Goldman's $200 Oil Call and the Hurricane Premium Theory

I read a new report recently from Goldman Sachs and watched another bullish report from CNBC's Fast Money. They both had me thinking about oil prices and possible future potential prices. Right now market sentiment is just horrible and remember that when analyzing fundamentals, technicals and sentiment, sentiment is the only one of the three that can override the other two.

Remember the Goldman analysts who predicted and theorized The "Super-Spike" in oil? Well they are back again and what they have to say this time should definitely perk ears. Goldman analysts Arjun Murti, Kevin Koh and Michele della Vigna raised the notion that a major disruption could spike oil to $200 a barrel. As the dollar continues to fall and commodities are seen as an instrument to hedge inflation, oil prices have been essentially melting up. The Goldman analysts said that prices have advanced more quickly than they had forecast back in 2005, when they predicted a range of $50 to $105 a barrel as part of its "super spike" oil theory.

Some comments:

We characterized the upper end of the band as more likely to be driven by geopolitical turmoil and that recession was a key risk to our view," the analysts said. "In fact, oil prices have reached $100 a barrel without extraordinary turmoil, and the U.S. currently appears to be in recession.

Tacking on $15 a barrel to all of its oil estimates, Goldman now sees average selling prices of $95 a barrel for 2008, $105 a barrel for 2009 and $110 a barrel for 2010. The high end of its range is now $135 a barrel although Goldman set the table for how prices could go higher.

As the lack of supply growth and price-insulated non-OECD demand suggest a future rebound in U.S. gross domestic product growth or a major oil supply disruption could lead to $150-$200 a barrel oil prices.

While saying it has a bullish long-term outlook, Goldman acknowledged that oil prices could correct from recent highs. Goldman also reiterated its view that oil prices could fall as normal market conditions return over the next four years. (Ok, nice they covered all the bases here! lol)

The core of our 'super-spike' view is that oil prices will keep rising until demand declines globally on a multiyear basis, resulting in the return of excess capacity and a lower cost structure," Goldman's analysts said. "Given this view, once excess capacity returns, we think prices can move sharply lower.

GS recently upgraded UPL, APC and CEO.

On Fast Money, one of my favorite shows, I watched an interview with John Roque, Senior Technical Analyst and Managing Director of Natixis Bleichroeder. It was fascinating to see his chart of the Commodities Index vs. S&P 500, 1956-2008 with a 3 year moving average.

Conventional wisdom suggests that commodities are in a "bubble" right now, says Roque, but I don't think that's the case. It looks to me as if the commodities surge is in its infancy. The commodities-outperforming-stocks relationship is far below its long-term average. In fact, it hasn't been at the average for more than 20 years.

He says to buy commodities on any pullback. He also thinks that the S&P could break down to 1236.

It seems to me that high oil prices are here to stay and as a result you want to keep an eye on the oil plays that are showing strength with the price of oil. Energy exposure should also be a focal point among the institutions and individual investor portfolios going forward. Although not immune to market sentiment, energy companies could be the first to regain strength and weather the storm better than most of the market. Remember that most of these energy names have a lower oil price assumed into their earnings estimates.

I'm thinking that if oil prices hover here for awhile and stabilize, analysts have no choice but to play catch up and raise estimates for next quarter and for the year (remember that Aug-Nov is hurricane season thus there will be a an added hurricane premium). Energy companies could have some spectacular beats in the coming quarters as expectations are too low. In this last quarter, I have already started to see that come to fruition as most companies have beat expectations on the top and bottom line.

USO and the Hurricane Premium That Never Left

Take the guess work out of finding a correlated oil play and just go long oil itself without worrying about sector or market sentiment forces upon the individual stock. I started writing this article on the weekend and am amazed at how strong oil continues to be. When looking at the weekly chart of the United States Oil Fund ETF (USO), I was struck at how the hurricane premium from August to November never really left the price of oil. The USO recently broke out of its Darvas consolidation box between the zones of $69 to $79 and is now establishing a higher consolidation box using previous resistance as support.

