Five Reasons For ETF Investors To Worry About Oil Prices (DIG, DUG, USO, SCO, OIH, ERY, ERX)

Sean Brodrick:  It’s funny — but not ha-ha funny — that oil prices are creeping higher even as the U.S. economy appears to be slowing down.

There’s a good reason for this: Almost all the global economic growth is coming from outside the United States, and this is leading to greater oil demand.

The United States may still be the world’s largest oil consumer, but our oil demand is growing more slowly than demand in places such as India and China. We are a smaller piece of the pie all the time.

We saw oil prices pull back into June, then head back to $100 recently. Will oil and gasoline prices go higher or lower?

Looking at a chart, you can see that crude oil pulled back sharply into June, then bounced higher. That pullback went down to test a 50% retracement of the move from March of 2010 through the high we hit this past April — a classic correction in a bull market.

Now, we’ve seen oil try to move above $100 and fail. Could we see oil go down and test that June low again and head lower, or is the bull market intact?

Let me tell you about five forces I’m watching in the market — forces that should have both bulls and bears sitting on the edges of their seats. And there’s one wild card that figures in as well.

Force #1: The IEA’s Oil “Experiment”

Last month, 28 members of the International Energy Agency (IEA) agreed to release 60 million barrels of oil into the market. That’s the primary driver that sent crude down to its June low. But it takes a while for that oil to be delivered. 

In the United States, some 30.64 million barrels were sold from the Strategic Petroleum Reserve, and some 8.7 million barrels of that is starting to show up right now and should be delivered through the end of this month.

However, oil prices recovered quickly from the IEA’s oil sale, and the IEA says it won’t repeat that kind of release. So, continued deliveries of the IEA oil should suppress market prices in the short term by pumping up commercial inventories. But the lack of follow-through is probably bullish.

Force #2: Signs of Global Recovery

The U.S. economy is slowing down and should continue to slow down if Washington comes to a budget deal that slashes hundreds of billions of dollars a year in government spending. But other global economies are growing, and their oil demand is growing with it.

China’s GDP grew 9.5% in the second quarter — above estimates. And China’s apparent oil demand climbed 0.5% in June compared with the same month a year ago. Meanwhile, India’s economy is growing at a respectable 8.5% clip.

Elsewhere in the world, the United Nations recently forecast that Latin America’s regional economy will grow 4.7% this year.

And Europe has come to a deal which has papered over the problems in Greece. I don’t think it’s a real solution, but the market is buying it. That raises business and consumer confidence in the euro zone.

Other countries are run by politicians who are focused on growth and jobs rather than apocalyptic, manufactured debt showdowns. They are the drivers of new global oil demand.

Force #3: We’re Heading Into Peak Hurricane Season

The killer drought in the Southwest has grabbed investors’ attention, so few are focusing on hurricanes, especially because hurricane season was a bust last year. 

In 2010, only Bonnie made direct landfall in the United States. Alex plowed into Mexico, as did Hermine. Earl passed just to the east of Cape Hatteras, N.C. Nicole chugged through the waters of the Florida Straits with minimal impact on the United States. All these near misses made people complacent.

Now here we are in 2011. The oceans are getting warmer as we are heading into August and September, peak hurricane season.


Source: Accuweather.com

Recently, Weather Services International forecast 15 tropical storms for this season, with eight of those growing into hurricanes, and four of those becoming major hurricanes.

But other forecasters say ocean heat and a developing La Niña could give us a longer, more vigorous hurricane season.

For example, Commodity Weather Group recently told Reuters it expects nine hurricanes, including five major hurricanes, and at least one major hurricane in the Gulf of Mexico. The Colorado State University team, which has been very accurate in the past, comes up with similar numbers.

The real determination of a bad hurricane season or not really comes down to where the hurricanes hit. If a major hurricane rips through “energy alley” in the Gulf of Mexico — the source of 1/3 of U.S. domestic oil production — that could send prices higher in a hurry.

