It’s been an exciting couple of weeks in the markets. May started with the death of Osama bin Laden, the U.S. regained some lost swagger and the greenback caught some wind in its sails.
Last week we saw those investors in the overcrowded anti-dollar “carry trades” rushed for the exits. Monday it was silver. Tuesday it was energy stocks. Wednesday it was emerging market stocks. Thursday it was copper and crude oil. Friday it was the euro and European stocks. It was like watching a train derail in slow motion.
Aside from silver, crude oil was the biggest casualty. After flirting with $115 on May 1, crude oil plunged to a low of $94.77 last Friday — a loss of nearly 18%. Energy stocks suffered as a result, with the Energy SPDR (NYSE: XLE) making a peak-to-trough drop of 9% before rebounding slightly over the last two trading days.
Will oil prices — and by extension energy stocks — continue to fall?
Much depends on the path of the dollar. This, in turn, depends on the fate of the euro zone and efforts to restructure bailout packages for Greece and Ireland. Yesterday, Standard & Poor’s cut the credit rating of Greece on increased risk the country will be forced to default and restructure its debts.
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As for the energy supply and demand situation, the team at Capital Economics believes that the civil war in Libya and unrest elsewhere in the Middle East has added a $30 risk premium to crude oil. They expect this premium to fade as the Libyan crisis eases.
Moreover, there is evidence that higher prices are resulting in lower demand, putting downward pressure on prices. Indeed, Saudi Arabia has reversed its earlier decision to raise output to compensate for lost production from Libya.
There also remains a disconnect between European Brent crude and American West Texas Intermediate due partly to high oil stocks in the United States. This suggests that crude shortages caused by Middle East turmoil are mainly impacting European refineries that focused on processing sweet light Libyan crude.
Overall, Capital Economics is looking for crude oil to drop to $90 a barrel by the end of the year as “the dollar continues to rebound, and the risk premium due to unrest in the Middle East eventually fades.”
With this in mind, I recommend short energy and commodities positions to my newsletter subscribers. These include the ProShares UltraShort Oil & Gas ETF (NYSE: DUG), which returns twice the daily inverse return of the Dow Jones U.S. Oil & Gas Index. As for individual short positions in the sector, I think Anadarko Petroleum (NYSE: APC), Talisman Energy (NYSE: TLM), and Atwood Oceanics (NYSE: ATW) are all worth a closer look.
Disclosure: Anthony has recommended the UltraShort Oil & Gas (DUG) to his newsletter subscribers.
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