With a possible resurgence of the economy (GS' theory) and also the upcoming hurricane season starting in August, one has to wonder if we will only see higher prices for the rest of the year or at the very least a hovering of high oil prices around $100. Last hurricane season was quite active, as soon as one left, one emerged sometimes two. With this type of hurricane anxiety, oil never sold off to lower ranges. Will this be the next impetus to push oil prices higher on a new leg like last year?

click to enlarge

Sometimes it is more important to ask the next question than to answer the question at hand. The question at hand is why are oil prices this high especially with a cooling economy and OPEC's notion of adequate supply (could it be from a weak dollar)? The question of the near future is after summer, how high will oil prices be going into the hurricane season? Another question to answer is will a stronger dollar cause an oil price correction? And with that, could a resurgence of the economy and the summer driving season nullify the stronger dollar? Then comes the hurricane season.

As the use of fossil fuels warm the Earth's atmosphere to create warmer waters in the Gulf. This only makes hurricanes ever more powerful, unpredictable and possibly more destructive on the US energy nerve on the South Coast. Which came first the chicken or the egg? Its a vicious circle for oil prices. This year it is still up in the air whether we will have an El Nino or La Nina hurricane season.

According to the World Meteorological Organization (Science Daily):

Most interpretations of existing climatological data suggest the likelihood of La Niña conditions remaining heightened through the second quarter of 2008 and, at a lower level of confidence, into the first part of the third quarter.

Longer seasonal forecasts beyond the third quarter of 2008 are not considered to contain useful information at this stage on the continuation of La Niña or the rise of El Niño.

It is rare for a La Niña event to persist for two years or more, such as occurred from early 1998 to early 2000. The likelihood of the current La Niña continuing for such a period will remain unclear for some months, but will be closely monitored.

Long-term statistics suggest it is more likely that in the latter part of 2008, neutral conditions will prevail, i.e., neither La Niña nor El Niño with no significant cooling or warming of Equatorial Pacific sea surface temperatures.

Whether it is La Nina, El Nino or neither, hurricanes will arrive during Aug.-Nov. and it seems the wall of worry will be built. It will be built faster if it turns out to be an El Nino season.

I do believe that oil prices should be range bound in a higher consolidation phase even after the coming "strong dollar" pullback. That being said, here's a list of energy companies to keep an eye on for the rest of the year:

• Devon Energy (DVN)
• EOG Resources (EOG)
• Petroleo Brasileiro S.A. (PBR)
• Apache Corp. (APA)
• CNOOC Limited (CEO)
• Suncor Energy (SU)
• United Petroleum (UPL)
• EnCana (ECA)
• XTO Energy (XTO)
• Southwestern Energy (SWN)
• Chesapeake Energy (CHK)
• Transocean (RIG)

Disclosure: None

Comments

[jwkjr]

How come nobody ever talks about the BILLIONS of dollars Iraq is costing the U.S. every day... Do you think that could be having an affect on, well I would say the whole economic condition....

[NJgolfer]

Don't posit that the use of fossil fuels and it's link to the global warming is a done deal. The sun and its solar cycles have a much larger impact. You should stick to investment theory and not interject your own environmental warming prejudice.

[optiondragon]

Yes i watched this movie called "An Inconvenient Truth" and there are "couple" scientists that say greenhouse gases cause a warmer atmosphere from fossil fuel use. Just saying that its kinda linked i think LOL

[Amidwesternneighbor]

To jwkjr...no. We are spending there, but we are seeing benefits as well, such as defense contractors remaining a source of steady jobs (the importance of which is not to be underestimated in these times) and the beneficiary of government spending...and the dependability of Iraqi oil has increased, leading to one less source of supply disruption. Not to be confused with the fallacious "blood for oil" slogan, btw - we saw how that, ironically, was not true, but rather the U.N. cadre was more than willing to neglect the plight of the Iraqi people in order to continue exploiting the "food for oil" program! No, we are doing good there, helping build stability for those people...and one more nation with a stable government is good for world economies everywhere!

[optiondragon]

please read my other article about the link between the Vix and the S&P and when the optimal time to buy the vix is

[Seriously ?]

I don't really see an end to high oil prices either, but as some point people will simply stop having enough to pay for it and something drastic will happen. What if say, $150 oil is enough to completely kill the american consumer ( if it isn't already dead ) and it throws us into a depression via runaway inflation. What if the petrodollar collapses due to this or simple lack of confidence in our economy ?

