Retail consumers of oil – and retail investors of oil – are the big losers now that oil has become a financial product, says Dan Dicker, author of Oil’s Endless Bid.

But the irony is they’re doing it to themselves—by buying oil ETFs (Exchange Traded Funds) and ETNs (Exchange Traded Notes) and other financial derivative products based on oil.

I only came up for three gulps of air while reading the book, and I emailed Dan immediately afterwards asking for an interview.  He writes in a simple, earthy and honest way—that I wouldn’t have expected from an oil trader on the floor of the New York Mercantile Exchange.

One point he explained so well to me was that the investment banks that now dominate trading have created a massive new market of buyers, and only buyers – no sellers – with their financial products like ETFs.  And that has inflated the price of oil for consumers.  The oil price nowadays is not just based on fundamental supply and demand.

“In 1980 oil demand was about 60 million barrels a day.  In 1990 it was 70 million and in 2010 it was about 90 million.  What’s interesting is that demand has been fairly steady in how it’s increased; about 10 million barrels a day each decade.

“But the oil price has been entirely flat for 20 of those 30 years.  What that says to me is that something clearly changed in how we’re pricing the stuff in the last 10 years.”

And that something is the involvement of the financial industry, he says.  “It’s all about the pricing mechanism, who’s involved and the money being thrown at it.”

That money comes in the form of ETFs and index funds all geared around the price of oil, and are obviously set up by the big investment banks.

But Dicker says that is ALL “long” interest, meaning they are all BUYERS and not SELLERS.  And we all know what happens to the price of something when are more buyers than sellers.  The price goes up.

“What has happened in last 10 years, those who have been setting price based on fundamentals in the market have been swamped out by the financial sector, who have very little engagement with the physical product.  Yet their input is equally important to the price of oil as those physically involved in the sector.

“The market is democratic, but it wasn’t designed to be democratic.”

And there is the irony!  Oil becomes a democratic market—where institutional and retail investors get to help set the price by all of their buying in these indexes, ETFs and ETNs to gain exposure to the oil price (which isn’t possible, Dicker writes) but in effect drive the price up.  So they pay more at the pump.  Democracy at work!

And sadly, the other side of the coin is that the investment banks make a nice share of the coin in the oil trade.

“The stock market can theoretically have a whole group of winners as the stock market goes up—forever.  With oil that’s not true.  When someone buys oil, someone has to sell it to them.  At the end of the day or month or year when trades settle the amount of money won equals the amount of money lost.  When institutions make money trading oil, that eventually comes out of the pockets of people filling their tanks, refrigerating their meats— it’s a zero sum game.”

Well, wait a minute Dan—you just said everybody in oil is long, i.e. they’re buyers, but then you just said there has to be a buyer for every seller.

“Yes, almost everyone who is investing and even hedging oil is long, so the market has to somehow generate sellers, something the stock market for example doesn’t need to do.  So how do you generate sellers where there aren’t any to begin with?

“Well, first, you must make the price pretty high:  Imagine you own a $100,000 house in a neighbourhood of $100,000 houses and all of a sudden, a new group of home buyers wants to have your house, for whatever reason.

What will get you to sell?  Well, someone knocking on your door with a $200,000 check might get you to think about it.  So, price is driven artificially higher, that’s the first thing.”

“But sellers in an oil market also don’t have physical assets.  Even when enticed by a high price, they need a hedge for those sales, because they don’t have oil to deliver, any more than buyers want to actually accept deliveries of oil.”

“So, in generating sellers,  you also generate trade correlations. Like, the corn chart and oil chart look almost exactly the same. And the correlation between oil and oil stocks become uncannily close.”

“So you get these trade correlations, but not a fundamental correlation.  So we now have a very different correlation between the oil market and the stock market than what we had before.

“The oil market-stock market trade looks like a correlation, it’s perceived as one, but it doesn’t make sense, because high oil prices are intuitively not good for the stock market.  So they call it a measure of growth.

“Now we’re looking at a double dip recession and EU going down and oil prices more than $110—how does that fundamentally make sense.  It doesn’t because the marketplace designed for producers and consumers is overrun by people who are financially engaged.”

OK, now I am a believer that there is big premium in oil because it has become a financial product.  How big is that premium and how does… can it ever go away… can we ever end The Endless Bid on Oil?

“You’ll never know what the premium is until you remove this financial mechanism.

“The chances of ending it IMHO are pretty slim.  The path to fixing this is simple to see—but making it happen is nearly impossible in practice.

“You would need to restore the market to close to the way it was before these financial influences took control of it, and let commodity markets operate the way they were intended.  The financial industry will say that’s a destructive rollback of investment trading.  The banks and the entire financial industry have big stake in this.”

In his book, Dan tells some great and funny stories about how he won and lost lots of money (for him) on the old NYMEX floor, despite being a very small independent oil trader. In between the wry smiles, you will get his core message:

“Treating what was a commodity as if it was a stock, is inherently a bad path toward a pricing model that will be volatile, unreliable and unfairly high.

