Option Investor

A Valiant Effort

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For six days the January crude contract held the high ground between $62 and $63. On Thursday night it appeared a breakout was imminent with a strong volume surge pushing it to $63.50. Unfortunately the rally could not find any traction and a late afternoon sell off knocked us back to $62 once again. It was a valiant effort holding the high ground all week and returning to $63.50 exactly as id did last Friday. It just wasn't enough.

There were many factors, which could have caused the decline but I believe it was just profit taking with barely a week left on the January contract. I mentioned last week I expected $63.50 to be broken but probably not this week so nobody should have been disappointed. I doubt it will happen next week either.

The noise out of OPEC is still leaning towards another production cut when they meet on the 14th, Wednesday night our time. How much is still a topic of debate and not everyone has boarded the production cut bus. The Saudi ambassador said on Thursday that prices were already imminently fair. I believe that was their attempt to be politically correct in the eyes of the US not because they really wanted less money. Saudi is the swing producer and no OPEC position will work unless Saudi agrees to it.

Late this week there was new violence in Nigeria but it had no immediate on production. The facility exports 200,000 bpd but while one person was killed and several others kidnapped there was no damage to production.

Warmer weather is predicted for next week so natural gas prices should soften although the inventory levels should decline further as a result of last week's cold spell. Falling gas prices will pressure heating oil and crude. Once the January contract ceases trading on the 19th we should be in the high demand cycle where overall weather is colder and shoppers are burning gasoline hitting all the stores and holiday parties.

I wrote about Chesapeake Energy in the Option Investor commentary but I know some readers do not get both newsletters. CHK issued 30 million shares in a new offering that was snapped up by Deutsche Bank (DB) for $31.85 giving CHK nearly $1 billion in proceeds, which they plan on using to pay down debt under its revolving credit facility. Lehman Brothers analyst Jeffery Robertson maintained an overweight rating saying CHK's 2008 production guidance indicates a +12% year over year increase. Armed with a strong balance sheet he believes CHK will fund an aggressive capital program aimed at growing production by +16% and maintain the ability to capitalize on future acquisition opportunities. He also said management has indicated they are planning on turning a large prospect inventory into proven reserves. CHK currently has 8.4 TCF of proven reserves and 16.4 TCF of probable reserves. Once they turn those probable reserves into proven the valuation of the company will rocket higher. That would turn into some $200 billion or more of valuation once proven and CHK only has a $14B market cap today.

I would be a buyer of CHK today at the $32.15 level but only if you have a long investment horizon. CHK has spent the last five quarters consolidating a three year move from fledging company in 2000 at $3 with only 1.2 TCF of reserves into the 3rd largest US independent today. They moved from $5 in August 2002 to $40 in October 2005. Since then they have been dormant trading in a range between $28-$34. Eventually they will breakout once they start being valued for their true reserves. Their current proven reserves are worth something north of $60 billion making them a strong takeover target for one of the majors. If somebody does make an offer you can bet it will be huge given their 25 TCF of Proved and Probable reserves. LEAPs are cheap and even more so when you consider their upside. Even though we have a full portfolio I don't think we should pass up adding CHK on this dip. CHK has their own meteorologists and they are predicting a colder winter than normal which could impact gas prices in January. Since most weathermen are predicting a warmer winter based on the El Nino patterns it will be interesting to see how it plays out.

The CEO from Sempra Energy was on TV this week and he had some interesting things to say about gas. They are building an LNG terminal in Mexico just south of California and although it will not be finished for a couple years they are already completely sold out of capacity for the next 20 years. That is the same story for other LNG builders. The majors know that production is already declining in North America and are planning decades in advance to secure their gas from overseas. How secure those overseas supplies will be is an entirely different question. Sempra is also building the longest pipeline in America in decades from Colorado to the East coast for an obscene amount of money. It is also already completely contracted for years in advance as drillers in the Rockies long for the high priced eastern market. I know most readers don't believe me but natural gas is going to be a real problem right along with oil in the not too distant future.

Sempra (SRE) has a nice chart but only pays a 2% dividend. If you are looking for a safe dividend play now that Canada has decided to tax Canadian trusts then I would look at Kinder Morgan (KMP) with a 6.7% dividend.