I am definitely bullish on oil, but I fear it's gains are at the direct expense of economy/dollar ( unless the fed miraculously stops behaving so masochistically )

What about buying oil sand trusts with the loon... havent made that trade but was def an idea. You get the currency moves + high yield + oil price moves ... seems pretty good to me.

[eric hart]

Coswf has returned 40% annually from 2002-to 2007--the Canadian Oil Sands Trust is one to tuck away fro the next 25 years.

[bmf trend]

The trend is your friend and the trend is up for oil. The cure for the high price of oil will, ultimately, be the high price of oil. With the oil bull charging, who knows just how high this run will end? 130? 150? 200?

What people seem to forget is when the trend changes and turns down, who knows just how low the price will fall? Enjoy the bull run while it lasts, just don't be a overly bullish the higher the price gets. Once the trend reverses and starts to come down, there will be a flight to the exits and you will want to be in front of the crowd BEFORE they head to the exits.

[NJgolfer]

For 'Seriously ?' - there was a good editorial in IBD today about the Canadian Oil Sands and the treatment it is subject to as an "alternative fuel". Oil Sands may not be such a slamdunk in the future if the US does not change some regulations. And while they are out changing regs on oil sands, I would love to see some ANWAR drilling allowed!

[smart money]

We are in a recession with 1.5% growth rate and oil is at $110 dollars a barrel. It will be much higher when our growth rate is about 5% or 6% in a couple years and inflation is at 15%. All the analyst have been saying for years that oil will trade around 30 to 50 dollars a barrel, including Goldman. In see oil around $250 to $300 in the next 5-10 years without a major terrorist attack on pipelines. Peak oil is getting closer and we do not have infrastructure to support anyother form of energy on a mass scale. Buy gold,oil services and drillers to offset inflation.

[Roger Wickes]

Excellent write-up Option Dragon! I agree that we are in a commodity supercycle, and that the Hurricane Premium never leaves. Commodity prices for fuels and other "can't do without" products have a pricing chart that looks like an inchworm climbing up a branch.

We do recommend LEAPS in our newsletter, Low-Risk-Investing, and I'm surprised you didn't mention any viable long-term option contracts. We were bullish on CHK last year, and it's still in our portfolio giving us gains that have eliminated any risk we initially had. Right now, I see that -VECAH is a LEAP with an in-the-money price at only $50, less than 10% above today's close!?! Lots of people are missing out on an easy double, I feel. For $15, even longer term -WZYAG, good until Jan 2010, also has a $50 in-the-money break even, a ridiculously cheap option to consider. By the way, holders of -WZYAG made 10% today. One day.

[optiondragon]

Thanks Roger and your ideas are great. LEAPS would be a great idea. I will suggest your site.

[Kunst]

Gas is $3.50 a gallon, pulling money out of people's pockets by the handful. Consumers are already stretched. Econ 101: consumption will decrease, causing prices to decrease. Combine that with slowing economic growth, lower employment, very worried consumers hunkering down for an economic storm -- what to you get? Pop goes the bubble, the oil bubble. This run-up is being driven by greater fools, convinced that it can only go up, up, up. Long-term, yes. Short-term, no. I expect a sharp drop in oil prices in the relatively near (days, weeks, few months) future.

[User 163508]

I would argue that this was the fault of the fed.
Oil stalled out for 2 days after the fed had a surprise rate cut on aug. 16. then oil took off, I believe oil started to take off, Because the rate cut indicated that the fed was going to swtich there policy and start easing. I still think there was some kind of hurracaine premium, but the majority due to the fed. Of course were saying the same thing I think the catalyst was 90% fed, and 10% hurricane. Great article , like to know what you think.

Also with those school districts taking interest rate swaps that would gain value as intrest rate went higher, they were in the right trade, but the whole picture change on Aug. 16. that was an indicator that the fed going to be easing.

[AmesTiedeman]

I think we may run to 125 then all but collapse to the 80's in Q2, 2008. This looks like a blow off like the NASDAQ did in 2000. Oil has gone almost parabolic. Yes, the dollar crashing is pushing up prices, but a tipping point is near. Longer term is $200 possible. Most likely probable.

[optiondragon]

User, yes fed cuts did help push the dollar lower and cause more inflation but it seems to me fear was the real driver during that timeframe. Fear of a hurricane in the Gulf. If you remember oil production was stopped in the Gulf a couple times during last season due to a Gulf hurricane and that was enough to keep prices afloat for awhile.