“This is a commodity that people rely on (in their daily lives), and they’re treating it like it’s investable—and the outcomes are fairly obvious to see.”

You can buy Dan’s book — again, it’s very simple English — at Amazon. Here is the link:
Oil’s Endless Bid: Taming the Unreliable Price of Oil to Secure Our Economy

- Keith

ETFs, or Exchange Traded Funds, not only track the price of oil, but they can actually provide clues as to where the oil price is going.   I’ll show you how to read their charts, and show you the ETF that I think most accurately follows and even warns investors of oil price moves. (Hint – it’s not who you think.)

Currently Light Sweet Crude futures remain in an uptrend, over the last month price has tumbled from former highs at $114.83 in May to $95.25 currently on the July contract.  The two-year chart below, in 2-day increments, shows the course of oil prices with a continuous futures chart.

ETFs allow individual investors to partake in the price fluctuation of oil in a way very similar to simply purchasing a stock.  (For further information on ETFs, see Keith Schaefer’s report: ETF Investing in the Oil & Gas Market).

The chart below shows the price of light sweet crude in yellow/red, and two ETFs – USO-NYSE, which is the United States Oil Fund (purple), and an ETF which gets far less attention – XOP (light blue).  XOP is the symbol for the SPDR S&P Oil & Gas Exploration & Production ETF traded on the NYSEArca exchange – so it is an ETF that covers oil stocks/equities, whereas USO tries to track the commodity.

How to use ETFs to predict moves in the price of oil How to use ETFs to Predict Moves in the Price of Oil

Source: Thinkorswim

General Chart Comments

From the chart above much information can be extrapolated.  Namely we can see that at this time oil still remains in a primary uptrend, even though we have seen a sizable correction.  There are two trendlines shown on the chart – the first one is red and indicates an aggressive upward trend.

At some point all aggressive moves slow down.  The green trendline is also present which marks the more stable rise of oil prices over the last year.

If oil prices move below that red line, currently intersecting at $92 (this will change over time as the line is sloping), it indicates that oil is correcting to its primary uptrend level (green line).

The green line currently intersects at $80, but will rise over time as the line is sloping. An upward sloping trendline such as this helps a trader gauge when longer term trends are shifting.  Markets move in waves – in an uptrend, markets have progressively higher low prices and progressively higher high prices.

If oil can hold above the $92 level it indicates strength, based on this simple method derived from former price action.  On the other hand, if the commodity moves below that level we could see prices in the low$80s, where there is likely to be buying interest once again.

Using ETFs as a Form of Analysis

The ETFs shown in the chart are not only investment vehicles, but they are also analysis tools.  USO (purple on chart) has already broken below its trendline (yellow line) indicating that lower prices are likely for that security.  This provides some confirmation of the decline in oil, although XOP is a better gauge.

XOP provides valuable information.  Not only has it been the far more profitable play from rising oil prices, but also generally leads oil prices – providing a bit of a snapshot into potential moves in crude.

This occurs because XOP is an ETF that doesn’t track crude – it tracks oil exploration and production companies – which provide a large input the for the oil market as a whole and thus the price of oil.  If investors are buying these securities, which are held by a sector ETF such as XOP, it indicates that the market is anticipating rising oil prices.  The same situation applies if investors are selling these securities help by the XOP ETF in anticipation of falling oil prices.

Looking at the chart, XOP (light blue) has moved aggressively higher over the last year.  Rarely did it pull back significantly, even when oil declined.  I have highlighted a few sections of the chart for educational purposes.  The first, light blue highlighted box on the left s (#1) hows XOP making a lower price high, while oil made a higher price high (all contained within the rectangle).  This was a warning for oil prices and quickly oil prices corrected by about 15%.  This is commonly called divergence.

The next box to the right (#2) shows oil correcting to the prior low yet XOP pulled back very little in comparison – oil quickly moves higher following XOP’s lead.  The next highlighted blue box (#3) shows a similar situation to the last – XOP leading oil higher.

The final box is highlighted in white (#4) and is a potential warning signal similar to our first highlighted area.  For the first time in over a year XOP made a lower high, while oil made a new high.  This was a warning signal for the correction in oil, and remains a warning signal.  XOP has shown a strong tendency to lead oil prices and now it is retreating, leading oil lower.

You will notice at the far right of the chart, which shows June 15 price action, that while oil has paused near recent lows, XOP has retreated below its recent low.  This makes further declines in oil likely, as long as XOP continues to decline or fails to rally on oil price rises.

Tying it together

Investors can use the XOP ETF to help them see the likely course the commodity will take.  XOP has been a sound indicator for the strength of oil prices.  It pointed to strong oil prices through the rise, and even when crude corrected, it indicated a correction which has come and currently it is pointing to a further correction in oil.

