Option Investor

Will This Be the Breakout?

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After two months of wandering between $63.50 and $60 I think we have a good chance of seeing a breakout soon. This is the 5th time in two months we have tested $63.50 on the January contract and factors are finally lining up in our favor. We have cold weather, possible civil wars and the likelihood of another OPEC production cut pushing prices higher.

The cold front covering much of the US is still pounding everybody from Utah to New York with frigid cold and causing heaters to run continuously. With just the initial edges of the front hitting last week gas supplies saw a -32 bcf draw and the fourth draw in the last five weeks. Substantial draws this early in the winter could set up a shortage in February. The draw down for this week could be much stronger. Gas prices rose over $9 on Thursday but eased on Friday on profit taking after weathermen said temperatures could warm late next week. Since oil and gas prices trade in tandem on a btu basis the rise in gas helped support the rise in crude even though the crude spike was due to other issues.

Saudi King Abdullah warned that Iraq was not the only country in the region with internal problems. He said we could easily see civil war breakout in 2-3 other countries if tensions were not eased. Since every other country in the region is an oil producer that caused prices to tighten in fear of a future supply problem.

Also on Friday the OPEC President Edmund Daukoru said another cut of at least 500,000 bpd was likely at the Dec-14th OPEC meeting. He said OPEC was still not fully satisfied with the level of oil prices. He said, "I am beginning to be happy with the current prices but not fully happy yet." Considering OPEC agreed to support the OPEC basket of crude at $50 at the last meeting and it is trading today at $55 they should be happy. With light sweet crude at $63.50 they should be ecstatic. Funny thing about addictions, enough is never enough. We may be addicted to the black crude running through our mechanical veins in the US but OPEC is also addicted to our dollars, which support them and their lavish lifestyles.

Oil traded in the $25 range as late as fall 2003 before it began its rise to the recent high of $78.50 in July of this year. The current price of $63.50 was not reached until July of 2005. That is more than double the price just a year earlier. Today $63.50 is not enough to make them happy. How quickly they became addicted to the higher prices. This should emphasize to everyone that oil prices are NOT EVER going significantly lower.

Dec-2007 Crude Chart - Monthly

Once OPEC saw that the world did not come to an end with $60 or even $80 oil they realized that maintaining their prior $28 target was ridiculous. You can bet that their target, now close to $60 for the OPEC basket of crude, will continue to rise. Previously their fear was a global slowdown if oil prices rose too high as well as increased exploration outside of OPEC adding to the supply of oil and reducing their pricing power. That fear no longer holds since they have seen no material slowdown from the price spike. Global exploration has intensified but global discoveries have not. They no longer need to fear a sudden surge of outside oil.

Discoveries of new oil have declined sharply since the late 1970s and have averaged only about 8-9 billion bbls per year since 1990. We consume 32 billion bbls per year. Do the math. OPEC has nothing to fear from exploration outside of OPEC.

If OPEC cuts another 500,000 bpd they might actually get to the -1.2 mbpd cut they made on Nov-1st. According to a survey by Reuters the cuts actually made amounted to only 785,000 bpd and were mostly in the high sulphur crude that is harder to sell and refine. There was very little cut from production of light sweet crude. Another 500K cut in high sulphur crude would be mainly symbolic and still not impact the overall supply glut. Their storage tanks are probably full of the high sulphur product and they need to cut production because they have no place to put it.

