Better Cynical Than Sorry

 | Oct 31, 2011 | 10:11 AM EDT
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It's time to be a cynic. As a trader of oil -- or one of any stripe, for that matter -- you'll often make the best decisions when you are cynical of the herd. In previous columns of mine during the downturn that started in late August, I spent most of my ink trying to find reasons why the market didn't deserve to be plumbing those depths. I focused on why Europe wouldn't fall apart in one big nuclear explosion, and why it was doom-saying hyperbole to project zero growth in gross domestic product and a double-dip recession. Amid all this, I wrote about where you might be able to find some real value and fantastic valuations in oil-patch stocks that scaredy-cats were dumping at alarming speed.

Well, guess what? Now the markets -- in oil, copper and equities -- have spectacularly run 1200 Dow points from their lows. Domestic GDP growth has been reported at 2.5% for the quarter, Europe has been "saved" and China seems to have its monetary policy and soft landing well in hand. As such, it's now time for the cynic to return once again.

It's a harsh thing to hear, but as a trader you were supposed to like the market 800 points ago, and not so much today. You should have been long oil for a pop at $81 per barrel, not here at $93. Instead, you should now probably be looking to take some of your longs off the table or to rotate into defensive names again. Let me explain why.

Too much ink has already been devoted to the specious nature of the European plan, so I need not get into it. Suffice to say that it strikes me as much more promise than plan. Instead, let me concentrate on the dark clouds in the commodity trade.

Reuters reported on the collapse of steel prices in China last week. The reason this is so telling is that steel rebar -- and iron ore -- are two "financialized" commodities less apt to be affected by the "risk-on" trade in which virtually every asset class moved in unified lockstep last week.

Instead, steel prices hit four-month lows while reports of Chinese output for 2012 dropped to a 4.4% growth rate, down from an estimated 11%. This translates to 20 million fewer tons of manufactured steel and 35 million fewer tons of needed iron ore for next year in China, where all the marginal growth in base metals and oil is coming from. For copper, a big beneficiary of the "risk-on" trade last week, this fundamental shift in demand for industrial inputs will be felt, even if inventory changes and "shadow banking" collateralization of copper in China aren't easy to track. With copper at $3.70 per pound, we can say -- in analogy with the stock market -- that you needed to be long $0.50 ago, so you can be selling now.

Oil experienced a meteoric rise, as well, particularly in the West Texas Intermediate contract. But, even with that rise, the Brent crude contract hasn't had nearly that level of participation. Refined products, while rallying, have also been limp. Over the last several weeks, dropping inventories at the WTI Cushing, Okla., delivery point provided a tremendous opportunity for a financialized short squeeze. That moved the Brent-WTI spread from a $28 premium to less than $17 in a mere five trading sessions.

But, in the process, the oil curve moved from a "contango" condition into "backwardation." There's been a long-standing argument as to whether this inversion of the curve is a bullish or bearish sign, with the oil analysts claiming bullishness. But take it from a 25-year trader of the stuff: It is anything but. One day I'll devote a column -- a long one -- to this subject. But, for now, just take it on faith. This inversion is a fairly strong indicator of an oncoming intermediate top. Again, you needed to be long $12 ago.

Still, I do not expect prices to immediately back off. Asset managers are well behind the curve of benchmarks and, with little more than two months remaining in the year, they need to catch up. Even worse for them is that many traders seem to be stuck short, praying for a respite to this wicked rally. That could buoy price action for the next week, or maybe even several. But, as much opportunity as I thought this market might hold three weeks ago, I'm as suspicious now.

For instance, then I touted high-beta stocks in the exploration-and-production and oil-services sectors, such as Schlumberger (SLB), Helmerich & Payne (HP), Apache (APA), Anadarko Petroleum (APC), Chesapeake Energy (CHK) and others. At this point, though, this exposure should be cut in favor of the high-dividend-paying mega-caps such as Chevron (CVX) and Exxon-Mobil (XOM) -- or even neutral master limited partnerships, if you can't bear to just sell shares and raise cash levels here.

Indeed, if you were bold enough to own high-beta names for the last two weeks, you've made a helluva year out of October alone, and probably should be thinking about Thanksgiving -- not the next trade. If you weren't so lucky, and instead happened to miss this move, I'd be especially cautious of getting aggressive here. Better to be a cynic -- it's safer.

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volatility is quite low here, and we could see some downsides here in the short term. ...



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