The rest of the year is probably going to be uneventful once the OPEC meeting passes. It will boil down to cold fronts and gas inventories and whatever real production cut OPEC actually makes and then sticks with it.

I am constantly asked for the top 5 recommendations from those on a limited budget. Unfortunately those change frequently on a short-term basis depending on the whims of the market. Long term I believe everyone should have a core portfolio consisting of a driller, service company, independent producers, international exploration and refiners. You can double up on those sectors you like, especially on the international explorers. I think having PTR, PBR and SNP broadens your exposure and reduces your risk. Valero, although not a strong performer this quarter is the leading US refiner with sour crude capability. Marathon and Devon are large independent E&P companies that make great sense to own. The majors like XOM, BP and COP have problems that make me want to avoid them. MRO an DVN fill that gap. Diamond and Transocean are bookends in the offshore drilling sector where 80% of the new oil will be found. Schlumberger is the premier service company. I could keep going but before long you won't be looking at just five but like me I keep shoehorning in one more candidate. Just make sure you are diversified within the energy sector. Don't have just drillers or just refiners. One sub sector will always be hot.

Reuters had an article this week suggesting the drillers are due for some consolidation in 2007. Norwegian driller SeaDrill has said they are interested in growing into a world class drilling company and A.G. Edwards thinks they have their sights set on a US company. SeaDrill has been on an acquisition binge and already reached the ranking of sixth in the world. This is remarkable since the company was only founded in May 2005. However, the man behind SeaDrill, John Fredriksen, has the money and knowledge to grow larger. He built tanker company Frontline (FRO) into a leading global carrier. Bear Stearns analyst Robin Shoemaker reported recently that Houston was crawling with private equity firms looking to make deals. Driller day rates are still rising and contracts are being signed for 2009 and later. Money is flowing but drillers are being valued at 2006 values as though the peak had arrived. According to Bear Stearns the most talked about targets for acquisition include GlobalSanteFe (GSF), Noble Corp (NE), Diamond Offshore (DO) and Ensco International (ESV). Merrill Lynch expects a +15% rise in the sector when the first transaction is announced. Competition between SeaDrill and the LBO players should guarantee a premium price for any acquisition.

The majors are starting to release their budgets for 2007 and beyond. Chevron announced a +20% increase in their 2007 budget saying it intends to step up exploration efforts. Chevron is at least going to try and find more oil. Conoco said their budget would be lower in 2007 due mostly to capital spending in their Lukeoil investment in 2006. However, Conoco admits the 2007 budget will not be enough to sustain its current production levels. Looks like trouble on the horizon. APC meets with analysts next week and should release their budget then. All eyes are also waiting for Exxon and Shell to see what they are going to spend.

Congressional Republicans pulled the offshore drilling bill from floor action on Tuesday after it became clear they did not have enough votes to pass it. Two thirds would be required under the existing rules for that vote. The bill would open 8.3 million acres in the Gulf that is now off limits to drilling. It would also funnel royalties of 37.5% from all production to the gulf coast states with Louisiana receiving about half the money. The bill was expected to be brought back to the floor in a manner that required only a majority vote but timing was still in doubt with the lame duck session rapidly expiring. The area in question is thought to contain 1.3 billion bbls of oil and 6 TCF of gas.

China kept outside energy companies waiting all week before releasing new rules for entry into China's markets. When those rules were released there was little for foreign companies to cheer about. China maintains tight controls on commerce and does not want outsiders breaking up the monopoly Petrochina and Sinopec have on the energy business. Between them they control more than half of the more than 80,000 gas stations and nearly all of the 7 mbpd of oil used in the country. For some insight into the process and limitations follow these links:


You will notice very few winners this week but given the outstanding gains in the prior week we were due for some profit taking. Fortunately it was light and left us near multi-month highs in most cases. Of course I am not complaining about PBR +4.32, TEX +3.94, CAT +2.21 and FXI +2.70.

Jim Brown

January Crude Oil - Daily

February Crude Chart - 30 Min

December Gas Futures Chart - Daily


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