Option Investor
Commentary

$78.40, Can $80 Be Far Away?

HAVING TROUBLE PRINTING?
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The sprint to a new record price for a current month contract took us to $78.40 on Friday but it was a short-lived event. The reason for the spike was geopolitical concerns surrounding Israel, Lebanon, Syria and Iran. I know it sounds strange that Iran and Syria would be involved since Syria's border with Israel is very tiny and Iran is two countries away. Both those countries support Hezbollah and Hamas and both want Israel to be destroyed. It is because of their support for those factions that Israel and Lebanon are currently fighting. Hezbollah is a major faction inside Lebanon with bases, offices, prominent leaders, etc. They exist for only one reason and that is to provoke Israel. They exist on donations from Syria and Iran. Hired thugs would be an apt term. Hezbollah, meaning "Party of God", was formed in 1982 to fight the Israeli occupation of southern Lebanon. Along with the Amal movement, Hezbollah has developed into the main political party representing the Shia community, currently Lebanon's largest religious bloc. It was founded with the aid of Iran and Iran continues to fund it. The civilian wing of Hezbollah runs hospitals, news services and educational facilities and participates in the Lebanese Parliament. Since Hezbollah initiates attacks against civilians in Israel and worldwide and supports such attacks by others the EU, U.S. and many other governments have designated them as a terrorist organization. In March of 2005 the European parliament voted overwhelmingly to adopt a resolution stating "Parliament considers that clear evidence exists of terrorist activities on the part of Hezbollah and that the EU Council should take all necessary steps to curtail them." Wikipedia.org has a complete list of Hezbollah activities, organizations and links to other terrorist groups. It is very informative.

Why the current conflict matters to oil prices is even less clear. Israel and Lebanon have almost no oil and do not export any. If you add in Syria the total exports of all three countries is well below 200,000 bpd and production from Syria is declining at about -25% per year. They are not a factor in the oil equation. However, Iran has promised to come to Hezbollah's aid and Iran is the number two oil exporter in OPEC and the most unstable. Iran can't participate in the attack militarily or risk getting hammered by Israel supporters led by the US. With their nuclear ambitions in jeopardy and under review by the UN Security Council it would not be in their best interest to start waging war with Israel. They can however wield their oil card to try and bring pressure on Israel by the more civilized world powers. If Iran threatened to cut off its oil exports the price would jump to $100 or more within days and severely impact global economics. They have threatened to do it if they are forced to stop their uranium enrichment and could easily do it to support their anti Israeli Hezbollah military arm. It would be a non-violent act and entirely possible. In most circles it is thought that Iran and Syria were behind the kidnapping of the two soldiers. Israel was already tearing up Gaza looking for the first soldier when Hezbollah suddenly crosses the border and abducts two more? Kill them yes but abduct them? It had Iran's planning written all over it according to most analysts. Iran wanted to take the focus off itself and put on Israel instead. Knowing America would side with Israel it would damage American credibility in the Middle East at a time when it was trying to develop support against Iran. Traders fearing an oil embargo by Iran bid prices higher on Friday triggering significant short covering.

Saudi Arabia joined the war of words on Friday by harshly criticizing Hezbollah for escalating the situation saying "uncalculated adventures" could precipitate a new Middle East crisis. With Saudi taking sides against Iran and Syria it is diffusing some of the impact. There are fears now that Israel will push Hezbollah back away from its borders and innocent Lebanese civilians are paying for Hezbollah's adventure with their lives. The infrastructure in Lebanon is being systematically destroyed and the best tourist season in decades has been eliminated. Hezbollah has always claimed their involvement in Lebanon was important as a security force against Israel. Lebanon could now look at them and wonder rightly if the cost is too high. The fledging government in Lebanon has been under pressure to reduce the Hezbollah presence given their terrorist ways. The billions in damage is far more than Lebanon can afford and this could eventually be a catalyst for Hezbollah to be evicted from Lebanon. I know this is far from being directly energy related but in the greater scheme of things it comes back to Iran. If Hezbollah is seen to be losing the battle Iran will be more likely to come to their aid rather than watch from afar as they are wiped out. Iran has already warned that any Israeli attack on Syria, Hezbollah's closest supporter and just miles away from the current battle, would be an attack on all of Islam. He said Israel would face a fierce response suggesting others beside Iran would come to Syria's aid. It would not take much for Syria to provoke Israel into trading fire and for Syria to then claim it was attacked. Once Iran takes action of any kind the entire situation will escalate to the next level and more players will appear and the potential for a disruption in oil exports will increase significantly.

Nigeria also added to the price spike with multiple explosions at production facilities and a further loss of production. Italy's Eni, the operator at the location said production would resume soon but the damage to production fears was already rippling around the world.

Stronger than expected gasoline demand last week and a sharp drop of -6 mb of crude inventories also helped fuel the spike. The drop in crude was due more to the ship channel closing the prior week than excessive demand. It also lowered refinery utilization by more than -2% while the cleanup was in progress. Everything should be back in full production next week.

