Today's Analysis: Oil and Drugs at the Crossroads

Oil remained below the $52 area. Mr. Greenspan will be in front of Congress. Markets were not happy overnight, setting up a weak open on Wall Street.

The worst case scenario for the oil bulls would be that the supply data due out later this morning shows a fall in supply, but the market sells off aggressively anyway. That would suggest that a significant top may have been put in.

The pre-market stock index futures were lower on 3-2. The U.S. Dollar was steady. Asian markets closed lower. European markets were lower. U.S. Treasury bond yields were higher . The U.S. Ten Year note was trading with a yield of 4.38% in electronic trading. Crude oil was trading just below $52. Gold was trading near $430.

The economic calendar for March 2: 10a.m. February Challenger Job Layoffs. Previous: -16.6%. Source: Wall Street Mr. Greenspan goes to the Hill. Oil supply data will be out mid morning.

Today's Analysis: Oil and Drugs at the Crossroads

The developments in the Middle East, the world of science, and the markets are difficult to connect in a precise linear fashion. But in a chaotic universe, where non linear order is the rule, a different picture is steadily emerging.

For several weeks investors have been bowled over by the prospects for long legal battles resulting from the COX-2 inhibitor drug debacle involving Merck and Pfizer, a stock that we own. Scientific data has implicated Vioxx, Bextra, and to some degree Celebrex as raising the risk of heart attacks and strokes under certain conditions. The three drugs are worth several billion in sales to the companies.

Just a few days ago, Biogen Idec, and Elan had to pull a promising drug for the treatment of multiple sclerosis from the market, citing the worst of all reasons, the death of a patient under treatment with the drug.

In the Middle East, violence in Iraq is still a daily occurrence, and the potential for a disruption in the supply of oil is still possible if the right set of circumstances develops. And the Northeast U.S. is the grip of a late winter storm pattern.

But, in the non linear world of the market, and its interface with reality, an extremely rare occurrence, something else is increasingly evident.

Large drug stocks have stopped falling, and oil stocks may have run into significant selling pressure.

The scenario, if it continues to develop along these lines, could well be a major inflection point for the markets.

Morgan Stanley: Oil Czar?!

A Morgan Stanley oil trader "Olav Refvik, has amassed leases on storage terminals around the globe. The Norwegian-born trader has struck deals to buy and deliver oil to big users, sometimes storing it in the tanks he leases." Mr. Refvik, accordign to the Wall Street Journal, has done so well for himself and Morgan that he is known as the '["King of New York Harbor,"] a nickname that also reflects his occasional tour of the waters with his yacht, Song of Norway."

In what could be the most amazing story of the, still alive, and now legendary bull market in oil, and perhaps a sign of a top in itself, Morgan Stanley, according to the Wall Street Journal, "has custody of a quarter of America's strategic reserve of home heating oil. And it is the second-most-active U.S. seller of electric power, ahead of scores of utilities, according to Federal Energy Regulatory Commission rankings."

Morgan, is riding high. "With energy prices high, this nitty-gritty operation, which includes trading desks in London and Singapore, is throwing off lots of cash. It produced net revenue of roughly $1.4 billion to $1.8 billion and pretax profit of $500 million to $700 million last year, according to various estimates from Sanford C. Bernstein & Co. and others familiar with the operation. The net revenue figure -- revenue minus some items, such as interest expense -- would be about 6.5% of the bank's total. Bernstein indicated the pretax profit was at least 8% of the bank's total. Morgan Stanley doesn't break out the figures."

And in what is an eerily familiar, (cough, cough, Enron) scenario, Morgan has a global, hands on, and very sophisticated infrastructure, that according to the Journal "is especially important to (the company) as it faces slowdowns in some traditional businesses such as bond trading and its brokerage for individual investors. One member of its team, Olav Refvik, has amassed leases on storage terminals around the globe. The Norwegian-born trader has struck deals to buy and deliver oil to big users, sometimes storing it in the tanks he leases. In electricity, trader Simon Greenshields oversaw Morgan Stanley's construction of power plants in Georgia, Alabama and Nevada in the 1990s. When utilities need extra power during peak demand, Morgan Stanley traders sell them some. Those tend to be times when prices are higher. In dealing with crude oil, the Morgan Stanley team at times buys the rights to oil companies' production in the Gulf of Mexico, then turns around and sells it while it is still underground."

Now, though, it gets interesting. According to the Journal: "Today, others are rushing to follow them. Merrill Lynch & Co., Credit Suisse First Boston and Citigroup Inc., among others, are stepping up their activity. Hedge funds -- investment pools for institutions and the rich -- leapt into commodity trading a year or more ago."

Goldman Sachs "recently bought 30 electricity-generating plants," and Morgan has expanded into gasoline and heating fuel.

Is The Oil Story Out Of Gas?

If the market is indeed a discount mechanism, then most things that can affect oil supply should have been discounted by now.

China and India have been gobbling up oil for several years now. OPEC is pumping full tilt. Russia's production is going to slow. Several oil companies, most prominently Royal Dutch Shell have misstated their proven reserves. Venezuela uses oil to further its political agenda. And the easy oil has been found. Hurricanes, tsunamis, global warming, and other natural disasters have also had their opportunities to affect price patterns.

