Over the past few issues, I have written about the potential for a pullback in crude oil to USD55 to USD57.50 a barrel and for a correction in energy stocks as a group. As I noted in last week’s flash alert “Playing the Pullback,” that move kicked off in earnest early this month due to concerns about economic growth; conflicting economic data have investors fretting over the durability of the US recovery.   

This correction could continue for a few more weeks, though I am sticking by my forecast that crude will reach the USD80 to USD85 a barrel by late this year and will top USD100 a barrel next year. In this light, I regard the pullback as a healthy buying opportunity and will be looking to take advantage by adding new recommendations to the TES portfolios over the balance of the summer.

In addition to ongoing macroeconomic concerns, the Commodity Futures Trading Commission (CFTC) announced last week that it will be conducting a series of hearings in July and August looking at two main issues: placing limits on the number of energy futures contracts speculators can own and scrutinizing the position limit exemption offered for “bona fide” hedgers.

The CFTC is, like all government regulatory agencies, a political animal. Last summer, the CFTC looked into whether speculators had caused the run-up in energy prices and concluded that this wasn’t the root cause. However, several prominent lawmakers have continued to push for more regulation on speculators, and it’s likely the agency will go further towards regulating the issue under an Obama administration.

Long-time TES readers know that I do not see “excessive” speculation or other ancillary issues such as the weak dollar as major forces behind the long-term uptrend in commodity prices. It’s true that pension funds, endowments, hedge funds and other investors have increased their exposure to commodity markets generally since the early part of this decade. And buying up crude oil futures tends to push prices higher.

But those that argue speculators caused the run-up are putting the proverbial cart before the horse. These investors are buying commodities because they believe there is a legitimate case to be made that fast-rising demand for oil from emerging markets like China and India, coupled with weak global supply growth, spells a long-term bull market in prices. In other words, these investors are reacting to the long-term fundamentals, not colluding to push prices higher.

Rehashing all of my long-term arguments in favor of an energy bull market is too lengthy a discourse for a Flash Alert; I highlight my main arguments in the June 3, 2009 issue of TES, “The New Super-Cycle.” I also address the nonsensical notion that the rally in crude oil prices this year is simply a bet on a weakening dollar in the June 10, 2009 issue of The Energy Letter, “$70 Oil: Myths and Reality.”

All of these longer-term arguments aside, investors can assume that the CFTC will take action to limit speculation in an effort to assuage Congress. The obvious question is what effect this has on oil and gas prices, energy producers and investors. I will discuss this issue at more length in the next week’s TES, but here are some quick points to keep in mind:

• In light of the financial crisis and the ongoing recession, it’s likely that true speculative activity in crude oil and gas futures is less than it was a year ago. Certainly a number of pension funds, hedge funds and endowments have exited these markets over the past year. Therefore, any attempt to limit speculation should have a far more subdued impact than it would have one year ago.
  
• Those that wish to maintain speculative long exposure to oil and natural gas may simply choose to shift their business to foreign markets where regulations are less onerous such as London, Dubai or Singapore. There is considerable incentive for some of these markets to maintain less stringent regulations as a way of grabbing business from US exchanges.
  
• Any changes are highly unlikely to impact energy producers directly. The CFTC will likely focus on whether financial institutions should be classed as “speculators” rather than “hedgers,” but there is little doubt that producers will be allowed to use these markets to hedge their output without limit.
  
• Major changes should affect the liquidity of US energy futures markets, pushing volumes offshore and  making legitimate hedging more expensive. This could have an indirect impact on producers seeking to hedge their production. 
  
• Much of the short-term downside has already been priced into oil, as traders now widely expect changes to CFTC regulations

In summary, these points suggest the real impact of any changes in CFTC regulation will be short-term and minimal. 

One impact of these changes that does bear watching involves exchange-traded funds (ETFs) and exchange-traded notes (ETNs) that seek to track the performance of commodity prices–Gushers recommendations, US Natural Gas Fund (NYSE: UNG) and PowerShares Double Crude Oil Short (NYSE: DTO), are two examples.

ETFs typically have an open-ended number of shares trading on the exchanges; when demand for a fund like US Natural Gas rises, the manager can create new shares in increments of 100,000, using the proceeds from the sale of new units to purchase natural gas futures, swaps and options. Shares can also be redeemed in the same manner in units of 100,000.

