Option Investor

Confirmation of Theory

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The announcement of Anadarko's acquisition of Kerr McGee and Western Gas Resources for a better than 40% premium above the current stock price was yet another confirmation of Peak Oil theory in progress.

Companies are having a progressively harder time finding new oil reserves and are resorting to buying those reserves instead. Each year every company publishes a statistic known as reserve replacement. You have seen the numbers like XYZ replaced 120% of its reserves in 2005. That means for every 10 barrels of oil produced they discovered 12 more. Unfortunately many companies have been showing negative reserve replacement because they found less than they produced. It is getting progressively harder to find new oil and progressively more expensive.

These companies are now finding it easier to buy another company with reserves to boost their own lack of discovery. In the case of Anadarko it also proved very lucrative. With a recovered cost of $12.40 per boe on Kerr McGee and under $10 boe on Western they have already announced plans to hedge up to 75% of the production from those two companies through 2008. Not only are they buying the companies for a bargain price per bbl but are using their own assets to fund the deal.

The announcement of the deals sent analysts scurrying to find the next most likely targets. In my Option Investor commentary this weekend I listed the targets and I am reproducing that list in the table below.

Takeover Candidates

You should note that all of them are US producers which eliminates the geopolitical risk and the risk of nationalism. It also narrows the targets for us as speculators.

I am not recommending any of these companies for new positions today. The first reason is due to the spikes on Friday's news. Secondly because I am expecting a decline in oil prices and stock prices once the July 4th weekend passes. It is tempting to jump on a couple in hopes of a couple follow on deals but we must use restraint.

The bounce in energy stocks gave us a lift to our current positions although some are still on life support from the -25% drubbing the sector took in May. Despite my expectations for some weakness in oil prices after July 4th we are not going to exit everything. There is always the potential for a string of hurricanes or for Iran to escalate into the danger zone. For these reasons we will continue to manage the positions and attempt to lower our cost in the 2008 positions.

Frontier Oil splits at the close of trading on Monday. It has experienced three days of decent gains and is nearing resistance at $57. It was even mentioned as a takeover target today even though it is a refiner not a exploration company. I am recommending we exit FTO on Monday ahead of the split. I am planning on keeping the July $45 insurance put despite it being well out of the money. After the 2:1 split FTO will be around $27 with the put at $22.50. If we see any post split depression and oil prices begin to decline we could get lucky. At this point I am looking to get our premium back rather than a profit.

To hedge ourselves against a potential August decline we are going to enter a put position on the Oil Index (OIX). The options are not cheap but thanks to the Friday spike we can get in at a reasonable price. If the index declines to only the lows of the prior week at $540 it would be a double and if oil drops to $65 or lower as I expect the index could see $500 and it could be a six hundred percent gain. But, if frogs had wing they could fly. The worst case would be protected from any declines in the other positions.

According to Baker Hughes the weekly rig count in the US fell by -3 to 1,669 compared to 1,370 for the same week in 2005. Active Canadian rigs fell -49 to 392 compared to 257 in 2005. Rigs in the Gulf fell by -2 to 88 compared to 94 in 2005. The overall rig count for North America fell -52 to 2,061 compared to 1,627 in 2005.

The Fed meeting next week could be an added bonus. You may think I am on drugs this weekend but there is a pretty good chance we could see a strong post Fed bounce. There is also a good chance much of that buying could be in energy stocks as the only sector guaranteed to produce strong returns for the rest of the year regardless of what oil does. The acquisitions this week only increased the desire of funds to show how smart they are by having some energy positions at the end of the quarter. Let's hope this scenario plays out and we get a couple good weeks of gains before the end of summer oil slump appears. We do want the slump despite our current positions because it will provide a buying opportunity for new 2008 positions on some of those takeover candidates above. Think long term and we will always win.

August Crude Futures - Daily

December Crude Oil Futures Chart - Daily

December Natural Gas Futures Chart - Daily


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