Option Investor

What Dip?

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After testing support at $59.25 the prior week the price of oil rebounded dramatically to near $64 as the week progressed. The dip in energy stocks was erased as multiple days of oil gains of more than a buck attracted buyers like ants to a picnic. The dip on Friday was likely a combination of factors linked to a quadruple option expiration more than anything directly related to oil.

As I explained in the Option Investor commentary this weekend the new rules going into effect for the formulation of gasoline and diesel inside the U.S. will cause prices to rise for those products. The demand for light sweet crude, which will be easier to refine to the new specifications will increase. As the price of refined products increases it will push the price of crude higher despite it being the tail wagging the dog.

Geopolitical risks continue to dominate the oil outlook with some kind of risk for each of the top five exporters. Why is it that high oil reserves tend to be in places with political instability? Is it perhaps the influence of billions in easy revenue that attracts the worst in governments and rulers? Of the top five exporters, Saudi Arabia, Russia, Norway, Iran and Venezuela, political unrest and/or unstable dictators afflict them all.

While that may be unfortunate for the rest of the world it will eventually make us a lot of money. We know that it is only a matter of time before once of those firecrackers explodes and disrupts the delicate balance of oil demand and consumption. Even if we do not have any external event the approach of Peak oil will provide the unsettling influence that triggers the disruption. It is only a matter of time and time is on our side.

The rebound in energy stocks right to resistance has given us another chance to sell covered calls against our leaps but I am not sure we want to take it. The end of March ad early April is typically when prices begin to rise ahead of the summer driving season. We might get one more dip but with the Iran problem and the promise of further attacks in Nigeria I am afraid we could be running the exercise for nothing if we get stopped out almost immediately for our efforts on a continuation of the current bounce. However, there is a good chance a part of the bounce was option expiration related so I am going to take the chance on a few positions where our cost is high. If you would rather not take the risk it is always your call.

I believe anyone invested in the energy sector should pay close attention to the December futures. They are currently trading just below $69 and reflect the potential for further geopolitical events and new disruptions as we enter the hurricane season again. 2005 was the worst hurricane season in the 154 years since records have been kept. The 2006 season is also expected to be very strong with 17 named storms expected. Nine are expected to be hurricane strength and five are expected to be category 3 or higher. In 2005 we had 27 named storms, 9 hurricanes, 8 category 3+ and 4 category 5 hurricanes. If the current 10 year storm cycle is still in place as predicted then the estimates for 2006 could be easily be exceeded. The hurricane forcaasters are predicting a 81% chance if at least one major hurricane striking the mainland (gulf) and 64% chance of a Florida strike. Given the 2005 record and the increasing strength of this cycle I doubt you could find anybody to bet against those odds. The official hurricane season begins June 1st and continues through November 30th. In 2005 storms were still being formed as late as December 30th (tropical storm Zeta) and it continued through Jan-6th, 2006 as only the second storm on record to exist in two different calendar years.

Many rigs and platforms damaged in the 2005 storms have still not returned to production with only three months remaining before the 2006 season. According to the Minerals Management Service 348,253 bpd of oil is still offline in the Gulf along with 1.403 bcf of natural gas. Any storm that forms and heads for the Gulf will set off alarms and evacuations on a greater scale than before. Repair crews are working at full speed trying to finish repair before the new season starts.

Regardless of how the winter season ends we will have no shortage of natural gas. With gas in storage currently +59% higher than average it appears almost a guarantee that we will end somewhere in the +70% range over historical norms. It positively amazes me that CHK, ECA and UPL are trading so much higher given the drop in gas prices.

According to the Baker Hughes rig count for last week there are 1532 active rigs in the US. 238 of those rigs are drilling for oil and 1292 for natural gas. You may find that incredible but the sad truth is that there is little oil left to find in North America and lots of gas. However we will need that gas very soon. That +60% extra we have in storage right now can be gone very quickly if a severe cold front settles in for a couple weeks or more likely a long hot summer appears.

