Option Investor
Commentary

Who Knew?

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Who knew the energy sector was going to explode off the bottom on Thursday? Next time you know in advance please email me. Without any warning energy and materials stocks and almost every other sector exploded on Thursday and fizzled on Friday.

I had several stocks I was watching for new entries but with oil still in a downtrend and riding support at $68.50 I was reluctant to call an entry given the recent market history. We went from impending doom on Wednesday morning to flying high in the blink of a buy program. Shorts were squeezed just like we have seen a hundred times before. Now the true test will be direction next week.

With no hurricanes in sight and a sharp rise in gasoline inventories there is growing pressure on crude prices. Iran is cooling off with the Iranian president saying positive things about the package of carrots and sticks. I am sure both arms are black and blue from twisting by Russia and China to at least appear interested.

There is nothing new on horizon to pressure prices and summer is rapidly ticking away. I know, it seems like only June but after the July 4th holiday the summer gasoline binge will begin to slow. With it will be a cooling of oil prices unless of course a few hurricanes appear headed for the gulf. Prices will again rise as we near the end of summer and the coming of fall as refineries switch to heating oil production. This is still a long way off but the market typically looks at expected demand three months ahead for pricing.

This may sound negative for energy stocks but remember oil is still hovering around $70 and most energy stocks are priced for $40 oil or even lower. Stocks will continue to trend higher just not in a straight line.

There was an item of importance on Friday afternoon that went largely unnoticed by the general media. I want to preface the event with some background first. Since 1956 when M. King Hubbert first correctly predicted the peaking of U.S. oil production in the 1970s there have been many peak prophets using the same decision process to predict a global peak. Hubbert's prediction came true in 1971 for the U.S. but the correct prediction of a global peak has yet to occur. Several have tried with almost a yearly target by someone since 1987. Most were flawed studies with limelight grabbing than actual science. The most recent prediction was Kenneth Deffeyes with a target date somewhere around New Years Eve 2005. Deffeyes has been steadfast in his support of that date and issued an update as recently as June 14th. Because Peak Oil does not mean the end of oil it can and will pass unnoticed and possibly for as long as a couple years. With thousands of fields, tens of thousands of producing wells and about 2000 wells currently being drilled it is a major undertaking to chart current and future production from all of them. Nobody in their right mind would go out on a limb in a very public fashion unless they were reasonably sure of their facts.

If somebody worth billions and with billions invested said Peak Oil was here we should believe them until proven wrong. On Friday Boone Pickens was arguing Peak Oil with John Stossel on the Kudlow and Company program on CNBC. Pickens went on record as saying Peak Oil is occurring now. He said based on his research 85.1 mbpd was the global peak in oil production. He said current global production was declining by -4% per year, the same number I have quoted many times over the last couple of years. That equates to a drop in existing production of 3.4 mbpd per year. He said all new production was going to offset that -4% decline in existing fields. If we only add 3.4 mbpd this year, which is exactly the number I used in my Option Investor commentary two weeks ago, we will only break even on total production. Just to stay even we have to add 3.4 mbpd every year from no on and that assumes no growth in demand.

Pickens also quoted the drop in Saudi production in May to 9.05 mbpd. He indicated it may not have been voluntary as they claimed. Saudi is spending $50 billion in a race to add 1.2 mbpd by 2009 and avoid a global shortfall. Unfortunately the race outcome is already known. By the time that production arrives the demand will already be much higher.

Think what you want about Boone Pickens. He has been called a crack pot by some but he has made millionaires of many. Last year Boone made over $1.5 billion personally and a significant amount for his investors. Stossel was quoting the oft-misused comment that the Canadian Oil Sands held enough oil to supply the U.S. for the next 100 years. It may hold that much but that does not mean they can get it out of the ground. Pickens quickly pointed out that for every 1 mbpd of new production from the oil sands it requires an investment of $70 billion and 5-7 years to build the facilities. Secondly, getting the oil out of the sands requires massive amounts of natural gas as fuel to heat the sand to the temperature required to release the oil. Currently there is a shortage of gas in Canada due to the already huge demand. Ramping up production by several million more barrels would require export of gas from the U.S. and that is NOT going to happen. Despite the apparent glut at present we barely have enough gas to get us through the year as it is. We produce gas all year and pipe it into storage just so we have enough to get us through the winter. With every new house, office building, factory and mall built that demand for gas increases. There is enough oil in Canada to feed the U.S. for 100 years but only if the U.S. goes on a crash diet.

