May 12, 2008
Energy Exuberance
Commentary from Frank Holmes, CEO and chief investment officer
Oscillators allow our investment team the ability to track the movement of a stock or commodity through price and time and are based on the concept that prices move in waves.
The high and the low movements of the oscillator signify the overbought and oversold levels of stocks and/or commodities over different time periods. This helps investment professionals manage risks and opportunities and as we like to say simply “better manage expectations with a probability model.”
As you can see below, we like to examine the quarterly or 60-day rate of change to the longest period of data with year-over-year percentage changes to create a stronger contextual perspective.
The oscillator helps us determine entry and exit points better. Seldom would we sell 100 percent of a position based on such a tool. However, overlapped with fundamental analysis, we can better anticipate before we participate in investing cash or taking partial profits off the table.
Below is an analysis of oil over two different time periods. Bottom line: Oil is overbought and due for a correction. With all the talk in the media about $200 per barrel oil and sentiment rising with a substantial increase in oil options, we like to be contrarian. We also like to apply different statistical tools to measure the probability of an “overbought” condition to manage our contrarian thesis.
We are active money managers and we apply a matrix of statistical tools and fundamental screens to guide us in our investment decisions.
Many years ago when oil was $30, we suggested that oil could trade over $100 per barrel and we were laughed at. Today, with oil at $125 per barrel, some of the old skeptics are now soothsayers calling for $200 per barrel.
We have always believed oil would have to trade at higher prices and the compelling driver of the 1970s (an OPEC embargo against the U.S. and Europe) would not be the significant factor this cycle.
Why? In 1970, both China and India were basically massively populated, extremely poor nations and isolationists. Today is very different. Today, “Chindia” represents about 40 percent of the world’s population, their economies are growing at 10 percent a year and they are global players in the world economy. Today, both countries have embarked on long-term sustainable infrastructure spending and urbanization and this is significantly different from the 1970s.
With strong economic policies for growth, the demand for oil remains very strong. In March 2008, it was reported China’s year-over-year oil demand was up 16 percent and India was just shy of a 10 percent increase in demand for oil imports.
So long term, we believe oil can trade at higher prices and short term it is due for a correction. So let’s try to put the risks and opportunities in context by comparing the price patterns for oil over a 20-year span and a 5-year span.
Looking at illustration one, the chart shows the average price of oil for the past 20 years at $30.14. The year-over-year oscillator, which is a measure of volatility, suggests that oil prices are up 2.51 Sigma over 60 trading days. In other words, this rapid rise over 12 months has only happened 5 percent of the time and we have over a 90 percent chance for a correction over the next 12 months.
And for a shorter perspective, the average price of oil for the past five years is $58.56 and a 60-day rate of change shows oil to also be overbought and this has happened only 5 percent of the time.
In other words, the odds favor for whatever reason, oil prices will correct $20-$35 per barrel over the next 60 days, before oil rises again. However, if Israel or the U.S. bombs military bases or nuclear research facilities in Iran, we could get another five Sigma event, but we believe at this moment this risk is remote.
As active money managers we regularly assess the price risk based on both sentiment and fundamental analysis. We would be cautious in the short-term when buying oil stocks because of the consensus it will quickly rise to $200 per barrel, but remain focused on highly undervalued oil stocks with our cash. Long term, however, we believe oil could easily trade at $200 per barrel.
All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.