Posted February 26, 2011

The recent rally in crude oil due to Middle East tensions has been extraordinary. As the chart below shows, crude oil has rallied 16% in the last 11 days.

CFTC Commitment of Traders Report

The amber line shows the price of crude oil while the white line shows Managed Money net longs for crude oil futures.

As can be seen, Managed Money net longs are the highest they have been in the past 5 years, and more than 100,000 contracts higher than when crude hit its all-time high of $145/barrel in July 2008. Furthermore, Managed Money longs increased more than 25% in the last week alone.

To us, the explosion in Managed Money speculation to the upside is a cause of great concern for crude oil bulls. While events in Egypt, Libya and other Middle Eastern nations have been sudden and unexpected, the actual disruption to crude oil supply appears minimal to date. Managed Money and other speculators are betting huge that turmoil will persist in the region, and eventually spread to energy production.

With such a rise in crude oil already pricing in significant supply tightness, any unexpectedly good news coming out of the Middle East could cause crude bulls to rush for the exits all at once. While we remain bullish on crude in the long run due to macroeconomic fundamentals, the current surge seems a bit overdone, and we prefer to be slightly bearish on the move.

Relationship with Natural Gas

As we highlighted in our article on Thursday, the ratio of crude oil to natural gas has reached extreme levels, and is not sustainable. While we have more conviction in a strong rally for natural gas than a decline in crude oil, we do believe the pace of crude oil’s ascent must moderate.

Trade Recommendation

Since crude oil retains the possibility of rallying on further deterioration of the situation in the Middle East, a cautiously bearish strategy seems prudent. We recommend selling the June 120 calls for $1.79, or $1790 per contract. With the June crude futures contract trading around 100, the trader would profit from this trade as long as crude remained below 121.79 until May 17, less than 3 months from today.

Considering that the trade only needs crude to not rally more than 21% from current levels, the trade is conservatively bearish on crude oil in the near term. If the situation becomes aggravated in the Middle East or if crude rallies above 110, the trader could buy a June crude oil futures contract to hedge.

We are short crude oil calls, and may add to this position on another rise in crude oil prices.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Posted on February 24, 2011

Due to the recent Middle East unrest, crude oil and natural gas have become even more dislocated. As of the time of this writing, crude oil is trading around $99/barrel, while natural gas is trading at $3.842/mmbtu

From a strictly scientific standpoint, 1 barrel of crude oil should cost about 5.8 times 1 mmbtu of natural gas, because 1 barrel of crude oil has 5.8x as much energy content as 1 mmbtu of natural gas. However, for various reasons, this ratio does not hold true. The natural gas lobby in Washington is not very popular, so even though the US could be thought of as the “Saudi Arabia of Natural Gas,” our country does not really support it for political reasons. Instead, our politicians support coal and continued oil usage, while publicly claiming they want to end our dependence on foreign oil. If there was real initiative, the US could be completely energy independent, but this digresses from our real goal: analyzing macroeconomic trends to make sound investments.

The Crude Oil Natural Gas Ratio

The below chart shows the ratio of crude oil to natural gas in white, and the price of natural gas in amber.

As can be seen, aside from a brief return to reality in late 2008, from about mid-2007 onwards, the ratio of crude oil to natural gas has been extremely high. Natural gas is pretty much the only commodity in the world that has not recovered since the 2008 financial crisis, and it trades at about the same levels it traded at in 2002.

A large reason for crude oil’s outperformance is due to the global nature of the crude oil market vs. the domestic natural gas market. Since crude oil is a much more international market, it receives the same bid that precious metals receive as an inflation hedge. This phenomenon can be seen when considering that institutional investors typically allocate 1% of their portfolios to crude oil, but none to natural gas.

The last time the ratio was this high was September 2009, and natural gas proceeded to rally 138% until the end of 2009. While much of this was due to the front month expiration and contango in the natural gas curve, one still could have made 68% being long the front month contract and rolling it over each month.

Historical Comparison

The chart above shows statistics on the ratio between natural gas and crude oil over the last 21 years. As can be seen, the highest ratio seen was 26.35 in late August 2009. The ratio as it currently stands is 26.11.

Additionally, the current reading is in the 99.82nd percentile of readings over the last 21 years, meaning that it is almost the highest reading ever seen. Considering that the median reading was 9.02, the current ratio stands almost 200% higher than the median.

CFTC Commitment of Traders Report

The chart below shows the Managed Money net short position over the last 5 years.

