When asked what the market would do, famed financier John Pierpont Morgan once quipped, “It will fluctuate.”

Markets don’t move in straight lines higher or lower; countertrend fluctuations and volatility interrupt even the strongest market moves. When it comes to key secular trends, don’t let short-term noise obscure the long-term growth opportunity. Instead, take advantage of pullbacks to pick up high-quality stocks at attractive prices.

Crude oil prices have declined sharply from their recent high. West Texas Intermediate (WTI) has dropped to $106 per barrel from a high of almost $113.50 on April 7, 2011. As I explained in the Jan. 25, 2011, issue Oil: $100 Isn’t a Magic Price, Brent crude oil better reflects global supply and demand, and should trade at a significant premium to WTI for the foreseeable future.  Brent crude topped out at $127 per barrel, retreating to about $121 per barrel in recent days.

Propelled by surging commodity prices, energy was the top-performing US economic sector in the first quarter. The S&P 500 Energy Index rose more than 16.3 percent, compared to the S&P 500’s 5.4 percent gain. By comparison, the S&P 500 Industrials Index appreciated 8.2 percent in the first quarter. Thus far in the second quarter, the S&P 500 Energy Index has pulled back almost 4.5 percent, reflecting the correction in oil prices.

The Energy Strategist has been bullish on oil prices since early 2009. At the beginning of 2010, I called for oil to touch $100 per barrel in the first quarter and to spike to $120 per barrel at some point during the year. Both calls have come to fruition, though geopolitical events pushed oil to $120 per barrel far sooner than expected.

The most recent issue of The Energy Strategist warned subscribers of the potential for a short-term correction in crude oil markets. Oil prices are in the midst of this near-term retreat.

A Crowded Trade

After a strong showing in the first quarter of 2011, crude oil and related stocks became a “crowded trade.” Seemingly everyone had become bullish on commodities and related stocks; investors who bought into the story early in the new year had significant profits to protect by the end of the quarter.

Investor’s can’t quantify precisely how crowded a trade has become, which makes it difficult to time bouts of profit-taking is difficult; markets can levitate a lot longer than one might expect if traders pile in to profit from upside momentum. Check out the graph below.

Source: Bloomberg, Commodities Futures Trading Commission

The data in this graph comes from the Commitment of Traders (COT) report released weekly by the Commodity Futures Trading Commission (CFTC). This report details positions in US futures markets, including WTI oil futures that trade on the New York Mercantile Exchange. The CFTC has added additional detail to the COT report in recent years, including a system for categorizing traders.

Historically, the data covers two major kinds of traders: commercial and non-commercial entities. The former would include any company engaged in the energy business that uses the futures or options markets to hedge their positions.

Non-commercial entities encompass traders or speculators. The graph compares total open interest to non-commercial participants’ net positions (long minus short) in WTI futures and options. When the line in this graph rises, speculators are buying oil futures aggressively.

As you can see, the non-commercial entities responded to unrest in the Middle East and North Africa (MENA) by buying oil futures. Although that’s a logical development, the sudden uptick in oil futures buyers suggests an excess of bulls at the end of the first quarter–a classic crowded trade.

Given the speed at which crude oil prices and related equities rallied in the first quarter, the recent bout of profit-taking could persist a bit longer. Traders tend to watch the technical indicators–support and resistance levels on the charts–to gauge the likely severity and duration of a correction. A barrel of WTI could pull back to $100 in the near term or perhaps its February high of about $92.50. For Brent crude oil, $115 and $108 per barrel are key levels to watch.

This short-term profit-taking doesn’t change the long-term bull market for oil; investors should regard this correction as a golden opportunity to buy energy-related stocks.

Demand Destruction

Demand destruction is the biggest risk to oil prices. In a functional market, oil prices increase when demand expands at a faster rate than supply; at a certain point, elevated prices prompt users to reduce consumption, bringing the market back into balance.

