Option Investor

$50 Oil

Printer friendly version

February crude futures hit $49.90 intraday on Thursday and that appeared to be a successful test of support at $50. However, appeared is the key word in that sentence. With a -$11 drop in the price of oil since 2007 began it was a perfect spot to close any short positions. This was even more compelling considering the February contract ceases trading on Monday. Why hold any short positions over the weekend where a geopolitical event could cause a monster spike in thin trading on Sunday night? It was the combination of multiple factors that caused a bounce at that $50 level. For the bulls it was a good place to stake a claim and begin venturing back into a decimated marketplace. For the bears it was the logical place to cover shorts. Add in the colder weather and expiration and you got a $2 bounce.

The key question is not what factors caused the bounce but will it stick? That my friends is the $64 billion question. Aside from the obvious challenges of temporary oversupply there are a myriad of other factors. All point to rising prices in the future but not necessarily next week. The government took away $14 billion in subsidies for offshore drilling in the gulf. That costs oil companies money. They are adding a $9 per barrel tax for environmental efforts. That also adds to the price you and I pay. Nobody expects the oil companies to absorb all that extra expense except for the democrats. You and I will pay at the pump for those actions.

Consider also that the oil produced from the Canadian oil sands is not commercially viable at much under $50. Ethanol is not commercially viable with oil under $50. It is already more expensive than gasoline once you add in the -30% drop in gas mileage. The oil companies cannot afford to explore in those very difficult places if oil is under $50. They are not going to spend $55 producing it from 30,000 feet under the ocean only to sell it for $40. Many production facilities will slow production if oil prices continue to fall just like the gas companies did this winter when gas prices fell below $6. Exploration and production companies are not in this business for the fun of it. It is a profit deal and without profit they will quit exploring. It has happened that way since the early 1900s.

In the late 90s when oil prices fell so low more than 500,000 oil workers were forced to find other jobs. Thousands of rigs were scrapped, literally cut up to make space for newer rigs that needed to be stored. Now there is a rig shortage that will not be rectified for another 5 years. Nobody wants a repeat of the 1990s. Nobody in the US, nobody in OPEC, Russia or Latin America. Everybody in the business whether a private company or a national oil company wants oil to go below $50. It is the new threshold where wants and desires will be turned into actions. Oil prices will move higher. They just may not move materially higher next week or next month. Oil is a long term business. Production decisions made today can take 3-6 months to have an impact.

Greenspan once used the tanker analogy to describe the US economy. It takes very little changes in policy to change the course of the economy but it takes a long time to see results. A small change in the rudder on the tanker can take miles to translate into a new course. It takes a lot of force to move a tanker from a standing start to full speed but it is practically impossible to stop once that speed has been attained. They have been likened to monster missiles that once launched they take miles to stop or turn. They say sailing ships have the right away in the ocean but having the right of way and being right in the way could have catastrophic effects.

Oil prices like oil tankers tend to move very slowly without the impact of external events. Prices are low today because Americans have experienced the warmest winter in 100 years in 2005 and the start of another scorcher in 2006. Only this week has regular winter weather returned to the northeast. The American Petroleum Institute released numbers on Friday showing that oil demand in America had dropped -3% due to the change in weather patterns. Since we are the largest consumer of oil on the planet that equates to about 750,000 bpd that is not being consumed. 22.5 million bbls per month. That is a lot of extra oil but that demand could return instantly with the return of cold weather. Granted it would take some time for heating oil supplies to be drawn down but it would have an eventual impact. It is probably too late this year to see any material impact from the weather on prices but that does not mean they would keep falling.

It may surprise everyone to learn that global supplies of oil have declined by 100 million bbls since Nov-1st. This was the target OPEC was shooting far with their November cuts. Saudi Oil Minister Ali al-Naimi confirmed last week that the reduction had been successful. You did not hear that on CNBC. You also did not hear that IEA said global demand rose +2% in Q4 compared to an average of just under 1% each in the first three quarters. This is a monster increase and was led primarily by India and China. This proves their need for oil is rising more rapidly than anticipated. The IEA also revised down for a second time their estimate of non-OPEC production growth for 2007 to 1.4 mbpd. This is a cut of 700,000 bpd since August 2006. At the same time they only lowered their global demand projections by about half that amount. Remember Kazakhstan and all the glowing reports about how much oil would be produced there. It was reported by Dow Jones that Kazakhstan's energy minister said there will not be any increase in production because existing fields are declining too quickly.

