Option Investor
Commentary

That Was Fun

HAVING TROUBLE PRINTING?
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Despite a rebound in crude from Thursday's $69.05 low energy stocks failed to gain any traction. The calming noises coming out of Iran and the elimination of Al-Zarqawi sent oil prices to a two week low but it was only temporary. Oil continues to trade in its four week range of $68.50-$73.00 as we await the first hurricane of the season.

Energy stocks and metals are still being dumped by panic stricken hedge funds. When cash is needed you sell whatever has value and then buy those positions back when the liquidity crunch eases. With plunging positions in other global markets the strain on cash and liquidity could be very strong. Many funds are highly leveraged using borrowed money and that increases the volatility. I don't believe the boom in the energy sector is over. I believe what we are seeing is forced selling and profit taking. Corrections tend to take on a life of their own with triggered sell stops taking out more stops producing a cascade of selling until bargain hunters appear in volume.

This is a buying opportunity but we need to wait until a new uptrend appears before taking advantage of it. This is not the time to catch falling knives.

Nothing has changed in the outlook for the energy sector. This selling in the equity market has no relation to the long-term fundamentals. This week the EIA raised estimates for oil demand for 2006-2007. This fact went unnoticed by most given the focus on the equity market collapse. The EIA did not say where this oil was going to come from only that we would need more of it. They did not address the depletion factor or the fact that Nigeria has lost production of 800,000 bpd of light crude rather than the 500,000 bpd previously reported. Using the EIA numbers and anticipated new production coming online over the next two years we will have even less oil available at the end of 2007 than we have today. The table below is a very rough approximation of production figures at the end of 2007. Obviously there will be some production increases due to new technology at some existing fields but these are impossible to quantify. Just using these hard numbers buts us in dire straights by the end of 2007 but there are other production events that may offset this decline. For instance Iraq is expected to boost production from 2mbpd to 4mbpd by 2010 with 1mbpd additional expected by the end of 2007. This is not included in any new production estimates because of the uncertainty surrounding Iraq. Accelerated global exploration surrounding existing fields has the potential to add production quickly as opposed to the 3-5 years needed for new fields. This is also not quantifiable since field build out tends to show up in a slower rate of decline rather than an increase in production. These plus hundreds of other factors make it impossible to predict actual future production but predicting future demand is relatively simple.

China is adding 1000 cars a day in Beijing alone and is expected to have more autos than the US by 2030 assuming they can buy enough oil to fuel them. China is the second largest consumer of oil with demand rising +7.5% per year. Currently they consumer 6.5 mbpd compared our 21 mbpd in the US. China's is growing at a +10.3% rate and accounted for 40% of the increased global demand for oil over the last four years. They are expected to account for 45% of the increased global demand over the next four years. They will increase their total consumption by +150% to 20mbpd by 2020. As China bursts into the 21st century and mobilizes its economy the countries surrounding China will do the same. Greenspan warned last week about the growing oil demand in China and its impact on oil prices. 40% of China's oil is imported.

India is only a couple years behind China in the growth boom with +8.5% growth for the year ended on March 31st. India's $775 billion economy is exploding. Housing is expected to expand by 80 million units by 2015. Think about that for a minute. 80 million new homes and apartments built from scratch over the next 9 years at a cost of over $750 billion. Demand for steel in India is expected to quadruple over the next decade. The increase in Indian oil demand over the next four years is going to be astronomical. Currently India consumes 2.5 mbpd of which 70% is imported. That consumption is expected to be more than 12.5 mbpd by 2020.

Additional demand by China and India alone is expected to grow to 23.5 mbpd by 2020 from the current 8.9 mbpd or +14.6mbpd. Add in the rest of the emerging economies and that additional demand will increase to something in the 20mbpd range. There is simply not enough production in the foreseeable future to accommodate that demand. Saudi Arabia is spending $50 billion to increase production to 12.5 mbpd from their current 11.3 mbpd capacity by 2010. $50 billion to increase capacity by 1.2mbpd in four years. The Iraq oil minister said they could increase production to 6mbpd if they had $20 billion in outside investment and peace. Obviously the money is not the problem but peace could take a decade.