The dynamics of Middle East politics and the potential for at least a temporary, but significant disruption in the world oil supply have also been trading fodder for some time.

Thus, at $50-$55 per barrel, much has been factored into the price of oil.

Drugs And Their Difficulties

Drug stocks, as measured by the Amex Pharmaceuticals Index (see below for chart) topped with the stock market in late 2000, and at their low point lost about 50% of their value as a sector, in 2003. Since then, a feeble recovery has taken place.

The two major problems for the pharmaceutical sector are self-inflicted.

First, large drug companies like Merck, relied too heavily on current blockbusters, and let their pipelines slip. This gave large biotech companies a chance to step into key niches, such as cancer, arthritis, and anemia treatments, shifting revenues away from the traditional leadership.

At the same time, pricing pressures from managed care and other external influences also began to grind at the top and bottom lines for the major drug companies.

The expiration of key patents and generic competition finished off the damage.

The COX-2 drug debacle and the latest and unfortunate situation with Biogen and Elan, have not spread throughout the rest of the large drug sector, though.

In fact, the Amex Pharmaceuticals Index was up five points since the news hit, and is on the verge of breaking above key resistance.

Indeed, aside from biotech stocks that were already weakening, and companies with relationships to Biogen and Elan, not much has happened in the biotech, pharmaceutical sector since the news broke.


The FDA is on the hot seat. Procedures will be revised. Labeling issues will be improved. And a period of intense public activity is coming, where Congressional hearings and policy changes are on the way. Also evident will be some head rolling and finger pointing.

That, in our opinion, is as large a sign of capitulation as there ever could be, as the admission that the FDA's review policies and way of doing business was not exactly what everyone thought it was.

From an investment standpoint, history could well show, that for long term investors the Elan-Biogen disaster might have been the signal that the drug sector finally made a bottom.

With the oil market, it seems to us that in the Middle of the coldest March in several years, with the Eastern U.S. knee deep in snow, and expectations of more coming, oil prices and oil stocks should still be moving higher.

Yet, unless there are catastrophic shortages of heating oil reported at 9:30 A.M. on March 2, when the API and the U.S. Energy Information Agency report supply data, we may actually see prices falling.

What we have is a classic mirror image trade possible developing.

If you compare the price of the Amex Oil Index (XOI) and the Amex Pharmaceuticals Index (DRG), both below, you can see that XOI is starting to struggle, as DRG is forming a bottom.

And while Morgan Stanley seems to have mastered the ins and outs of the oil distribution system, it is possible that hedge funds and other Wall Street firms may have entered the game late, and could be getting set to pay a big price for their lack of timeliness.

If and when the sell buttons get hit, in true Wall Street fashion, somebody is going to get hurt. And when that happens, as the Chinese government and the management team and creditors of China Aviation Oil Singapore found out, the pain will get spread around, and could be substantial.

That means that, at some point, as the current oil trade gets unwound, we could see rapidly falling oil prices, and money that could be looking for a home.

To us, it looks as if money coming out of oil might already be starting to make its way into the very oversold pharmaceuticals.

Oil Market Summary And Outlook: Supply Report Could Break Up Trend

The worst case scenario for the oil bulls would be that the supply data due out later this morning shows a fall in supply, but the market sells off aggressively anyway. That would suggest that a significant top may have been put in.

Oil is still testing the resistance near the $52 resistance area. Cold weather is back in the Northeast U.S. Syria, Iran, Israel, and the Palestinians are a source of concern.

Normally, this would be a scenario related to higher prices. But the action on 3-1, where oil stocks got aggressively sold, suggests that the market is ready to do some selling if the supply data does not show a catastrophic and unexpected drop in supply.

But with OPEC saying that $50 oil will keep them pumping at full capacity, the potential for a glut is now actually plausible.

Expectations for the supply report are mixed, and the results will almost certainly lead to volatility. According to "Citigroup expects crude supplies to range from unchanged to a build of 2 million barrels, gasoline to range from a fall of 500,000 barrels to a gain of 500,000 barrels and distillates to fall by 500,000 to 1.5 million barrels. Phil Flynn, senior market analyst at, said he sees a draw of 3 million barrels in distillates supplies, a draw of 2 million barrels in crude and a build of 2 million in gasoline stocks."

As usual, we won't hazard a guess, other than the market is likely to move on the data.

The gasoline picture on Wednesday is most likely to set the stage for what's next.

The Philadelphia Oil Service Index (OSX) got sold off, and has room to go lower . Volatility will likely increase here in the next few days. For more details on trading the energy sector visit our energy timing page, featuring our highly effective OIH timing model and our Top Ten Energy Stock List.

The Amex Oil Index (XOI) was also sold off. XOI has made a series of new highs lately, and delivered another one on 2-25. XOI remains above the 50 day moving average, preserving an up trend. For immediate analysis, including stock picks, and the latest in technical analysis of the entire energy complex, our subscriber section has a full complement of recommendations in oil service and the rest of the energy complex.

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