What to Buy Before the Oil Bubble Busts

Today's comment is by Mike Burnick, emerging markets expert and editor of Market Shock Trader for The Sovereign Society. 

Recently, many investors have begun to speculate that the bull run in crude oil prices has reached bubble-like proportions. Some folks are saying that "speculators" have driven the price of crude to unsustainable levels and a painful correction is just around the corner.

There's one sub-sector of the energy industry that would actually benefit big time from such an oil correction: Refiners.

Since 2001, the price of a barrel of oil has risen more than 600% to a recent high of US$145. The price of unleaded gasoline however has jumped "only" 300% or so over the same time frame to a recent price of US$4 per gallon.

Stuck Between High Taxes and Refining Costs

That math just doesn't add up if you're in the refining business. Not surprisingly, the price of oil is the biggest factor that determines the price of gas. In fact, crude oil accounts for 75% of the total cost of gasoline. The other next two biggest factors (at about 10% each) are taxes, and refining expenses.

There's no way to avoid the taxes. One of the Presidential candidates proposed temporarily suspending Federal taxes on gas recently. But then someone pointed out that nobody would fix the potholes or widen the lanes on the interstate highway system if they stopped collecting gas taxes. That comment effectively silenced the idea.

So with taxes pretty much a "fixed cost" and crude prices escalating, the companies that refine oil into unleaded gasoline and diesel have been caught in a squeeze play. And it has decimated their profit margins.

In fact, profits at U.S. refinery operators plunged 98% in the first quarter because they were caught behind-the-curve on skyrocketing oil prices. Refiners have been raising prices to be sure. But they just haven't been able to hike prices for gasoline, heating oil, and jet fuel fast enough to keep up.

To Know When Refiners Are a BUY Again...Keep an Eye on the Crack Spread

As a result, refinery stocks in the S&P index have been clobbered. These stocks have sunk 40% even as oil prices set new record highs. But the key to refinery profits is what's called the crack spread.

The crack spread is the theoretical profit margin a refiner should earn from processing three barrels of crude into two barrels of refined gasoline and one of heating oil. That spread has plunged 38% over the past year. And it's taken industry profits down the drain along with it.

But crack spreads, like so many relative price relationships in financial markets, are constantly shifting from peak to valley and back again. Last year the crack spread for refiners was almost US$23, today it's just under US$14 — a big shift.

As you can imagine, this huge shift has come from crude oil's unusually strong advance. Falling crude prices however can actually be a boon to refiners. "You really want to own refiners when oil's going down, and not straight up," according to Cambridge Energy Research.

But now energy sector fortunes may be reversing. At least that's what smart-money investors, including industry insiders and hedge fund mangers, are saying.

In the last month alone, refining company executives have purchased US$2 million worth of their own shares, according to Bloomberg. That's more insider refiners buying than at any time since 2000. In fact before March of this year, insiders had been very consistent net-sellers of refining stocks — "dumping more shares than they bought every week since 2003.

"Anyone right now buying the refiners would have to be banking on a pullback in oil prices," according to one fund manager interviewed by Bloomberg.

A Lower-Risk Way to Make Money Off a Widening Crack

Buying the refinery sector right now just might be your best bet among the various energy sector plays, especially considering the "speculative" overbought state of crude oil futures at the moment.

Unfortunately, there's no ETF I know of that gives you a broad based bet on the refining sector, at least not yet. Several leading refiners including Valero Energy (VLO) and Tesoro Corp (TSO) are among the stocks with big recent insider buys, according to Bloomberg.

This should even make a good "pairs-trade" strategy for you. Typically a pairs-trade involves going long one stock or ETF — in this case a refiner. Meanwhile, you would sell-short another major, integrated oil firm like say, Exxon Mobil (XOM) at the same time.

But here's a pairs-trade twist that goes long-long — perfect for retirement accounts.

Buy the ProShares UltraShort Oil & Gas (DUG), which is designed to go up in price as the overall energy sector declines. At the same time, buy your favorite refiner, and earn potential gains as the razor thin crack spread widens again.

MIKE BURNICK, Editor of Market Shock Trader

EDITOR'S NOTE: Hurting at the gas pump? If so, a few well-placed energy investments can help you compensate for the rising gas prices. And if you position yourself in a few key plays right now, you'll be ready when oil takes its next, steep, short-term pullback. Our monthly newsletter, The Sovereign Individual has key recommendations to help you ride oil's next pullback. We also have the best long-term plays in our portfolio for when oil rises again in the future. But don't take our word for it. Check out our long-term Sovereign Individual portfolio for yourself, simply by trying a risk-free 30 day trial membership today. You'll also get members-only access to our website. Get the full details here.

It's Official: We're In A Bear Market -- But The Next Big Profit Wave Is Taking Place RIGHT NOW!