Patterson Energy (PTEN) produced the following slides for the 2006 Small and Mid-Cap Conference on March 14th. The first one shows the faster depletion of gas fields than previously thought. By the end of 2005 existing fields were estimated to be declining at a 30% rate. This requires more gas to be found faster to offset the faster depletion in old fields.

U.S. Natural Gas Depletion Rates

They also posted a slide indicating a trend of smaller discoveries as the number of wells increased but the density of the finds decreased. From 1990 to 2000 wells in the lower 48 states produced -28% less than previous wells. In western Canada they produced 75% less. This is a rapidly growing problem since huge amounts of natural gas are required to melt the oil out of the oil sands.

Gas Production Rates per Discovery

In order to offset the decline in production per new well and the faster depletion rate of mature fields the number of wells has skyrocketed. 60% of the gas supply for the US comes from US land based wells. 24% comes from offshore wells and 16% is imported, mostly from Canada. Gas imports from Canada declined -8% in 2003 and an additional -1% in 2004. Numbers for 2005 are not yet available but it is assumed there was another decline based on the demand for gas for the oil sands projects. To offset the decline in gas production the number of wells drilled in the US has risen more than 100% in the last five years to more than 23,000 in 2004. 23,000 new holes were drilled and yet total production has remained topped out at just under 23 TCF since the level was first reached in 1996. Just under 130,000 gas wells have been drilled since 1996 without increasing total production more than 1 tcf per year. This is an amazing statistic from the US Dept of Energy.

Gas Wells Drilled

Gas Produced

This entire presentation is available at this address:

I can summarize the gas crisis in two sentences. In order to maintain the current level of gas production more than 23,000 new gas wells must be drilled each year in the US. Gas consumption is increasing daily and within a couple years it will require as many as 30,000 new wells per year just to stay even.

This is the law of decreasing returns in its finest form. We simply cannot continue to punch more holes faster just to stay even. There are simply not enough rigs and they can't be built fast enough. There are an estimated capability to build 170 rigs per year at $10-$12 million each. To continue gas production at the current rate more than 850 new rigs will need to be added over the next five years.

Wells are being drilled deeper which means slower. One of my sons works for a gas driller. They were drilling shallow wells of 6000 ft northern Colorado at one every 7-10 days. When he transferred to the Utah-Wyoming border to drill in the Pinedale anticline they are drilling twice that depth and it now takes them 22-25 days per well. You do the math. 25,000 wells in 2006 to maintain current production at an average of 36 wells per year for a shallow rig and 15 wells for a deep rig. According to Baker Hughes there were only 1292 active gas wells last week. Bottom line the price of gas is going up. Way up! It may not happen this month or next but once the summer heating season arrives the excess in storage will disappear and the race will begin again. That is why the gas stocks are moving higher while gas prices are currently stagnant.

I hope everyone was not bored this weekend with the lengthy dissertation on the gas industry. The oil story is the same only the cast of characters and the stage is much larger. To illustrate briefly the dire circumstances in oil I need to only show one statistic. Saudi has averaged less than 20 active rigs for the last decade. Sometimes only 10-12. Over the last year they have contracted for rigs from every part of the globe and currently have more than 100 rigs under contract with 52 active as of last week. Why would Saudi suddenly launch into what could only be described as an extremely aggressive exploration campaign if they had all the oil capacity they claim to have? It is obvious to anyone who studies this daily. Their aged super giant fields have begun to decline rapidly and they need to add new production from satellite wells as fast as possible or the world will find out before they are ready that the oil giant has no more oil.

If anyone tells you there is plenty of oil don't try to argue with them. You can't teach a pig to talk or a cornucopian energy math. It will only frustrate you both. Just agree with them and smile and then go buy some more leaps.

AApril Crude Oil futures Chart - Daily

December Crude Oil Futures Chart - Daily
(390 min to remove bad ticks)

April Natural Gas Futures Chart - Daily

December Natural Gas Futures Chart - Daily


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