Tharp's Thoughts Weekly Newsletter (View On-Line)

• Article An Energy Game Changer by D.R. Barton, Jr.
• Trading Education Find Trading Opportunities Daily
• Trading Tip Finding My Path To Trading Success by Kevin J. Davey
• Offer Position Sizing Power Pack Special! Free Course Included!

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An Energy Game Changer

by D.R. Barton, Jr.

Exactly one year ago, CNNMoney.com ran an article about the explosive growth of crude oil production in North Dakota’s Bakken shale. The reporter waxed rhapsodic about the huge gains and big projections into the future.

The March 2011 article pointed out that oil production for North Dakota’s Bakken shale deposits had jumped from 3,000 barrels per day (bpd) in 2005 to 225,000 bpd in 2010. The government’s Energy Information Administration (EIA) was quoted as projecting that production could increase to 350,000 bpd by 2035.

The only problem is that the projections for the future were too low. WAY too low.

In January of 2012 (the most recent numbers available from the state of North Dakota), a minimum of 475,000 bpd was coming from the Bakken shale deposits. Whoops–that’s a tad higher and a tad earlier than projected!

The same technology that revolutionized natural gas extraction, hydraulic fracturing or fracking, is doing the same for crude oil production. Let’s look at what’s happening in these industries and why we should care about it as traders and investors.

It’s All about Technology and Productivity

Perhaps I’m getting ahead of myself. For those who don’t follow natural gas closely, there’s been a natural gas extraction bonanza in recent years with U.S. production increasing about 25% since 2005. Thanks to production increases brought about by recently developed fracking technology, the U.S. passed Russia in 2009 as the top dry natural gas producer in the world. The chart below shows the dramatic rise in production (data source- EIA):

Coupled with this increase in production, however, has been a separate, successful effort over this same period to improve energy efficiency in the U.S. We can see both trends in the following chart comparing the domestic production and consumption (data source- EIA):

And from basic economics 101, we know that when supply grows faster than demand, price goes down. That has certainly been the case for natural gas. In the chart below, we’ll look at the spot price (meaning the current market sales price) for natural gas. Here is the very picture of a downtrend:

Right now, the price for natural gas is at a 10-year low. Is this the bottom? If I had a nickel for every analyst and technician who said it was time for a natural gas price rebound over the past three years, I’d have a jar full of nickels. The laws of supply and demand are now catching up with drillers, though, as drilling rigs around the country are being taken offline. Regardless of the number of active rigs, however, what doesn’t change is capacity availability. The new extraction techniques have created huge available natural gas reserves in the U.S.

We may have a similar situation developing with crude reserves. Many crude oil deposits around the U.S. were believed to be locked up in rock formations, but fracking technology can release oil from them for the first time. Most notably, drillers are succeeding in the previously mentioned Bakken shale deposits, as well as in Texas, Colorado and other states. While the crude oil production boom has not yet risen to the level of its natural gas cousin, the increases in the Bakken shale production rates show that the technology offers the reality of production rather than just the hope. And in the inevitability of that reality lies a lesson for traders and investors.

Fight the Macro Fundamentals at Your Own Risk…

If fracking has the potential to change the crude oil industry even a fraction as much as it has changed natural gas, the question quickly becomes, “Why haven’t crude oil prices dropped?” Crude oil prices have been above $100 for most of 2012 and are within spitting distance of last year’s highs set during the Arab League’s spring turmoil. The chart below shows the persistent price action in crude this year within the same time horizon as the natural gas charts above:

Oil continues to remain high for two very different reasons. The first relates directly to recent problems in the Middle East. Tensions with Iran–the world’s fourth largest oil producer–are as high as they have ever been, leading to fears of a disruption in production that could have drastic effects on oil prices. In fact, many analysts estimate that there is as much as a $30-$40 “fear premium” in oil right now related completely to the problems with Iran.

The second reason that oil prices aren’t dropping rapidly is that fracking is still a relatively new extraction technology that will take some time to materially impact domestic oil production rates. Extracting crude oil from tight rock formations is more difficult than extracting much smaller natural gas molecules from similar formations. Also, fracking certainly has its opponents–both in the environmental camp and from competitors hiding behind the environmental mantle. This means that the production ramp-up could hit snags along the way.

But if the natural gas experience has taught us anything, it’s that traders and investors shouldn’t fight major developments in production technology. The current landscape is ripe for a pullback in crude oil prices, especially once the threat of violence involving Iran has subsided.