As can be seen, the amount of net shorts from Managed Money has increased drastically in the past month to a current reading of 173,434 net short contracts. This reading is in the 5th percentile of readings over the last 5 years, and almost twice the median.

Because so many traders are short natural gas, any sustained rally off the bottom should trigger extensive short-covering. This would make a rally of 10-20% not out of the question.

Trade Recommendation

Usually when witnessing this large a disparity, I would recommend a trade to short the perceived overvalued commodity and go long the undervalued. However, because I believe in crude oil in the long-term for macro reasons, I would not recommend a short position in crude oil. Rather, I would recommend being long both, but with an overweight bias towards natural gas. Being short crude oil may provide a false sense of security as an inter-commodity spread hedge, but because the 2 commodities trade on entirely different rationales, this is not an appropriate trade.

Our recommendation is to sell puts on natural gas, as well as buy the futures contracts outright if you can stomach the volatility. Because natural gas is such a depressed and volatile commodity, put options on it are expensive, making their sale an attractive risk/reward scenario.

For example, the June 3.65 puts (expiring on May 25th) could be sold for $0.11, or $1,100 per contract. With June natural gas trading at $3.983, this means the trader would keep 100% of the premium collected as long as natural gas does not fall an additional 8.4% in the next 3 months. While 8.4% is by no means a huge cushion, considering natural gas has already fallen 14% for the year, we would think that a floor must be put into natural gas in the near future.

We continue to be short natural gas put options and long natural gas futures, and will add opportunistically on pullbacks.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Posted February 22, 2011

Much has been made of Netflix’s precipitous fall today. As readers of Seeking Alpha know, Netflix has been a hot topic of both long and short investors, with fervent argument on both sides of the tape. Since conditions have changed somewhat since we published our response to Whitney Tilson’s short NFLX article, we’d like to reexamine a trade on Netflix.

While we made 225% on the calls we purchased after reading the weak arguments made in Tilson’s short piece, we ended our long exposure when the stock was around $240, as it looked ready for a pullback. Because of the overvaluation of the stock (a well-publicized phenomenon regardless of what the short sellers may think), we would tend to want to be short the stock, but we need to wait for key pieces of data to become available before having confidence in this thesis.

Fundamentals

As has been discussed at length on this site, NFLX is trading at a high valuation using any metric. NFLX’s P/E ratio is ~75, and its P/FCF ratio is 38.09. Even though there are companies that trade at significantly higher ratios, NFLX has been a longtime target of short sellers because of its well-chronicled future struggles with costs.

Because NFLX signed their content deals at a time when the streaming business was nothing more than an afterthought, they are currently paying far below market value for their streaming content. As these deals expire and must be renewed, it stands to reason that NFLX’s costs are going to soar. The long investors’ standpoint has been that NFLX is adding subscribers and growing revenue so fast that the future hit of increased content costs will be absorbed easily. However, since NFLX now faces huge competition from both studios and other online goliaths such as AMZN and GOOG, NFLX’s costs could be rising at a time when they face more competition than they ever have before. This combination of negative events could lead to margin compression that causes long investors to finally be unwilling to pay the high multiples for the stock that they previously have.

The problem with this short thesis is that it has existed for years. The short story behind NFLX only gets stronger, yet the stock continues to rally and defy expectations. The reason for this outperformance is that there are far too many short sellers of the stock.

Short Interest

The short interest as a percentage of the available float of NFLX is the most determinative data there is on whether this stock will continue to rally.

As can be seen from the chart, short interest on NFLX stock is currently at 21.6% of the outstanding float, and has been as high as 24.1%. To illustrate just how large this is, at current levels the amount of shares sold short are worth $2.5 billion given a price of $223/share for NFLX.

As we discussed at length in our previous article, the $2.5 billion short interest in NFLX are all future buyers of the stock. Since short sellers must eventually buy the shares of the stock they are short to close out their trade, a high short interest in a stock can mean the stock is primed to rally.

What this means is that even though NFLX has rallied incredibly since January 2010 (306%), it may not be ready to fall just yet. As of the last short interest publication date (short interest data from the exchanges is only published once every 2 weeks), there were still $2.5 billion worth of disbelievers in NFLX stock. Once the amount of skeptics falls to a more manageable level, perhaps around 10%, the stock may be ready to fall.

If the next short interest data point shows that short interest has fallen drastically, a short position in NFLX may be warranted. The next short interest publication date is on February 25th, and it will show short interest on the stock as of February 14. Considering that the 14th was the peak of NFLX so far, this should provide a very good indication as to how many people are still short this name.

