Option Investor

Even Experts Fail

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The headlines carried the news almost in disbelief. Bo Collins energy hedgefund is closing because of large losses. Bo Collins was the past president of the Nymex and should have understood the risks. He hired the best traders and at one time managed over $420 million in energy investments. The fund, MotherRock, announced this week it was closing after suffering $220 million in losses in June and July. Makes our losses seem rather tame.

It shows that even the best of minds and experts can sometimes make bad bets when they refuse to ignore the facts in favor of their biases. MotherRock believed in natural gas. They were long an obscene amount expecting the price to rebound higher after the collapse from the April highs. Unfortunately the first six months of 2006 were the warmest on record. Natural gas demand evaporated without strong demand to heat homes and businesses. The fundamentals of gas never changed. The uncertainty of seasonal weather patterns simply postponed the inevitable. Prices will go higher but only when normal seasonal weather patterns return. Betting tens of millions on short-term fluctuations is suicide if Mother Nature is not on your side. Ironically two analysts appeared on CNBC late Friday suggesting natural gas was the best bet for the future given its decline and long-term fundamentals. I am sure Mr. Collins will back into his kicking machine every time gas ticks back over $10 for as long as he lives. He disobeyed the rule every trader should live by. The market can always remain contrary to your bias longer than you can remain liquid. Millions of traders have folded trades after watching them plunge into ruin long after they should have been closed only to see the position reverse immediately after they exited.

It may be time to start bailing on oil positions because the number of analysts now predicting $80 oil and higher is growing every day. This is a sure sign of a bubble that needs popping. Once everyone goes long there can be no further gains because there is nobody left to take the other side of the trade. Without shorts thinking we longs are crazy there is nobody being forced to cover.

The analysts have good reasons to expect higher oil prices in the future because we have seen almost daily some new evidence of a problem. Last week Mexico announced the Canatrell oil field was in steeper decline than previously expected. This is the second largest field in the world and second only to Ghawar in Saudi Arabia. Production from the field has declined -15% in the last two years, -10% in the last five months. This is a problem for us because 88% of all Mexican oil exports come to the US. 8% of our total oil consumption comes from Mexico. Mexico was the 5th largest exporter in the world but declines in their fields and increased internal consumption will rob them of that place very soon. Our top three importers are Canada, Mexico and Saudi Arabia in that order. Mexico produced 3.42 mbpd in early 2005. 2.1 mbpd came from Canatrell. That production has fallen to only 1.74 mbpd and is slipping fast losing -10% in just the last five months. According to an official quoted in the Wall Street Journal, Canatrell production could drop -75% by the end of 2008.

I have preached the depletion problem long and hard over the last two years and nobody wanted to listen. This is a perfect example in our own backyard. Once a field goes into decline there is no recovery. The faster that field was produced the faster it will decline. It is a geological fact and no amount of posturing will make it not so. As fields reach their output peak those in charge of producing will begin to resort to more extreme measures to maintain that peak. Gas injection, water injection, additional wells, additional types of wells like horizontal drilling, workover wells, down hole pumps, etc. All these methods are fine and accepted the world over but they only delay the inevitable and at great cost. If a field has one billion bbls of recoverable oil you can only extract 50% before the field begins to decline, sometimes less depending on the geology and oil type. The last 50% will always come out slower and at higher cost than the first 50%. Each percent over 50 will be harder to extract than the one before it. It is a fact of life and like gravity it cannot be changed.

Hastening the depletion problem is a lack of investment in additional infrastructure and the latest technologies. Mexico is a poor country and oil facilities are old and inefficient. Without tens of billions of dollars in new investment this depletion curve will accelerate. The historical depletion rate for an average field is a -4% decline in production per year once the peak has passed. Some much faster and some much slower but they all decline. This is why new global production cannon be added fast enough to prevent Peak Oil. Currently global production is around 85 mbpd. Many of those fields are more than 50 years old. Using the -4% average depletion rate that means we have to add 3.4 mbpd of new production each year just to stay even while demand continues to grow. It is a technical impossibility to beat the depletion clock forever. Experts theorize that 2.2 trillion bbls of recoverable oil exist on the planet. We have already produced and consumed half of that. Much of the remainder has yet to be found because it lies in places that will be very hard to recover once found. The easy fruit has already been picked.

Adding to the problem was an admission from Kuwait this week that they were going to revise down their reserve estimates. No big deal, right? Wrong! For the last two decades Kuwait has been claiming reserves of 100 billion bbls. All the OPEC members raised their reserve estimates by as much as 100% when OPEC went on the quota system. The more oil you claimed you had the larger your quota and the more you could sell. Each country also raised its claimed reserves to preserve their bragging rights. OPEC is a very close-knit club and claimed reserves determines your stature in that club.

Kuwait said they were considering lowering their proven reserves to 25 billion bbls plus another 25 bil-bbls of unproven or probable reserves. Those are reserves yet undiscovered or requiring future technology to produce. The result of their 50% haircut is a sharp drop in the claimed reserves for OPEC and the number used by the IEA and EIA to project future production. Everyone outside of OPEC has known the emperor, Saudi Arabia, and his kids, the other OPEC nations, had no clothes. In other words they were overstating their reserves by as much as 100%. Kuwait stepped into the light and admitted this problem. Eventually the other OPEC nations will be forced to do the same. If you cannot produce more oil this year than you did last year then your veracity will eventually be questioned and the truth will eventually come out.

