Option Investor

OPEC Is Our Friend, Really!

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The American consume would never call OPEC their friend but as energy investors they may turn out to be our not so silent partner. We both have the same goal in mind. We want oil prices to continue higher so our investments pay a higher return. Along the way we will pay more for gasoline but I would happily trade an extra $10 a tank for an extra $1000 profit per position.

OPEC met last week and agreed to potentially cut an additional 500,000 bbls per day beginning February 1st. The deciding factor will be the price of oil on Feb 1st. If the price of the OPEC basket of crude is $60 or over they will probably not make the cut. The OPEC basket of crude typically trades at a $5 discount to the light sweet crude prices referenced by our futures contracts. This means they are looking for a LSC price around $65 as being reasonable. Whether this cut actually occurs is anybody's guess but the announcement had the desired impact on prices pushing oil higher to close right at $63.50.

When OPEC decided to cut 1.2 million bbls per day as of November 1st they decided at the meeting exactly how much production each member country would cut to meet their goals. At last week's meeting there was so much disagreement they did not make any quota allocations preferring instead to wait until the cut was actually needed. Since the allocations they made for the November 1st production cut never occurred it makes it even less likely that any cut will occur in February. Even those countries who were the most vocal in calling for the November cut, Venezuela and Nigeria, failed to cut any production. OPEC is notorious for failing to follow through on their quotas and this time around it will probably be no different.

PetroLogistics, the leading tanker tracker and OPEC production analysis company, said November production fell only -100,000 bpd and nowhere close to the -1.2 mbpd OPEC had said it would cut. According to PetroLogistics the December shipments are also holding at the same -100,000 bpd level. PetroLogistics is forecasting the December supply to be 29.3 mbpd according to the preliminary data. The official OPEC production quota after the November 1st cut is 27.3 mbpd. Obviously there is some serious cheating in progress.

You may be wondering why the OPEC announcement last week is so beneficial to us if they are not obeying their own rules. The major point that should not be lost on anyone is that OPEC has shifted from a posture of maintaining a supply of oil at an economically stable price to a more aggressive posture of maximizing their profits. Formerly OPEC wanted to maintain the supply of oil and prices at a level where it was not economically disruptive but still cheap enough to discourage large scale exploration by non OPEC countries. As long as OPEC could maintain that balance they were happy knowing they would eventually become the only global vendor when other supplies began to decline. Basically they knew higher prices would be coming in the future and they were content to wait rather than be faced with competition from other sources. Essentially they were waiting until the time was right to play their trump card.

The difference today is the non OPEC supply is getting tighter as depletion rates are rising and offsetting new discoveries. Demand is also rising as countries like China and India explode into the 21st century. OPEC feels the time is right to play their trump card and begin raising prices to a more market centered rate. They are confident that there is no source of global supply available to compete with them and they are risking nothing now by taking a more aggressive posture. This is the day they have been waiting for since 1950. Actually they probably jumped the gun by a year or so but it will not make any difference in the long run.

With the spike in oil prices over the last two years they have seen that $60 oil has failed to depress the global economy to any great extent and was actually a relief after the spike to the $78.50 high. Now $60 appears to be the floor OPEC is willing to defend. Even better for us it appears they are prepared to slowly push prices higher once winter demand absorbs the current excess supply of oil in the market place.

OPEC members are not stupid even if they are greedy. They will ignore their own quotas only as long as they can get away with it. If the price does begin to fall they now have the official vehicle in place to deal with it. If they actually cut production back to their target of 26.8 mbpd as of February 1st the amount of surplus oil in the market place would be consumed very quickly. According to analysts the current surplus in global inventories is somewhere in the 70 million bbl range. This is down -40 million bbls from the level seen only two months ago. With global consumption of approximately 85 mbpd it is less than one day of excess supply. That is not the total of oil in the system just the excess. For instance the US has 335 million bbls in inventory at refiners and storage facilities not counting the strategic petroleum reserve. That represents just over 15 days of inventory at current consumption levels. That stretches to 24 days if you take into account current North American production including imports from Canada and Mexico. Still 24 days is not a long time considering the volatility in the Middle East. Even with the excess inventory we are always vulnerable to any oil shock anywhere around the world.

The excess inventory came about as the result of three factors. First the winter of 2005 was the warmest on record in modern times in the northern hemisphere. Demand for heating oil and natural gas were minimal allowing supplies to remain at high levels without normal winter depletion. Those supply levels were kept at high levels ahead of the 2006 hurricane season, which was predicted by forecasters to be worse than 2005. Refineries and storage facilities continued to stockpile oil in preparation for a repeat of problems seen in 2005. We suffered months of lost production, some permanently lost and the loss of hundreds of oil facilities in the Gulf. Inventory levels rose in anticipation of another gulf disaster. As you know that disaster never arrived and we were blessed with almost zero impact from the few hurricanes that skirted our shores. The third event was a result of the first two. Prices rose to record levels prompting gasoline prices to move well over $3 in the US and even higher elsewhere in the world. Demand destruction set in and consumers altered their driving habits to consume less gasoline. There was a temporary move to more efficient vehicles and gas-guzzling SUVs actually fell out of favor for many months. This demand destruction was thought to have caused a temporary dip in demand of approximately 1 mbpd worldwide. That left us with high supplies from lack of winter demand. Even higher supplies from a nonexistent hurricane season and a temporary drop in demand for those supplies. The combination of those factors were coincidental and temporary.