In the beginning of this report the low $80’s was discussed as a potential target for the oil price.

If oil continues to drop below that level, we can look to the XOP indicator as a sign of a potential bottom.  When oil makes new lows (compared to recent price action), but XOP fails to make new lows, oil prices have a high probability to begin moving higher as well.

While USO comes to mind when looking for a place to take advantage of a rise in oil prices, it has proven not to be the most efficient vehicle.  XOP, when oil prices are rising, has proven to lead oil and also generally outperform.

Investors must remember XOP will also lead on the way down, retreating fast and more aggressively than oil; therefore, a prudent exit strategy is required. XOP also lacks the trading volume that USO has (still 2-10 million shares a day), yet it functions as an excellent analytical tool for oil prices.

- Cory Mitchell, CMT

Understanding the future—not just the present—is very important to ETF returns. And this is where the two basic questions for investors get answered.

What is the timeline of the trade?

The real question here is, how many times does the ETF have to “roll” its futures contracts between now and that trade date?

Use oil as an example. Because the ETF issuers never want to physically own the oil, they must sell their futures contract before it expires, at which point they would need to take possession. So they sell it and buy a longer-dated futures contract — either the next month or several months out. This buying and selling of futures is called “rolling” it forward.

Are the futures contracts showing higher prices (in contango) or lower prices (backwardation)?

When the market is in steep contango or backwardation, that is to say when the futures market is very different than the spot price, indicating a big move in commodity prices, the ETFs get caught in a tight spot.

InvescoPowerShares’ Lake explains: “If you’re rolling into a contango market, an upward sloping curve, you will roll into a more expensive contract, and there will be a drag on performance.” (The PowerShares oil ETF symbol is DBO-NYSE.) “We use a more flexible rolling strategy, so we can reduce the impact of contango and increase the benefits of a backwardated futures market.”

In 2009, that drag was severe, as the spot price of oil rose almost 70%, and the futures market correctly anticipated that move, as there was a ladder of higher prices in the futures contracts. The problem: ETFs had to sell their lower-priced contracts that were nearly expired and buy the more expensive contracts dated farther out. And the more often they rolled, the greater divergence there was between spot prices moving and ETF prices moving.

That scenario caused many retail and professional investors, like Philip Treick, managing partner of Thermopolis Partners, to avoid going long the ETF sector.

“The contango futures curve forces an ETF manager to sell the current expiring contract low and buy the replacement contract higher — hardly a recipe for success,” says Treick, who manages two natural resource funds out of San Francisco and Jackson Hole, Wyoming.

“Institutional and individual investors bought these ETFs hand over fist assuming they were gaining exposure to a rising commodity price when actually, the roll was obliterating returns.”

In 2010, however, Hyland says it has been a different story.

“Year-to-date, the amount of contango in the front-month oil contract for WTI has been eroding a bit more than 1% from the return. If someone is looking at this investment as a three- or four-week play, how much do they care about contango or backwardation? It’s not that you won’t feel it, but in the bigger picture, how much does it really matter? In any single day the spot oil price often moves 1% to 1.5%.

“But if you’re looking at 12 months, then it’s a bigger factor.”

In other words, the trade timeline is greatly affected by the roll.

Hyland’s funds continue to roll their contracts forward monthly, to the nearest contract. While this is simple, it also increases any distortions from contango or backwardation. Other ETFs, like PowerShares’ DBO, use a more flexible strategy that can roll once or many times a year.

Morningstar ETF analyst Abraham Bailin says the ETF issuers are evolving their products to meet the market’s concerns about the roll.

“Futures-based funds are using dynamic strategies, like USCI, The United States Commodity Index Fund, for instance. They can choose contracts out as far as 12 or 13 months, that can maximize gains or minimize losses posed by the implied roll yield. Some of these dynamic methodologies are getting very crafty.”

USCI trades all commodities, not just energy, and will buy futures in backwardation, where it can sell higher-priced, near-term futures contracts and buy lower-priced contracts farther out in time, pocketing the difference.

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Tax Issues with ETFs

A secondary characteristic of ETFs that few investors pay attention to is their tax treatment, which depends on the funds’ structure. The Wall Street Journal reported in April of this year that ETF holders could get taxed at 23% — higher than the 15% rate investors are used to paying on stocks and mutual funds in the U.S. — on gains they haven’t taken yet under I.R.S. rules, which state that open positions in futures contracts are to be “marked to market” at year-end.

“We find it (futures-based commodity funds) irritating to customers at tax time,” says Richard Shaw of QVM Group, South Glastonbury, Connecticut. He buys a lot of ETFs for his clients, and writes about them as well—but he doesn’t buy energy ETFs, because of the roll issue, and “they are taxed in complicated ways. A CPA has to take more time.”

There are other issues with energy ETFs as well. Sometimes the popularity of an ETF will cause it to trade above its net asset value if the issuer is not granted permission to increase the number of units.

