Overheated Heating Oil Market

I was fortunate enough to be interviewed for a Wall Street Journal heating oil story last week. The primary question was, “How high can prices soar?” Supplies have tightened up considerably during Mother Nature’s onslaught and another bout of cold weather is hitting us, pushing prices higher yet again. Short-term demand related issues like the ones we’re experiencing now due to the weather are never a reason to jump into a market. My less than sensational outlook on current prices pushed me to the closing section of the article. This week, I’ll expand on the topic by looking at the diesel and heating oil markets and formulating a trading plan for the current setup.

I’ll work from big picture to fine detail in order to provide some context for the current situation. First of all, the fracking boom has fundamentally altered the energy landscape of the United States. We are quickly moving from net consumer towards becoming a net producer in the oil and natural gas markets. This paradigm shift is leading to an energy market structure that places us on the side of selling price spikes that are demand based. In this instance, bad weather has created a temporary increase in heating oil use. The price spike will not hold because we have the capacity to rebuild domestic energy stocks cheaply and rapidly.

The same bout of weather is responsible for driving heating oil costs to record levels in the Northeast where more than 80% of all heating oil is consumed. The flip side is that this same weather pattern is keeping people indoors. People staying inside only create heating oil demand. People in normal conditions add to diesel demand through their purchases of goods and services while they’re out and about spending money. Therefore, the net balance of the broader term market shifts towards a bearish supply issue as diesel fueled trucks have less to deliver and fewer miles to cover as citizens remain toasty and warm in their homes instead of out shopping and eating.

The domestic energy market can control supply but has little control over demand except at extremely high prices. Energy production costs are fairly fixed. The primary variable in an energy producer’s arsenal is capping low yielding wells. Prices as a trend however are falling in general as the current processes become more efficient in their cost of execution. Therefore, over time, energy prices should generally decline. Furthermore, energy producers in times of price spikes will sell as much of their expected forward production as possible at these higher prices. This allows energy producers to slow down price spikes through their implementation of profitable short hedges at unsustainable current market prices.

The best way to view these actions is by comparing spread prices to Commitment of Traders data. Spread prices allow you to compare the current market price against a forward price. Current prices or the cash, “spot” markets are the most volatile as they are the most susceptible to short-term supply and demand disruptions. Forward prices are more predictable due the amount of time left to factor in risk variables. Typically, these risk variables include physical storage, insurance costs and interest rates. This leads to forward contracts being priced structurally higher the farther out one looks. This is normal market behavior and the gradually elevated price along the timeline is called, “contango.” Conversely, in times of drama the spot price can overshoot the prices of the deferred contracts. This situation is called, “backwardation.” Backwardation is the market’s incentive to get producers to sell the physical product at the currently elevated price.

Drilling into the details, (pun intended) we can see that there’s definitely a premium in the delivery month futures contract. Knowing that this pricing structure is temporary along with the weather I’m going to let this entire rally pass. There are two reasons I think there’s a better place to buy. First of all, the heating oil market is nearing solid resistance on the daily, weekly and monthly charts. Secondly, I expect the demand numbers along with the general economic numbers for the next month to be dismal. This will lead to a selloff and drop the market under $3 per gallon. I expect the market to be supported around there and provide a solid bottom to buy into the spring driving rally. Don’t let the hype suck you in.

This material has been prepared by a sales or trading employee or agent of Commodity & Derivative Advisors and is, or is in the nature of, a solicitation. This material is not a research report prepared by Commodity & Derivative Advisors’ Research Department. By accepting this communication, you agree that you are an experienced user of the futures markets, capable of making independent trading decisions, and agree that you are not, and will not, rely solely on this communication in making trading decisions.

Protecting Stock Market Gains

This is the third cautionary report I’ve written on the stock market in six weeks. The last time I focused this heavily on the stock market was in early 2009. Back then, I was making a point to everyone who’d lost their shirt on the way down that employing the leverage provided by stock index futures contracts would be a great way to recoup some of their lost funds when the market bounced. This week, we’ll discuss the same strategy only in reverse. I’ll explain how to use leveraged futures to protect your equity portfolio ahead of time in case you haven’t taken the appropriate actions.

Everything that I’ve written over the past several weeks regarding the stock market still holds true. Quoting from our December 5th article, “… we have reached valuations that bode poorly for long term investing. Research abounds on the usefulness of long-term valuation models. Very simply, expecting these returns to continue through long-term investment at these valuations would set an historical precedence. Anything can happen in the world of markets but the odds clearly show that bull markets do not begin when the P/E ratio of the S&P 500 is above 15. The S&P 500’s P/E ratio currently stands above 19 and Nobel Prize winning Yale economist Robert Schiller’s cyclically adjusted price earnings (CAPE) ratio is over 25. Both of these will continue higher as long as the equity markets continue to climb. Neither is sounding the, “Everyone to cash,” alarm bell. Their history simply suggests that it would be foolish to expect these multiples to continue to climb and climbing P/E ratios are necessary for stock market growth.”