OPEC knows if they reduce the excess inventory before winter is over they will be ready for the next chapter in the price of oil. That chapter will be the 2007 hurricane season. We were lucky in 2006 but as we all know every year brings with it new risk. That risk is actually growing as global warming increases the severity of weather patterns with the potential for even stronger and more frequent storms. By depleting inventories ahead of the summer driving season OPEC can create a situation where any hurricane event will produce a repeat of the price spike seen in 2005. The price will rise in the mind of the consumer because of the storms NOT because of OPEC. They can sit back and watch prices move to a higher level confident they can then raise their price supports to a higher level once the storm season abates. They have time and geology on their side. They know they have the majority of the remaining oil and they know non OPEC sources are rapidly depleting. They know they will eventually be getting $100, $125 or even $150 per bbl. All they have to do is bide their time and let nature and consumers do the work for them. As energy investors OPEC is our friend. Like in grade school it was always beneficial to have the biggest kid in class as your friend. OPEC will be the biggest bully on the planet and in terms of remaining reserves they are growing stronger as each day passes as non OPEC sources are depleted. Every time you hear about an OPEC decision on the news just say to yourself, OPEC is my investment partner. They are providing for my secure retirement and an education for my kids.

Encana (ECA) needed protection last week but there was none to be found. Encana fell -4.5% on Friday after releasing production guidance that was lower than their guidance of just five weeks ago. Encana, like other energy companies operating in Canada is seeing a sharp spike in exploration and production costs due to a shortage of equipment and personnel. Several companies have either shutdown or postponed exploration in Canada until the situation moderates. Encana announced a budget of $5.9 billion for 2007 to grow natural gas and oil sands production, a -6% decrease from 2006. The company will fund the budget entirely from internal cash flow and have $1.7 billion in free cash flow remaining. Natural gas production is expected to grow by +9% but oil production is expected to decline by -5% due to accelerating depletion of existing fields. On the plus side they are scheduled to finalize an agreement on Jan-2nd with Conoco Phillips to create an integrated heavy oil business, which will generate immediate additional cash flow for Encana. Encana's average daily production from the partnership is expected to grow about +44% in 2007 to an additional +31,000 bpd. They expect additional pre tax cash flow in the range of $550-$650 million net to Encana in 2007 from the partnership. Encana had planned to repurchase 10% of outstanding shares in 2006 and they have completed 9.4% to date, 81 million shares, and expect to complete the buyback before year end. In 2007 they plan on purchasing another 3-5% or 24-40 million shares out of free cash flow. They are also planning on DOUBLING the dividend to 80 cents per share in 2007. Encana has hedged 1.5 Bcfpd of their 1.75 Bcfpd of 2007 production at $8.49 per Mcf with put options on the rest at $6 per Mcf. Personally I think Encana is doing exactly what they should do and that is increase profitability while targeting their budget dollars where it will do the most good rather than just throw money at everything all at once. What many people don't understand is that those reserves in the ground will become more valuable as each day passes. Encana can afford to wait until the economics make sense to produce them. Why pay high prices today to extract them for $8 per Mcf when they can wait a year or two and get $12 or higher for the same gas?

The sharp sell off came from a downgrade to a SELL by Citigroup citing concerns over the company's portfolio and the reduction in guidance. The selling accelerated by a triple digit loss, -156, in the Canadian markets with energy, materials, metals and financials all taking severe hits. Petro Canada (PCZ) dropped -5% or -$2.11. I am not recommending Encana as a play this weekend because we don't know how long this weakness will last. Chesapeake was hit with the same kind of selling the prior week and continued lower on the fall in natural gas prices this week. Encana, currently $50 is too expensive for the at-the-money $50 LEAP and too far away from the $60 LEAP. It has strong support in the $44-$46 range and I would rather wait to see if we can buy it cheaper.

Encana Chart - Daily

Our Chesapeake play from last week did not get off to a good start but our China plays are doing very well. PetroChina, Sinopec and our Asian ETF the FXI all hit hew historic highs for the week. Definitely no complaints. Unfortunately I do have a complaint about LNG and BTU as they led the loser's list. Remember, we are long term investors not short term traders and we have to take the bad weeks with the good.

January crude futures expire for trading on Tuesday and with Friday's close at $63.50 and strong resistance I would not be surprised to see some strong volatility before Tuesday's close. It all depends on who is holding the most positions in the expiring contract, the longs or the shorts. Longs will be forced to sell and shorts forced to buy so whoever has the biggest position will determine the direction of the price.

The last Commitment of Traders (COT) report for Dec-12th showed commercial traders were long 1,874,312 contracts and short 1,866,618 for a net long position of 7,694 contracts. That does not tell us much since those positions are spread out across all dates. Speculators were long 176,713 contracts and short 140,334 for a net long position of 36,379 contracts. That was a change from the prior week with a drop of -1197 for the longs and +13,659 for the shorts. Again, this does not tell us exactly what is remaining open in the January contract but speculators typically deal in the front month contract. Even with the sharp increase in the short interest it still left that sizeable imbalance to the long side of those 36,379 contracts. If those positions still exist it would suggest a downward bias as they are closed. Just remember, this data is a week old and was prior to the OPEC meeting. It could easily be completely reversed by now.

I am constantly asked for profit targets on existing plays. Even more so now that some are up so strongly. Unfortunately I can't give you a target on a LEAP with two years to go. With oil support at $60 and most predictions for $75 to as much as $85 in 2007 and even higher for 2008 I don't know why anyone would want to be exiting a profitable play. Now we have OPEC acting aggressively in our favor to keep prices high. I do expect exiting some plays in September depending on the hurricane season is playing out. We will reenter with longer leaps at the end of October once the normal end of summer demand dip is over. Remember, we waited for months in 2006 for the October dip to arrive to establish these positions. Don't be in a hurry to exit just because your profits are stacking up. There are more to come. We will be selling some calls in late January and early February to reduce our costs ahead of the normal March demand decline.

Jim Brown

January Crude Oil - Daily

February Crude Chart - 30 Min

December Gas Futures Chart - Daily


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