Professional traders claim they can “front” the roll at the expense of other ETF shareholders, by buying large amounts of the same futures contract that the ETF does — just before the ETF buys it. They then sell into the ETF buying.

There are also a growing number of levered commodity ETFs, which try to give investors two or three times leverage to the moves in commodity prices or commodity indexes or commodity equities. These often take the form of exchange-traded notes, or ETNs, which have completely different issues for investors and taxation methods.

But for ETFs, understanding how the futures market works, and how the ETFs play that market, are two sides of the same coin that investors must have comfortably in their pocket before spending a dime on the funds.

People invest in ETFs like they would a stock, but because of the way they are structured, they act more like a bond. Like a bond-maturity date, the futures market tells investors where their investment in a futures- based ETF is likely headed, and they need to determine which ETF product gets them there the most profitably.

- Keith

Follow this link for Part 1 of my report, ETF Investing in the Oil & Gas Market

* Article originally published in Oil & Gas Investor in December 2010

*Editor’s Note: The following is a report I developed for Oil & Gas Investor magazine, published in its December 2010 edition. Part 1 of the story is re-printed below with their permission.

Exchange-traded funds have been on a roll. Here’s how to find the one with the best fit, and make it pay off. But watch for the “roll.”

Commodity exchange-traded funds, or ETFs, were created early in the last decade to give retail investors an easy way to play hard assets such as oil and natural gas and metals in one broad investment vehicle.

And the strategy has worked—in spades. A low fee structure, preferential tax treatment and strong marketing have propelled commodity ETFs to $97.8 billion in assets under management as of September 30 2010, according to industry data from BlackRock, one of the largest ETF issuers. BlackRock’s data also indicate that overall ETF assets at the end of September were just under $800 billion and growing—up 13% over 2009.

Now, almost 10 years after ETFs’ launch, retail investors have a lot of access—31 energy ETFs and related products alone; 890 total, across all sectors in the U.S.; and 149 new ones just this year. But quantity hasn’t equalled simplicity.

Management from even the most straightforward—and largest—energy ETFs have had to defend themselves at congressional hearings in describing how their funds work. And other energy ETF issuers have launched products that use new and different ways to both track commodity prices and increase returns.

With all the choices of energy ETFs and the confusion around how they work, how can investors decide which one is right for them? And more importantly, how can they make money at it?

Choosing ETFs

ETF issuers and independent analysts say investors need to know the answers to three basic questions before making a purchase:

• What is the timeline of the trade?

• Is the futures market for that commodity in contango or backwardation?

• Do you know what you’re buying? ETFs now have very different exposures to energy prices.

“It’s not that complicated,” says John Hyland, chief investment officer for U.S. Commodity Funds LLC, which issues the United States Oil Fund LP (USO-NYSE) and the United States Natural Gas Fund LP (UNG- NYSE).

“By the time you’ve answered question No. 1 and No. 2, your choices have now been limited to a couple ETFs—those questions have done 90% of the work” for investors looking to invest in ETFs, he says.

“If someone comes to you with a bond, you ask what the time frame is (until maturity), and ask yourself are interest rates going higher or lower over that time, and then you pick what you’re going to do. I don’t think it’s any more complicated than that, really,” Hyland concludes.

Michael Johnston, senior analyst at ETF Database in Chicago, agrees, adding, “What we find is that people don’t understand how they’re getting exposure” to the underlying commodity when they buy ETFs.

An energy ETF can try to track the spot commodity price, or an oil and gas stock index, or a basket of stocks—or, as the market is seeing now, the ETF can track a custom product that the issuer has made up itself.

But Hyland’s USO and UNG are by far the largest and most liquid investments in the energy ETF world, and they use—in fact, most issuers use—the futures market to run their ETFs.

And using the futures market is where the biggest frustration for investors becomes apparent, in the cost of “rolling” futures contracts. Knowing how the futures market works, not just how the spot price market works, is key in who wins or loses in ETF investing.

“Some investors came into ETFs looking at spot prices to gauge the success of their investment, but that exposure is not something you can always achieve,” says Bryon Lake, senior product manager for Invesco PowerShares, an ETF issuer. “The next best thing is to use a futures contract.”

But the wild volatility in energy prices over the past two years brought about the near- market collapse in 2008, and the recovery so far in 2009-2010 has meant that the futures market sometimes did not track spot prices.

Tracking the future

Most energy ETFs actually track a futures contract, not spot prices. And during volatile markets, investors were getting the former, when they thought they were getting the latter. That made for some big discrepancies in 2009; Johnston says the price of natural gas was only down 1% on the year but Hyland’s UNG ETF lost half its value. (Johnston wrote in March 2010 that while UNG continues to decline, it is actually tracking the natural gas price almost perfectly once the wild volatility stopped.)

