Option Investor

Oil Traders Can't Stand Prosperity

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After a sudden sprint to $61.35 on Thursday the price of oil imploded again on Friday falling 1.75 to $59.50. The sudden prosperity evaporated as traders took profits into the close. It is all about the news and the news on Friday was a forecast of slowing demand by the IEA. Despite the IEA being the most unreliable predictor of oil demand their routine announcements add further volatility to the market through headline risk.

It is all about the headlines and Friday's headline that "global oil demand had slowed." That conjures up visions of tankers lining up outside offloading points with millions of barrels of oil and no place to put it. That is far from the case. The IEA said demand for 2006 had only grown +1.10% vs +1.12%. That equates to a drop in demand from 84,500,000 bpd to 84,483,100 bpd. This represents a whopping -16,900 bpd drop in the demand estimate. Was that worth a drop of -1.75 in the price of oil on Friday. I seriously doubt it but it proves that it is all about the headline not the facts.

The IEA also reduced their demand growth estimates for 2007 from a daily demand of 86,000,000 bpd to 85,900,000, a drop of -100,000 bpd. What was lost in the headline shock was the translation that even with the -100K drop in estimates it still represented a jump in demand of 1,500,000 bpd. That is the equivalent of adding the complete output of another Libya, the 7th largest OPEC exporter, to the daily production demand. That is just slightly below the daily output of Kuwait. The bottom line was no material change in the forecast but a carefully worded press release succeeded in capturing the global headlines by the IEA once again.

In other news demand from China in September fell to growth of only +6%. That was also trumpeted as a major change but it is all based again on the context of the statement. So far in 2006 China oil demand growth is roughly +7-8% for the year. Earlier this year it was growing at a +9% rate. September saw growth dip as China raised the prices on gasoline and diesel for the second time this year. This pushed growth to the lowest level for the year as consumers absorbed the rate increases. Usage is expected to rebound just like demand in the US did once the sticker shock of $3 gasoline passed. The demand dip is only temporary and growth for the entire year is expected to be in the +7-8% range as is the expected growth for 2007. When putting this in perspective it growth of 8% that much worse than the 9% growth at the start of 2006? Not in my book.

Also overlooked was the IEA claim that oil demand in Q4 would rise +2.4 mbpd over Q3. That jump of +2.4 million bbls will quickly erase the current surplus and put the markets back in balance. The October decline was simply a seasonal decline accelerated by some demand destruction from late summer due to higher gasoline prices. Readers of this newsletter will remember that we were expecting the decline as far back as mid August. It is only those who are unfamiliar with the oil sector and seasonal trends that get excited and shaken out of their positions when these headline occur.

There are signs that a global contraction in economic activity did slow growth in oil demand and should this economic contraction continue we would have slower oil demand growth until that contraction passed. Remember, that is slower growth not a reduction in demand. Keep that fact in focus as you review future headlines.

The earnings for the energy sector are over and there were quite a few surprises to the upside. The expectations for lower earnings due to the reduction in oil prices did not come true and the sector performed beautifully. The drillers were the standouts with strong earnings and strong guidance. Those who felt the drilling sector would show the effects of a pause in exploration were wrong and drillers like RIG, NBR and DO posted strong earnings with rising backlogs and rising day rates. The expected cooling in the sector did not appear.

I am not adding any new plays this week. We have a full boat of energy plays and we need to wait for either a strong dump in oil prices or an upward trend to appear before adding new targets. I also could not find any non energy plays I was willing to put my money in given the current lackluster state of the market. If I am not willing to buy them I certainly can't recommend them. The Dow is wandering sideways and has lost its leadership role. The Nasdaq is trying to assume its normal end of year role as leader and is finally trading over the prior 2375 resistance range. I would take a chance on a tech LEAP but I could not find any that were stable enough to place a bet. Hewlett Packard was the only tech that attracted my attention but I added it to the watch list rather than making it a firm play. If the Nasdaq does take over as market leader then we will catch HPQ on the breakout. I refuse to add plays just to add plays. We are better off waiting for the market to stabilize than entering a new position on hope alone.

Chart of December Crude - Daily

December Gas Futures Chart - 30 min


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