For those readers new to this newsletter there are multiple grades of oil. To simplify the explanation there are heavy and light crudes and sweet and sour crudes. Sour crudes are high in sulphur and very few refineries can use them. The same goes for the various grades of heavy crude. The product needed by the majority of refiners is the light sweet crude. This is the easiest to refine and produces the most gasoline per barrel. Refineries are like your car. They are setup to refine certain types of crude only and cannot use the other types. Just like your gasoline powered car cannot use diesel a light sweet crude refinery cannot process heavy sour crude. We could be floating in heavy crude and gasoline could be $10 a gallon if there is a shortage of light sweet crude. Roughly 80% of the US refineries require light sweet crude. This is the grade of crude you see quoted on TV and in the press. The price for other grades is never mentioned. According to the EIA the global demand for light crude has been rising over the last decade while the demand for heavier crude has been declining. Some of this is due to rising emission standards making it less profitable to refine sour crude and by the rising demand for gasoline and middle-distillates. The EIA also said the global refining capacity for heavy crude has been declining since the early 90s as refiners elected to shutdown older heavy crude refineries rather than spend billions upgrading them to current emission standards. There were 320 refineries in the US in 1980 and that number has fallen to just over 170 today. Total global refining capacity at the end of 2005 was just under 85.4 mbpd. Heavy oil capacity was less than 27.5 mbpd or less than 30%. Much of that heavy capacity is dedicated to producing other products rather than gasoline because the oil has different properties than that used to make gasoline. As demand for gasoline increases the demand for sweet crude will also increase. The IEA estimates that refinery demand will reach more than 95 mbpd by 2010. That would require the addition of 9.6 mbpd of capacity or 48 average sized refineries. This is NOT going to happen. There are refineries planned and under construction but they require a 4-6 year construction cycle. Those under construction only add about 3 mbpd to capacity through 2011.

Hearing in the news that there is 100 million bbls of excess oil in the system as we heard from Saudi last week, is meaningless. If that was all sweet crude oil prices would be plunging. The price of oil is set by the refiners, not OPEC, not the drillers or producers. Refiners buy oil in advance of their needs for future delivery and you can bet they would not pay $63.50 a bbl if they could buy it cheaper. It is a bidding war for sweet crude and it will only get worse as gasoline demand increases. This is why Valero is in the right spot at the right time. Valero made a decision years ago to increase their refining capacity for sour crude into gasoline. Sour crude typically sells at a $10-$12 discount to sweet crude. Based on current trends it was the right decision. Their margins will rocket higher as gasoline from sweet refiners is priced higher to offset the price of the higher crude. Valero will still be receiving the higher gasoline prices but paying lower crude prices.

Back to the original topic the price of sweet crude will continue to rise long term. OPEC has figured out that higher prices did not hurt the market and I am sure they have a $100 price target in mind for the years to come. It makes no difference how much heavy crude is in the market, sweet crude will continue to be in strong demand. Raising prices though market manipulation is another way to punish the US for attacking Iraq. The US consumes 26% of the world's oil and much of that comes from OPEC countries. This is a way to get back at us while smiling and maintaining a politically correct posture.

While I would like to believe oil prices will breakout of the $63.50 resistance next week I am not convinced it will happen. Factors may be working in our favor but that is strong resistance and there is only two weeks left on the January contract. Trading terminates on Dec-19th. This suggests we could see some profit taking because any refiner who actually wanted to take delivery has probably already bought what they needed. However, the February contract has already broken over it's corresponding resistance at $64. I do expect the later contract months to continue rising. In the short term any profit taking in the front month January contract should provide additional entry points for those considering additional positions.

On Tuesday afternoon I sent out a new play on Sinopec (SNP) when the drop in the dollar knocked it back to $74. SNP does not have LEAPS so I recommended the July $80 calls then trading at $5.40. SNP closed the week at $81 and those same calls are now $9.20. There was a volume of 14 and open interest of 94 when I sent the email. Volume jumped to 140 before the day was out and open interest is now 292 with no corresponding increase in any of the other strikes. It is encouraging to see that many readers respond to my email and it is fulfilling to see them so richly rewarded. Congratulations to all who acted on that recommendation.

With the addition of Sinopec and Cheniere Energy, which was triggered on the watch list we are up to 30 total positions. I was not going to be adding any new positions until some were removed but after reading the news on RIG this week I had to add TODCO to the watch list. The game plan was to load the boat on an October dip in oil prices and we did that with great success. Now we need to let these positions mature and then collect profits. Continue to read the play descriptions on any position you hold. I am going to be changing the stops and insurance over the coming weeks.

It was a great week to be long oil and we saw major moves in many of our positions! Like George Peppard used to say in the A-Team series on TV, "I love it when a plan comes together!"

January Crude Oil - Daily

February Crude Chart - daily

December Gas Futures Chart - 90 Min


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