CME CME Group Inc

Wednesday trading action in crude oil saw the black gold stick its head above $100, which may be the least psychologically-significant round number out there since the people who do the trading are mostly professional speculators and energy companies who have lots of other things on their minds. In essence, this is not a retail market driven by reactionary extremes of emotion as much as it is a battle of titans who use either arsenals of supply/demand data or algorithmic trading firepower, or both, to move the price.

Despite the occasional fear spike due to Middle East tensions, or covert price manipulation at physical market delivery hubs (as is being investigated regarding the 2008 price highs above $140), the pros aren't scrambling to buy tops and sell bottoms because they aren't driven by fear -- greed maybe, but we'll get to that. And they don't necessarily care where the price of oil "should" be. They just want to know what the other guy will pay, and depending on their time horizon and how deep their pockets are, the energy trading firm that can make solid predictions about the next 3 days, 3 weeks, or 3 months wins big.

For example, I sit and write a couple of blocks from one of the biggest energy trading desks in the business. BP (BP) moved its energy trading operation from the Chicago suburbs recently to take over the old CME Group (CME) trading floors on Wacker Drive when "the Merc" bought the CBOT and moved all the pits to LaSalle Street in 2008. I don't know how many traders they have there, but I can tell you that they are involved in just about every facet of the physical markets for crude, gas, and distillates, as well as using futures, options, and OTC derivatives to make markets for customers, manage their own risk, and, of course, for pure speculation.

You've no doubt heard about the crude oil futures curve being in either contango (future delivery contracts have successively higher prices) or backwardation (prices trend lower for farther-dated contracts). One can buy or sell a futures contract for WTI at every delivery month going out over five years. Make no mistake, a firm like BP knows and "owns" every nuance on that curve, and there are dozens of hedge funds and smaller proprietary firms I know of that try to duplicate their success simply using computer algorithms and price forecasting models.

That doesn't mean every professional trading firm wins all the time. In theory, they can't since trading is a zero-sum game and on the other side of every winning position is a losing one. And while this is true within a given contract market, say crude for delivery in July 2011, players may have multiple hedged or offsetting positions in options or OTC contracts. The point is that it is a pros' battlefield where sophisticated knowledge, tools, and resources are the weapons.

The firms that win consistently are either titans like BP, who are spread out through every niche of the industry, or hedge funds and smaller prop shops without physical market business interest who focus on a particular trading model like futures curve spreads. I use BP as an example to show you what a typical titan in this market looks like and what they are doing. The thing to keep in mind is that we can't compete with the pros' knowledge and market access, so we just have to follow the long-term trend.

Emerging Markets = Peak Oil

Speaking of competing forecasts on oil, we were given a big reason to doubt whether it should cost over $100 per barrel recently when the CEO of Exxon Mobil (XOM), Rex Tillerson, made comments earlier this month at a Senate hearing about $60-70 being fair value, if based purely on supply and demand. His explanation for the current excess value was that price was being driven by the speculation of big oil companies and the high-frequency trading firms we just talked about. I wonder if any of the Senators thought to ask, "Is Exxon involved in this speculation?"

The more important question is whether or not Tillerson is correct. The market seems to be giving a much different answer than this expert. And most of that answer revolves around two synergistic themes. First is the idea of scarcity for a non-renewable resource. This idea often comes by the moniker "peak oil," symbolizing that we may have seen, or are about to see in the next few years, the maximum levels of reserves globally.

The second theme is that Emerging Markets demand for energy is very strong and will only continue to grow as billions of people aspire for the lifestyles of the developed world. This isn???t just a long-term investing trend for the next five to ten years. It???s what I call a global secular mega-trend for the next decade and beyond. Of course it will ebb and flow, especially if China is forced to put the brakes on growth. But the big picture supports the idea that triple-digit oil is here to stay.

Whether or not peak oil is here yet -- especially as new discoveries are made and new technologies like tar sands extraction, hydraulic "fracturing," and biofuel and natural gas alternatives supplement conventional crude supplies -- EM demand will make it come true faster. The macro-fundamental call by Goldman Sachs (GS) analysts Tuesday about crude prices averaging over $115 per barrel for the next two years was as much a function of EM demand growth as it was a commentary on the "machinery of speculation" that someone like Tillerson might decry. Rex might be right about what fair value "should" be, but the market is going to err on the side of global economic trends and we should too.