To summarize any 25 individual researchers could predict various dates for Peak Oil and unless I knew them personally I would have to take their claims on blind faith that they actually knew what they were talking about. Or, I could choose to believe somebody that has billions invested in oil and makes billions for his investors based on his research. When Boone Pickens claimed Peak Oil had arrived on national TV and backed it up with facts I already knew to be true and had been reporting for a long time it is hard not to believe him. I also have read Twilight in the Desert by Matthew Simmons and spoke with him at last years Energy Conference in Denver. He is a very well respected investment banker to the energy business. He is not a crackpot and his research is so well documented it is extremely boring to read.

I choose to believe Simmons and Pickens but that does not make their claims 100% accurate. BUT, even if their claims are off target by a couple months or even a year or two the fact remains that Peak Oil is upon us and it is only a matter of time before it become irrefutable fact. In Dec-2005 by combining the research of dozens of authors and production data readily available on the Internet I predicted Peak Oil should arrive in 2007. Granted I could just be propagating somebody's bad research but the same facts kept appearing in dozens of unrelated places. The acceleration of demand growth in China and India coupled with production declines in places like Venezuela and Nigeria may have accelerated the schedule. Every day that passes without the addition of 10,000 bpd of new production is a day that we get that much farther behind on the supply curve.

Current production is 85.1 mbpd or 31 billion barrels per year. We have not added 30 billion bbls to known reserves in any year since the early 1980s. You can't continue to burn 31 gallons of gas in the family car every week and only add 10 gallons every Saturday. It is a simple fact that eventually you will be walking. I used the graphic below last week in a different commentary. It still applies. The IEA raised demand growth estimates for 2006 to an additional 1.7 mbpd and raised 2007 growth estimates by 1.9 mbpd. That means we have to produce 88.6 mbpd by early 2007 or somebody is going to be short some oil. Existing fields are declining at a 4% rate each year. This is the same rate Pickens used on Friday. That is a drop of -3.4 mbpd each year. Add up the new demand and the declining production and you get a negative number and it is coming our way fast.

Back to the present. Oil prices are sliding because of the seasonal demand curve. We had nearly the warmest winter on record and heating oil and natural gas usage at multiyear lows. Inventories rose and we currently have a surplus in both. It is only temporary. Unless the U.S. thermometer suddenly sticks at 68 degrees year round it will get hot as the summer progresses and it will probably get cold this winter. When demand returns to normal those surplus inventories with suddenly begin to shrink. Eventually, either in the winter of 2006 or sometime in 2007 the global demand is going to outstrip global supply. The you know what is going to hit the proverbial fan and $100 oil is just around the corner. Actually $150 oil will not be far behind.

China and Russia have already taken steps to safeguard their future supplies. Analysts tell us not to worry because oil is fungible. That means if Venezuela suddenly quit selling oil to the U.S. and sent 2mbpd to China instead then whomever had been selling 2mbpd to China would then sell it to someone else freeing up someone else's 2mbpd to sell to us. In other words as long as there was 85 mbpd of production and an equal 85 mbpd of demand it would not matter who sold to who since it would all equal out.

THIS IS A WRONG ASSUMPTION! China is buying oil reserves and production with an intent to HOARD. They know their demand will continue to grow. They are NOT planning on selling that oil on the open market but saving it for future use. Why sell it now for $68 a bbl when it could cost them $150 five years from now to replace it? Some people just don't get it but China does. So does Russia and Russia is taking steps to protect their reserves and limit the amount that can be taken out of the country. Within a very short period it will be clear to the world that whoever has oil and can protect it will win. Those who have no oil or not enough oil to continue business as usual will lose. Inflation will not be a concern. High interest rates will not be a concern. $5, $6 or even $7 gasoline will be a strong concern and those who can find a station with gas will gladly pay it.

I know I wandered off on a tangent today but you need to realize this problem is coming our way faster than a speeding locomotive and there is no fix. Nothing anyone can do can stop it. When it appears it is going to devastate the global economy, which was built on cheap oil. Oil will be around another 100 years in decreasing supply but it will no longer be cheap. Wars are going to be fought over oil in the very near future.

Now that I have exhausted my allotted space I will get to the point.

1. We need to buy the late summer dip with the longest LEAPS we can afford.
2. We need to keep cash available once any July/August spike passes.
3. We will move out of current positions in July/August except for those with 2008 LEAPS already.
4. The arrival of hurricanes in the Gulf should be seen as an exit opportunity. Hopefully they will be early and allow for a significant September dip.

I know the last several weeks have been rocky. Market corrections normally are and the fact this one was led by a commodity implosion made it even worse. Keep the faith our time is coming.


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December Natural Gas Futures Chart - Daily

 

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