Insiders Preparing for Major Drop in Oil Prices

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 |  Includes: IYE, OIL, SUN, TSO, USO, VLO, XLE
by: J. Christoph Amberger

Experts still forecast that oil will trade for $150… $175… $200 a barrel by December. Just last week, oilman T. Boone Pickens predicted $300 oil before a Senate panel. And new Russian Prez Alexander Medvedev recently pegged the upside at $500. It’s supply and demand, the argument goes. The new economic superpowers China and India will exponentially increase demand over the next couple of years. So will the assembled Russians and citizens of Arab petrocracies.

Many analysts are discounting the argument that speculative pressure has anything to do with the doubling of crude prices. It’s not the hedge funds and commodities funds and pension funds and institutional investors that are running up prices for oil, gasoline, gold, silver, nickel, indium…. it’s demand, plain and simple.

I agree… to a point. Undoubtedly, the nascent economic superpowers of the Far East are hungry for energy. They need it to make things they can sell to Europe and America. They need it because the people who make things for sale to Europe and America no longer are content with a bowl of rice and a hand-me-down bicycle. They now want to live in tiny apartments, take hot showers, play video games, punt at the cockfighting pits and stock markets.

And drive silly little cars with lawnmower engines.

But demand for crude has not doubled between the Fall of 2007 and Summer of 2008. Prices have… and then some. A week ago, I moderated a TFN Round-Table discussion between Money Morning’s Martin Hutchinson and Bill Patalon. Bill believes that “near term, you can make the argument that speculators are behind it. But long term it’s definitely demand driven. I think we’re going to see oil prices at $225 a barrel within a year, year and a half, and I think we’ll be looking at gasoline prices at $7 to $9 a gallon.”

Martin Hutchinson disagreed to a point: “I think it was certainly demand-driven until late last year, with China and India increasing their demand very rapidly. But I think we’ve had an increase from $80.00 to $150.00 since last September, and I’m sorry, but the fault for that goes squarely towards Mr. Bernanke.”

(We’ve made this round-table available for you, if you’re interested.)

But if immediate demand for oil does not explain the doubling in price in less than a year, it is the expectation that demand will one day indeed justify that price.

Which is just a cumbersome way of saying “speculation”.

Sidelining supply

With record tides of liquidity sloshing around the world thanks to globalism and electronic trading, speculators have a powerful arsenal at hand to direct money flows.

The first is the deft manipulation of public perception. The higher oil prices go, the higher oilmen push expectations. If an OPEC minister was still chuckled at 3 years ago for stating that a reasonable price for oil would be $120, people now nod in agreement when T. Boone Pickens is predicting oil at $300.

They’re like scalpers buying up tickets to Mama Mia to charge rustic rubes quadruple the price of admission. And the rubes are happy to buy, because otherwise the Greyhound fare from Scaggsville would have been wasted.

The other wonder weapon in the targeted inflation of the commodities bubble is hoarding — the active sidelining of supply.

Now, there’s a subtle difference between investing and hoarding. Investors and traders buy and sell equities and assets to make money. Hoarders pile up assets in the hope of values rising. Converting them back into money is often not a priority. (Be honest, have you ever encountered a gold investor who actually sold his Krügerrands?)

The commodities super-cycle has taken hoarding to a professional level. Commodities funds have been buying up gold, metals, oil, sidelining them from the market, increasing demand while reducing available supplies.

Shell games like this have become increasingly popular as panicked investors are fleeing real estate and stock markets toward the presumed safety of gold, oil and metals. The more that pile in, the higher prices go. And the higher prices go, the more investors pile in.

If this were real estate or internet stocks, people would call it a bubble. But since gold and oil are involved, this is part of divine providence.

Bubble business

Back in the 1990s, budding Internet entrepreneurs still required a cocktail napkin to write their business plan on before they issued an IPO. Today, a Post-It note is sufficient.

Take the perennially “upcoming” IPO of Specialty Metals Group Indium Corp. (IND.U). They want to take the proceeds from their IPO, buy a stockpile of indium, sit on it for a couple of years, and hope to watch their stock price rise along with demand for indium. They won’t even bother with actively speculating on price fluctuations.

Indium is actually a useful industrial metal that is used in the manufacture of flat panel displays, touch-screen interfaces, iPhones and solar energy.

The company filed on February 27, 2008 and intends to sell 11 million shares at five bucks a pop. No IPO date has been set yet.

Sadly, this commodities Ponzi scheme is probably going to be one of the hottest and oversubscribed IPOs coming down the pipeline this year. If they ever get around to it. It will make plenty of money for the underwriter and the market maker. Hey, even in this market, two out of three ain’t bad.

