December 13, 2014 Oil Trick Or Treat

Risk/Reward Vol. 246

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

“Now won’t you treat me, baby
I’ve been tricked so many times before
I can’t wait til Halloween to find out
If it’s trick or treat.”---lyrics from “Trick or Treat” sung by Otis Redding

“Now is the time/The time is right
We’ve got no reason to wait/Let’s do it tonight.”---lyrics from “Now Is The Time” sung by The Jefferson Airplane

“I go up/I go down
I go crazy/When you’re around.”---lyrics from ‘Up and Down” sung by The Pet Shop Boys

Eurozone deflation fears and domestic prosperity have been two of the three drivers of stock market performance for the past month. This week, however, both took a back seat to the third driver---the decline in the price of oil. On Friday, the price of domestic oil (WTI) fell below $58/barrel for the first time since the recession of 2009. Until this week, lower oil prices have been a boon to stocks (other than those in the oil patch). But, this week oil prices sank so low, so fast, many have come to believe that they are a harbinger of slowing economic growth worldwide and that they could lead to the collapse of oil dependent economies. Bears took control of the markets with the Dow falling 678 points (3.8%) and the S&P falling 73 (3.5%). So what DO lower oil prices mean? Are they a “trick or a treat?” I do not know. I DO know that “I’ve been tricked by oil prices many times before” and as a consequence I am out of the sector at present. That said, I doubt that we will have to “wait til Halloween to find out.”

Several subscribers contacted me this week to inform me that they believe “Now is the time” to start buying oil company stock. One is so convinced that “the time is right” and that “we’ve got no reason to wait,” he sold a substantial position in Apple (AAPL) (which he had held for years) and purchased Chevron (CVX) which hit a 52 week low on Wednesday. He views CVX’s decision, announced this week, to slash next year’s exploration budget as a shareholder-friendly move. Moreover, he likes being paid a 4% dividend while he waits for the stock price to recover. Other subscribers are buying Conoco and Shell. One of my fellow preferred stock devotees initiated a position in MHRpD which I have held from time to time over the years. It is trading so low that it yields a double digit return amortized monthly. Both of us saw MHR’s (Magnum Hunter) CEO on “MadMoney” where he made a compelling case that MHR should no longer be considered an oil play. Ninety percent of its revenues are from natural gas, and it can remain profitable so long as natural gas trades above $2.50/mmBTU. Natural gas currently trades at $3.70/mmBTU.

If oil drove the markets this week, news from the December meeting of the Federal Reserve will dominate next week. According to Jon Hilsenrath of the Wall Street Journal (see Vol 236 www.riskrewardblog.blogspot.com ), the Fed will consider dropping its assurance that short term interest rates will stay near zero for “a considerable time.” This would signal a rise in those rates in mid-2015. If the Fed retains that assurance, short term rates are likely to be zero bound until the fall of 2015 or after. So, if the assurance is dropped, what impact would it have on longer term rates including the rate on the bellwether US 10 Year Bond? Will longer term rates “go up/go down/or drive me crazy by going around?” As noted in earlier editions, the power of the Fed to affect longer term rates has diminished in recent times due to the persistence of low rates paid on comparable securities throughout the rest of the world. In the global bond market, given a choice, why would one own a German 10 Year Bund paying 0.68% or a French 10 Year bond yielding 1% when one can own a US 10Year yielding 2 to 3 times as much--- even at Friday's closing yield of 2.10%? Moreover, there are direct relationships between the price of oil and the rate of inflation, and between the rate of inflation and the yield on government bonds. Thus, if the price of oil continues to drop, the yield on bonds likely will continue to fall---at least according to newly crowned Bond King, Jeffrey Gundlach ( see Vol. 235 www.riskrewardblog.blogspot.com ). Gundlach opined this week that the yield on the US Ten Year could dip below 2% if the price of oil falls below $40/bbl. This would enhance the value of the interest rate sensitive portion of my portfolio.

Although I resisted buying oil stocks this week, the conviction shown by several subscribers is tempting me to re-enter the sector once a turnaround is confirmed. I am holding a lot of cash and am itching for an opportunity to profit. Last year, I bought preferred stock and municipal bond closed end funds when they were down---and to great advantage. Maybe oil is THE play as we head into 2015. When that sector does recover (and it will), I do not want to be singing Otis’ refrain:

“I was sittin' on the dock of the bay
Watchin' the tide roll away, ooh
I was just sittin' on the dock of the bay
Wastin' time”