So understanding the future—not just the present—is very important to returns. And this is where the two basic questions for investors get answered.

What is the timeline of the trade? And are the futures contracts showing higher prices (in contango) or lower prices (backwardation?)

Follow this link for Part 2 of my report, ETF Investing in the Oil & Gas Market.

- Keith

* Article originally published in Oil & Gas Investor in December 2010

Want to learn more about investing in junior oil and natural gas stocks? If you have a Facebook account, just “like” this article and a hidden link to Keith’s 10 page how-to on oil and gas investing will appear:

Why oil services stocks are outperforming oil producer stocks

By Brian Hoffman

There are several other ETFs that track the shares of oil and gas producers and services companies, although those other ETFs do not experience the same magnitude of trading volume as the XLE and OIH ETFs.

The XLE ETF tracks the shares of U.S. large-cap oil and gas companies with recent trading volume about 10 to 20 million units per day.  This ETF has a heavy weighting of Exxon Mobil Corp. (XOM-NYSE, $72.80), which significantly influences the direction of the ETF.  Since XOM has lagged the XLE ETF during the last several months the recent influence has been a drag on the ETF’s performance.

The OIH ETF tracks the Philadelphia Oil Services Index (OSX, 242.22), which is comprised of the shares of U.S. large-cap oil and gas service companies.  Recent trading volume is about 4 to 5 million units per day.  This ETF includes oil and gas service companies such as Schlumberger Ltd. (SLB-NYSE, $82.81), Halliburton Co. (HAL-NYSE, $40.41) and Baker Hughes, Inc. (BHI-NYSE, $56.76), which have all outperformed the OIH ETF since Sept. 1.

The comments below provide a technical analysis of these two ETFs in terms of the current price chart pattern that each ETF’s price action has formed and their relative performance against each other, but first a refresher on support and resistance levels.

A support level for the price of a security or ETF is the level at which buyers have become as powerful as sellers and stop a price decline.  Whereas resistance is the level at which sellers have become as powerful as buyers and stop a price advance.  A resistance level becomes a support level after an upward breakout of a resistance level occurs, whereas a support level becomes a resistance level after a downward breakout of a support level.

As you can see in the chart below, except for the big pull-back in the spring of 2010 after the BP Amoco PL (BP-NYSE, $43.61) gulf oil spill, the OIH ETF has outperformed the XLE ETF since Dec. 1, 2009.  The trend lines on the ratio of the OIH unit price to the XLE unit price as well as the RSI and OBV technical indicators favour continued outperformance by the OIH ETF, but breaches of those trend lines may change the bullish outperformance case for the OIH ETF.

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OIH’s unit price has bounced around a much wider US$90 to US$130 price range during the period August 2009 to November 2010, which is quite volatile.  The unit price managed to penetrate the US$130 resistance level in November 2010 and has also traced out a fairly steep rate of ascent, which is unlikely to be sustained.  The bullish case for oil services companies outperforming oil producers is strengthened should OIH’s unit price confirm a breakout with a move up to US$143.

Notice how the resistance level of each ETF was breached in April of 2010, but the unit prices quickly dipped below those levels quite substantially after April.  Essentially, the sellers became more powerful than buyers and stopped those advances.  Recall that there was general market weakness in May.  These false break outs, or whip saws, have a greater probability of occurring if the price movements are less than 10% above the resistance level.  Normally, a break out is confirmed by a 10% price move above the resistance level, although with penny stocks you would generally want to see at least a 20% price increase to confirm a break out.

There significant short interests in both ETFs’ units (i.e. 40 million, or 35.6%, of XLE’s 112.4 million outstanding units and 6.5 million, or 36.1%, of OIH’s 17.9 million outstanding units), so a short-covering rally could take their unit prices considerably higher, although the unit prices will not diverge much from the net asset value of underlying market constituents of each ETF.

Conclusion:

The broader stock market is due for a pull-back, which could take the XLE and OIH unit prices to their support levels, which would provide low-risk entry points.  For OIH, a move to US$143 first to confirm the breakout would improve that ETF’s technical outlook.

Disclosure: I don’t currently own any units of either the OIH or XLE ETFs or common shares or debt of any of the companies mentioned in this article.

Or did investors come to believe that the natural gas price is a runaway train on a dead end track?

Despite a natural gas injection this week (52 bcf) that was smaller than forecast, and quite a bit less last year’s 88 bcf injection (and less than 5 year average injection of 64 bcf), natural gas prices tumbled.

Investors focused on natural gas inventories inching closer to being full. The  fear of natural gas companies having to shut in production en masse, in the near term, took over sentiment.

While the natural gas price tumbled, natural gas stocks, however, did not. The Amex Natural Gas Index was up almost 1%.  That has me intrigued.

