An underperforming commodity about to take off, and why high oil prices are to blame.
Tuesday, March 7, 2006 | Teeka TiwariRating:
Just when you thought it was safe to go back in the water ... BANG, they smack the commodity stocks again! More of the same here. Don’t have a cow, and quit hiding under your desk, because if you have any doubt whatsoever about energy, you shouldn’t ... and I’m going to show you why.
There are two types of oil prices, “spot” oil (what oil costs if you wanted to buy it today) and "forward” oil (sometimes called far futures -- what people are willing to pay for oil in the far future).
“Forward” oil goes all the way out to 2012.
Here’s what that means:
Let’s say that you are a manufacturer with heavy energy needs, and you’re worried that oil could go much higher in the future and you want to cap the price you pay for energy over the long term.
Well, you would go into the futures market and buy “Forward” futures contracts that would let you take possession of oil at a date years in the future at a specific price.
Normally future oil prices are lower than “spot” oil prices, and the technical term for this is “backwardation” (I’m not kidding, that’s what they actually call it).
If “Forward” oil is priced higher than spot oil, then prices are said to be in Contango (again, I’m dead serious).
Right now oil prices are in Contango.
A barrel of oil for July 2006 delivery will cost you about $65.50.
March oil (spot oil) can be had for about $62.50.
Now here’s why I’m not sweating the oil gyrations ...
January 2010 oil is trading for over $66! That’s almost $4 over “spot” oil prices.
what that means to you is that the earnings profile for all of these energy companies are solidly intact for the next four years minimum, and what it really means to you is a huge buying opportunity because the Wall Street analysts are still only valuing these companies as if oil was being priced at $40-$45!
Now how can they value oil at $40-$45 when “Forward” oil four years out is over $66????
I don’t know, but what I do know is that this is a disconnect that we can make a lot of money from.
Standard rules apply.
If you're gonna play oil, only buy oil companies that have long reserve life indexes (call investor relations. Anything under 15 years is NO GOOD). Make sure that they have their reserves in secure parts of the world, and most importantly, you must make sure that they are replacing their reserves at a faster rate than they are depleting them (once again, ask the investor relations person what their replacement rate for their reserves are; anything below 200% is unacceptable!).
Let me tell you how else we can profit from escalating "Forward” oil prices.
If you’ve been following the base metal stocks, you will know that they have been having a stellar time of it with one noticeable exception ... and that is the Aluminum stocks.
Aluminum prices have been the poor starving orphan staring through the frosted window watching everybody else eat and get fat while they’ve been out in the cold.
Let me explain why I think that’s all about to change.
A big reason for this under-performance is that many of China’s -- and to a lesser extent, Europe’s -- aluminum companies receive massive state subsidies, and so there has been plenty of aluminum to go around.
Here’s the thing, though:
Aluminum production consumes VAST amounts of electricity.
VAST AMOUNTS!!
Now most of the aluminum smelters to be found in Europe, America, and especially China are wholly dependent on fossil fuels.
With “Forward” oil at $66 and rising, it now costs many aluminum producers more money to make aluminum than they can sell it for.
So what’s happening is that in Europe, China AND America, the big aluminum boys are shutting down unprofitable smelters and starting to build hydro-electric and geo-thermal powered smelters.
But guess what.
It takes five years MINIMUM to get one of these puppies built, and what do you think is going to happen when supply gets taken out of the market by all of these inefficient smelters going offline?
Higher prices for aluminum.
That’s what’s going to happen.
Now here’s the really exciting part:
No one is talking about the aluminum story - yet.
It’s still a back page story, and I love buying into back page stories and so should you.
The closing of inefficient smelters is already starting to have an impact on global aluminum production.
The reason I say that is because aluminum consumption is increasing at a faster rate than companies can build new smelters or reopen existing ones.
The world demand for aluminum this year is expected to outstrip supply by over 300,000 metric tons!
