What Oil and Bond Traders Know About Inflation

Is it the prospect of global recovery or the prospect of inflation that's driving oil prices higher? You don't have to choose – the opportunity for profit is there either way.

So far over the past several columns, I have written to you about cars and tires. So today, let’s talk about something completely different. How about oil?

Damn it!

Okay fine: it’s the American obsession, and last I checked, my passport said I am an American too, so why should I be any different? Besides, there’s some interesting stuff happening with oil futures and energy stocks.

Crossing the Line

Let’s start with crude oil setting its 2009 high at $54.83 in New York intraday trading. For most of this year, $50/barrel has been one of those psychological “lines in the sand,” much like Dow 8,000 for a while there.

Now that traders have firmly stepped across both lines, interest is perking up from all quarters, both in stocks and in oil. One really must follow the other for two reasons.

The Cost of Doing Business

First of all, there is the obvious: if the global economy recovers even in the slightest, the ensuing increases in manufacturing, shipping and travel will require energy, and despite the best of green intentions, for now energy still means oil.

Second, despite all the rumblings about finding a new world currency, oil is still priced globally in dollars. And while it may be taking Washington an agonizingly long time to actually disburse all the dollars it has promised, it is finally getting around to it.

Eventually, an increase in GDP might soak up enough of those dollars to make a difference. Just as eventually my wife’s dog will grow thumbs and learn to open his own food. Could happen: he’s a pretty smart little guy and all. Still, I am not holding my breath – on either front.

It’s Baaaack (cue the creepy music)

Yeah, yeah, I know: the Fed claims that inflation is actually “below rates that best foster economic growth and price stability in the longer term,” and plans to keep rates at or below zed for the foreseeable future. That’s their story and they are sticking to it.

Traders, on the other hand, are already starting to act on the idea that inflation IS creeping back into the picture. Taken a gander at 30-year T-Bonds lately? Last December, futures were hovering around 142 and change with yields under 2%. Now we were looking 122, a drop of some 14%, forcing yields to just about double.

Best part is, you really don’t have to say which argument is your favorite, as they are not mutually exclusive. Beyond that, they are value arguments: we could tussle over which one is driving oil futures up till the cows come home.

The Heart of the Matter

What truly matters is that oil futures are up, and are likely to keep moving up. While many analysts are having a blast tussling over the penny changes caused by weekly rises and falls in stored reserves, most all concede that crude will be in the vicinity of $65-$70 by year’s end.

With oil’s downside risk clearly defined by a rounding bottom, and a strong upside story playing out both in the news and charts, interest is also returning to oil and energy stocks.

Looking to the Energy Select Sector SPDR (XLE) – which still contains the world’s most profitable companies – we see that investors have crossed that same line in the sand. The recent price recovery has put the XLE up over the resistance node at $46.65 and firmly on the path through $55.25 and $63.74 as it moves towards the attractive node at $74.32.

Simply buying shares of XLE could net you a reasonably satisfying gain just shy of 50%. But if we are seeing the return of inflation and the demise of the dollar (and we really, truly are), then you might want to make your very own dollars multiply a tad faster than that.

If so, then you could consider speculating on the XLE January 2010 50 Calls (WHA AX). That same move would allow these calls to rise from $621/contract to as much as $2,091 for a gain of some 237%.

Comments

[Larry House:]

I am bullish on oil as well, but I prefer not to have to time the move with options. XLE is a great vehicle, as well as integrated companies and large offshore drillers.

May 08 10:25 AM

[blu:]

Nicely written.
The evidence of the energy turnaround is beginning to be more obvious.

May 08 10:38 AM

[athena:]

Oil moves opposite the dollar. The dollar is falling. That is why oil is going up.

May 08 05:23 PM

[dcb:]

two weeks ago they were saying it wouldn't break 50, now near 60.

May 08 06:12 PM

[Old Trader:]

Because it takes "more" dollars to buy a barrel of oil. (So the lower the dollar gets, the higher the price of oil, in dollar terms..)


On May 08 05:23 PM athena wrote:

> Oil moves opposite the dollar. The dollar is falling. That is why
> oil is going up.

May 09 12:14 AM

[RiskReturnO...:]

I've been long XLE, and will add to the position until it gets above the 200 day moving average.

From stock market perspective, you are seeing aggressive buying by mutual funds and others trying the advance the SPY which is now at a tough resistance area of 93-94 (high for 2009). With leadership groups like tech, materials, and consumer discretionary (all above 200 day MA) taking a breather, you need new sector strength to move SPY higher (or keep it there). Energy has become this new sector, so XLE should continue to do well.

Inflation and weak dollar of course plays into the commodity side, but you could be wrong on direction of oil by quite a bit (say oil stays in $45-$60 range) and still make money on XLE.

For more defensive investors and those with a focus on more balance risk/reward optimization, long XLE and selling some covered calls at strike of 10-20% out of money makes a lot of sense. The premium alone can get you 15% annualized return even if XLE stays flat. If it turns out there is no inflation and oil drops below $40, then the options premium provides some hedge on the XLE position, roughly supporting a fall to the 50 day MA.

May 09 05:07 PM

[Mayascribe:]

I'm not a big fan of oil ETF's. I'd rather do the DD and make my own pick.

My favorite oil growth stock is ATP Oil and Gas (ATPG). The stock has doubled since late March, and will likely double again before summer's end. ATP has great fundamentals and will easily cover any debt obligations, and, more importantly, ATP has a 98% success rate of squeezing more oil out of "spent" fileds. Lastly, ATP will be opening up another big field in the North Sea during the fouth quarter, just maybe right before oil really takes off next year.

May 10 04:24 PM