Option Investor
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That Was Fun!

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The rebound of oil to $63, crash back to $59.65 and rebound to $63.25 in only four days sent energy stocks in motion like a leaf in a hurricane. Fortunately we were not stopped out on any energy positions but unfortunately we were not triggered on any new watch list entries either. The volatility was too fast and geopolitical fundamentals too strong for stocks to suffer much damage.

I expounded on the various world events impacting oil in my Option Investor commentary this weekend so I won't repeat it here. I do believe that al Quaeda will eventually be successful in damaging the Saudi infrastructure. It is simply a matter of time. I believe Chavez will eventually restrict oil deliveries to the U.S. once he has contracts in place with other countries. Venezuela can't pump at full production due to lack of investment in the fields so he has no excess capacity. Anything he sells to someone else he will not have available for export to America. Somebody in the U.S. will eventually buy the Citgo refineries from PDVSA. Chavez will then be free to cut off the oil since his retail profits will not be endangered. Nigeria rebels will not go away. The country is too poor and the rebels are heroes to those in need. All these problems will continue to support prices on a long term basis but there will be short term swings.

Iran is the next real problem. Their nuclear ambitions are scheduled to be reviewed by the UN in early March and that should provide another war of words and threats from both sides. Since an attack on Iran by somebody could eventually impact its energy production that will always be a wild card in the deck.

Iraq is in full blown civil war and while the hostilities are between religious sects today it just provides another reason for somebody to attack pipelines. Insurgents will be trying to take advantage of the unrest to up their activities against the troops on the ground and the evil Satan through attacks on oil.

These events should combine to offset any normal spring decline in prices that occurs in four weeks surrounding March 1st and that means the lows for the spring could be behind us. It would be folly to bet the farm on that but we should continue to buy the dips and add to positions when they are offered.

With the summer rally energy ahead of us we are positioned to take full advantage of whatever forces push oil higher. Our last non-energy position was stopped out on Wednesday when MGIC Investments (MTG) spiked higher nearly +$3 higher on three times the normal volume on no news. We were stopped out by only 7 cents before the decline resumed. Since MTG just authorized a new 10 million share buyback program it is entirely possible that was them in the market supporting their own stock price as it neared a new four month low. Either way we are out and are now entirely energy driven.

Natural gas prices remained firmly above $7 all day Friday and locked in the $7.30-$7.50 range in defiance of the extreme overabundance of gas in storage. Just before the close they were slammed back to $7.00 where they have found support for the last two weeks. Gas prices are not getting off the matt it appears and it is only a matter of time before that support breaks. Discussions about two different pipelines, one from Alaska and one from Alberta Canada prompted industry experts to discuss the gas shortage. The outlook coupled with a -123bcf draw in supplies for the week helped provide support but $7 is doomed as we approach the spring demand slump.

Gasoline supplies are rising as refiners switch to the summer products. I got a kick out of one talking head this week predicting an abundance of gasoline over the coming years. You only need to look at the facts to know he was wrong. Current global vehicle production is around 30 million units per year. (US 17M, China 6M, Japan 1M, Germany 1M, Others 5M+) Between now and the end of 2010 that amounts to an addition of nearly +150,000,000 vehicles to the global consumption pool. Using a very minimal consumption average of only 10 gallons per week that represents new consumption of 150 million gallons per week, 36 million bbls of oil or 5.1 mb of oil per day. Since the majority of those vehicles (17Mil per year) are built and driven in America that 10-gallon average estimate is probably woefully low. This means not only will we have to raise global oil production from our current 85 mbpd to 91 mbpd simply to supply the additional gasoline but even higher to supply oil for all the other uses. OPEC currently estimates that demand will increase +1.7 mbpd in 2006. With China adding 7500 miles of interstate highways and 600,000 cars a month that estimate will be low for 2007 and after. If we are scrooges and increase annual demand by the same 2% OPEC expects it to increase in 2006 then demand in 2007 would be 88.4 mbpd, 2008 90.2 mbpd, 2009 92.0 mbpd and 2010 94 mbpd. Demand in 2010 would be nearly 9 mbpd over the current 85 mbpd rate. I believe that is understating it by several million barrels. Remember China grew demand by +8% last year and should continue to grow its pace of use very quickly. India will also accelerate its use of gasoline and oil products as it builds on its new found wealth as an outsourcing center.

The determinant factor here is simply supply. You can increase demand exponentially until hell freezes over but if you can't produce it in those quantities then the numbers are meaningless. What we will end up with is a price war. Competition for every available barrel/gallon. That price war will slow demand but it will continue to exceed supply every so slightly. Market factors will produce demand destruction due to price but that only makes all available oil even more valuable.

If gasoline demand did increase by 6 mbpd over the next five years it would mean that refining capacity would need to run at 110% to produce the needed fuel. Obviously you can't run at greater than 100% capacity in the reaal world. We simply do not have an extra 6 mbpd of capacity just lying around. That is the equivalent of 12 super size refineries at full capacity.

The winners in this scenario are the refiners because refining margins will widen as prices rise. Valero, Tesoro, Chevron, Exxon, Conoco, etc. On the production side the winners will be Conoco, who replaced their reserves used by +230% in 2005, is my all time favorite simply because of their aggressive stance. They currently control 9.4 billion bbls of proven reserves. Conoco produced 674 million bbls in 2005 but replaced that with 1.55 billion bbls of new reserves. Contrast that with the smaller companies like Marathon, which controls only 1.3 billion bbls. Exxon produced 917 million bbls in 2005 and replaced that by +112%. It means they only added 110 million bbls more than they produced or only 75 days worth of production.

This is why I am so focused on the energy sector. In a world of shrinking supplies those companies that are increasing reserves and increasing refining capacity will be the most profitable as time passes. There is no other investment vehicle that can produce the kind of returns I expect over the next ten years.

Stop losses, where applicable, will be left VERY loose due to the potential for oil to test $55-$58 range. If the stops are too wide for your risk profile please adjust them accordingly.


Natural Gas Chart - 60 min

Crude Oil futures Chart - Weekly

 

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