Force #4: Pain at the Pump

The U.S. Energy Information Administration (EIA) forecasts U.S. gasoline prices will average $3.56 a gallon in 2011. The bad news is that’s up from $2.78 in 2010. The really bad news is the U.S. national average gasoline price was recently $3.694 per gallon. The EIA seems to be behind the curve.

The really, REALLY bad news? Every 10-cent increase in gas prices equates to an additional $14 billion a year out of consumers’ pockets. Higher gasoline prices cut off economic recovery.

What this means is that a sure cure for higher gasoline prices could be higher gasoline prices. But that comes at the price of a worsening economy, and that’s not a price that anyone wants to pay.

Force #5: Global Demand Keeps Climbing While Supply Is Squeezed

The IEA forecasts that the world will use 89.5 million barrels per day. Looking forward, the IEA forecasts the world will use 91 million barrels of oil per day in 2012, an increase of 1.5 million barrels per day.

So we keep using more and more oil. Two problems with that: One is that while there is more oil to be produced, it’s increasingly harder to find.

The Deepwater Horizon disaster is a perfect example of this. You don’t drill 35,000 feet into the seabed (for comparison Mount Everest is 29,029 feet) if the easy stuff is still to be had.

Secondly, major oil-producing nations are using more of their own product. For example, in the early part of the last decade, Saudi Arabia burned less than 200,000 barrels per day (bpd) on average. By 2009, it consumption climbed to more than 450,000 bpd.

The total Saudi domestic energy demand is expected to rise from about 3.4 million bpd of oil equivalent in 2009 to approximately 8.3 million bpd of oil equivalent by 2028 — a growth of almost 250%. That makes the Kingdom the second-biggest source of global oil demand growth after China.

Every barrel of oil that the Saudis use for domestic consumption is one less they can sell to the world. This is a long-term bullish force in oil.

The Wild Card: The Debt Crisis

This isn’t so much a force as an obstacle. You probably know that President Obama and the Republicans in Congress are battling over the debt ceiling.

The longer this crisis goes on, the more it eats away at the trust investors have in the U.S. government — and the trust they have in the U.S. dollar.

Since oil is priced in dollars, they usually (not always) move in opposite directions.

You can see how the dollar is probably going to test support from April. The question that has me stumped is what happens to the dollar and oil next.

If the debt ceiling is successfully resolved, that should be dollar supportive. But that would also remove some uncertainty from the market, potentially kicking the economy and oil prices into higher gear.

If the debt ceiling isn’t successfully resolved, and the U.S. government is forced to start defaulting on select debt, that should send the U.S. dollar lower. But it will probably put even more pressure on an already uncertain economy and market.

So I’m watching the dollar and oil very closely as Washington battles it out.

How You Can Play Oil’s Next Big Move

Maybe, after reading all this, you think that crude oil is going lower. If so, you might want to check out the ProShares Ultra Short Oil & Gas fund (NYSE:DUG). It aims to track twice the inverse of a basket of leading oil industry stocks, stocks that are leveraged to oil. If those stocks go lower, DUG should go much higher.

If you think that oil is headed higher, you might want to check out the ProShares Ultra Oil & Gas (NYSE:DIG). It targets twice the move in that same basket of oil industry stocks, only in a positive direction. If oil and oil industry stocks are going higher, this should make the most of that move.

Whatever you do, be careful, and make sure you know what price you’ll sell anything you invest in before you buy it. Protective stops and profit targets are just common sense in such a volatile market.

Related ETFs: United States Oil (NYSE:USO),  ProShares Ultra Oil & Gas (NYSE:DIG), ProShares UltraShort Oil & Gas (NYSE:DUG),  ProShares UltraShort DJ-UBS (NYSE:SCO),  Oil Services HOLDRs (NYSE:OIH), Direxion Daily Energy Bear 3X Shares (NYSE:ERY), Direxion Daily Energy Bull 3X Shares (NYSE:ERX).

Good luck and good trades,

Written By Sean Brodrick From Money And Markets

Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Nilus Mattive, Claus Vogt, Ron Rowland, Michael Larson and Bryan Rich. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Andrea Baumwald, John Burke, Marci Campbell, Selene Ceballo, Amber Dakar, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.

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