Option Investor

No Blizzards Yet

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Winter demand for heating oil and natural gas has yet to be seen as the northern areas continue to bask under balmy skies and mild temperatures. Natural gas finally broke support at $12 and dipped to end the week at $11.40 despite a smaller than expected injection into reserves. Reserves rose only 29 bcf to 3,168 bcf for the week ended on Oct-28th. This was below the average injection for that week of 79 bcf. Gas storage is now 3% above the five-year average thanks to the warmer weather and lack of demand. Remember, there is insufficient production and pipeline capacity to supply winter demand and getting through the winter without shortages depends on building up storage supplies ahead of the cold weather. 3,200 bcf is the level needed to supply a cushion in normal years.

I did not add any gas plays last week pending the start of winter demand and it appears to have been the right decision. I know most investors are thinking gas prices will continue lower but I still believe we are in for a shock once the thermometer begins dropping. All we need to see is a couple negative weeks for gas injection and prices will quit dropping.

Baker Hughes, BHI, weekly rig count said the number of rigs drilling for natural gas rose to 1,260 an increase of 13 from the prior week and +183 over the same period in 2004. Active oil rigs rose to 231 in the U.S. and Canada, an increase of +4 over the prior week and +41 over 2004. Note the difference between active oil exploration compared to gas exploration. Only 231 oil rigs in the entire U.S. and Canada. This should go a long way towards convincing diehards that there is little oil left to find on this continent.

Saudi Arabia announced last week it was going to spend $14 billion to raise output capacity from 11 mbpd to 12.5 mbpd by 2009 according to a report by Samba Financial Group, a Riyadh based bank. However, the International Energy Agency said oil prices could rise another 50% if Saudi does not invest additional billions for additional production increases. The IEA said Saudia must invest enough to double production by 2030 to avoid shortages but Fatih Birol, the groups chief economist, said the kingdom does not have the will to make the investment. Saudi is deep in debt and has the largest family welfare program in history. Over 30,000 members of the royal family receive from $17,000 to $270,000 per month in support from the family. Few Saudi men have jobs and depend on the family for income. 70% of government jobs and 90% of private jobs are held by foreigners. The kingdom would have to make substantial cuts in those welfare payments to raise the additional $100 billion necessary to increase production materially. That of course assumes they could increase production given the state of their fields. Water cut in the Ghwar field is said to be over 70% now meaning for every million bbls of liquid to reach the surface 700,000 are water and only 300,000 are oil. They are said to be injecting over 10 million bbls of water a day into the outlying edges of the fields to push oil towards the wells. This is a last ditch effort commonly used to squeeze the last remaining amounts of oil from a field. With a water cut this high it is doubtful they could increase production substantially regardless of how much money they spent. Birol said: "We may end up with much less oil from the Middle East than we demand. There is substantial risk of substantially higher oil prices if current investment in the Middle East is not stepped up substantially.

The IEA will issue its eagerly anticipated World Energy Outlook next week. Oil demand is expected to double by 2030 but global production is expected to top permanently at somewhere under 90 mbpd in 2006. Nobody has explained how these numbers will be eventually be reconciled. Demand could be projected to grow to a 200 mbpd but it will never happen because of limits to production. That is like saying my wife's spending could grow to $10,000 a month by 2010 but if I never give her more than $1,000 a month she would never get to that $10,000 number regardless of how much she tried. Oil is not like credit. You can use it if you don't have it.

The different agencies continue to ignore the obvious and paint the picture that oil will continue to flow if only we apply enough money to the problem. The price of oil paints a different picture. With oil holding steadfast over support at $59 it suggests those who actually buy the oil are facing a different set of realities. I said last week we are only marking time until the winter demand cycle appears and nothing has changed. Oil is holding and gas only dropped slightly on the inventory number. Eventually we will see demand rise and prices will begin to firm.

I also believe any price increases are only temporary and we will see another decline early in 2006. This will be our buying opportunity for the next year. Leaps will be cheap during the lull between winter heating oil and summer driving season. Refineries begin to coast in January and make the switch in early spring. That will be our window of opportunity. Until then we are going to keep the portfolio light and pick targets of opportunity as they appear for shorter term trades.

More than 20 energy companies report earnings next week so there is still some risk to individual names and sub sectors within the energy sector.

This week we saw both our watch list candidates be triggered as plays. That boosts us to seven active plays and about as many as I want to carry until energy begins a new uptrend. However, I believe the drop in refiners on Friday may have been an entry point ahead of the winter refining cycle. Once heating oil demand begins to ramp so will refiner margins and stock prices. I am adding one refiner to the watch list on hopes for a continued dip rather than a blind entry.

This week I am going to a PEAK Oil conference and should have a lot to write about next weekend.

Natural Gas Chart - Daily

Crude Oil futures Chart - Daily


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