Short Squeeze Ahead

Jim Brown
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The massive selloff in oil and energy stocks has prompted many traders and hedge fund to short energy equities as well as crude oil. News at the close today could upset their plans.

Crude prices plunged today with WTI closing under $75 and a five-year low. There were no headlines responsible for the decline although several were blamed. The most likely reason was the expiration of the December Brent futures contract on Friday. This contract had high open interest and apparently everyone rushed to close losing positions at the last minute.

This could also have been a last frantic plunge as a result of margin selling. When commodities go down they incur margin calls along the way. Close the position or put up more money. I am sure there were plenty of fund that bought the dip thinking oil would rebound and then bought it again at a lower and then bought it again, etc. Eventually their emotions overload their accounts and the margin calls on an ever growing pile of futures contracts finally force capitulation. Everything is sold to stop the bleeding.

Commentators tried to blame the drop on Mexico buying put hedges at $74.60 back in September. Sorry, not a factor. They tried to blame the EIA news that U.S. production topped 9.0 mbpd for the first time in 28 years. Sorry, that was only 34,000 bpd higher than the prior week and anyone that watches the market reports every week has known that was going to happen. Any smart investors already knew about it before it happened. I am sure there were some low information investors out there that were surprised by the commentators making a big deal out of it on TV but they were hardly a material force in the selling.

There were just as many news headlines about how badly OPEC countries needed the price to rise to make their budgets and why there should be a production cut at the November meeting. Those were ignored. Bad news captures attention not good news that does not fit the narrative.

Oil corrections ALWAYS overshoot and are normally followed by decent rebounds once there is an event to halt the slide. This is a classic overshoot because the supply demand story has not changed that much. China may not be growing as fast but 7% growth is still strong. Europe may be flirting with recession but business is still being conducted.

OPEC says the market is over supplied by 1.0 mbpd. However, the dramatic decline in global fuel prices is going to cause a huge spike in demand. I paid $2.46 a gallon in Denver today, which included a few cents off from a loyalty card but I filled that tank to the very top and I am sure everyone else was doing the same.

A few weeks ago Goldman said the drop in gas prices would probably boost demand by 500,000 bpd. That was $10 or more higher on oil prices than we are today. The longer fuel prices remain this low the faster demand will build. I would not be surprised if demand rose 1.0 mbpd over the next three months. Surprise! Supply and demand will be back in balance. If OPEC announces a production cut on the 27th of even 500,000 bpd we could see prices back at $90 or above by the end of the year.

I teased in the headline about a short squeeze. Here it comes. News broke just before the close about Halliburton (HAL) and Baker Hughes (BHI) in merger talks for HAL to acquire BHI. Baker Hughes shares rallied from $48.65 to $61.03. That is great news for Baker Hughes but it is also good news for energy investors.

With energy stocks so oversold and heavily shorted it will be a race to find the next stock to be acquired and a race to cover those shorts so nobody else ends up on the wrong end of an acquisition story. Nobody wants to be on the wrong end of a candle like the one below.

I wish I had the answer for everyone today. Which five stocks are going to be acquired before the end of December? If you knew that it would be the last five trades you ever made because you could retire in January.

Nobody knows and but that is not going to stop everyone from speculating. It is just possible that instead of trying to decide which energy stock to short next week that the hunt will be for the energy stocks to bet on for an acquisition. That could turn the energy sector around and possibly give the broader market a boost too.

With oil prices at $75 a lot of companies are going to be cutting capex spending. If oil prices drop to $60 one major bank said they expect 30% of the drillers to default on obligations. That is a scary thought but it shows you how much everyone is leveraged to higher oil prices. The companies with assets but not enough cash to drill them will be the ones on the auction block first.

The BHI/HAL news shows you it does not have to be a small company to attract a bidder. BHI has a market cap of $26 billion and HAL $46 billion. We heard today that GE was looking to pick up some more companies in the oil service sector. While I doubt they will be a competing bidder on BHI there are plenty of smaller niche companies they could target.

Opportunity is everywhere in the energy sector. It is a bear market and that is when deals get done. They say buy when there is blood in the streets. WTI under $75 would qualify as a bloody event for energy investors.

Jim Brown

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