Negativity hit a new high today on natural gas.  Look at the volume on the ETFs in the US and Canada.  UNG-NYSE traded had its biggest volume day in two months and set a new low.  Investors were clearly voting with their feet and walking.  In Canada, the Betapro Horizons 2x leveraged natural gas long ETF, symbol HNU:TSX,  had record volume and dropped 10% to dip under $3/share.

These are good indications of capitulation, which is “a volume surge after an extended decline reflects a selling climax or capitulation that exhausts selling pressure”, according to www.stockcharts.com.

 But of course, it could get worse.  Calgary-based, First Energy Capital Corp. Analyst Martin King, was quoted in a Reuters story today saying “This is the precursor to a bit more of a pullback down into the $2.25 to $2.50 range. Producers have to carve back supply, otherwise it’s going to run into a big wall come late September.” 

For me, this is the beginning of opportunity.  The next 6-10 weeks should bring some of the natural gas stocks I have been tracking into buying range. 

Subscribers will be kept updated on any new portfolio purchases.  The most recent purchase has a natural gas play that one analyst showed as having one of the best economics of any play I have ever seen.  I bought shares in the company for its new oil discovery and debt free balance sheet, but once the natural gas price moves up, it will be one of the most highly levered companies – as a low cost producer.

By Brian Hoffman, CA, CPA

Oil prices have made a big move up since March with the recent move to almost US$73 per barrel retracing over a third of the drop from the US$147 peak last summer to the low of almost $US30 earlier this year.

Retracements during market rallies generally recover anywhere from a third to two-thirds of the price drop, so oil prices could run-up as far as US$110 in the near-term before facing serious resistance. 

However, there are several resistance levels that oil prices need to break through, particularly at US$78, US$88 and US$100, for the rally to continue.  As shown in the chart below for light crude oil, the 50-day exponential moving average is about to cross above the 200-day exponential moving average – this is called a golden cross - which is bullish.

Oil prices have outperformed the share prices of oil companies in recent months and further oil price increases could continue to outperform.  Since March, oil prices have gained 93 per cent to their recent peak (see chart for light crude oil prices above), which compares favourably to the gains experienced by the Energy Select Sector SPDR Fund (XLE-NYSE, US$48.05) and the iShares CDN S&P/TSX Capped Energy Index Fund (XEG-TSX, $16.65). 

The XLE and XEG exchange-traded funds (ETFs) gained only 53 per cent and 62 per cent to the height of their recent peaks, respectively, with the XEG ETF receiving additional returns in U.S. dollar terms from Canadian dollar strengthening this year (see charts below).

As I marked on the chart, oil prices could potentially move down to the US$56 support level if the Relative Strength Index (RSI) uptrend line is breached (see bottom panel in the chart above).  RSI is a momentum indicator, or oscillator, that measures the relative strength of a security against itself. 

Alternatively, oil prices could break through resistance at US$78 if the RSI uptrend line remains intact.  I am holding my oil stocks for now, but watching this indicator closely.  I will likely sell some individual positions once this RSI uptrend line is breached.

The XLE ETF’s trend lines for price, On Balance Volume (OBV), which measures the general buying and selling pressure on a security’s price, and RSI have all broken down with the price trend line breach occurring first, which is unusual.  In any event, the technical outlook for the unit price is bearish for now.

The XEG ETF’s trend lines for OBV and RSI are close to breaking down, although the price uptrend line has already been breached.  Similar to the XLE ETF, this situation is unusual and the technical outlook for the unit price is bearish for now.

An affordable way to participate in future oil price movements is through the United States Oil Fund, LP (USO-NYSE, US$38.74), which is an ETF that tracks the performance of oil prices.  Since March, this ETF has gained 82 per cent to its recent peak (see chart above), which is not as good as oil’s 93 per cent gain, although the oil price gain does not reflect transactions costs.

The USO ETF is facing technical difficulties similar to the XLE and XEG ETFs, at least in the short-term, as the OBV and price uptrend lines have broken down, the RSI uptrend line is close to breaking down and there is resistance at US$40.  A safer entry point to buy the USO ETF may present itself if oil prices break down and successfully test the US$56 support level mentioned above.

The USO ETF may test its support at about US$32 (see red line in chart above), which would provide a lower risk entry point for investors interested in participating in oil’s potential ongoing outperformance of oil stocks.

Brian Hoffman, CA, CPA, is an affiliate of the Market Technicians Assoc. and a member of the Canadian Society of Technical Analysts (E-mail: bk.hoffman@rogers.com)

Could the natural gas ETF (UNG-NYSE) lose its tracking of natural gas prices?  In one very specific (and quite realistic) circumstance, it could.  And could it possibly skew the real, physical price of natural gas in the US?  Many people say it is doing that right now, which is open to debate.

As background, the volume in UNG has gone from 1,000,000 shares a day six months ago to almost 100,000,000 a day this month – peak volume being 96 million on June 11.  It has become very popular, as millions of retail and institutional investors see the current $3.75/mcf as unsustainable; it must rise to some higher level to meet the cost of production.  Most research analysts say this is between $6-$8/mcf.

