Oil Markets Approaching the Fiscal Cliff

Markets declined significantly again yesterday.

In two days, the S&P has shed almost 3.6%.

On Wednesday (November 7), both crude oil and gasoline futures declined significantly. Yesterday (November 8), while the overall market slid, oil and gas began to rebound.

Now the undergirding of the energy sector in general – and oil in particular – is poised for a major move up. As I am writing this, six of the nine elements I regularly monitor to determine oil price direction are pointing north. The relationship between refinery margins (the difference between what it costs to produce oil products and the price that can be charged at the wholesale level – where the refiners make their profit) and inventory in gasoline are also indicating an oversold market, even without factoring in the East Coast double whammy of Hurricane Sandy and a Nor’easter.

The underlying dynamics, therefore, haven’t changed. If left to its own devices, oil should be moving up (and our profits right along with it).

So why the dip?

The first issue is short-term.

The aftermath of an election usually produces a downward pressure, regardless of who wins. The market bought into the election moving up smartly. It came out of the election moving in the other direction.

Nothing unusual there. The markets opened Wednesday morning with the election as history. That always occasions misgivings about what is coming next.

Yet cross currents over demand projections will be giving way to a more robust energy sector. This is not going to be a straight upward movement in prices. But those levels are currently depressed because of outside questions about overall economic prospects.

The oil market itself (and the energy sector as a whole will move essentially in the direction that its dominant component moves) has underlying dynamics that would dictate a crude price higher by about 15% at current levels. But the outside “distractions” need to be weeded out first.

Especially this time around.

There are two major elements preventing the energy sector from moving up.

I discussed both of these with my Energy Advantage and Energy Inner Circle subscribers yesterday, along with the way in which we have positioned both Portfolios to profit from the current situation.

Here is the summary of what I told them. Two matters remain foremost in the mix, assuring that the next two months will be marked by considerable gyrations.

First, the clock is ticking in Washington on the “Fiscal Cliff.” Second, Mario Draghi, the head of the European Central Bank (ECB), has prompted new concerns over the Eurozone.

[Editor’s Note: If you want to know the full story and how to play the Fiscal Cliff and European problems, click here now. You’ll find out how the oil markets really work, and what stocks Kent is recommending right now.]

The massive spending cuts and tax hikes obliged by the “cliff” would certainly push the U.S. economy over the brink into a deep and prolonged recession. However, despite the low regard given to politicians in Washington, there are already indications they will reach an agreement before the end of this year.

This will not be an ultimate solution. Yes, Congress and the White House will compromise to kick the can down the street one more time. But that will be sufficient for our purposes. Expect a rally in energy when the central powers begin to telegraph the compromise.

The second problem – Europe – was actually the major reason why the markets tanked on Wednesday. Draghi said publically what a number of folks had been saying privately. European economies are slowing, with that slowing now beginning to hit the continental engine – Germany.

Draghi subsequently made additional comments on Thursday that tempered the impact somewhat. Yet, new riots in the streets of Athens following the controversial passage by parliament of an austerity package have once again put a visual on the situation. A truly incredible admission by the Greek government of an almost 25% official unemployment rate simply intensified the concern.

Well, here is what will happen with the ECB. The mechanisms are in place allowing the central bank to buy distressed paper, although there are still some domestic decisions that have to be made by EU governments. It also remains unclear when Spain will formally request a bailout.

These details will finalize.

The European capitals have no other option, despite the political unpleasantness of the requirements. Even then, the most important decision (setting up the structure to buy cross-border commercial bank paper) has already been made.

Europe will not regain its financial footing without a lender of last resort. The ECB has now assumed that position. Despite the disagreements resulting, the path is laid out to ease the situation.

Once again, as with the financial cliff in the states, we will experience a stop-gap measure, not an ultimate solution.

The market has been trading on emotional reading of headlines for some time. We have undergone two downward slides in oil prices that went well beyond anything the actual market justified, followed by recoveries just as quickly.

All in the last few months.

This will remain a volatile situation in both directions. The objective in developing and balancing an energy investment portfolio in such an environment is two-fold.

First, the stock selections need to reflect the tradeoffs in the sector itself. That is, not all reactions to market activity will move in the same direction. Second, there are ways to establish ceilings and floors on risk short of simply using puts and calls.

As we move through the current cycle of market instability, I’ll be providing some general suggestions in OEI on how to design such a portfolio.

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