And what that means to you is the jingle jangle sound of money in your pocket. And what that REALLY means to you is having the satisfaction of getting in on a trend before you read about it on the front page of the Wall Street Journal, and before every stock jockey in America is calling you telling you to invest in the next big thing ... aluminum.
There are many stocks in the group, but my personal favorite pick has got to be Alcoa.
I own it, and I intend to own it for the next several years.
There is another interesting trade that I put on recently, and I’m almost not sure if I should talk about
it, because it’s really more of a rank speculation than an investment ... but it’s still interesting nonetheless.
I don’t know about you, but I definitely enjoy a good gamble every now and then.
I take a very small percentage of my investment funds (usually less than 5%) and I earmark that money for straight-up wild speculating.
Let me share a method with you that I oftentimes use to make truly fantastic returns on my invested capital.
But let me warn you first, these types of trades are “play money” only ... don’t use the kid’s college fund for this stuff!
Anyway, what I do is when a very volatile company is a day or two from reporting earnings, I put on an options straddle.
I’ve used this to make a ton of money on companies like Google and Apple computer.
Depending on the stock, I’ll buy a call option 5-10 points out of the money, and I’ll simultaneously buy a put option 5-10 points out of the money.
If I’m doing this to play earnings, then I usually buy the shortest time frame option that I can find.
By doing this, I can typically pick up these short duration, out of the money options dirt cheap.
You only want to do this on very volatile stocks.
Stocks that have a history of big upside breakouts or big downside break-downs on earnings.
So come earnings day, if the company surprises big either way, your out of the money options all of a sudden EXPLODE in value.
I mean I’ve literally made over ten times my money before on trades like this.
Quick disclaimer: It’s like playing roulette.
If it’s an inline, ho-hum earnings report, and the stock does nothing, then you’ve got to dump your options quickly.
Whenever you put one of these trades on, you’ve got to be mentally prepared to lose the entire investment, just like when you gamble on the roulette wheel ... it can sometimes come up double zero.
Anyway, I recently put on a trade like this that I wanted to share with you.
The BKX index is an index of the major regional banks in America, and it’s been trading sideways for the last 6 years between 60 and 110 ... closing yesterday at 105.21.
Now with a hinky yield curve, it seems weird that this thing is on the verge of breaking out to new all-time highs.
The pros that I speak to are split between two camps.
Half of them feel that the Fed is just about done raising rates, and that when they stop the lid is going to blow off the financial sector.
The other half thinks that this is a giant head fake, and the BKX is going to collapse.
I wish I could tell you who’s right, but I do believe that whatever move takes place it will be dramatic, either to the upside or the downside, with the bigger move I think being potentially to the upside, because the longer a stock trades “sideways” (what we in the trade call “base building”) the wider the base building period.
Typically, a bigger move to the upside will take place if (and it’s a big "if") the stock actually manages to break out of its trading range.
Now there is no telling how long this will take to break out, or if it even will break out.
It just might stay static, and in that case you’d lose your entire investment.
But the good news is that the options premiums on the BKX aren’t too bad, so you can actually buy some time on these things and go all the way out to September and put on a straddle for about $500.
The September 110 calls (symbol BIHIB) are quoted at $2.45 bid by $2.80 offer, and the September 100 puts (symbol BIHUT) are quoted at $2.15 by $2.50.
If the BKX breaks out, then I think you could see north of 125 on the index, and potentially much more.
But even at 125, you’ll make about a nice 200% profit on your trade.
If the BKX fails to break out, and instead breaks down, you’d probably see a move to 88, with a worst
case scenario of 70.
If the index traded to 88, the put option would be 12 points in the money and you’d have about a 100%
gain on the whole position.
Just remember: if it stays static, you lose it all.
I feel like I’m giving a kid dynamite to play with, so don’t blow off your fingers!
(Please let us know what you think about Teeka Tiwari's article.)
Rate his article here »
Rate his article here »
Teeka Tiwari
Chief Investment Officer
ETF Master Trader