The only question is, how long will that take – weeks, months, or quarters.

When all that volume comes into the fund, the fund manager takes that money and issues more units of its fund to match demand so that the Net Asset Value (NAV) of the fund does not change.  As volume decreases, they can redeem units.

When I called the fund Tuesday June 23, the customer service person said the fund (via its charter or bylaws) is allowed to issue up to 400 million units.  At its peak on June 11, the fund had issued as many as 285 million, and had never issued more than 20 million units in a day.  That day it had 258 million issued.

So theoretically, if the physical natural gas price did start to perk up, it could cause a massive trading rally in UNG, and in just a few short trading days the fund could be out of units to issue. Then we have a classic supply and demand situation where the supply runs out – no more units can be issued – and demand is steady or higher.  The price of UNG must then go up, more than the price of gas or even if the natural gas price doesn’t move.  Think of it as a short squeeze in reverse. 

In this instance, the NAV of the fund would be greater than the natural gas price until such time the volume decreased so that the fund had less than its maximum 400 million units issued.

How likely is this? I don’t know.  It would take a lot of consistent volume.  But UNG does attract the volume, as everybody is seeing it as the no-brainer trade of the year, especially as the number of rigs drilling for gas has been cut in half in the last year.  That will eventually start showing up in lower weekly gas injections.

The fund itself freely admits it can “lose track” with the natural gas price – see this note from its fact sheet “There is the risk that the changes in the price of UNG’s units on the NYSE Arca will not closely track the changes in the price of natural gas. If these correlations do not exist, then investors may not be able to use UNG as a cost-effective way to invest indirectly in natural gas or as a hedge against the risk of loss in natural gas-related transactions.”

To combat this from happening, the fund’s manager has asked the US regulatory body for securities, the SEC, to increase the number of shares they can issue to 1 billion, from the current 400 million.   The SEC is still considering the matter.  Reuters reported on June 24 that several fund managers were against the increase, as they saw it as increasing speculation in commodity markets. 

The head of the CFTC (Commodity Futures and Trading Commission) in the US was on Canadian TV this week saying they are aware that several funds or ETFs were over their limit in the number of contracts they could buy (whatever that means) and they were looking into it. ( He looked very serious and I’m sure he meant every word.)

Does the ETF affect the physical natural gas price?  Many people on the web say UNG is already impacting the market, by purchasing more contracts of natural gas than otherwise would ever happen, propping up current front month prices.

There is a good story on this issue from June 25: http://tinyurl.com/neayvn

I spoke to one ETF manager about this who basically said there really is no way of knowing whether natural gas would be $2/mcf if it wasn’t for the ETF buying.  

I do not own UNG .

(An ETF, or exchange traded fund, is a security that tracks an index but trades like a stock.)

The two charts tell us that despite all the bearish fundamentals for natural gas in North America (and there are lots!), the time to buy UNG is very near.  The chart for the Canadian natural gas ETFs (GAS-TSX, HNU-TSX) tells the same story.

In February of this year, when everyone thought oil was going to stay at $40-$45 per barrel throughout 2009, the ETF for oil in the US, USO-NYSE, bottomed.  Its downward momentum was matched almost exactly with a rising crescendo of volume from investors.  The ultimate low was still a couple weeks away, but as soon as the volume started to subside, the ETF tracked higher. 

UNG-NYSE and GAS-TSX are now showing signs of going through the same tell-tale crescendo of volume.  This would indicate that investors believe the natural gas price in North America has bottomed, or is very near bottom.

There are several bullish fundamental factors for natural gas. 

 1)         The most compelling is that the number of rigs exploring for natural gas in the US is down 50% from last year at this time, at 700. Industry analysts are predicting a sharp drop in supply resulting from this.  I wrote in an earlier article that oil and gas specialist Tristone Capital out of Calgary is expecting a 7 bcf/d (billion cubic feet per day) drop in production in the US by late spring 2010.  This would be a huge drop.

2)         Combine this with any increase in industrial demand and the table is set for significantly higher prices.

3) An increasing number of experts are explaining how the real, all-in, cost of production, including land costs, are $7 – $9 per mcf (million cubic feet), and twice the price of natural gas right now. Investors who don’t think this can continue should remember the phrase “the markets can remain irrational longer than investors can remain solvent.”

But there are several bearish factors for natural gas prices as well. 

1) New shale and tight gas plays in the US and Canada continue to prove up huge supplies of low cost natural gas, lowering the break-even price for operators.

• 2) The amount of gas going into storage is almost at record levels – and the rate of injection increases this year over the 5 year average is going up, i.e. demand destruction is still outpacing supply destruction – by an increasingly wide margin. Not by a narrowing margin. Yet. (This is what the bulls are waiting for – watch natural gas stocks scream upwards when that dream becomes reality.  The market thought they had a sniff of that yesterday & took natgas stocks higher, even though the actual number was bearish.)