Saudi Arabia could be the next confessor. Since they claim more reserves than anyone else, 262 billion bbls, they have the hardest case to prove. If you are sitting on an ocean of oil then why has your production slowed substantially over the years to its current 9.2 mbpd estimate from the nearly 12 mbpd in the past? Saudi claims it could produce 15 mbpd in the near future and keep it up for 50 years. Saudi currently has a record 100 drilling rigs in operation compared to the dozen it maintained for decades. Saudi claims it is spending $100 billion in an effort to raise production to 12.9 mbpd by 2010. The problem according to the EIA is the 5-12% decline rate in its existing fields. This was based on a recent revelation by Aramco Senior Vice President Abdullah Saif, as reported in Petroleum Intelligence Weekly and the International Oil Daily. This means the country needs to add between 500,000-1 million bpd in new capacity each year just to maintain current levels. According to Saif, the average total depletion for Saudi fields is 28% with Ghawar at 48%. Many experts believe the depletion rate is much more severe. Saudi has been injecting water and natural gas into its fields for years to maintain pressure and according to experts the water cut in some fields is reaching unusable proportions. In other words the proportion of water to oil in the production output has reached a level where it is not worth the effort. Saudi also announced last week it was now injecting steam into some of its fields to increase the flow of stubborn deposits. Steam production of that magnitude requires monster amounts of natural gas. Gas is in short supply in Saudi due to a rapid build growth of electrical demand from buildings and homes using air conditioning modern appliances and electronics. They would not be burning gas to create massive amounts of steam if they have 262 billion bbls of oil just waiting to be pumped?

Getting behind the depletion curve is an often fatal event. By not investing in infrastructure and advanced drilling and production methods the depletion event will occur sooner rather than later. Once it begins to occur without additional accelerated recovery methods it is many times impossible to return to prior production levels. Once the curve accelerates the availability of funds to increase production is normally a problem. Declining production produces declining income and normally that income is already allocated to other areas. This is especially true in the case of countries like Russia and Venezuela. Once you have driven out the third party oil companies by imposing horrendous taxes or confiscating assets there is no incentive for them to return. Money is spent on social programs to remain in power rather than increasing production. It is a death spiral for the industry and one that can rarely be reversed. Both Russia and Venezuela are experiencing production declines and there is no outside investment to remedy the problem. Venezuela announced that it was no longer going to sell gasoline to 1800 Citgo stations in the US because it was not profitable. Actually it was because they could not produce enough oil to keep them supplied. They also had to commit to buy 100,000 bpd from Russia to meet prior commitments overseas.

I know this rant took on a life of its own this weekend but once I get on my soap box it is hard to quit. I am constantly amazed by how many "experts" fail to do even the most basic analysis before making fools of themselves. I am also amazed by how numbers from the IEA and EIA tend to be accepted as gospel by the press when their estimates are so laughable to those inside the energy community. I just keep this phrase on my desktop, "Those who laugh last laugh loudest."

Tropical storm Chris was demoted on Friday to a tropical depression but it is still headed straight for the oil patch. Oil prices fell on the downgrade but once Chris leaves the Caribbean and its various landmasses and hits the open warm water of the Gulf it could quickly gain strength and become a problem again. Don't ignore Chris until it makes permanent landfall in the US.

NOAA Storm Path

Gasoline Demand Chart

Oil prices may have faded into the weekend but remain centered around $75. This is the neutral zone for oil as we await a resolution in the Middle East, resumption of shipments from Nigeria and Chris. Gasoline demand continues to be strong at 9.639 mb for the week ended 7/28. This was slightly higher than the 9.586 mb from the same week in 2005. This is even more amazing since the price of gasoline is well over $3 across the US. I paid $3.09 for regular in Colorado this week. I know those on the West Coast would kill to get that price but it was the most I ever paid in a non hurricane environment. This is keeping the crack spreads high and refiners like Valero should be printing money. According to one analyst the crack spread last week hit 56 cents per gallon. That is about 250% of normal for this time of year. The problem is refinery utilization, which has fallen to 90.8%. Several refineries are running well below capacity due to problems and the huge outage at the Venezuelan refinery, which is expected to continue for a long time. Crude oil inventories were down -1.8mb this week and gasoline inventories were down -162,000 bbls. With refinery utilization rates so low gasoline imports are rising but the VZ refinery problem is raising the demand and price on the global market. If Chris did develop into a hurricane and its present course did not change it would probably hit the Texas refinery complex and/or the Louisiana complex as well. This could further crimp output and push gasoline prices higher.

Crude oil imports fell by -76,000 bpd last week and domestic production fell -201,000 bpd to 4.94 mbpd. Last August oil production was 5.427 mbpd.

Natural gas spiked to $8.55 on Wednesday due to very hot weather and increased demand. After the gas inventory report showed a +19bcf injection last week prices eased to close at $7.24 on Friday. The prior week saw an unprecedented -7bcf withdrawal from storage rather than a gain. The week was 21% hotter than normal based on heating degree-days. The spike in gas prices from the $5.63 low on July 18th to the $8.55 high on Aug-2nd is an extreme abnormality. That was a +52% jump in price in only three weeks. I sure wish I had been long gas futures! It is no wonder MotherRock is getting out of the nat gas betting business with volatility like that.

The hot weather sent coal stocks soaring along with gas prices and we recovered a lot of ground in our coal plays. If the hot weather continues I would expect them to continue higher.

I considered selling some calls at this level but with the potential for a hurricane disruption I elected to pass. Until Chris hits the Gulf we need to hold off. If Chris evaporates I will send an update with any strategy changes. Fortunately with hurricanes we can see them coming a long way off and can react to manage any short call positions.

I am still expecting a decline in oil prices as the summer draws to a close but geopolitical conditions are providing support. Keep the faith and we will play the cards we are dealt. With earnings over for the majority of energy stocks there is little to provide motive power other than Chris.

September Crude Futures - Daily

December Crude Oil Futures Chart - Daily

December Natural Gas Futures Chart - Daily


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