The End of the Beginning?

The energy sector's surge over the last two days may lead some to believe that the rush is now on.

Well, not so fast.

The markets pulled back this morning.

That's expected after a run up. But we need to understand the primary concerns moving forward.

Those are direction and conviction.

The energy sector got slammed worse than the overall market as a whole when it was going down, and it advanced quicker when it increased.

So, what will happen from this point onward?

The safe answer is to suggest mostly lateral movement over the next several months. And that is what most of the TV pundits are doing.

And as usual, they are going to miss another boat.

What has happened over the last two sessions, overlooking the anticipated pullback today, is the first wave in the next move up. It is, therefore, actually the end of a beginning cycle that will put both prices and volatility for energy in general - and for oil in particular - back on the radar.

No move up in oil is accomplished by regular, easy to calculate increments.

But one genuinely new factor has emerged.

And it will dictate more of our investment moves as we get further into this event-filled summer.

Riding the Wave of Anticipation

The return of instability, marked by price acceleration both up and down (but on aggregate leading to higher price levels), will be taking place over shorter periods.

This is an important new wrinkle to understand. It introduces a novel risk element into the equation while, at the same time, setting the stage for increasing profits. Those profits will develop over shorter time periods for the investor who is capable of riding ahead of this curve.

I call this development compression, and it has a pervasive impact on how you should approach to the market.

Traditionally, major market swings were thought to be rare. They were thought to be infrequent enough to be discounted by longer (and relative) periods of apparent stability. Value destruction or inflation would take place, but then a protracted period of consolidation would follow.

With the introduction of volatility indices (VIXs) - for the Dow, S&P, more focused market sectors, oil - analysts began charting the instability and (surprise, surprise) paper cutters found ways to trade derivatives off of VIX figures.

Today, just about every TV talking head will tell you that volatility is subdued, at inordinately (some are even saying "historically") low levels. What they don't factor in is a very important subsector pressure that is rapidly developing.

(Remember, these are the guys who predicted seven of the last two market swings!)

This is not hitting the market across the board, although when it erupts it will have market-wide effects. It is centered in the energy sector and in oil investments specifically.

Compression takes place when considerable change occurs over a short period.

More of the result takes place in a rapid advance or contraction. What I identified in the standard deviations (or sigmas) in option trading that led to my new Energy Sigma Traderservice is a case of this phenomenon.

We are now about to witness a similar development in the broader oil market.

Some of this (as ever) is the result of geopolitical events - primarily the approaching European embargo of Iranian oil imports, the simmering "Arab Spring," global demand levels, and emerging regional supply imbalances. Other causes include the continuing spread between Brent prices set in London and West Texas Intermediate (WTI) set in New York.

That spread increases volatility on both sides by distorting actual supply-demand calculations and magnifying pricing distortions for the bulk of daily oil trades worldwide using these two benchmarks as a base.

We have become so accustomed to those factors that they serve as 30-second "explanations" for the TV folks.

Unfortunately, these explanations do not really explain anything about the real wave coming.

Two Aspects of the New Reality are Coming Fast.

Two new factors will undermine the previous way of looking at things. The new reality will not look much like the old one.

First, the cycles of compression will intensify.

In other words, not only will more be happening over shorter periods, those periods will be occurring with greater regularity. The time between peaks or valleys will itself compress, as will the activity within the deviations.

The usual assumption that a "normal" period will follow the instability, allowing the market to repair itself and establish a new trading equilibrium will be severely tested.

The technicians will have greater difficulty reading and interpreting their graphs.

Measuring the ripples from throwing a rock into the water is one thing. What we are going to experience is the equivalent of somebody throwing a handful of rocks in a short period of time.

It will distort the ability of traditional analysis both to define and explain what is taking place.

Second, once this cycle begins, it is likely to be derailed only by a major outside (exogenous) event.

The 2008 oil-pricing spike did not end because of something that happened within the oil market. It ended because of the demand and credit constriction resulting from an external collapse - the subprime mortgage mess.

I have been writing for some time now that the usual internal safety valves tempering oil-pricing fluctuations are having less and less success. That sets the stage for accelerating movements in oil being subject to more extreme outside restraints.

These continuing compressions will ultimately lead to an energy equation that demands significant change, both in terms of sourcing and usage. But that is still some time off.

What we have now is rising instability and pricing dynamics that will provide some real opportunities to make substantial profits.

There is a new trading environment emerging.

What we are experiencing is not the beginning of the end, but the curtain is coming down on the first act of a new play.