BTUs and the 700% Crude Premium

For some perspective on how far natural gas prices have dropped and how elevated crude oil is, let’s take a look at 22 years of relative pricing. For context, crude oil is priced in dollars per barrel, and natural gas in dollars per 1000 cubic feet of volume. A relatively fair comparison would be the amount of energy contained in each unit of volume. A barrel of oil has an energy equivalent of 5.8 million British Thermal Units (BTUs), while 1000 cubic feet of natural gas contains 1.0 million BTUs. Let’s see how the price ratio of the two has fared over the years:

The blue line near the bottom of the chart shows the 5.8 multiplier. If crude oil and natural gas were priced strictly on their energy content, one barrel of crude would buy 5.8 1000 cubic foot units of natural gas. You can see that for brief periods, the price relationship has dropped below that level, but in general, crude has demanded a premium vs. natural gas. Crude oil’s use as a heating fuel, a chemical raw material, but mostly for gasoline explains the petroleum premium. Gasoline is such a convenient and energy-dense way to power vehicles that it dwarfs all other uses. According the EIA, a little more than 25% of all crude oil produced in the world is consumed as gasoline. In the U.S. that number leaps to almost 50%!

However, no amount of convenience and installed base of users can justify the current ratio. Right now, a barrel of crude will buy you 46 units of natural gas. That’s a 700% premium! This very unbalanced relationship cannot be sustained. Over time, natural gas prices will creep up (though I believe that sustained prices greater than $6-$7 are a thing of the past) and crude oil prices are likely to come under some pressure as drillers bring more fracking production online in the U.S. and abroad.

If you trade in these markets, use whatever techniques you wish, but prudence dictates that you also keep track of the fundamental forces at work in the big picture context.

I’d love to hear your thoughts and feedback–just send an email to drbarton “at” vantharp.com. Until next week…

Great Trading,
D. R.

About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "vantharp.com".

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Trading Tip

Finding My Path to Trading Success, Part 1

by Kevin J. Davey

Six years ago, my trading was at a crossroads. I’d enjoyed both successful trading years—like 2005, when I’d achieved a 148% return in a year-long, real money trading contest—and not-so-successful years—the kind that had me running to the bank at lunch to wire money to meet a margin call.

I had a system or two, but I didn’t always follow their signals. I knew enough about myself to know that I shouldn’t take discretionary, spur-of-the-moment trades, especially revenge trades that doubled or tripled a losing position, but I regularly attempted such trades anyway. Needless to say, these bad habits almost always cost me money. When they didn't, I was emboldened to take on more risk for the next trade, which inevitably turned out bad.

The truth was that I had no clear understanding of what was working and what wasn’t. My trading lacked long-term consistency, and I wasn’t sure why. I wanted to be a full-time trader, but I was trading like a part-time amateur, a hobbyist. The big question for me at that point was, "what is the best way to get to where I want to be?"

After a lot of fruitless searching, I finally found the answer to this and other questions in Van Tharp's material.

Six years earlier, around 2000, I had purchased Van's book “Trade Your Way to Financial Freedom,” and it quickly became an indispensable reference for me, one I still use today. However, it wasn’t until 2006, when I saw that he offered an “Investment Psychology Inventory Profile,” that my involvement with Van really began. I jumped at the chance to find out what kind of trader I was. Despite my spotty trading record, I actually imagined that Van would be astounded by what a “perfect” trader I was when he saw my results and excitedly call me up with plans of writing a book about me!

Just in case Van overlooked my greatness, though, I decided to purchase the Peak Performance Home Study Course, which I felt would help me improve in what I thought were the one or two VERY minor areas with which I needed assistance. Still, I was confident I’d already learned most of what there was to know.

And then the results of the test came back. I’d believed I was one of the elite traders out there, but I was shocked to find that, according to Van's analysis, I was only better than 50% of the traders who had previously taken the test. I was just average. And I knew that, over the long haul, average traders lose. Uh-oh.

Van's summary of my shortcomings shook me awake. Not only was I not a great trader, I barely had the characteristics of an average trader. According to Van, I needed work in a number of areas, including several key ones:

• My personal life interfered with my trading success.
• I had a poor attitude toward trading.
• I lacked sound knowledge of trading fundamentals.
• I displayed poor intuition toward the markets.

As dismayed as I was with these results, I also understood that there was an upside: the survey had exposed my weak points, and now that I knew what they were, I could put an improvement plan into place. I decided I would conquer each of my weaknesses, point by point, using Van's Peak Performance Course, along with materials from other sources.

I'll discuss exactly how I did this—how I used Van's knowledge and expertise to improve my weak areas—in part two.

About the Author: Kevin Davey has been trading futures for over 20 years, the last four years full-time. He can be reached at his website www.kjtradingsystems.com or at kdavey "at" kjtradingsystems.com.

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