Coincidentally, the market is trading exactly where it was when I wrote that and after Friday the 24th’s action, we are in fact sounding an alarm bell. Friday’s action sounded a technical alarm based on the 90/90 rule. In short, 90% of the stocks in the S&P 500 closed lower for the day and 90% of the volume was on the downside. This analysis was originally publicized by Lowry’s Reports in 1975 and has been appropriately updated over time. The general market response is for an upward blip for a few days to a week followed by continuation of the selloff. This typically signals a momentum swing and could very well be the catalyst that brings the market back in line with long-term valuations.

The single most common phrase I hear for peoples’ failure to take protective measures for their portfolio is, “I don’t want to pay taxes on anything I have to sell.” The key to using stock index futures as a hedge against your portfolio falling with the broader market is the cash advantage that allows their low margins and high leverage to be put to work for you. The e-mini S&P 500 futures contract is one of the most liquid markets in the world. The face value of the contract is $50 multiplied by the index price, currently 1777.00. Thus the contract is worth $88,500. The margin, which is the amount of money the Chicago Mercantile Exchange (CME) needs on deposit to carry every contract from every market participant is currently $4,510. Both the buyer and the seller of the contract place this amount with the CME. This leaves a margin to equity ratio of approximately ten to one ($88,500/$9,020).

Here’s how it plays out in real terms. First of all, customers need more than the minimum margin requirement to trade. Otherwise, the first day the market closed above the initial entry price, the customer would be issued a margin call by the clearinghouse to make up the difference. Therefore, I suggest allocating enough capital for the minimum margin plus enough additional cash to cover general market fluctuation or, to a point that the trade becomes invalid and the hedge should be removed. In this case, I’d use the recent market highs of 1846.50 as a price that would invalidate the hedge’s necessity. The math works out as follows; $4,510 for margin plus $3,475 to allow for market movement from 1777 to the high at 1846.5 equals a necessary beginning cash balance of $7,985. This is the amount that’s needed to hedge $88,500 worth of the S&P 500 Index against further declines.

If we do get the 10% correction that we discussed in our January 16th letter, the cash balance in your futures account will have grown to $13,760. This would offset the loss incurred by your equities account without forcing you out of any positions or, leaving you with any capital gains tax to pay.

Finally, this is one case where a leveraged ETF simply won’t provide the same bang for the buck. There have been many studies that track inverse leveraged ETF’s against the underlying index and the research consistently shows that they fail to capture the same percentage gains on big down days as the futures markets on which the ETF’s are based. This is one of those times when trading and investing are best done via two separate vehicles.

The Significance of Thematic Investing

Index Services are dominating the investment markets from quite a long time by now. People who have the preference for diversity when it comes to investment are venturing towards the Thematic Investing. Here is the highlight on the significance of thematic investing.

It is an intuitive investing

This implies that instead of venturing into something unknown you can invest your hard earned money into the ideas as well as the trends that you are fully familiar with and the ones that you find exciting. Having a good knowledge about the same can provide you the capability of making the smart investment choice. As you go in for researching on your own this further makes your position comparatively strong. It further enhances your ability so as to customize your portfolio. You can invest in areas that interest you such as real estate, travel and healthcare.

You can align your values

Here you get the opportunity to be able to align the values that you think are important for you when it comes to your investment. You can simply invest in areas for which you hold the passion or the ones that are primarily focused on the social responsibility. You can simply make the world a better place to live with the help of your investment.

You have a vast choice

There are companies that give you the portfolio well prepared in advance if you so desire. On the contrary, you have the option to create a portfolio for yourself. There is a plethora of option of mutual funds that are available to you as an investor.

Helps to generate alpha

Thematic investing is the best way to get the opportunity for to generate alpha. By imply focusing you’re your investments in the hot spots where you can distribute the sizeable amount of your capital, you can easily generate the alpha. By simply analysing the other portfolios you can come at a decision for yourself.

Gives you flexibility and transparency

By simply creating your own portfolios you open up the gateways to great opportunities. Being able to customize your portfolio is a great advantage in itself. All that you need is to have a great visibility as well as control in addition to the transparency with no hidden cost. You get the clarity of your fractional share as well as the penny.

It is easy to access

Gone are the days when only a limited number of people had an access to the thematic investing due to the fact that the portfolio structures were not only expensive but at the same time restrictive as well as complex that consumed a lot of time for their maintenance. Most of these were available to high net worth investors. Today such is not the case as it has gained popularity, and become accessible for investors f all the brackets.