Why Oil Has Bottomed And How To Trade It With Less Risk

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 |  About: The United States Oil ETF, LP (USO), Includes: SLB
by: portfoliV

I have made some very precise predictions on natural gas (NYSEARCA:UNG), silver (NYSEARCA:SLV) and Green Mountain Coffee Roasters (NASDAQ:GMCR) on SA. Those predictions and the associated trade suggestions turned out to be extremely accurate and I did post some follow up articles to those trades, touting the accuracy and profitability of those trading suggestions.

So it is only fair that I should disclose, in late March 2012, I did post a largely inaccurate prediction in an article on SA about oil (NYSEARCA:USO). That trade suggestion to go long oil actually did perform to some extent until early May of 2012. However, from then onwards to as of this writing, oil proved to be one of the worst assets to go long.

(Oil: The Best Way To Play The 'Bernanke Boost' Until May 2012)

As of the writing of that initial article, oil was trading around $105 and Bernanke had just given an indication that he would take necessary steps to backstop a financial crisis if the eurozone worsened. I had argued that oil was the best asset to play that Bernanke boost, since it was very closely correlated to the liquidity increases in the market.

Despite the failure of that initial article as a trade, the reasons to go long oil are even stronger as of late May 2012.

One fact that makes oil at least relatively better than other major assets is that oil is the most oversold one. It is very safe to assume that the asset class that has declined the most on a downward move in the financial markets, will go up the most when the markets turn around.

I would argue, however, that the major reason for my bullish argument on oil is the clarification on the need for more QE since March 2012.

Since my initial article, financial markets have gotten a lot more clarity on their expectation of more quantitative easing in both the U.S. and the EU. Back in March 2012, the market mood was still very positive and there was at least a question about whether markets could advance on their own without quantitative easing measures. However, as the markets have reacted very negatively to the developments in the eurozone, it is a clear indication that the financial markets will refuse to move along without the additional liquidity backing from Bernanke and Draghi. As the markets force those two into making additional liquidity available to the market, oil will be a major beneficiary.

As the bond yields have made some very erratic moves, decreasing from 1,73% to 1,45% in only three days, and stocks have become very oversold, the markets are probably at a short-term bottom. Based on price developments and the extremeness of oversold conditions, I would argue that $83 is actually going to be the bottom for oil, at least for June 2012.

To take advantage of a rise in oil, investors can simply go long the Oil ETF USO.

For investors who are a little more risk averse, I would suggest a rather market neutral trade. The trade is to actually go short USO (to take advantage of the loss to contango), and then buy Schlumberger (NYSE:SLB), which is the highest quality oil stock, in my opinion. Schlumberger is not a very cheap oil stock at 15X P/E and 7,4X EV/EBITDA. However, it is the most highly regarded oil service company, as well as the largest one, so in this unstable market it might be worth the high multiples to go with the best.

Separately, I have received some private messages in response to some of my trading suggestions, asking for more specific advice. However, I am hesitant to do that because I am not a RIA in the U.S. Instead, investors who find my analyses and trading suggestions of good quality can use the "Follow" feature on SA. Most of my trading suggestions will be posted in my articles anyway. So that is the more efficient way.

Disclosure: I am long USO, SLB.