Oil Prices May Weaken

02/06/2008 12:00 am EST

Focus: COMMODITIES

Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

Elliott Gue, editor of the Energy Strategist, says oil prices may go down in the short term as the economy softens and he suggests some ways to play it.

Although the long-term supply and demand picture is bullish for oil, a recession in the US coupled with a stock market correction or bear market will have major psychological impacts on commodity prices and related stocks.

And I do expect that in the very short term, US and EU oil demand growth could be weak. Oil demand isn’t particularly sensitive to economic growth in the developed world, and growth in developing countries is likely to remain strong.

However, there’s a risk that high prices coupled with weakening growth could slow US and EU demand at the margin; at least from a sentiment perspective, this will tend to have a negative impact on oil prices. In short, this is more of a short-term “headline” risk, but it’s worth considering.

No market moves in a straight line higher; however, the oil market moved in about as close to a straight line as I can imagine last year. Corrections in bull markets of as much as 30% or more are to be expected, especially for markets as technically overextended as oil.

I believe these factors suggest a fall in oil prices to the $70 area. Although I still suspect oil prices will average above $80 this year, this correction could feel severe at times.

These factors are behind my recommendation to short the US Oil Fund, an exchange traded fund (ETF) that tracks oil prices. I’ve also recommended you double your position in my recommended oil short.

Adding to this position is particularly important if you have heavy exposure to energy stocks. And I see more downside for oil than for energy stocks from current levels.

For those who are unwilling to play shorts, an alternative would be to purchase the US Oil Fund July 70 put options (UNASR-X). Put options gain in value as the price of the underlying security—in this case, the US Oil Fund—declines. Therefore, a selloff in oil would spell a gain for these puts.

And finally, if you’re uncomfortable either shorting the US Oil Fund or buying the puts, consider the UltraShort Oil & Gas ProShares (AMEX: DUG). This is an ETF that shows performance equal to double the inverse of the Dow Jones Oil & Gas Index. In other words, the ETF rises when oil- and gas-related stocks pull back.

There are two key points to keep in mind about this ETF. First, it’s leveraged; it will gain in value at twice the rate that the stocks in the Dow Jones Index decline in value. Therefore, it’s highly volatile.

I recommend setting a stop loss around $36 if you hedge using the ProShares. Note that stop is more than 20% from the current trading price of the ETF; you should set your position size accordingly. (The ETF closed around $47 Tuesday—Editor.)

The second point to note is the UltraShort Oil & Gas ProShares track the performance of energy stocks, not energy commodities. So when oil prices fall, that doesn’t necessarily mean that the value of the ProShares will rise.

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