Option Investor
Market Wrap

Throwaway Day

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Tuesday was a wasted day due to an extended weekend by many traders resulting in a lack of volume and the lack of any material economic reports. Volume was light at 3.9 billion across all markets and the indexes traded on both sides of zero with a 2:PM buy program rescuing them from a negative swoon. If you had also extended your holiday weekend you would not have missed anything in the markets.

Dow Chart - Daily

Nasdaq Chart - Daily

The only economic report of note this morning was the Challenger Layoff Report. The report showed that corporate layoffs surged +75.6% in August to 65,278 workers compared to 37,180 in July. The July number was a six-year low and may have been an anomaly in the numbers. The rebound in August put layoffs right back in the range we have seen earlier in the year. Layoffs started the year with 103,470 in January, 87,440 in February and then a decline to average 60,000 for the rest of the year to date except for the sharp dip in July. The sectors showing the biggest cuts in August were computers (-17,731), automotive (-7,639) and aerospace/defense (6,399). The automobile sector has cut -77,897 workers year to date. The report also showed that hiring had fallen substantially to only 7,291 new jobs and well below the 34,537 created in July. The Challenger report is not seasonally adjusted and the summer months are typically tough for workers due to higher layoffs. Layoffs in the real estate sector were twice as high as last year but layoffs are still expected to increase in this sector.

A housing survey was also making the news showing that housing prices rose +1.17% on an annualized basis in Q2 compared to +3.65% in Q2-2005. This was the sharpest drop since records were started in 1975. The gain was produced from sales in several areas still seeing buying while many previously hot areas were falling in double digits. For instance, home sales fell -36% in Las Vegas with prices heading south at a high rate of speed. The property values are dropping fastest in the same areas that saw the hottest markets during the housing boom. This is directly related to the end of speculation and the impact of Option ARM loans. Many borrowers are finding their payments double or even triple when the loans reset. Business Week magazine this week highlights this story in a front-page article. The sudden drop in the housing market is causing borrowers who took on far more than they could afford in hopes of having rising home prices bail them out are now finding their negative equity increasing rapidly on a daily basis. The race to sell is driving prices lower where those loans were marketed aggressively. Business Week warns that companies with a high percentage of these loans in their portfolio are at risk for large losses. Countrywide Financial (CFC) reportedly has $26 billion of Option ARMs and they are booked at 100% of value. If the current housing trend continues they could be forced to take a substantial write down. Other companies with exposure include Washington Mutual (WM) and Golden West Financial (GDW).

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Microsoft announced the price of their new Windows Vista operating system. The suggested retail price for Windows Vista Home Basic will be $199 with an upgrade price of $99. The expanded consumer version, Windows Vista Business was priced at $299 with upgrades at $199. Windows Vista Ultimate, which adds consumer entertainment features, was priced at $399 with upgrades at $259. Microsoft released a test version called Release Candidate 1 to more than 5 million worldwide customers on Friday. They will get to fight all the bugs and problems prior to the general release late this year.

Intel announced 10,500 job cuts after the close but as usual the headline number was deceiving. 1000 of those cuts were management positions, which had previously been announced back in July. Another 2000 were employees at business segments they had sold so that does not really count as a layoff either. Another 2000 were coming from attrition, starting in July. Only 5,500 workers were actually going to lose their jobs between now and the end of 2007. This was a case of Intel trying to get the most bang for their buck out of the announcement by claiming a cut of 10,500. Intel said it would save $2 billon by the end of 2007 due to the cuts. Intel has lost market share to AMD and is involved in a price war with current inventory. Intel market share fell to 73% in the last quarter, down from 82% in Q2 2005. Profits fell -50% while AMD profits rose +50%.

Viacom announced that its new CEO, Tom Freston, was no longer CEO and had been replaced by Philippe Dauman. Freston had only been CEO since January when Viacom split up with CBS Corp. He left with a monster severance package of $60 million plus $20 million in stock options. Would somebody please fire me?

The big announcement for the day was another deep-water discovery in the Gulf by Chevron, Devon and Statoil. The well, Jack #2, was drilled to 29,000 feet in 7,000 ft of water. The estimated discovery was widely said to contain 3 billion to 15 billion bbls. The oil crisis was quickly claimed as over and dependence on OPEC was a thing of the past. You know I am a student of the energy industry and these kinds of comments in the press drive me crazy. But we all know, it is not a long drive.

Let's take this announcement and see what it really means. First, Chevron first announced this potential find back in 2004 followed by a successful test of Jack #1 and another announcement in Sept 2005. Nobody bothered to shout it from the rooftops before. BP, Devon and Anadarko announced a similar discovery in the same formation just last week. Devon said the discovery was "the largest to date" in the lower tertiary formation and could possibly hold 500 million bbls. Their stock rose $1 on the news. That BP/DVN/APC well Kaskida was drilled to 32,500 feet. Why were the past discoveries largely ignored? Because they did not claim they found oceans of oil like Chevron. The BP/DVN/APC claim was only 500 million bbls not 15 billion. The CVX/DVN/STO claim was for 3B to 15B NOT just 15B. How quickly the press seizes on only the big numbers. The Chevron well ONLY tested at 6,000 bpd from 40% of the net pay. That is good but quick math shows that it would take seven thousand years to pump 15 billion bbls at 2.1 mb per year or 1500 years to pump 3b bbls. The reason Chevron claimed such big numbers was the amount of acreage they hold in the 300-mile wide area that "may" produce oil from this formation. Probably the correct wording of the announcement would have sounded something like this. "Chevron announces today the discovery of oil in the lower tertiary formation in the deep water portion of the Gulf. If Chevron completes several hundred wells at the cost of $80-$120 million each over the next 50 years it is possible this field could produce 3B to 15B bbls of oil within this century. Completion of these wells could cost from $600 million to $1.5 billion per platform. Chevron acknowledges there are no pipelines in the area which is 175 miles offshore in 7,000 feet of water."