[optiondragon]

ames, yes short term pullback or consolidation before another push at the first sight of a major hurricane seems like the logical pattern. But who knows.

[cyberman]

Wondering what measurable and significant steps the Bush administration has accomplished in the last eight, count 'em, eight years towards reducing American reliance on oil? Or is that a dumb question? Good reason to buy leaps, buy oil sands, buy enpix, buy just about anything that is honestly run and has substantial in the ground oil and gas assets. Cover your downside with a nice dividend. Does monster oceanic PBR oil find change the equation at all short term or long term? Do hurricanes hit off the coast of Brazil? Or is that a question for 2015.

[User 137327]

Hurricane season is Jun 1st - Nov 30, peak is Sept 10, heaviest months Aug-Oct.
A rare hurricane hit Brasil last year (or the year before), also hit have been Spain and Morocco. More energy in the system suggests more and stronger hurricanes.
Some will just affect GOM platforms, shut down, evacuations, temporary supply interruptionsHu; others may destroy platforms and cause longer term grief.

[David in DC]

When discussing oil price, the psychological of the oil producer, either company or exporting country, must be considered.

If you made a million dollars in 2003 selling oil and you invested the money, chances are you made less money than if you kept that million dollars worth of oil. Today, that oil would be worth 5 million dollars.

Seeing how oil prices have gone up there is no incentive for oil producers to produce and sell more.

As long as that is the case, oil prices will go higher and stay higher.

As the value of dollar drops, the cost of oil will be cheaper for the other oil importing nations such as EU countries and China. Their consumption will help sustain the high prices even if the US consumption doesn't.

[JamesSeaberg]

The rapidly rising general price level in the US will put a floor under oil prices and the price will stay high and eventually even go higher. The 640 dollar question is; will the oil price rise faster than inflation? Will your hedge against inflation outpace inflation?

[User 164820]

What's $12 Billion a month on IRAQ when you are $9 TRILLION in debt???

The "Bush/Cheney Economy" will persist for a generation, no matter who wins the next election. The USA has ceased to be a capitalist economy. The capital is now in the hands of foreigners who know how to save. Now they will wait until they can bottom-fish.

The US Government will no longer be able to tell China(and others) not to invest in American companies because this will be tantamount to suspending the convertability of the Dollar and lead to a useless $$$currency faster than current policies. This will prompt most to insist in payment in EUROS in order to protect themselves from our monetizing the US Federal Debt with emergency
monetary and fiscal bailouts of firms who don't know the meaning of "due dilligence".

[Roger Wickes]

I think some of you might be taking an overly simplistic view of oil consumption in this country. Specifically, to natural gas, it is not at the pump but is used for home and commercial heating and cooling, and for industrial use, e.g. producing plastics, fertilizer, and electricity. Even if natural gas prices double, people are not going to heat their homes less, or instantly switch to heat pumps. The price of rents and the indirect consumption cost component will cause prices to simply rise to reflect the increased cost.

Oil in general is used much more than just to fill up your tank; boilers that burn oil to make paper, generate electricity, for example, are not going to shut down or slow down. Even the gas in people's cars - people are not going to stop going to work when prices rise - they will go to work more so they can earn more to fill up their tank!

Therefore, these rising prices create inflation. So, yes, I think the price of oil is a major driver of inflation because of its effect on the cost of production. As a result of inflation, the price per barrel of oil rises, in a never-ending vicious cycle.

[Ace22]

Optiondragon i enjoy your articles keep them coming. But i was wondering when do you think the next pull back would be & of the list you gave what co. do you like?

[optiondragon]

Thanks Ace really appreciate it....the pullbacks are fast and they do not last long. DVN , EOG, APA, OIH(RIG), UPL, SU, ECA, RRC. There is a host of them. I like to watch for great setups with confirming volume for trades and investment. For trading I rotate between all of them and for investment I try to buy the pullbacks and cost avg in. Another strategy might be to buy calender spreads on the USO through October or buying the XLE. please consult your financial advisor too!

[Ace22]

I own RIG but have been watching SU for a while i had a limit order at about 91 on the last pullback but it never made it there im a little upset. What do you like about SU & RIG?