However, if short interest comes back largely unchanged, a short position in NFLX would be unwise. In fact, if NFLX has fallen closer to the $200 level by then, we may initiate another long position on the stock because of inevitable short covering taking this name higher.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Posted February 21, 2011

The past few weeks (and past few sessions in particular) have seen precious metals sustain a voracious rally. Last week, silver gained 7.7%, platinum gained 1.64%, palladium gained 5.28%, and gold gained 2.07%. While we are bullish on all precious metals going forward because of loose monetary policy around the developed economies, picking which metal to invest in over others is a frequent topic of debate among readers.

While we had very few direct positions in platinum and palladium, gold and silver were largely responsible for our 67% gain in 2010, and continue to power us into 2011. However, we understand that most investors lack the resources to directly invest in all of the precious metals, so they must pick one.

In the short term, we believe gold offers the best risk/reward opportunity.

The above chart shows gold, silver, platinum and palladium from October 22 until close of trading on February 18. As can be seen, gold has significantly trailed the other precious metals since they all made a short term bottom on January 28th. Similar to a “buy the laggards” theory that is usually applied to the Dow, we believe that gold presents a very good risk/reward opportunity as it will inevitably catch up to the other metals.

Fundamentals: US Manufacturing

The reasons for gold’s underperformance vs the other metals is most likely that gold’s lack of industrial use causes it to not participate in rallies based on US manufacturing/industrial strength. Taking a look at recently released economic numbers sheds light on this subject.

The ISM Manufacturing Index for January came in at 60.8 vs. an economists’ survey of 58.0, while the ISM Prices Paid Index came in at 81.5 vs. an expected 73.5 (more than 10% higher than expected). These numbers show that US manufacturing is recovering very quickly, and at an unforeseen pace.

All of this positive manufacturing data is signaling that US currency debasement is having the intended effect, to stimulate our country’s export and manufacturing sectors

The employment numbers from January also tell a similar story. While the overall Nonfarm Payrolls number disappointed greatly, coming in at a 36k job addition when 146k jobs were expected, the Change in Manufacturing Payrolls number was spectacular. In January, the US added 49k manufacturing jobs even though economists only expected us to add 10k.

All of this positive manufacturing data is signaling that US currency debasement is having the intended effect, to stimulate our country’s export and manufacturing sectors. As we discussed in a previous article, while the US dollar index has not shown widespread dollar weakness, comparing the US dollar to pretty much any resource or emerging market economy shows that the US dollar has gotten decimated.

The loss in purchasing power of the US dollar against almost every economy except the developed markets (UK, Eurozone, and Japan) means that US exports look much more attractive to foreign buyers than they did a few years ago. While Bernanke and Geithner speak publicly about defending the US dollar, they are not fools. They know that their policies are massively currency debasing, but the beauty is that they do not care. The surge in manufacturing was their goal was they undertook these inflationary policies, and that is exactly the effect we are feeling now.

Because recent economic data has favored increased industrial output instead of reflecting inflationary pressures, gold has underperformed the rest of the precious metals (even while witnessing a not too shabby rally of its own). However, going forward, gold will continue to regain luster.

Inflationary Pressures

The Fed will not tighten until they see a sustainable upwards trend in employment and housing, a phenomenon which could be a year or two away in the case of housing, and may never come for employment

The largest catalyst going forward for precious metals is that even though “real” inflation is already being felt on the streets, none has been reflected in the CPI, and no recovery has been felt in the two most important areas, jobs and housing. While we can argue that jobs and housing are in structural bear markets that will take a lot more than just loose monetary policy to reverse, it is not a point worth making, because policy makers have already deemed this the best course. And one thing you will always know about policy makers is that they will never admit they were wrong.

All this means that Bernanke and Co. have free license to print as much money as they want. While quantitative easing inflates assets such as gold and silver, it also inflates the stock market, which makes many Americans happy due to the appreciation of their retirement portfolios. The Fed will not tighten until they see a sustainable upwards trend in employment and housing, a phenomenon which could be a year or two away in the case of housing, and may never come for employment.

Trade Recommendation

These long-term inflationary pressures mean that gold will be a great performer, along with silver, platinum, and palladium. In the short term, we favor gold due to its recent underperformance against the other precious metals, but we would like to be long all four for the long-term.