The Dow Jones is down 20% from its October high signaling a TRUE bear market - but many smart individuals were waiting in line to grab big profits when the European Central Bank (ECB) announced their NEW (and controversial) monetary policy earlier this week.

Any investor worth his or her own salt -- knows turmoil spurs opportunity.

In fact, a small group of ordinary individuals have discovered profits in a highly focused sub-niche of the currency market - that is literally driven by political and monetary uncertainty.

And recently, my currency research team compiled 12 months of statistical data to create a thoroughly documented case study of this currency sub-niche. This report outlines the exact details of how 487 BETA-testers (of an experimental program) had the opportunity to collect, on average, an extra $5,970 every 30 days following a simple 3-step formula.

Click here to read the FULL REPORT

The New Stagflation and His Evil Sidekick Attack Europe

The term "inverse stagflation" is not widely quoted among the popular financial press.

That's because most investors and analysts still believe the industrialized economies are in a period of 1970s-type stagflation. That's not necessarily the case — a point I've argued here in the A-Letter over the last several months.

Inverse stagflation is a twisted version of stagflation. The word "stagflation" is defined as a period of rising inflation accompanied by flat or sluggish economic growth. Stagflation dominated the 1970s when the United States and Europe were caught up in soaring commodity inflation, stagnant economic growth, and rising wages. But it's not entirely accurate to label the current macroeconomic environment as strictly stagflation.

That's because this decade, stagflation has an evil sidekick called deflation.

Although the United States and, increasingly, Western Europe are being pulled into stagflation, a growing housing crisis and the contraction of bank credit are deflationary forces working to cool rising inflation; at least to an extent.

Europe, unlike the United States, currently suffers from a bad dose of renewed wage pressures. In fact, it was those new wage pressures that forced the European Central Bank or ECB to hike rates last Thursday.

Increasingly, the Europeans are being pulled into an economic slowdown. Some countries are already technically in recession, defined as two consecutive quarters of negative GDP growth. Denmark and Ireland are now officially in recession while Spain, France, and Italy are approaching contraction. In England, the economy is also slowing sharply and will likely fall into recession this year.

If falling real estate values and rising food and energy prices aren't enough for the ECB, the surging euro is causing all sorts of economic challenges.

The single currency continues to strengthen this year, depressing Eurozone exports at precisely the worst time.

Europe is now facing heartache. This helps to explain why stock prices are down more than 20% across the continent in 2008 compared to about a 13% in the United States. Earnings expectations remain too high in Europe. A strong euro also continues to depress European corporate earnings this year and on top of all that, they're facing weak consumer spending.

Global stocks look increasingly attractive compared to bonds as the bear market intensifies. But it's still too early to be aggressively shopping for bargains until oil prices cool off.

Europe, like the United States, is now comfortably entering inverse stagflation. This promises to be a volatile summer. Stay defensive in underweighted stocks.

ERIC ROSEMAN, Investment Director

Your PC is Toast When Hackers Discover this Vulnerability

With apologies to Shakespeare, "There's something rotten in the Internet."

It has nothing to do with online scams, identity theft, or any of the other evils infesting the Internet. Instead, it's a recently discovered and fundamental vulnerability that will shake the very foundation of e-commerce.

I learned of this vulnerability through a series of emails with a network security engineer. Without getting overly technical, he told me there is a problem in the system that facilitates the interconnection of computers on the Internet.

The basic gist of the vulnerability allows an attacker (either a human or a computer virus or similar "malware") to easily "spoof" DNS servers with incorrect IP addresses. This in turn presents a range of possible outcomes.

Imagine if one or both of the following scenarios became a reality:

1. Imagine if someone could spoof the DNS and change the address of www.ameritrade.com (or any other website) to another website under their control. That person could harvest login names and passwords, then go to the real Ameritrade website and attempt to transfer funds to an account under the attacker's control.

2. Imagine an even more sinister scenario where the motivation is not theft, but shutting down e-commerce, both on and off the Internet. You're in Wal-Mart trying to pay for your purchase with a credit card or debit card, but the transaction won't go through. The point-of-sale computers are online and functioning, the network is properly connected, but all transactions are declined. Since the world — particularly wealthy countries such as the United States — has moved to a cashless society, this scenario could literally shut down the economy in these countries.

On August 8, one of the researchers who discovered the vulnerability will reveal it at a convention of computer hackers in Las Vegas. You can expect attacks on the DNS to begin within a few hours of his presentation, perhaps even sooner.

In the meantime, what can you do to protect yourself? First, keep enough cash at home to deal with the possibility of not being able to use ATMs, debit cards, credit cards, etc. for an extended period.

Second, make sure your own PCs are fully "patched" with the latest security upgrades. If you use Microsoft XP or Vista, you can automatically download patches to your PC as they're created. Or, go to http://windowsupdate.microsoft.com and download the latest patches.

MARK NESTMANN, Privacy Expert & President of The Nestmann Group
www.nestmann.com

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