OK, summer is officially done. It's time to get back to work. Are you ready to take on the markets again and try to make some money to pay for all those kids going back to school? I'm going to try to answer the five big questions that you should have about oil and gas to get you up to speed and ready to tackle these volatile and mercurial oil markets and the stocks that go with them. Maybe by answering these, we can come up with an idea or two as well. Ready? Here we go with the first question. No. 1: With oil down to $73 a barrel, where is it going and what does it mean for oil stocks? I've been watching oil ratchet between a range of about $70 and $81 a barrel this summer, and one of the great indicators that I've been using to recognize the limits of the range has been the spreads between futures months. Remember, oil prices use monthly deliveries, and each one of these months prices individually and we can tell a lot by the differentials in prices we see in the months as well as in the trading these differentials. One of the great influences on oil for the past three years has been a consistent "contango" market, where the months for the futures continue to price at a premium. In other words, the further into the future we go and the further "out on the curve" we go, the higher the price of oil is being traded. This was not the historical norm before 2007, but it is now and has created an oil "carry trade" opportunity for physical buyers and sellers of crude oil. To put it simply, when the differential in, let's say, six-month traded contracts gets extreme, it can put a financial "floor" under the traded price of current barrels of crude. I've been using a rough six-month differential of $5 dollars a barrel as a "bell-ringer" for me to look for an interim low in oil prices. Now we get to it. As of yesterday, the October/March crude spread had ballooned out to $6, which does not necessarily indicate that a bottom has been reached, but certainly makes me much more apt to buy oil than sell it. And indeed I am looking to buy some integrated oil companies, which obviously react well to a rising price. Two quick names? Exxon ( XOM - Get Report) and ConocoPhillips ( COP - Get Report).
No. 2: Obama has recently spoken of financing his latest infrastructure "stimulus" plan by eliminating the "dual-capacity" tax credit for oil and gas companies. What is this and does it matter? A "DCT" refers to a U.S. company (almost always an oil and gas company) that will receive a U.S. tax-credit against taxes paid to foreign governments on foreign-generated profits. It is designed to prevent double taxation and is a complicated code that dates back to 1983. The short answer is the continued burden, if the president gets his way, of the elimination of this tax credit will have negligible effect on big oil and gas. Mostly this is because the possibility of him being able to eliminate this tax credit program for U.S. companies that pay foreign taxes is very slim indeed to begin with. We could debate the relative merits of looking to end this tax credit, or the political effect of the proposal, sure to cause another Republican firestorm. But, what we really want to know is: is this tradable news? The answer is no. No. 3: It's 80 degrees here in New York today but winter's coming. What will happen to oil and oil stocks on the first day that temps sink under freezing and can I position for that? I spend a lot of time as an oil trader looking at relationships between crude oil and the products on crude oil. These relationships are known as cracks and indicate not only the margins that refiners might expect for the products they make, but also indicate the likely demand of these refined products in the near-term future. The heating oil cracks have hovered in season (during the winter time) during the years from 2005 through 2008 at a far higher premium than they are being priced today. In 2005, heating oil cracks hit $25, in 2006 and 2007 close to $20, and in 2008 a stunning $40. Since then, the destruction of refining margins in heating oil (and in gasoline too, for that matter) has been complete: in 2009, cracks in heating oil barely reached a high of $10 and this year, the December 2010 crack has been hovering around $11 and gets no better anywhere on the curve. From the way cracks are trading, it doesn't look like anyone is expecting a very difficult winter or any kind of products shortage in the near term. Of course, it is early yet and the crack market can change markedly this winter, but from these first indications, there is no reason to expect a banner winter for refiners. As I recommended a number of weeks ago, this doesn't look like a good time to be invested with the dedicated refiners like Valero ( VLO - Get Report) and Tesoro ( TSO). These continue to look to be a sector that will markedly underperform the energy space this winter.
No. 4: What's up with natural gas? I've watched natural gas trade for two decades now and it never ceases to amaze me. The most mercurial and volatile of all the energy markets, more traders have wrecked their boats on natural gas's rocky shores than any other. The number of natural gas companies that have been destroyed by this fuel's monster moves would fill a list a mile long. You can see, even with a cursory look at any monthly natural gas chart of prices how volatile it's been: 2004 saw prices close to $10/mMbtu, 2005 an incredible $16, 2006 and 2007 a peak of a more moderate $8 and 2008, another amazing spike to almost $14. Since 2008 however, prices have only barely reached $6/mMbtu and then only once at the start of 2010. Today, spot prices are trading again under $4. As a trader, I'm always looking to buy low (and yes, sell high) -- and even with the huge increase in supply in shale gas supply and demand as weak as it's been in 20 years, I still cannot see how much lower the price of "natty" can possibly go. When natural gas spikes, as it did in 2004, 2005 and 2008, it catches investors by surprise. This may not be the best reason to get long natural gas stocks, but how about this: There is no one who can argue that domestically produced natural gas represents our immediate energy future: it is cleaner, cheaper and more plentiful than crude oil and it is entirely ours. The US is literally the Saudi Arabia of natural gas. Put that along with natural gas's ability to spike in price -- to "catch fire," to use a bad trader's pun, and you've simply got to have some exposure to the space. There are a few dedicated nat gas companies to look at: Anadarko ( APC), Apache ( APA - Get Report), Chesapeake ( CHK - Get Report) and Devon ( DVN - Get Report) to name some of the biggest. Of these, Devon is my favorite, not only because it is as lucky as it is good (it sold all of its Gulf of Mexico assets right before the BP well blow-out), but also because it is committed to its domestic assets. It continues to sell all other assets, including a recent deal with Chevron ( CVX - Get Report) that disposed of its off-shore assets in the South China Seas.
No. 5: Where's the best opportunity to make money in the energy space post-Labor day? I know this is the question everyone wants answered, including me! I've liked the way the market index has backed and filled. I like crude oil because of the spread differentials I've discussed and I'm convinced that a November juggernaut of mid-term elections, while I may not agree with their proscription, will likely be good for the stock market. For all these reasons, I'm looking for stocks to buy - but less excited about any individual issue. For people looking for a portfolio hold, something to buy and put away, I still like Exxon. It hasn't seen these share prices since 2005, when oil prices were a heckuva lot cheaper. It represents a value, compared to the rest of the big integrated space that I don't think you're likely to see again anytime soon. On the higher-beta side, if you're looking for a trade, I still believe the off-shore moratorium will come off sooner than expected and long before the mid-term elections and that should give a boost to the off-shore drillers, notably Transocean ( RIG - Get Report) and Diamond Offshore ( DO - Get Report). These have rallied already since my recommendation of them two weeks ago, but still, I believe contain upside to capture should the moratorium fall.