Option Investor

Selective Vision

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Oil spent a week trading flat between $73.50 and $75 while waiting for the next geopolitical shoe to drop. That drop came on Friday as the UN and several nations friendly to Israel called on them to end the fighting and for a peacekeeping force to take their place. This calmed fears that the conflict would escalate and oil dropped -1.15 on the news to a four-week low on the September contract.

Energy stocks were already trading on both sides of the ledger with some moving higher and some moving lower. Traders were using selective vision in their stock choices based on guidance from the various earnings reports. Exxon, a tortoise of a stock with six-billion shares outstanding, gained nearly +$10 over the last eight weeks as investors fled to the safety of large earnings. Exxon posted a profit of $10 billion for the quarter and claimed for the first time in recent memory that they were selling all their production and hinted at tight supplies. Under their prior CEO the price of oil was always blamed on the market because there was "plenty of oil" and no Hubbert's Peak in sight. Evidently the new regime has not caught on to the finger pointing elsewhere to take the focus off the record profits. Exxon did manage to increase their production by +6%, which is an amazing accomplishment given their broad scale.

Chevron disappointed with lower than expected earnings after analysts over compensated for the addition of Unocal production to their revenue and earnings. Oil companies are reaping massive profits with an average selling price for the quarter around $66 for a bbl of oil. With oil hovering between $73-$75 last week it would look like there were more good times ahead. Several analysts disagree. JP Morgan expects prices to remain over $70 in Q3 due to hurricane risk but falling to $65 in Q4. Oppenheimer sees a continued $67 average for the rest of 2006 and rising to $71-$72 in 2007. For prices to average $67 for the rest of 2006 that suggests we could see numbers around $60 before the year is out. Of course this estimate was also predicated on nothing happening on the geopolitical arena or weather in the Gulf.

Based strictly on the charts there is very strong support at $70 with a decent speed bump at $72 where the 100-day average is resting. The refinery problems over the last two weeks raised the crack spreads to more than $20 again and producing huge profits for the refiners, especially Valero. That will not last once the summer driving season ends. I created a nice bar chart for the Option Investor wrap this weekend and I am repeating it below for reference. Gasoline demand has yet to ease significantly since the July 4th peak but it is only a matter or time. Once inventories begin to rise again the price of oil will drop sharply, weather permitting.

Natural gas was the winner for the week with a spike from the $5.63 low on the 18th to a high of $7.38 on Thursday. The rise in gas was due to the very hot weather across the country. Utilities experienced record electrical demand and gas supplies saw their first decline of the summer of -7.0bcf. This compares to the net additions we have been seeing of +60 to +70bcf. With some supplies still offline in the Gulf and the potential for hurricanes to at least temporarily shut in some more it appears there could be additional upside for gas prices. Just two weeks ago the outlook was grim with supplies +28% over the 5-year average. That was down from the June-1st level where supplies were +52% over the 5-year average but still very plentiful. If the hot weather continues the trend in the graph below will continue as well. This image represents how much larger gas supplies are compared to the five-year average. The percentage was higher late in the spring because the warmest winter on record failed to produce any demand. Gas supplies rose sharply to peak in mid-April. As summer progresses the percentage over the 5-year average actually fell steadily despite the very strong insertions into storage. Just a couple weeks ago analysts were talking about the potential for record storage levels going into the coming winter. Now that talk has reverted back to worries about supplies if August temperatures follow the pattern for the last couple weeks.

Gas Inventories

Earnings are nearly over for the energy sector. Energy companies tend to congregate in the past week and everyone report together. Only a few stragglers remain who have random reporting dates. The analysts were mostly positive about the energy sector and guidance with oil still comfortably over $70. Energy companies are still valued based on oil under $50, sometimes well under $50. That leaves plenty of room to grow but not until after we get the end of summer decline in oil prices. There is a neutral zone where demand declines and refineries begin the switch back to heating oil. This is where I hope to pick up some bargains before the winter price rise begins. My only hope is that we don't see any hurricanes before we get our entries. Otherwise we could get a crisis spike that prevents the regular dip from occurring.

I am not expecting any material gains over the next couple weeks without a hurricane. Energy should go dormant once earnings are forgotten. Be prepared to jump if the situation warrants as we maintain the hurricane watch.

September Crude Futures - Daily

December Crude Oil Futures Chart - Daily

December Natural Gas Futures Chart - Daily


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