This rationale underpinned my call for oil to spike to $120 per barrel in 2011. In 2010 global oil demand increased by 2.9 million barrels per day, one of the largest annual increases in the past 30 years. Two factors drove this growth: a secular increase in emerging-market consumption and a cyclical recovery in developed-world demand after the 2008-09 recession.

Meanwhile, non-OPEC output rose just 1.1 million barrels per day. With oil prices on the rise, non-OPEC nations have ramped up output as quickly as possible. North America, for example, increased its oil production in 2010, primarily because of stepped-up activity in the Bakken Shale and other unconventional plays. But even this uptick in output failed to offset demand growth; the oil market last year relied on additional OPEC production and a drawdown of global oil inventories to balance supply and demand.

OPEC’s spare production capacity–idled oil fields that can be brought online quickly and sustained for a long period–provides the oil market’s primary supply cushion.

When demand rises faster than supply or global output is disrupted, OPEC can dip into its spare capacity to meet demand. The additional supply of oil production helps ease shortages and should bring down prices. But the equation isn’t that simple: When OPEC dips into spare capacity, the world’s supply cushion shrinks and the oil market is more vulnerable to supply or demand shocks.  That’s why oil prices often rally when OPEC boosts output; the market reacts to the diminished spare capacity.

At the beginning of 2010, I expected demand growth to outstrip supply once again, pushing oil prices above $100 per barrel. Such a scenario would have forced OPEC to boost output to meet global consumption. A sustained spike in oil prices would have reduced demand.

My initial forecast didn’t account for a civil war in Libya and subsequent disruptions to the country’s oil output. In early 2011, Libya exported 1.5 to 1.6 million barrels of oil per day–a seemingly modest amount in the context of a global oil market that’s approaching 90 million barrels per day.

Source: Bloomberg

This graph tracks Libyan oil production over the past few years. In March Libyan oil output averaged less than 400,000 per day, down roughly 1.2 million barrels per from the beginning of 2011. The nation likely won’t be able to sustain even this modicum of production.

The Libyans have managed to load a few tankers over the past couple of weeks, primarily from eastern ports controlled by anti-Qaddafi forces. But these tankers contain stored oil that was produced before the country descended into civil war. The fighting has inflicted significant damage on pipelines and production facilities; once the stored oil ships, the well will run dry until the country rebuilds.

Even if the African Union did manage to secure a ceasefire agreement between the opposition and pro-Qaddafi forces, oil exports would remain stunted until critical infrastructure is repaired and foreign oil workers return to the country.

Moreover, the civil war effectively has split the country in two: the opposition-controlled eastern half, with its capitol in Bengazi, and the Tripoli-run western half. Although this division makes sense because of historical tribal relations, the majority of the nation’s oil-related assets are located in the east; this fight won’t be over anytime soon.

Meanwhile, Saudi Arabia and other major OPEC producers have tapped their estimated 5 million barrels per day of spare capacity.

Source: Bloomberg

Kuwait, Saudi Arabia and the United Arab Emirates have made good on their promise, boosting production to offset Libyan output. Saudi Arabia has increased its oil output by more than 700,000 barrels per day since the end of 2010, offsetting roughly half of Libya’s typical production. With an estimated 3.5 million barrels per day of spare capacity, the Saudis could flow even more oil.

But these efforts have reduced global spare capacity to about 3.9 million barrels of oil per day and Saudi spare capacity to almost 3 million barrels of oil per day. Remember that rising demand would have prompted OPEC to bring idled supply online and reduce spare capacity. The Libyan civil war merely accelerated this process.   

The sharp, unexpected drop in global spare capacity pushed Brent oil prices above $125 per barrel, a level that should catalyze some demand destruction. The International Energy Agency noted in its Oil Market report that preliminary data from January and February indicated that demand had slackened in some countries. 

As I explained in Energy Costs and Energy Policy: Advantage USA, the US is relatively sheltered from rising oil prices but isn’t immune. Elevated energy prices are taking a bigger toll on Europe and emerging markets because these nations lack an abundance of inexpensive natural gas.

