Option Investor

Expiration Strikes Again

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December futures prices fell off a cliff on Thursday to hit $54.86 and well below last week's high of $61.35. This massive -6.49 drop in only a week, -4.44 in only 48 hours, was due to options and futures expiration with the December contract expiring on Friday. Traders holding December contracts and hoping to see the normal Q4 bounce were forced to dump them when that bounce did not appear. The January contract dropped -$3 but rebounded to close at $58.90 and +$3 over the December contract close at $55.90. The lack of a rebound from the three-month decline has confounded traders who continue to buy the dip only to have it dip lower. The OPEC production cuts and continued supply disruptions have given traders reason for hope but that hope has been crushed. Eventually a Q4 rebound will appear but for holders of the December contract their time ran out. The January contract did decline with the December on Thursday but managed to post a +26 cent gain on Friday. Last month there was a similar rush to the exits and when the new contract began trading as the front month on Monday Oct 23rd it was also crushed as shorts rolled positions forward. It will be interesting to see if the same trend repeats on Monday given the +$3 difference in prices at Friday's close. Regardless of the price action on Monday or the action last week the price of energy stocks has remained firm. There was some volatility on Thursday but most rebounded on Friday. The long-term outlook is still bullish and stock traders are buying the dips.

There was a report released by the Cambridge Energy Research Associates (CERA) titled, "Why the "Peak Oil" Theory Falls Down Myths, Legends and the Future of Oil Resources." This report received much attention in the press and was taken as gospel by many. Unfortunately it is total crap. CERA is even more outrageous than the IEA and EIA. CERA charges $1000 for their reports and would have trouble finding buyers unless they continued to wage verbal war with the Peak Oil crowd. Countries and companies looking for a positive justification to continue business as usual and not be forced to face the coming end of the oil age can purchase this report and sleep comfortable at night. When the bad news finally arrives they can produce the CERA report as justification for their position.

Basically CERA projects that there are 3.74 trillion barrels left or roughly a 122-year supply. Unfortunately 2 trillion of those barrels are still undiscovered according to CERA. They also added to the total things like bio diesel, shale oil, gas to liquid and coal to liquid components. It does not make any sense to claim we are not running out of lemons because we have oranges, apples and watermelons to fill the gap. We are either running out of a finite resource or we are not. Changing what components you consider as part of the resource only confuses those who are not smart enough to read between the lines. It does guarantee a snappy headline and more sales of your $1000 report.

CERA is so grossly optimistic is should be criminal. For instance they project a gain of +800,000 bpd by 2013 from the new discovery in the lower tertiary zone in the deepwater Gulf of Mexico. There has only been one test of the Jack wells, which tested at 6,000 bpd. The oil companies themselves claim the technological challenges from drilling over 30,000 feet under 10,000 feet of water may make eventual production commercially unfeasible. There are no pipelines even remotely close and pumping oil over long distances that deep underwater is not practical. The oil itself is heavy crude, which complicates the production problems and makes the oil less desirable. To eventually produce this oil will require investments of billions and hundreds of new technological developments. For CERA to suggest that we will see 800,000 bpd by 2013 is pure smoke. This is similar to the problem in the Falkland Islands. The area has the second best source rocks on the planet. Oil was found, test wells were drilled and the project eventually scrapped as being to difficult and expensive to produce and too far from land to pipe. CERA also claims the Artic has plenty of oil. Unfortunately there is no route to market. You can't ship it by tanker or create pipelines in sub zero temperatures across hundreds of miles of ice. Building a railroad would be a 20 year project and probably technically impossible. There may be oil there but you simply cannot get it to market in quantity. That makes it useless as a component in any Peak Oil conversation. Any oil that cannot be produced in quantity by 2015 is not relative. It may eventually be produced when prices are $200 to $300 per bbl but not in any volume and not over the next decade.

To recap the Peak Oil scenario there are only a couple facts needed. Demand is continuing to rise with the average daily 2006 likely to come in somewhere in the 84 mbpd range. Most forecasters use demand growth of 1.2% to 2% per year. China and India are prime drivers but the rest of the globe is still contributing to to rising demand. Current production capacity is currently seen to be about 86.5 mbpd once Saudi brings their new 1.2 mbpd online in 2007. Call it 85 mbpd today. The depletion rate on current fields is as high as 10% on some and as low as 4% on others. Using an average of 5% that means we have to add +4,250,000 new barrels per day of new production every year just to maintain current production. With demand rising over 1-mbpd each year and depletion subtracting 4-mbpd that means we need to add 50-mbpd of new production over the next ten years just to stay even. Saudi Arabia claims to have 25% of the total reserves on the planet or 267 billion bbls. Their maximum production capacity is currently 8-mbpd. Adding +50 mbpd of production over the next 10 years would be the equivalent of discovering more than 6 new Saudi Arabia sized fields, drilling 40,000 new wells and constructing more than 20,000 miles of pipeline. Since it takes 5-7 years to begin production of a major new field this means that those 6 new super giant fields will have to be discovered over the next 3 years. Since no super giants have been found since 1961 the odds are exceedingly slim this fairy tale will come to pass.

Peak Oil is simple math. The world consumes 31 billion barrels of oil each year. Over the last two decades discoveries have averaged less than 9 billion bbls per year with recent years dipping as low as 6 bb. Proven reserves are somewhere in the 850 billion range, 1,000 bb if you allow for the erroneous reserves reported by OPEC members to justify their higher production quotas after 1985. We have already used one-trillion bbls over the last 150 years. At the current rate of use our current proven reserves would run dry in only 32 years. That date is not our problem. The date we have to worry about is the date production begins to decline. From that point on oil prices will only move higher, gasoline prices will skyrocket and we will no longer be debating the topic of Peak Oil. The topic then will change to global resource wars. Countries will try and take what they need to survive. They will go to war to protect what they have. Since the US consumes 26% of the worlds oil we have the most to lose and the most to protect. Permanent global recession will arrive as the oil age begins its decline. Oil will not run out for 100 years or more. Only cheap oil will disappear and with it the energy consumption lifestyle we all enjoy.

It is not a question of whether Peak Oil will arrive. It is only a question of when. Some claim it is here now, others claim 2007-2009. Still others feel it will be between 2010-2015. CERA claims it will not arrive until 2040. This target assumes the globe shifts to bio diesel, electric cars, solar heating and another two trillion bbls of oil are discovered over the next 20 years. That would be equal to the amount of oil discovered since oil exploration began. You decide which future is likely to come to pass. I already know where I stand.

We were triggered on the PCU entry on the watch list and right at support. I am moving Marathon from the watch list to an active play after it rebounded +$2 on Friday from the lows created from the crude expiration dip. We are not likely to get our entry point and it is showing strong support. I am writing on the road this weekend and the play descriptions will be short. I am sure you already know these stocks so little direction should be needed.

Chart of December Crude - Daily

January Crude Oil - 30 min

December Gas Futures Chart - 30 min


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