Chevron acknowledged it would cost tens of billions of dollars to complete these wells and they were not even sure at the present time if they could be commercially completed. That means it MAY cost more to get the oil out of the ground and delivered onshore than it is worth. All they have proven at this point is that oil exists 30,000 feet under the ocean in this formation. It will take years before any oil is actually produced if it does prove commercially feasible. The earliest date for potential production is 2011-2014 but without several more grossly expensive wells they don't have a clue how much they can produce. Estimates are 300,000 bpd to 500,000 by 2015. Until they spend several hundred million more dollars and several years they will not know for sure. BP and Chevron both set records for depth, pressure and duration while drilling the wells. The perforating guns were fired at record depths and the test tree and other drill stem test tools set records for operating at depth. Just setting records with specially constructed test equipment is not the same as producing oil from record depths. All production equipment would have to be specifically designed for this application. It could literally cost tens of billions of dollars before any commercial production appears from this formation. The official estimate I heard from several sources is production of one million bbls per day by 2020. That is a lot of oil and it will take many years for the companies to recover costs much less turn a profit.

To quickly put this into perspective we only need to look at the chart below. The world currently produces about 83 million bpd of oil and consumes 82.5 mbpd based on numbers provided by BP at the end of 2005. The depletion rate of existing fields is normally 4-5% and sometimes much higher. Saudi Arabia is currently facing an 11% depletion rate on Ghwar and Mexico's Canatrell field is losing production at an even faster rate. At the energy conference I attended in August the consensus among the major presenters there was about 8.5%. This means for every 100 bbls of oil produced today they have to find and produce an extra 8.5 bbls just to stay even next year, 17 bbls the year after, 25 bbls the year after, etc. This is the current gospel from major producers in the business, not from an analyst like myself. In the table below I only used a TWO PERCENT depletion rate, not 4%, 5% or 8% as the industry is currently seeing. Using only a 2% depletion rate and the current +1.5% increase in the annual consumption rate (per BP) the world will have to find and produce an extra 2,397,500 barrels per day just to stay even in 2007. Five million additional barrels per day by 2008, 8 million by 2009, etc. By the time 2020 arrives and the BP/CVX deepwater discovery is fully online the world will need an additional 39 million bbls per day just to stay even with current consumption trends. Obviously this demand/production chart will break down well before 2020 as the rising price of shrinking oil supply kills demand growth. However, just holding demand where it is today at 82.5 mbpd won't work either. By 2015 we will need to add 13 mb per day to existing production just to stay even. Unfortunately because of the long lead times from discovery to production we already know what oil should be online by 2015 and it is only about 7 mbpd of new production. That leaves us short by 6 mbpd. Are the Chevron/BP discoveries important? Heck yes but they are not the answer to the problem. They will produce huge amounts of oil by 2015 and it will be sold for record prices well into triple digits. Today's news is a tree falling in the forest. A month from now it will be forgotten and life will go on inexorably toward the point where demand finally exceeds production and the world changes as we know it.

Oil Depletion Chart

Gold rose +$14 to $646.90 on the layoff and housing news as well as buying ahead of the winter jewelry season. Gasoline prices fell -8.7 cents to $1.64 a gallon as driving season ends and oil prices continued to fall. Oil closed at $68.60, down -58 cents despite a new storm forming in the Atlantic. Tropical storm Florence is headed towards Florida but is not expected to swing into the gulf. The best guess for a storm track is northward along the eastern Florida coast. There is always the possibility for a storm to dodge left through the Cuba/Florida gap and hit the oil fields but Florence does not appear to be headed in that direction.

Tropical Storm Florence

Chart of October Crude - Daily

SPX Chart - Daily

Tuesday was a light volume day but internals were positive with advancers getting the nod over decliners. The bulls bought the dips but very cautiously. It was just enough to hold the Dow at 17-week highs and push the Nasdaq to a new three-month high at just over 2205. We have a few more economic reports tomorrow with the Beige Book, ISM non-mfg and Productivity. They should not be earth shaking but volume should increase as more traders head back to work.

Tuesday was a sleepy day without much to power the markets and it showed in their performance. My outlook has not changed. We need to remain long over S&P 1300, cautiously buy any dip to 1290 and go flat or short should 1290 break. With Tuesday's close at 1313.57 the S&P continues to creep higher point by point. There was a lot more talk today about the historical September decline and I heard several fund managers claiming more than a 10% cash position. As I said before, should the normal September correction not appear soon they will be throwing that money at the markets in an effort to catch up and not be left waiting on the sidelines. For us retail traders we need to play what the market gives us and not try to outsmart it. Follow the guidelines I listed above and it could be a September to remember.
 

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