Playing the Oil Field

But if we can???t speculate on the price of crude and compete with the pros, how can we profit from it? By finding solid stocks that allow us to invest in the trend and win. Tuesday, I highlighted the buying opportunity in, Suncor (SU), to take advantage of the pullback in crude and its related equities. Today, I want to discuss two candidates that offer exposure to oilfield services. Lufkin Industries, Inc. (LUFK) and Baker Hughes Inc. (BHI) both provide essential equipment, technology and services to energy E&P firms, and both names became Zacks #1 Rank (Strong Buy) stocks on Wednesday morning.

Lufkin Industries designs, manufactures, sells, and services various types of oil field pumping units, power transmission products, foundry castings and highway trailers. Lufkin manufactures four basic types of pumping units: an air-balanced unit, a beam-balanced unit, a crank-balanced unit, and a Mark II Unitorque unit. The stock has consistently been a Zacks Rank Buy or Strong Buy since early March when it was trading in the low-$80's and ran to highs near $95 in April.

The Zacks Rank for this period was based on analysts revising their estimates upward at a rapid pace, with the consensus for 2012 moving from $4.58 EPS to $5.13. If we look back 120 days, analysts were a lot closer to $3.50 for 2012 when LUFK was trading in the $60 handle. Clearly, increased visibility for the company's earnings, and analysts in agreement about those projections, helped the stock price move as much as 50% higher in the past few months. Granted this is just a 2.5 billion-dollar concern, with only 4 analysts following it, but as a "sell the bullets" (in this case, "pumps") kind of company in the peak oil war, the table is set for it to show up on the menu of more sell-side investment firms with hungry research analysts.

Baker Hughes, according to the company website, provides "products and services that enable you to drill, evaluate, complete, and produce the energy that drives the global economy. Our reservoir technology experts also offer independent consulting services, geomechanics modeling, petroleum engineering, and reservoir simulation services to achieve superior results." If Lufkin can be considered providing the "bullets" in the oil war, Baker Hughes could be said to have the "guns." As a one-hundred year old oilfield service company that specializes in helping E&P companies maximize their reservoir values, BHI has a $30.5 billion market cap and about 30 analysts covering it.

BHI earned a Zacks #2 Rank (Buy) last November for the first time since the before the recession hit in 2008. And in the past 30 days, analysts spoke even louder about their earnings projections with over 20 upping their estimates for the current year and 2012 to consensus EPS of $4.07 and $5.22, respectively. Then this week, a couple of company experts offered some very bullish estimates of $4.48 and $6.00, which effectively bumped the consensus up a penny for each year. This was definitely part of the calculation that pushed BHI to a #1 Rank on Wednesday.

Earnings Estimate Revisions--A Powerful Leading Indicator

The size of the rally in both of these stocks on Wednesday -- LUFK and BHI closed up nearly 6% and 5%, respectively -- was a little surprising to me, since there was no company-specific share-moving news for either. But on top of positive sentiment across the sector following the Goldman Sachs commentary, there was an energy E&P company attracting attention that may have added some fuel to the buying fire in the oilfield service names.

Cabot Oil & Gas Corp. (COG) is a $6 billion firm with oil and gas properties located in four areas of the United States: the onshore Texas and Louisiana Gulf Coast; the Rocky Mountains; Appalachia; and the Mid-Continent or Anadarko Basin. The stock was up over 7% on double the average volume as buyers stepped in at the 50-day moving average just below $53. Of note, COG has been a Zacks #1 Rank (Strong Buy) stock since April 29 after all four analysts covering it raised their earnings estimates to boost the consensus by 11% for this year and by 23% for 2012.

Which brings me back to another thing LUFK and BHI had in common that could be curiously linked to their big price moves. As already mentioned, they both received the Zacks #1 Rank (Strong Buy) before the start of Wednesday's trading. This is not a wildly unusual coincidence since our proven quantitative model is reliably predictive of stock prices because of the simple fact that earnings estimate revisions are closely tied to institutional investor buying or selling decisions.

It's just that, normally, upward earnings revisions that bring about a boost in the Zacks Rank take weeks to unfold into potential share price appreciation as the big money elephants of capital markets lumber slowly into large positions. In this case, the markets were "on to us" early and couldn't get enough of the guns and bullets needed for triple-digit oil.

Kevin Cook is a Senior Stock Strategist for Zacks.com

 
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