Natural gas futures rebounded even more strongly than oil prices with the August contract spiking from last week's $5.47 low to a high of $6.46 on Friday. This +18% spike came on a strong jump in demand due to very hot weather returning to the south. Temperatures will have to be triple digits from coast to coast for the rest of the summer to produce any sizeable draw in natural gas inventories. Injection into storage over the last week was a net addition of +89 billion cubic feet bringing storage levels to 2,704 bcf. We only need a net addition of +37 bcf for the next 18 weeks to match the highest storage on record of 3,327 bcf going into winter.

America's gas drillers are punching holes as fast as they can setup drilling rigs. My son works on an Ensign rig in the Jonah field in Wyoming. They are paying top pay with raises almost monthly and strong incentives and they can't keep workers. There is so much demand workers change jobs almost monthly for even more money. My son had no experience when he started 8 months ago and now he is second highest in seniority on his rig making about $68K a year working two weeks a month. I would have killed to make that kind of money when I was 27. This illustrates how much demand there is for gas rigs and why there is a glut of gas at present.

The glut is only temporary and due in most part to the warmest winter on record in most of the US. Gas levels were never depleted and a mild spring continued that low demand. Unless temperatures move over 100 and stick for the next six weeks we will have a new record for gas in storage going into winter. That is where the rubber will meet the road. Having two record winters back to back is nearly unheard of and odds are good the climate will shift to an icebox winter and normal gas consumption will return. The December contract for gas rallied back over $9.80 on speculation the trend was about to turn in favor of consumption.

You may have noted that although oil prices were at record levels very few energy stocks were moving higher. It does not take a rocket scientist to see that crude inventories are nearly +10% over the five-year average and we are in no danger of running out of oil over the next month. Demand will begin to slow beginning this week and fall off a cliff on September 5th. The markets are already pricing this into stock prices although oil prices are still impacted by geopolitical concerns. Most energy stocks are still valued on less than $50 oil but established demand cycles are hard to shake. Seasonal demand is going to slow and that means lower prices ahead as we head into August. The wild card here is the hurricane season and of course Iran. Iran is already priced into the market unless they do something stupid. Hurricanes are not since we have not yet had any. Once the first one is spotted prices of crude, natural gas and service company stocks and drillers will begin to rise. No hurricanes, no August gains.

This is why I have not been adding any new energy plays. There are several I wish I had added since they have broken from the pack and pushed higher but overall it is better to wait for the dip and pick our entries.

The International Energy Agency, adviser to 26 nations, said demand will rise faster in 2007 than previously expected. They are currently estimating global demand will increase by 1.57 mbpd in 2007. This compares to the +1.6 mbpd growth the EIA projected for 2006 and the +1.4 mbpd growth expected in 2007. Averaging them still suggests growth will climb by nearly +1.5mbpd in 2007. The IEA went farther and suggested that demand growth would continue to rise by +2% per year into 2011 to 93.7mbpd. Currently we will consume something just north of 86.5 mbpd in 2006 after averaging the seasonal demand patterns. My math must be questionable because I calculate +2% demand growth to be 95.5 mbpd at the end of 2011 but 93.6 mbpd at the start of 2011. They must be using Jan-1-2011 as their calculation date since they say "IN" 2011 rather than at the "end" of 2011.

Since there is only about 600,000 bpd of excess production today, all heavy crude, I constantly wonder where this 7.2 mbpd of new production will come from over the next four years. We already know production from Venezuela and Mexico is falling. Saudi is spending $100 billion to raise production by 1.0 mbpd by 2010. Where is the rest? Iraq hopes to add another 1.0 mbpd by 2009 but do we really count on it until it is on the boat? The IEA says non-OPEC supply will increase next year by +1.7 mbpd compared to an increase of only 1.1 mbpd in 2006 and zero increase in 2005. According to the IEA after 2007 OPEC will have to supply all the additional increases. Unfortunately I don't see any other OPEC countries spending $100 billion to increase production. There is some frantic gas drilling in progress but very few oilrigs. Why? It is because they already know there is very little oil left to find! Most have already resigned themselves to improving their gas extraction rather than waste money punching dry holes searching for oil. The IEA and the EIA are good at issuing monthly and yearly projections of demand growth but are far from adept at suggesting exactly where that oil will appear. I have never heard either one discuss depletion. You know, that -4% annual decline in existing production from old fields. Using the IEA/EIA models existing fields must continue producing forever. I wonder if anyone actually uses their data or do the governments pay them to keep producing pretty numbers to avoid the public from knowing the real truth? That truth will eventually come back to bite them and us but at least we will be prepared for it.

Since there will be less play commentary over the next several weeks as we await the August decline I am going to devote more space to the general commentary and outlook for the future. Once we get a serious dip in prices we will start adding position targets again. I know this is boring for those itching to add some new positions but I only want to add profitable ones and those will be on the next correction in oil prices. Until then we wait and watch.

The sharp drop in the market subtracted from our recent gains on some positions. Despite the rise in oil and gas prices the profits from the June gains were an inviting target for sellers. In times of market stress, recent gainers are often big sellers as holders try to extract those gains before they turn into losses. This is not a trading newsletter so we will see some evaporation from time to time. Some stocks like Walter gave back -$5 while others like BHI gained +$5. We pay our money and take our chances.


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