Higher oil prices have also provoked action on the supply side, though these efforts will take longer to effect prices. For example, the Saudis have stepped up their drilling activity in an effort to develop new fields and add to their spare production capacity–a move that would give them even more power within OPEC.

At this point, global oil markets are settling into a balanced state after the shock of the Libyan civil war and OPEC’s decision to ramp up output. If a barrel of oil spikes to $120 or above, concerns about demand destruction should eventually lower prices to comfortable levels. At the same time, reduced spare capacity and robust demand growth should limit any downward moves.

This is a great environment for most oil-related stocks, especially shares of oil services companies. These names have taken a hit, even though these firms benefit more from an uptick in drilling activity than higher oil prices.  

Meanwhile, producers reap the rewards of higher oil prices. Nevertheless, the share prices of many exploration and production (E&P) companies don’t reflect oil priced at $100 per barrel–let alone oil that costs $125 per barrel. At these levels (or even slightly below the current quote), the best E&P companies should grow earnings significantly in coming quarters.

In short, the recent pullback in oil prices stems from profit-taking and growing concerns about potential demand destruction. However, tightening spare capacity among OPEC members should buoy oil markets. Take advantage of the corresponding pullback in energy-related stocks and buy high-quality names.

Around the Portfolios

Earnings season is full swing. Here’s a listed of expected announcement dates for The Energy Strategist’s Portfolio holdings.

Wildcatters Portfolio

Baker Hughes (NYSE: BHI)–04/27/2011
BG Group (LSE: BG)–05/10/2011
Core Laboratories (NYSE: CLB)–04/19/2011
Cameron International (NYSE: CAM)–04/28/2011
Dresser-Rand Group (NYSE: DRC)–04/29/2011
Eagle Rock Energy Partners LP (NSDQ: EROC)–05/05/2011
Linn Energy LLC (NSDQ: LINE)–04/29/2011
Occidental Petroleum Corp (NYSE: OXY)–04/28/2011
Peabody Energy Corp (NYSE: BTU)–04/11/2011
Petrobras (NYSE: PBR A)–05/13/2011
Range Resources Corp (NYSE: RRC)–04/26/2011
Suncor Energy (NYSE: SU)–05/04/2011
Sunoco Logistics Partners LP (NYSE: SXL)–04/27/2011
Weatherford International (NYSE: WFT)–04/21/2011
World Fuel Services Corp (NYSE: INT)–05/05/2011

Proven Reserves Portfolio

Chevron (NYSE: CVX)–04/29/2011
Eni (NYSE: E)–04/27/2011
Enterprise Products Partners LP (NYSE: EPD)–04/26/2011
ExxonMobil (NYSE: XOM)–04/28/2011
Kinder Morgan Energy Partners LP (NYSE: KMP)–04/20/2011
Natural Resource Partners LP (NYSE: NRP)–05/04/2011
NuStar Energy LP (NYSE: NS)–04/27/2011
Penn-Virginia Resource Partners LP (NYSE: PVR)–05/05/2011
Teekay LNG Partners LP (NYSE: TGP)–05/13/2011

Gushers Portfolio

Alliance Holdings GP (NSDQ: AHGP)–04/26/2011
International Coal (NYSE: ICO)–04/27/2011
Joy Global (NSDQ: JOYG)–06/03/2011
Knightsbridge Tankers (NSDQ: VLCCF)–05/19/2011
Nabors Industries (NYSE: NBR)–04/26/2011
Oasis Petroleum (NYSE: OAS)–05/06/2011
Petrohawk Energy (NYSE: HK)–05/05/2011
Petroleum Geo-Services (Oslo: PGS, OTC: PGSVY)–05/04/2011
Seadrill (NYSE: SDRL)–05/31/2011
Spirit AeroSystems (NYSE: SPR)–04/29/2011
Tenaris (NYSE: TS)–04/28/2011
Valero Energy Corp (NYSE: VLO)–04/26/2011