with declining oil.

The second position I have taken is in DCR, Macroshares Oil Downtradeable Trust. You won't find a lot of love for DCR when you do research, and the price movements don't follow any rhyme or reason. Since I started buying DCR, I have had a 12% move up, a 10% move down, and today (Tuesday) a 19% move upward. DCR is risky, so with a 2% move upward in the price of oil, you may see yourself 15% in the hole. Tread lightly on this one. I have made money on it trading in and out, but you will need to be able to stomach the volatility.

The third move I have made, ahead of the FED, is selling off a full position in the Mexican Peso, and half positions of the Swedish Krona, Swiss Francs, and UDN, the dollar bearish ETF. I plowed that into UUP, Powershares Dollar Bullish ETF. Regardless of what the FED does, I will be selling off the rest of the foreign currency within a month, but on the off chance the FED holds rates steady, it'll be sold immediately. I highlight these trades because the movement of currency goes hand in hand with the price of oil, and I the moves I am making with currency reflects my view on oil.

It's time to chuck oil overboard. Any takers?

---Jonathan

Comments: View Comments |  Tuesday April 29, 2008