Option Investor

Another Retest

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Sooner or later we are going to pass this support test once and for all. For four weeks we traded in a narrow band between $59-$62. Last week that band was lowered to $57-$60. Traders are trying to find a bottom but each week manages to find us a few cents lower. Eventually the combination of factors will finally come together and produce a bottom.

On Friday we had a bomb threat at the 400,000 bpd BP refinery in Whiting Indiana. The American Embassy in Nigeria warned that 10-20 coordinated bombings were likely against oil targets on land in Nigeria. Nigeria is the 5th largest OPEC exporter and the 6th largest importer into the US. Nigerian crude is the light sweet variety in high demand for gasoline. Further violence there would add to the current problems.

Iran also took center stage again by highly publicized launching of dozens of different types of missiles including anti-ship and ballistic missiles with more than a 1200 mile range. They made no attempt to hide the reason for the tests and warned the US and its allies to stay out of the Persian Gulf. Both sides are preparing for an eventual conflict and Iran wants everyone to know they will not be as easy to defeat as Iraq's army.

The combination of these factors produced a +$1.26 gain on Friday but that gain was only to $59.15. It is going to be an uphill battle to move over the low $60 level. Fortunately strong earnings by most energy companies has produced a rebound in share prices and stocks are primed for takeoff when oil finally decides the bottom is in place.

December natural gas is fighting its own battles and starting to win the war. Gas prices rallied from a post November expiration low of $7.06 to trade over $8 and close at $7.89 on Friday. The gas inventory report last week showed a draw of -9bcf instead of an expected build of +34bcf. The weather across the country is cold and getting colder. The amount of gas in storage has fallen from the record levels seen over the last month and it is not expected to rise for the rest of the winter. Gas prices had disconnected from crude on a BTU basis as storage became full but that disconnect is evaporating now that winter is upon us. Gas had traded as low as 38% of oil to a high of 73% last week. It should continue to move higher as we move into winter. The demand for gas as an energy source is rising faster than any other US fuel. Gas heats 57% of US homes and powers 130,000 vehicles. There are 62 million gas customers in the US. With new gas powered electric generation plants under construction and 1.7 million new homes, many heated by gas, being built each year it is easy to understand why gas prices will continue to rise. Gas production has peaked in the US and Canada and all current new production simply replaces that lost through depletion of the 425,000 or so producing wells.

According to numbers on the EIA website gas production peaked in 1999 and production in 2005 was -3% below 2004 levels despite a +16% jump in gas well completions. Working wells rose from 302,421 in 1999 to 405,048 in 2004, the last year reported by the EIA. An estimate of producing wells at the end of 2005 is 417,000. Gas production peaked at 24,500,779 mmcf and production declined to 23,518,088 mmcf in 2005 despite the addition of more than 110,000 wells between 1999 and 2005. The EIA claims gas consumption fell -2.23% in 2005 (hurricane impact) and -1.64% so far in 2006 but it is expected to grow by +4.22% in 2007. If you are following the thought here we are rapidly heading into a crisis. Annual production fell nearly 1,000,000 mcf over the last five years but consumption is expected to increase nearly 1,000,000 mmcf in 2006. Eventually this is going to be a major firestorm but consumers remain blissfully ignorant and exploration companies are punching holes as fast as they can just to keep up with declining production. Several energy analysts not related to any private company have predicted the lows for gas this winter could be $8-$9 despite the current surplus in storage. Long term the EIA is depending on imports from Canada and an accelerated LNG build out to rescue the US from a disaster. Unfortunately most of the gas targeted for eventual LNG imports comes from the same politically unstable countries or those unfriendly to the US. We are already at their mercy for our oil supplies and will soon be at their mercy for gas supplies. If a civilization becomes totally dependent on long supply chains from other countries for a vital resource it will eventually be targeted by an enemy. Unfortunately LNG tankers would take only a minimal force attack to transform into a major explosion. They are sitting ducks in any conflict. I am afraid my kids and definitely my grandkids will spend a lot of cold nights thinking about the good old days when gas was available for heating.

Next week we will get the IEA World Energy Outlook, which is released to the public every two years. It is 600 pages of nearly worthless political posturing and costs about $175 per copy. The IEA projections are pure fiction but the world press will lap it up and repeat it ad nauseum as gospel. They will project that the world will consume 125 mbpd by 2030 when there is absolutely no hope of ever producing anything even remotely close to even 100 mbpd. That would require the addition of two more Saudi Arabia's to the mix and those types of fields just don't exist on the planet. The best, brightest and greediest has been searching for the last 100 years and there have not been any major discoveries since the early 1970s. Reaching 125 mbpd is pure fiction but optimistic projections keeps the IEA in business and selling reports. They have developed it into quite a business now selling about 40 titles a year. Some of the other topics in next week's World Energy Outlook 2006 are:

Is Brazil learning new lessons or teaching the world?

Can 2.5 billion people in developing countries switch to modern energy for cooking?

Can biofuels erode the oil monopoly in road transport?

Are conditions shaping up for a nuclear revival?

Is oil and gas investment on track? (They claim any amount of oil can be produced with enough capital investment. Sounds good until you put a pencil to it.)

Of course these are the burning questions I am dying to get answered so I have already ordered my copy. Obviously the readers of this newsletter will get the Readers Digest condensed version about a week later.

We saw several stocks in the energy sector get crushed this week. It was not because of oil or gas prices but due to a change in Canadian law. They are closing the trust laws to prevent companies from changing to a trust from a regular business just to duck taxation. There are dozens of Canadian energy trusts and they were literally crushed by the sudden change in laws. Nobody saw it coming. A sample would be the $54 to $40 drop in Enerplus Resources Fund (ERF) or the $37 to $39 drop in Penn West Energy Trust (PWE). I am sure glad we were not playing that sector. On the positive side money in those Canadian trusts may now be shifting into regular oil and gas stocks benefiting our current positions.

The Watch List this week was an exercise in frustration. The orderly declines we were seeing in some candidates in the prior week turned into a spring higher in the case of MRO and MDR taking them out of range for all practical purposes. All the prospects moved higher without us but we do have a full boat so it was not a serious problem.

I tried to find some candidates outside the energy sector but the pickings were slim. There were some nice candidates but I could not justify the cost. Las Vegas Sands (LVS) is building a string of casinos in China, which are expected to be extremely profitable. The Sands took a major hit on Thursday when they missed earnings slightly for the quarter. With the stock at $72 the $80 2009 LEAP was $16. That seems like a lot of money to me but you do get what you pay for. I am adding it to the watch list to see if the premiums deflate.

Whole Foods (WFMI) received a -23% haircut on Friday due to a reduced outlook for sales. The LEAP premiums are reasonable but will they turn into the next Panera, Krispy Kreme or Boston Chicken? I doubt it but I am not sure I want to gamble this close to their crash.

After spending several hours researching possible plays I kept coming back to energy plays as the best opportunity in this market. Since we already have a large energy portfolio it made it more difficult to add another. In the end I chose HES from our current watch list. We were trying to buy it at $38 and it dipped as low as $40.35 on Tuesday before rebounding to $44. I am afraid if we don't take the entry it will break current overhead resistance and be off to the races like many others we are holding. Because it has not broken out yet LEAPS are cheap.

Chart of December Crude - Daily

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