Option Investor

Warm Weather Continues to Allow Inventory Builds

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Warm weather continues to be the biggest problem for energy investors. A build in inventory levels last week has extended the streak and continues to pressure prices. If you remember the same forecasters that predicted a stronger than normal hurricane season also predicted a colder than normal winter for the northeast. So far that prediction has yet to come true but winter lies just ahead.

Predictions for a cold front this weekend did provide support for natural gas prices, which refuse to break below $11. Oil prices declined to $57 on Friday and various futures houses are talking about a test of $55 or even $50. The break below support at $59 took out the 200-day average at $58 for the only break in more than two years on the December contract. On the continuous crude contract, @CL.P on TradeStation the 200-day was pierced briefly in June-2005 for the only break since Nov-2002. It has dipped to the 200-day numerous times since 2002 but each time resulted in a rebound.

Personally I would think this touch of the 200 on the December contract would be a buying opportunity but there are still too many factors impacting price to take the plunge. On Thursday the IEA cut estimates for winter demand by -400,000 bpd due to unseasonably warm weather. The market reacted to this news while ignoring the rest of the report. The IEA also said that there was little evidence of a country-wide drop in demand due to demand destruction from the price spike. They said demand could be understated and could increase the need for crude from OPEC as winter progresses. They likened the current calm weather as the eye of the storm with a strong likelihood of a new period of volatile weather once this calm passes.

The IEA said Chinese oil demand in September surged +9% led by a huge jump in gasoline consumption of more than +14%. This bumped their daily consumption to 7 mbpd and solidifying their position as the second largest oil consumer in the world. The IEA also said global Q4 demand would rise to 85.5 mbpd, slightly over the 84 mbpd currently being produced. The IEA projected demand table below puts this into perspective.

Projected 2006 Demand Compared to 2004/2005 Actual

I attended the 2005 PEAK Oil Conference last week and nothing has changed from the 2004 outlook. If anything the situation is accelerating. I am not going to repeat the 2000 word commentary from this weekend's Option Investor newsletter. Please see that commentary for a better description of the long-term problem.

As energy investors that leaves us with a problem. We should be seeing a rise in oil/gas prices as winter demand kicks in but the warmer weather has not only postponed that demand but is erasing the impact on a daily basis. Every day that passes without increased demand allows a further build in inventory levels. Those levels will control the price for the rest of the winter.

Q1 demand is normally only slightly less than Q4 but the inventory buildup for Q1 occurs in Q4. This means price appreciation normally occurs in Q4 and the warm weather is negating that spike. It may still occur but I am not hopeful it will return us to the Aug/Sept levels.

If you will look at the table above you will see there is normally a pause in demand in Q2 as winter demand eases before summer driving demand increases. This is where I have repeatedly suggested we want to be buyers. Any demand slump in late Q1, early Q2 is our buying opportunity ahead of the Q3/Q4/Q1 demand cycle.

Our problem today is the demand lull. I had hoped to ride the Q4 demand bounce into late December before exiting to sit on cash until the March dip. With no Q4 bounce there is little to play. We can continue to nibble at positions here at the 200-day average but the risk reward ratios are slim. Each position will require insurance to protect against an oil drop to even lower support at $51. Gas positions should continue to rise once winter weather appears. Gas is less susceptible to the fluctuations of oil since so much of the U.S. is either heated by gas or from electricity from gas.

Despite a positive long-term environment for coal we saw a dramatic sell off in coal this week. BTU fell from $82 to $72 in slightly more than one day on the confluence of demand pictures for gas and oil. Nothing changed in the coal sector and utility companies are still adding to stockpiles in advance of the cold. It is just the added volatility that is produced by the lack of a trend in all energy sources. The energy sector is suffering from a very strong run that lasted for more than two years. BTU was trading at $9 in July of 2003. It is only natural that we should see volatility at this level with oil in a two month down trend. Eventually the energy trend will resume. It is only a matter of time but we must be patient through the various stutter steps until the trend resumes.

One reader suggested shorting energy stocks over this period but the problem remains in the fundamentals. The fundamentals for energy are very bullish and we are approaching the mother of all spikes once PEAK Oil arrives. I believe we will never know when the next uptick is the one that eventually goes to the moon. It will occur when that first oil buyer attempts to contract for oil delivery and there is none available. That will be the domino that starts a decade long chain reaction. With that view I feel it is not in our best interest to short energy. I would rather look for bottoms to form in individual stocks and take long-term positions with insurance. Let's keep our eye on the ball and not be distracted with short-term fluctuations.

CChart of BTU - Weekly

Natural Gas Chart - Daily (390M)

Crude Oil futures Chart - Daily

Crude Oil Futures Chart - Weekly


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