The bottom line to this rant is simply demand is increasing faster than supply and oil prices will continue to rise forever. Not in a straight line but in a long-term trend. We need to be long-term investors and ride out these temporary dips.

I mentioned in an Option Investor commentary earlier in the week that Saudi cut their production back to 9.1 mbpd last month due to an excess of oil in the system. This was from a comment at the OPEC meeting from the Saudi Oil Minister. He said rather than push prices lower Saudi elected to lower production. This is a major change in attitude by Saudi. They have always been the swing producer relied upon to control prices. When prices rose too high they opened the spigot and pushed prices down with oversupply. If this tactic has changed then oil pricing as we know it has changed. By reducing production with oil at $70 it guarantees oil will stay around $70. Minister Naimi said "We will not leave money on the table" when questioned about the drop. If $70 is the going price they will quietly reduce production to maintain that price. This is a phenomenal change in attitude and it went unnoticed by the mainstream press. Ignore the OPEC chatter saying oil prices are too high. That is a sound bite for TV and not reality. It sounds good that OPEC thinks prices are too high but in reality they are maintaining those prices. As long as the demand remains strong they will continue to let prices rise. The Saudi minister said they continued to have problems selling their different grades of crude. There is not enough refining capacity capable of refining their heavier grades of oil. They are working to remedy this by signing contracts with Total and Conoco to build two 400,000 bpd refineries to begin operation in 2011. The refineries will cost $6 billion each and will process Saudi heavy crude into gasoline and heating oil for export to global markets. By refining their own heavy crude into gasoline at what should be $4 per gallon by 2011 the Saudis greatly enhance their income potential. Saudi heavy crude sells at a steep discount to light crude but gasoline sells for a premium. They get to pocket that additional profit and the gasoline can be sold worldwide. This was a wise move by Saudi Arabia.

Halliburton made the news this week saying earnings would double in the next 3-5 years and announced a major contract with Saudi. The contract is the largest oil development project in the Persian Gulf region since the 1950s. It will use 23 rigs to drill some 300 wells in hopes of producing 1.2 mbpd of light crude by the end of 2009. This Khurais project is part of the Saudi effort to raise production to 12.5 mbpd by 2011. No price was put on the Halliburton contract but Saudi said the entire project would cost more than $6 billion including gas plants and pipelines.

Position Adjustments

It was a rocky week for the portfolio but the Thursday dip allowed us to reduce our costs in several positions by selling our insurance puts. In the Trinity Industries position we now have a negative cost and a nice profit. Others were not so lucky. Petrochina has fallen off the cliff and the previously announced exit on the put insurance was triggered just before that put drop leaving us with a sizeable loss. We will work our way out of that loss but we need a new uptrend in energy stocks to appear before we can start. To save space here I am going to discuss the individual position adjustments in the individual play descriptions.

Tropical Depression One

The National Hurricane Center has formally upgraded the storm off the coast of Cuba to pre hurricane status. The first tropical depression of the season is not expected to morph into a hurricane but the storm track is headed directly into the gulf. High winds and heavy rains are expected and the track will serve to revive hurricane fears now that the season has started. This should help push oil prices higher regardless of whether or not it turns into a real storm.

Map track of Tropical Depression One

Outlook for the week

I believe oil will hold over strong support at $68.50 and any dip to that level should be bought. Iran has said it will make a counter offer to the UN Council but hardliners in Iran continue to say that giving up the enrichment process will never happen. The council has given Iran until June 28th to respond to the offer. The IAEA said on Friday that Iran had begun a new stage in the enrichment process and is planning on having a 3000-centrifuge cascade by the end of the year. Iran is taking pages from the North Korea playbook and will benefit from dragging out the negotiation process as long as possible. The press is sure to brag about the talks proceeding and oil prices could moderate if it appears to be working. The impending hurricane season should counter this decline given the approach of storm one.

I would look to add to existing positions on any further dips. Most are at long term support and any resumption of a bid in the broader market should send bargain hunters back into the energy sector in hopes of a deal.

Check out the watch list commentary tonight for some suggestions for adding to or entering new positions for existing plays.


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