Instead of chasing this stock in the aftermarket, I had recommended in February that TFN readers take an early position in a few of the publicly traded small indium miners that could be profiting from tight supply. One of them was Avalon Ventures [TSE: AVL], which trades on the Toronto Stock Exchange. The plan was to sell a few days after the IPO “for potential gains of up to 50%”. We were recently up close to 70%, without any sign of the IPO materializing any time soon.

Now, did demand for indium increase by 50 or even 70% in the time? I don’t think so. But other people’s hoarding does pay nice dividends after all…

I have looked at this phenomenon quite carefully. And I have come to the conclusion that there is one very human need behind the run-up in oil prices:

The need to park capital in productive assets

Just think back to the beginning of the U.S. real estate boom.

As a publisher of financial information services, I dislike reminiscing about 2001. Even though April 2000 had marked the end of the Internet stock market boom, the flight out of equity didn’t really gather full steam until 9/11. But the trillions of dollars in stock market capitalizations did not “vaporize”, as many financial gurus claimed and instructed their marketing folks to trumpet. Capital flows shifted… away from stocks and straight into the one asset that, common sense told you, “the good Lord wasn’t making any more of.”

Instead of automatic contributions to 401(k)s and IRA portfolios, they transmogrified into mortgages. Down payments. “Earnest money.” They went to service 30-year mortgages, sub-prime mortgages, ARMs.

I recall talking to one of our Taipan VIP Members then who patted me on the shoulder, assuring me he had moved out of stocks completely and put all his money into real estate.

And for the next five years, real estate was the place to be.

All of America became like Hoonah, Alaska.

Desolate fish packing plant turns into tourist mecca

Hoonah, population 860, is a small village on Chichagof Island in Alaska, United States. It is only accessible by boat or plane. Its claim to fame was a fish packing plant that employed most of the population. About 14.3% of families and 16.6% of the population lived below the poverty line.

There are also about 3,000 coastal brown bears roaming the island wilderness. Their presence is not conducive to the desire for all-round safety instilled in normal American suburbs. But it was sufficiently attractive for cruise line Royal Caribbean to chose Hoonah — or Icy Point Strait — as a day stop for some of its Inside Passage Cruises back in 2005.

Now, every couple of days, a cruise ship disgorges several thousand passengers onto the island. They go look for bears, paddle kayaks up and down the rocky shore, watch bald eagles fight over fish carcasses — and flood businesses with cash in exchange for smoked salmon, mini Ulu knives (Made in China) and miniature totem pole keychains.

The town is awash in money. And in less than two years, real estate went through the roof.

On the one major road leading into town, you walk past a shack. In Maryland, you’d be able to buy a prefab counterpart from an Amish barnmaker for three thousand bucks. In Hoonah, they’re asking $300,000. Bring your own paint. And nails. And tar paper.

Not that anyone is buying. People live the way they have always lived… most of them in cottages provided by the Federal Government after a fire wiped out half the village back in the late 1940s…

Cottages that on paper are now worth more than a prosperous Mid-Atlantic suburb.

Landrush 2000

Alas, while the dear Lord hung up his shingle of creating more real estate six-thousand or 60 billion years ago (depending what time table you subscribe to), real estate developers and home builders had no such qualms.

Between 2001 and 2007, every quarter acre of free land in the vicinity of a fixed settlement was plastered with boxes made of ticky tacky boasting cathedral ceilings and brass entry lights. First, there was genuine demand. And it was obvious: American real estate was clearly undervalued… the Echo Boom generation was pushing into elementary schools… and the U.S. are adding the equivalent of Chicago’s entire population each and every year.

Then the pay-off of owning real estate became apparent. Soccer moms turned into real estate agents and carpenters turned into professional property flippers. Home equity loans fueled spending.

But demand for timber, copper, consumer appliances pushed up commodity prices. Especially oil.

In America, people started burning corn for heat and destilling grains into hootch to fuel their ride to Whole Foods. To the sensitivities I inherited from my German WWII- and Cold War-imprinted parents, that’s worse than lining a litter box with pages torn from a first edition of Goethe’s Faust.

For agro-commodity speculators, it was a windfall…

Until the greater fool theory ran out of greater fools.

Reversal of fortune

Suddenly, there’s little money left in selling real estate. (Except maybe in Hoonah!) And since the banks who enabled people to leverage themselves are running low on cash as well, stocks have been taking another beating — the second in a decade.

And with equity and real estate out of the picture, the markets have begun to look like the line-up of Presidential candidates in May.