But to issue new shares funds like US Natural Gas need permission from the Securities and Exchange Commission (SEC). In early June, the US Natural Gas Fund asked for SEC permission to issue up to an additional 1 billion new shares to meet strong demand for the fund. As of the current time, the SEC has approved the request; the fund ran out of new shares on July 8.

When the ETF issues new units to meet new demand, the value of the fund on the exchange will trade closely in-line with its net asset value (NAV)–the market value of the futures, swaps and options it holds. However, when the ETF can’t issue new shares, investors who wish to buy US Natural Gas must buy the ETF units from other investors. This means that the ETF becomes a sort of closed-end fund; if investor demand for shares is high the value of the fund can rise to a significant premium to NAV. When demand is weak, in contrast, the fund can trade at a stark discount to NAV. 

I suspect the SEC’s delay in grating permission for new shares is related to the CFTC’s announcement of new hearings. Specifically, new CFTC regulations could limit the number of futures an ETF can own, effectively capping its ability to issue new shares because the ETF would no longer be able to purchase futures to back up those shares.

From an investors’ perspective, strong demand for US Natural Gas may actually cause the value of the fund to rise faster under a situation where it’s not allowed to issue new shares or buy more futures because traders would drive the fund to a premium to its NAV.

Portfolio Updates

Amid the broader energy market correction, three Energy Strategist recommendations have made sizeable moves in recent days and require updates. Here’s a rundown:

Hess Corporation (NYSE: HES) – Hess is an integrated oil company that derives about 90 percent of earnings from oil and gas exploration and production (E&P). Given Hess’ heavy focus on E&P, the primary fundamental driver of the company’s success is various exploration projects it’s been undertaking in hot markets such as Africa and Brazil.

As I noted in the last issue of TES, the stock was hit recently after BM-22, a well it has been drilling off the coast of Brazil, didn’t yield a major discovery. Hess’ Brazilian project was perhaps the most eagerly anticipated well scheduled to be drilled in 2009. That said, Hess does have several additional wells being drilled that could well produce major finds and act as upside catalysts for the stock later on this year.

I have recommended two positions in Hess this year: a covered call trade we closed out in a May 18, 2009 flash alert “Linn Energy and Hess Covered Calls” for a profit of about 34 percent and an outright long position in the stock. The latter recommendation touched my recommended stop loss last week, taking us out of the stock for about breakeven.

I still like the Hess story over the long term because it has a number of attractive international exploration opportunities and I view the selloff since early June as an overreaction to BM-22. I am adding Hess back to the Wildcatters portfolio as a buy under 57 with a stop at 39.

US Natural Gas Fund (NYSE: UNG) – Natural gas prices sold off in sympathy will crude oil last week and this ETF, discussed at length above, also touched my recommended stop, handing us a loss of about 17 percent.

My bullish take on natural gas remains undimmed. In fact, for the past three weeks US natural gas inventory builds have been in-line with what was expected given summer weather trends. This, coupled with the EIA-914 report I highlighted in last week’s Flash Alert, suggests that US gas production is now falling and that drop will continue to accelerate in the final months of 2009. Meanwhile, sentiment on gas remains too bearish, and the worst possible news is already priced into the commodity.

I reserve the Gushers Portfolio for my riskiest and highest-potential recommendations; the SEC’s failure to allow US Natural Gas to issue new shares does increase the risk in this position but also increases the potential rewards. I am adding US Natural Gas Fund back to the Gushers Portfolio with a new stop at USD10.45.

Finally, my recommended position in the PowerShares Oil Double-Short ETN (NYSE: DTO) I discussed in last week’s Flash Alert has continued to soar, approaching the USD100 level over the past two days. This ETN is designed to rise in value when crude oil falls in value.

Crude oil is bouncing today, but I still see the potential for a further decline towards the USD55 to USD57.50 area. Such a move would send the PowerShares to roughly the USD104 to USD113 range. 

Most of the money has already been made in this position; it’s time to take steps to lock in gains. Therefore, I am cutting my recommendation in the PowerShares Double-Short ETF to a hold and raising my recommended stop loss to USD77 to lock in a breakeven on the position.

I am also recommending that you place a good-until-cancelled (GTC) limit order with your broker to sell you out of one-half of your position in the ETN at USD100. This limit order will instruct your broker to automatically sell you out of the ETN at a price of USD100 or better; this will lock in a nice profit on half your position if executed.