Energy investing, particularly in oil and gas, has usually had a strong follow-the-leader herd instinct to the behavior of its equity opportunities. That influence appears to be experiencing a resurgence. But the "leader" is not simply a dominant stock. It is the dominant common denominator of the energy industry, the price of crude oil.
The warning comes most dramatically in the exchange-traded fund DJ AIG Crude Oil (NYSEARCA:SCO), a 2x leveraged ETF tracking the WTI price of crude oil as a commodity. It currently trades over 1 million shares a day. Not surprisingly, when we examine the investment prospects of some 250-plus energy equity investments regularly covered in our Block Traders' Oil & Gold Monitor letter, published on Forbes.com, only three of them appear attractive, instead of the usual dozen. The best, by far, is SCO. For those not regularly readers of our letters, we determine investment professionals' price range expectations for specific equity investments from the self-protective hedging actions taken by market-makers as they incur necessary risks in aiding big-money fund manager clients adjust their portfolio holdings.
These pro forecasts involve both upside and downside uncertainties, which have had historic odds of subsequent occurrence. Those odds-weighted payoffs can be netted against one another as a yardstick of investment prospects. Our benchmark, or hurdle rate to qualify for investment consideration is +5%, which in the three-month period involved is a 22% annual rate.
The ETF SCO is the only one in a group of nearly two-dozen energy-related ETFs that meets the test. Alarming, because its contractual structure is inverse -- it produces increases in the ETF's price as the price of its holdings go down, not up. And structural (not borrowing) leverage multiplies the effect by two. SCO's prices have a different register than the COMEX market prices for West Texas Intermediate (WTI) crude, the exchange specification product, so to put the equity market-makers' forecasts in recognizable terms we will use percentage changes. Their forecasts indicate protection is being sought for price increases by the ETF of 19%-plus. Since that is double the underlier, due to the ETF's leverage, it implies a decrease in the crude price, near term, of some -9.5% to -10%.
WTI crude is currently being exchanged in near-next months of around $97 a barrel, so a decline of -$9 is implied, to a level under $90. Not a disaster, but a strong headwind for long investments in energy. For several decades now, the WTI price has been the dominant benchmark for many forms of energy transactions, due to the U.S.'s role as the world's leading energy consumer. Geographic source differences have set North Sea sourced crude as the principal pricing focus for European consumption, where "Brent" quotes recognize transportation cost inclusions, and Brent occasionally also reacts to disruptions in supply.
We are starting to see changes in this pattern as the influence of changing extraction technology (from horizontal deposits, using hydraulic fracturing) is changing import/export behaviors nationally, and may establish new exchange specifications for grades of crude that is lighter (less viscous) and sweeter (less sulfur content) than present standard exchange specs. Additionally, the concurrent liberation of huge volumes of natural gas from reliably consistent supply sources is altering the energy demand picture worldwide, introducing a competitive alternative to crude-sourced refined products. This will have a further impact on world crude prices over a several-year period.
Extraction cost norms for the natural gas are in a process of being reduced as the relatively new technology develops and improves recoveries and expense experiences. In most cases there is a dual-product operation being conducted, and cost allocations between them are often not a simple matter. The present negative outlook for crude's price may bear little impact from these potential influences at present. Still, it will have the usual obvious implications on corporate earnings and on stock prices. That is the probable cause of our not having many promising energy investment alternatives to suggest.
But the prospects for SCO, as market-makers see them, are quite encouraging. Here is a two-year picture of how their recent past forecast price ranges (the vertical bars) compare with the ETF's prices (heavy dot) at the time of the forecast. These are once-a week forward looks of daily forecasts, not backward-looking high-low-close records of past price ranges.
Click to enlarge image.
Used with permission.
The current-day (April 3, 2013) forecast for SCO is a high (sell target) of $46.16 and a low (drawdown exposure) of $36.72. Those changes from the market quote of $38.58 are an upside of +19.7% and a downside of -4.8%. We standardize the representation of that upside-to-downside, reward-to-risk, balance in all equity investment alternatives by a measure we call the Range Index. It tells what percentage of the forecast range lies below the current price. Small or negative numbers indicate cheap pricing, large ones the opposite. Here the 19 Range Index is calculated by (38.58-36.72)/(46.16-36.72).
While that forecast suggests four times as much upside (100-19=81) as downside (-19), we always want to check on how well the market pros' prior forecasts have done in a disciplined, practical, set before-the-subsequent-market-prices (ex-ante) test. To do that we look at all their prior daily forecasts with Range Indexes at least as attractive (to a buyer) as the present 19. We have over four years' history of daily forecasts for SCO, virtually all of its existence. In those 1059 days it has seen a Range Index forecast of 19 or less 52 times, a frequency of about once a month. Our standard test is to take the high end of the forecast range in each case as its unchangeable sell target, and set a fixed holding time patience limit from the forecast date. If the target is not reached before the time-out date is reached, then that position is closed out regardless of loss or gain.
For stocks we typically use a 63 market day (three months) time limit, and for ETFs double that, or 126 days. The results of that test for SCO as an ETF is 26 of the 52 positions have been closed out at the current date, with only three at a loss included in the average for the 26 of a gain of +19.2%. The average days held for the 26 was 53, resulting in an annual rate of return score of +130%. Including the remaining 26 open positions, most of which are recent, changes the average gain per day per holding from 0.21% to 0.17%, or an annual gain rate of 85% to this date. Carried to their current targets, the annual rate 53 market days from now would be over +140%
The loss/win ratio of 4/52 is a batting average of over .900, exceptional by most investment standards. The average maximum drawdown from cost in the closed-out positions has been -10%, and -3% for the open positions. History suggests that these guys seem to have a pretty good grip on what may happen to crude oil prices. We tend to rely on the demonstrated judgment of experienced and motivated players, rather than attempting to acquire (and keep current) all the relevant price-impacting information otherwise necessary.
The observation of Nicholas Machiavelli is as powerful today as it was in the 1600s, that "everyone has his reasons." To that, we add: "Extend your gaming skills to the third level, and play the players, not just the game."
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.