Oil right now is the Obama of commodities: The one remaining thing left bobbing in a sea of ennui and disenchantment. Lightweight yet full of perceived potential usages. An object of hope for the drowning, the desperate, the drifting. And those who prefer the rainbow sheen of surface refraction to deeper exploration.

Much like the bubble machines for real estate and Internet stocks before, rampant speculation masks as solid demand. Predictions of $170 or even $300 per barrel seem as reasonable as a $300,000 price tag for a Hoonah shack or $500 for a share of Pets.com in 1998.

But the tide may already be turning. Insiders and hedge funds are now moving into position to profit… from a dramatic DROP in crude prices.

Oil may still be trading around $130 a barrel. But signs of a trend reversal are popping up everywhere: Energy prices aren’t going up. They’re going down. Fat-cat insider bets prove as much – and when they turn out to be correct, you could make a bundle! Just how much?

Depending on just how low oil will go, you could see gains of 50… 60… or even 75% by November 1!

But let’s review the evidence

Some of the world’s biggest hedge funds are now quietly betting on a turnaround… by stocking up on beaten-down U.S. refinery stocks.

* Bruce Koyner’s $12 billion hedge fund just increased its shareholdings in six refiners, including Valero (NYSE:VLO), Tesoro (NYSE:TSO) and Sunoco (NYSE:SUN).

* Citadel, a $22 billion fund, quietly sequestered an incredible 192,610 shares of Tesoro and increased its stake in Holly almost eightfold to 190,681 shares in the first three months of 2008.

* Renaissance, a $30 billion fund, just bought 609,888 shares of Valero and increased its existing stake in Calumet by 5.3%.

But it’s not just hedge funds that are betting top dollar on a turnaround in crude oil prices: Refinery executives are buying more of their own stock than at any time in the past eight years! Oil and gas processors have experienced a 40% decline in share prices since January after crude oil prices gained 43%. That’s the largest drop since 1995.

But it’s not really surprising when you consider that profits of U.S. refiners plummeted an incredible 98% in the first quarter after companies were unable to make up for higher crude prices with higher gasoline, heating oil and jet fuel prices.

Now, earlier this year, chief executive officers, directors and other senior officials of oil refineries had been dumping their shares like there was no tomorrow. After all, they knew that if oil prices went up, their margins would go down. Suddenly, things have changed: Executives at 10 refiners gobbled up $2 million of their own companies’ shares in May… that’s twice the amount they had sold!

One of these insiders is Irl Engelhardt, chairman of the Federal Reserve Bank of St. Louis, who has put $509,000 of his own money into Valero (VLO)… a battered refinery stock.

The logic is quite simple: Refineries have been unable to pass higher crude oil cost on to customers. (If they could do that, you’d be paying $6 for gas!)

So any drop in crude prices means increasing margins for refiners. Which will mean higher share prices!

* Tesoro director John Bookout III increased his insider stake by 58%.

* Calumet Specialty Products Partners CEO William Grube bought 50,000 shares in May – his first purchases since the company went public in January 2006.

But one company’s management has been buying up shares at an unprecedented clip: The Executive Chairman of the Board bought 53,000 shares of his company for $727,250… at between $12.43 and $14.74 a share. Even better, the refiner’s parent company acquired a whopping 880,000 shares for $11.4 million… paying between $12.03 and $14.79 a share.

Insider buying is good… increasing output is better

Now… insider buying often is a bullish indicator. But betting on lower oil prices alone would not be sufficient for us to recommend this stock… even though right now, you can buy it for under $14. The thing is, this company’s stock price has been depressed artificially since February due to an incident at one of its plants that knocked out part of its capacity.

An estimated 70% of the company’s consolidated EBITDA was produced by this very facility in 2007. It is now working at 50% of capacity… but the company estimates it will be fully back online in late July.

There is another catalyst that could send the stock price soaring in the very near future. You see, the company has just completed the acquisition of another facility, which will increase its output by another 50%! The stock is currently trading at a 73% discount over its July 2007 high. The Hot Stock Confidential team has given it a conservative 67% upside by November. 

News that a major bank just increased its holdings in this stock from under 95,000 to over 150,000 shares sent the stock price up almost to our buy limit last Wednesday. You may have missed our initial recommended entry level. But you’d still be in an almost perfect position for explosive gains by December if you buy now.

Overall, playing oil refiners in expectation of further drops in the crude oil prices may be a tad indirect for your taste. But I think it is time to risk a limited amount of money on the downside of oil.

Just call me a speculator!

Disclosure: None