Did that just happen? Did sentiment on a multi-trillion dollar market just change in a few trading days? I have been asking myself that question as I watch oil futures in today's trading. I have learned, sometimes the hard way, that sentiment on crude can change rapidly, and I believe that is what happened this week. After such a strong run to begin the year, a pullback in crude futures is not shocking, but also does not reflect current fundamentals.
That begs the question: do oil prices ever reflect current fundamentals? Well, no, because we're talking about futures prices, and there really is -- other than in certain conflict zones -- no active "spot" market for crude. It's always a matter of near-term prices and the amount of hedging major producers and consumers choose to apply to protect intermediate-term prices. Just as an aside, there is a huge drop-off in liquidity as you go out behind 18 months on the oil futures curve, so if you go to the CME's website, looking at the value of the December 2023 contract -- currently $53.00 -- is not informative. But looking at the December 2018 contract is very helpful, and the fact that that month's futures price is still $1.50-$2.00 below the front-month (July) contract is instructive.
That curve inversion, known as backwardation, is a sign that traders fear near-term shocks much more than the steady pressure caused by seemingly endless increases in demand from Asia.
So, that's what's scary about trading oil futures and owning stocks of companies that produce oil (E&Ps.) The U.S. inventory data we received from the EIA was not bullish this week, but overall inventories are still below their five-year average, and, remember, that data is only useful until next week's data are released (on Thursday, delayed one day due to the holiday)
A more systemic factor, however, is the attitude of major oil producers toward production. This week, Saudi Arabia's oil minister, Khalid Al-Falih, has been quoted as saying that OPEC and Russia are "re-examining" their production cuts. Those announced cuts have been adhered to by the cartel, which surprised many cynics, and with Venezuela's national oil producer, PDVSA, spiraling out of control, there are already incremental OPEC barrels not hitting the market.
So, Al-Falih put a chill on the market, and forced me to act on my clients' portfolios. I still like the "four horsemen" independent E&Ps I have been touting in RM - Sanchez (SN) , Gastar (GST) , Denbury (DNR) and Evolution (EPM) -- but this week I have been lightening up those positions. I still think those companies are massively undervalued based on their production levels, but when Mr. Market speaks, you'd better listen.
Also, this week, for the first time, I bought protection against a further decline in oil by buying the ProShares UltraShort Bloomberg Oil ETF (SCO) . I can't tell you how much I hate leveraged ETFs (SCO is 2x leveraged to the inverse of the daily price move in oil futures) and how destructive I believe they have been to the healthy workings of equity and commodity markets. And yet I bought one, this morning, and have already made a couple percentage points on the trade.
That's how it works in the energy arena. There is no room for self-righteousness, and no time for dithering. When the wind changes direction you must change also, or you will lose money.