3) The fast growing, low cost Liquid Natural Gas (LNG) sector is a wildcard. It could swamp North American shores as a cheap source of supply or it may miss here completely and end up in Asia or South America.

Almost all research analysts and the talking heads on business TV say natural gas prices will continue to go down through August, and then begin to rebound.  How big the rebound is, is where opinions begin to differ.

These ETF’s are strange creatures in that stocks inherently track the future, they track expectations of financial picture 6-9 months from now. Yet ETFs track indexes that are based solely on current prices.  I think the only way you can see the future in an ETF is by the volume. And that’s what makes the natural gas ETFs so intriguing right now.

If and when I buy a natural gas ETF, I will buy the GAS:TSX.  For my American audience, if gives you a Canadian dollar denominated security, which is good if you think the US dollar will continue lower.  Second, I prefer it over the HNU:TSX ETF by Horizons Beta Pro.  GAS-TSX has no leverage, and does not reset itself every day, and I believe it more accurately tracks the commodity price.  Remember that GAS:TSX tracks the Canadian gas price out of Edmonton, AECO, which can be found at www.ngx.com.  It does not track NYMEX.

By Brian Hoffman, CPA, CA

Natural-gas prices have shown some strength recently, piggy-backing on higher oil prices.  Although last week’s higher than expected gas storage update is bearish in the short-term for natural-gas prices, the longer term outlook bodes well for significantly higher natural-gas prices.

Although oil prices will also probably pull-back from the recent run-up with the technical outlook turning bearish in the short-term if oil prices breach the US$50 support level, oil prices are likely to remain strong in the years ahead, which will help to support natural-gas prices.

Despite the current over-supply of natural-gas, the supply-demand situation is likely to achieve equilibrium over the next two years that will support higher long-term natural-gas prices.  Supply has increased substantially primarily due to reduced industrial demand during the recession and a warmer than usual winter in the north east U.S.  However, many natural-gas exploration and production companies have reduced their drilling plans for 2009, which will result in less gas going into storage over the next two years.  The supply-demand fundamentals are expected to improve considerably when industrial demand starts to pick up in light of reduced drilling.

The energy equivalency of natural-gas compared to oil is generally 6,000 cubic feet to one barrel of oil, and the price for 1,000 cubic feet (1 Mcf) will generally trade for one-sixth of the price for one barrel of oil during normal times.  As you are well aware, we are definitely experiencing anything but normal times in the current environment.

Over the past two years oil has traded for about 10 to 12 times the price of natural-gas.  With current prices for oil at about US$61 per barrel and natural-gas at about US$3.40 per Mcf, the ratio is almost 18 to 1.  Natural-gas prices stand to benefit from closing the gap in pricing relative to oil prices.

Natural-gas prices have spiked twice in the past four years and accompanied spikes in oil prices – in 2005 after hurricane Katrina hit Louisiana and during last year’s run-up in prices.  Another price spike could occur when the supply-demand outlook improves.

An opportunity to benefit from a recovery in natural-gas prices, particularly a price spike, is through the United States Natural Gas Fund (UNG: NYSE, $13.70), which invests in near-month natural-gas futures contracts.

In the chart below note the significant downtrend in the price of UNG over the past year.  The downtrend is still intact but the price is ripe for a breakout later this year, which could set the stage for a significant trend reversal.

UNG-NYSE Natural Gas ETF

Over the past few months UNG’s chart has formed a right-angled broadening formation, which is an accumulation pattern.  A buy-signal will be triggered if volume expands on a breakout above the top line in this formation, which is at about US$18.  A breakout will be confirmed if the price moves 10 per cent above this top line – to about US$20.

A subsequent pull-back towards the top line of the formation, which would become a new support level, would offer a low-risk entry point.  Although the gain from US$13.70 to US$18 is foregone, the US$18 entry level after a pull-back would reduce the risk of the investment considerably.  Also, breakouts from these consolidation patterns are generally followed by substantially price increases, so the potential increase from the US$18 level is enormous.

Inflation is pending in the U.S. with the government “printing” money to save its economy.  The U.S. dollar is expected to weaken relative to other currencies, including Canada’s petro-currency, and commodities – particularly oil and gold – are seen as hedges against inflation and a considerably weaker U.S. dollar.  As a result, investors need to consider that higher commodity prices in U.S. dollar terms will likely be impacted by a weaker U.S. dollar.

In any event, the outlook bodes well for natural-gas prices beyond 2009 and UNG provides investors an opportunity to benefit from a recovery in natural-gas prices.  The potential for the price discrepancy to close between gas and oil prices adds to the appeal of this investment opportunity.

Brian Hoffman, CA, CPA, is an affiliate of the Market Technicians Assoc. and a member of the Canadian Society of Technical Analysts (E-mail: bk.hoffman@rogers.com)