Trader’s Narrative

Last summer, on June 2007, to be precise, I wrote that the caution was warranted for energy sector. Let’s take a look to see how I did and what lies ahead for this area of the market.

The energy sector managed to push a little bit higher in July 2007 but it then succumbed to the general market weakness. So since I wrote about my apprehension it didn’t go anywhere really for the next two months:

The strength of this sector was undeniable in 2007. In fact, last year it bucked negative seasonality to deliver one of the best sector returns. Usually, from the beginning of June to the beginning of December energy stumbles. In fact, in the past decade only 3 years have bucked this negative seasonality. On the other hand, once December rolls around, things do tend to rock and roll.

Seasonality
The logic behind the seasonal influence is the seasonal weakness in the commodities themselves. Natural gas and oil are weakest in the summer (May to July) and strongest in winter. So right now we are just about to enter the worst time of the year to be long oil and gas stocks.

On top of that 82% of stocks in the Energy Select SPDR (XLE) are trading above their 100 day moving average. That’s not the maximum but it is high. As well, the bullish percent for the sector is a bit “toppy”, hovering below 80%:

The smart thing to do was buy in January and March 2008 when the bullish percent spiked down to 20% (and less). But you already knew that because you know how to time the market using bullish percent charts, don’t you?

On Wall Street it depends who you listen to. Goldman Sachs is hyper-bullish on oil awaiting $150-200 a barrel oil while Lehman Bros. thinks that prices will fall to $83 a barrel in 2009 and $70 by 2010.

What about Peak Oil?
I don’t buy into “Peak Oil”. We will either discover more oil, better extraction methods for existing reserves or move to alternative energy sources. Take new discoveries for example: Thanks to the Tupi discovery, Brazil will become a major oil player - probably joining OPEC as a result. But that is years in the future, assuming all goes according to plan. Petrobras will have to drill more than 16,000 feet under the seabed, itself under 10,000 feet of water. The reward though is tantalizing: 5-8 billion barrels of oil and natural gas.

Last year saw an epic battle between two giant hedge funds over the natural gas market: Amaranth Advisors and Centaurus Energy LP. The two funds went head-to-head in a winner take all battle royale. The result was a massive flow of assets from one small group of people to another. Amaranth and the trader responsible for their bullish natural gas bet, Torontonian Brian Hunter, were demolished by the bear: Texan John Arnold of Centaurus Energy.

It was great fun for me to read about the story of natural gas because it reminded me of the way things worked on Wall St. in the time of Jesse Livermore with pools pitting their wits and capital against the public and other pools. The only thing that has changed is that outright manipulation is a bit harder these days thanks to stricter regulation. Everything else is pretty much the same.

The big score propelled Centaurus (fee structure of 3/30) and Arnold to the top of fund performance ratings. Arnold’s performance since starting in 2002 is simply breathtaking. He’s finished every year 200%+!!

And although the loser in this, Brian Hunter is doing much better than the Amaranth investors. He’s still has the couple hundred million he made before he nuked Amaranth and being quite cheeky, he’s actually shopping around a new fund!

Report Card Time:
The first time I mentioned natural gas was on June 1st 2006 (leftmost green arrow on chart). I was bullish and it sort of worked out. But at best I would give this call a C+. The second time I mentioned natural gas was on September 21st 2006 (rightmost green arrow on chart):

I suspect that Amaranth’s exit from the energy arena is a tell that natural gas will find support here and retrace some of its decline.

That second call is an A+ But why did I claim it was a tell? When you’ve got a player with a very large position going against them, sooner or later they will have to liquidate - either by their own choice or their prime broker’s. And as soon as they unwind their position, that will mean putting the breaks on the trend because they will be applying liquidity the other way.

Think of it as a string with a weight on one end that is twirling in one direction. It reaches a point where its acceleration slows, then stops and then reverses. This is exactly what happened. An inflection point was reached when Amaranth couldn’t sustain their long position anymore. They wanted to get out and Centaurus wanted to ring the cash register.