Option Investor

Pause Before The Storm

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Oil prices dipped early in the week as institutions adjusted positions ahead of year-end. When trading resumes next week we could see a flurry of activity and that bias could be higher. Energy is one of the few sectors still expected to prosper in 2007 and OPEC is determined to see that happen. How determined still remains to be seen but they are making all the right noises to convince traders they mean it this time.

It will be interesting to see what the first week of 2007 brings. We could see a sharp flurry of activity as those institutions and funds still long energy into year-end take profits while others establish new positions. You never know how the New Year is going to kick off.

A couple of stocks, which have benefited over the last couple years are PetroChina (PTR) and Sinopec (SNP). Last January both saw very sharp gains but that trend is not replicated in prior years. I prior years it was Nov/Dec that the big gains much like the gains we saw in 2006. I would like to believe that Jan-2007 will be a repeat of Jan-2006 but we need to trade what we see not what we wish to see. I am adding some insurance for PTR and raising the stop on SNP since it is not a LEAP.

Oil inventories fell by a huge -8.1 million bbls last week but it was due mostly to the week of dense fog on the Gulf coast that kept dozens of tankers from offloading their cargo for more than a week. We can expect inventories to climb for next week's report. This could pressure prices even though everyone knows it is only a snap back rebound.

We are about three weeks from the beginning of earnings in the energy sector and those earnings should continue to be strong due to the continued high oil prices. $60 may be low given the spike back in the summer but it is still +$10 above support for 2005 and +$20 or more above prices before 2005. The key for 2007 will be OPEC determination and continued strong demand from Asia.

The long-term problem is not going away. Since 1985 US oil consumption has increased by more than 5 mbpd while US production has fallen by more than 4 mbpd. Once $1 billion is invested monthly in the US in drilling new wells but the production numbers continue to decline for one simple fact. The larger fields which were easy to find and produce are gone leaving only the smaller, harder to find and slower to produce fields for current explorers. Oil found in these fields costs more per barrel and those numbers will only continue to rise. Over the same period since 1985 our imports have risen more than 9 mbpd. That is an amount equal to all the production of Saudi Arabia. Meanwhile demand from Asia is rising at the rate of Kuwait's production each year. These countries cannot continue to raise output at the rates needed to meet the additional annual demand each year. It is simply impossible. There is a substantial amount of new non-OPEC production coming online in 2008 but this is a one-time bounce and there is nothing on the horizon after 2009 to equal it. Since major new fields require 5-7 years minimum to begin full production analysts already know every major project scheduled through 2015. After late 2008 and early 2009 the outlook is bleak. This long term outlook will continue to support prices although there will still be peaks and valleys along the way.

That long-term view is why we are investing in oil. These are not trades that we get in and then jump out on the next spike. They are long-term positions that will be adjusted periodically to take advantage of the seasonal demand cycles for oil. The next seasonal change should be in Feb/Mar as winter demand begins to slacken and before summer demand is anticipated. Oil prices tend to historically weaken in Feb/Mar and then begin to rise again in Apr/May. We will plan on hedging our bets in late January and then adding to positions in April. Should a geopolitical event disrupt this cycle we will deal with it when it occurs.

Remember I expect volatility in the week ahead so don't be alarmed if long-term support is tested again.

A warning for those with weak hearts the natural gas chart below is very ugly. A complete breakdown of gas is underway due to the very high storage levels and lack of a real winter in the last two years. It could get worse before it gets better unless the perfect storm appears, blankets the entire US and lasts about a month.

Jim Brown

February Crude Chart - Daily

February Gas Futures Chart - Weekly


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