Option Investor

Marking Time

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The energy earnings cycle has come and gone with various results depending on how much hurricane damage each company suffered. Exxon was the winner by far with profits of nearly $10 billion for the quarter. A number that is unimaginable to me and represents over $110 million per day in profits. Still XOM failed to perform in the market despite +79% profit growth and closed the week with a gain of less than a dollar. The reason is of course the more than six billion in outstanding shares and expectations by analysts for an even larger profit.

On the other side of ledger was Chevron which posted a profit of $3.6 billion, +$1.64 per share or +12% after the storms damaged almost every Gulf asset owned or operated by the company. Analysts had expected profits in the $1.91 range. Chevron lost 40 days of production at its 325,000 bpd Pascagoula Mississippi refinery for a loss of more than $600 million in profits. Chevron saw damage to refineries, platforms, pipelines and drilling rigs with an even stronger impact to profits expected in Q4. You would have expected investors to flee the stock after the strong Q4 guidance warning and only +12% rise I earnings but CVX finished like XOM with a gain of slightly less than a dollar for the week.

The only stock that really took a hit with earnings was Encana. It was also the only oil/gas stock left in the portfolio last week. "Was" is the keyword in that sentence. After resisting the prior week's downdraft on takeover rumors ECA plunged -$7 on lower than expected earnings and removed itself from our play list. Encana said a wetter than expected Q3 slowed drilling and completion efforts. Encana also said it suffered non-cash hedging losses related to its take over of Tom Brown Inc in 2004. Typically companies like Encana and Chesapeake pre sell a portion of production after an acquisition to guarantee debt payments and satisfy bank requirements. It is an easy way to finance acquisitions by using the acquired companies assets to pay the bill. In a situation like we have seen in 2005 with gas prices more than doubling that same hedging program returns to bite them as they are forced to sell that now current production at the much lower hedged rates. There is no free lunch. The Tom Brown Inc hedging program ends late in 2006. The non-cash loss was a mark to market write down of future production on the portion of production previously hedged. ECA also announced the CEO was leaving after 12 years and would be replaced by the CFO.

I did not add any new plays last week in advance of energy earnings because of the potential for earnings misses due to hurricane damage and the overactive expectations for earnings given the ramp in oil prices. That turned out to be a wise move in light of the volatility we saw in the market. The energy sector was not the only sector to see volatility with the Dow having its first triple-triple week of the year. That is three days of triple digit moves in the same week.

The price of oil continues to hover in the $60 range with strong support just over $59. Natural gas prices are barely holding over $13 after seeing injections into reserves of more than 75bcf for two consecutive weeks. Gas storage now stands at 3,139bcf and very near the 3.2tcf target needed by Nov-1st as a cushion for winter demand. Current production and existing pipelines are unable to satisfy winter demand and gas in storage must be increased to the 3.2tcf level ahead of the demand cycle to prevent shortages. Last winter we came within hours of shortages more than once as long bouts of cold weather produced a strain on those reserves. With forecasters calling for a colder than normal winter we should see that again this year.

11% of U.S. annual gas production has been lost and more than 50% is still offline in the Gulf. Eleven gas processing plants are still offline and are hampering a return to full capacity. A sudden cold front before that capacity is brought back online could start the winter off behind the curve and setup three tense months of watching the thermometer for relief. Without a sudden draw down we could see gas prices decline to support at $12. This is still a sharp increase from the $7 levels we saw last December.

With the oil price decline slowing and hurricane Beta making landfall into Mexico rather than continuing into the Gulf I am still cautious about rebuilding the energy portfolio. If you recall I had been expecting a seasonal decline in December but the storms and various market events like the multi billion dollar Refco liquidation skewed the price patterns and brought us all time high prices and a -$12 drop from those highs. The question now is of course what comes next?

After reviewing nearly 100 energy stocks this weekend the majority appear to have stabilized in the middle of their last four week trading range. While I have no problem entering a few speculative positions personally I have no desire to do that to any great extent in the portfolio. I can move quicker in my personal positions than I can in a weekly newsletter. I would like to see oil start a new upswing and move over $64 for confirmation before jumping back into the game. However, nothing ventured, nothing gained so I am adding my two best bets this weekend and we will hedge our plays with puts once again. I had not been using that option given the strong trend prior to September.

I am also going to add a couple non-energy plays. I received numerous emails asking what we were going to do while we waited out the seasonal weakness between the winter demand cycle and the start of the summer demand cycle. Since I do not want to be in the position of betting against oil that leave us with nothing to do if we don't dabble in other sectors. While the focus of the newsletter will continue to be energy ahead of the coming oil crisis it does not mean we can't profit from other opportunities as they appear.

Nothing has changed in my view on the coming energy crisis with 2007 still the target for a peak in global oil production and the beginning of an eventual permanent decline. I am going to a PEAK Oil conference in Denver in two weeks where I hope to get an update on the current forecast from Matthew Simmons, author of Twilight in the Desert. I will update everyone on what I find out.

Until then we are left trading what we see, not what we want to see. I was overly aggressive on buying the dips in early October in expectations of a rebound. For whatever reason that rebound did not come and we gave back some of our gains. That is no different than investors in other sectors given the broad market sell off and high volatility over the same period. There was some additional volatility in energy due to the Refco problem and with funds taking profits ahead of their October year-end. That should all be behind us now but until a new trend develops we are going to be cautious.

Remember my cautions about Conoco and their high profile TV ads prior to earnings? There was no surprise with their +89% rise in profits although expectations were dimmed by damage and lost refinery production. However, their strong advertising run ended abruptly once earnings were announced. COP gained +$7 in the four days prior to their earnings and only declined slightly afterwards. I still believe the heavy advertising campaign was an effort to manage expectations around earnings. Good job Conoco!

Check out the watch list section for some general thoughts on some riskier positions.

Natural Gas Chart - Daily

Crude Oil futures Chart - Daily


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