We recommend purchase of gold outright and gold mining stocks to profit from the current rally. We continue to be long gold and silver futures, short gold and silver put options, and long GDX, GDXJ, SWC, and SLW. We will look to add to positions on any pullback.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Posted February 20, 2011

Precious metals were responsible for a large portion of our 67% gain in 2010 and have caused our accounts to rally aggressively in February after pulling back 0.5% in January (we’ll have to wait for full month February numbers but our average account is up more than 10% for 2011 already). However, it is always wise to be most cautious when things are going well. With that in mind, let’s take a look at the silver market for signs of where it may head next.

The past week saw silver jump from 29.995 to 32.3, a 7.7% gain. As we have long opined, silver and gold are in the midst of structural bull markets that should take them far higher in the coming weeks, months, and years.

Volume on Silver Futures and the SLV

The below chart shows silver futures and their corresponding volumes on a weekly basis over the last year.

Last week, volume on silver futures was 333,000 contracts, or about 23% higher than the 10 week moving average

As can be seen from the chart, volume on silver futures increased greatly with the rally, a good sign that investors are gaining confidence as the price of the metal increases. Aside from the low volume weeks around Thanksgiving and Christmas/New Years’, silver futures volume has been greatly elevated.

Last week, volume on silver futures was 333,000 contracts, or about 23% higher than the 10 week moving average. This larger than normal volume on silver is a positive sign that there is wide breadth in the silver rally. Generally speaking, the higher the volume behind breakout moves in a security, the more confidence can be had in that security continuing to rally.

However, since silver futures are highly leveraged, requiring only $10,400 to control $156,500 worth of silver at today’s prices, futures traders can quickly become skittish and bail, causing a correction. We need to look at the SLV in conjunction to determine whether institutional and individual investors are also participating in silver’s rally.

The chart shows that the SLV traded 135 million shares last week compared to 113 million for the 10 week moving average. This amounts to a 19% increase in volume.

Clearly, both futures traders and ETF buyers are heavily participating in silver’s rise. The increased volume behind last week’s move gives credence to the notion that the current uptrend can be sustained.

This Week’s CFTC Commitment of Traders Report

This week’s COT report shows a continuation of recent trends. The chart below shows the price of silver in gray, Managed Money net longs in green, and Producer net shorts in blue.

Even with Managed Money net long participation up 78% in the last 3 weeks, it remains more than 14,000 contracts below the peak

The last 3 weeks has seen the Managed Money net long participation increase almost 78%, a huge increase in net long positions. As we have stated repeatedly, increased Managed Money long participation is necessary to keep the silver bull market alive, as they arrive quickly and push prices around. However, the trend in Managed Money longs can be thought of as somewhat of a contrarian indicator because of the huge leverage involved in futures. As we saw in January, Managed Money can be very fickle, and bail at the first sign of trouble, but then reenter quickly once it appears the uptrend has resumed. This phenomenon is an inevitable cycle of futures markets, and the resulting volatility can be utilized to a savvy investor’s benefit by selling put options and increasing long exposure during pullbacks, but one must have the patience to wait for the inevitable corrections.

Even with Managed Money net long participation up 78% in the last 3 weeks, it remains more than 14,000 contracts below the peak set on September 28. We may see a new high in Managed Money net longs during the current surge in silver prices, so the upwards trend could continue significantly longer before pulling back.

During the same 3 week period, Producer net short contracts increased 15.5%. It is interesting that the short covering theme of the huge surge in silver late last year has reversed course even with silver hitting new 31-year highs. As we commented quite a while ago, due to the massive size of the Producer short position, it is most likely comprised of commercial bank prop trading as well as the traditional producer hedging. Because silver has displayed backwardation recently, it is entirely plausible that the recent increase in Producer shorts is due to producer selling of long-dated silver futures. While we are not of the belief that commercial short covering is the primary driver behind the silver rally, it is an interesting story to keep an eye on, and possibly more fuel for silver’s fire.

Trade Recommendation

While the large increase in Managed Money long participation could cause a short term correction if they sense trouble, the silver rally is well intact. Any correction or pullback should see a hard floor around the 26.75 level, the same level it bounced off of a few weeks ago. We would advocate selling puts at or below this level, as a return to it is highly unlikely in the near future. As has been the case, all pullbacks should be seen as a buying opportunity and should be utilized to build or add to an existing position in silver. Selling covered calls against existing silver positions is a great way to hedge a bit in case of an extended correction.

We continue to be long silver and gold futures, short silver and gold put options and long GDX, GDXJ, and SLW. We will add on all pullbacks.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.