With oil inventories dropping and production slowing why is it that oil prices are still declining? According to Goldman Sachs it is due to the excessive hedging by various groups. Production companies hedge by either selling future production into the futures market at the current price or by purchasing puts to create a floor for their prices. According to Goldman the open interest in put options is clustered heavily in the $50, $55 and $60 strikes. The speculators who sold the puts found themselves in danger of having the oil put to them and were forced to sell increasingly larger quantities of oil short to hedge themselves against a possible put execution. This is called delta-hedging. As prices collapsed through $60 it set off a round of selling that combined with the speculation shorting forced oil to $55 and that triggered yet another wave of sell stops to cover that strike price. Now that oil has tested $50 without another wave down we may be nearing the end of this vicious cycle. With February futures expiring on Monday there will be a lot of speculators breathing a serious sigh of relief.

That is good for you and for me. When oil tagged $50 last week it triggered another set of events. My volume of hate mail rose significantly. I use the "hate mail" term in jest because many just wanted to give me some "constructive" criticism. Basically readers were venting because we did not capture profits when oil prices broke $60. I understand perfectly. I eat my own cooking by taking my own recommendations and some of it was hard to swallow. This is supposed to be a long-term position and not a group of short-term trades. In long term investing you have to take the dips in stride and sometimes add to positions on those dips. However, I guarantee everyone had I known that oil was going to break $60 and go straight to $50 in little more than two weeks I would have exited some positions. Hindsight is 20:20 but foresight is always a little hazy. I had nobody email me before New Years and say "exit, oil is going to $50." I assume that means you were in the same boat with me waiting for that three month trading range from $60-$65 to breakout to the upside.

January is supposed to be a bullish month for oil prices with Jan/Feb the highest demand for heating oil. In Jan-04 oil gained +$3 on its way to a +$25 gain to $55 in October. In Jan-05 oil gained +$5 on its way to a +$30 gain to the August highs of $70.40. In Jan-06 oil gained nearly +$11 from the 12/23/05 lows of $60.55 to the Feb-1st high of $71.70. In all three years the beginning of January marked the low point with rising prices into the fall hurricane season. If somebody would have told me this year was different I doubt I would have listened thinking the Aug/Dec decline to support was the worst of it.

If you feel I let you down, I am sorry. I feel your pain because my portfolio is down also. I feel I represent the facts as I know them but I never want to be seen as representing the future as fact. Nobody can ever know exactly what is going to happen in any market. If I always had the right answer this newsletter would be $10,000 a month and worth every penny. I would rather readers see me as a seeker of the truth in the reasons behind the moves in oil and as a fellow investor trying to make the most out of the facts as we know them. I probably spend 60 hours a week researching the oil story as I write this newsletter and my coming book. Even with all that research it is impossible to foresee the short term swings in prices. That is why investing is a long-term proposition. We need to buy the dips and not cuss them, or maybe do both. I am always at my computer and I welcome any emails both positive and negative. (Jim@OptionInvestor.com) I don't claim to have all the answers but I will try to answer your concerns.

For the most part I think the decline in oil stocks ended about two weeks ago with only a few exceptions. The sharp drop in oil prices was seen by most investors as temporary and they refused to bail out of their positions and began buying the dip last week. Look at the charts of stocks like APC, BTU, DO, DVN, HES, RIG, SU, SUN, UPL and VLO and they all look the same. Higher highs and higher lows this week after a bottom the prior week. Where we got hurt the worst was the Chinese stocks PTR and SNP. Those were killed by profit taking in the Chinese indexes after the New Years high. It was not specifically oil but the entire index that was sold off. Those are now beginning to recover as well.

We got a lot of help from Schlumberger on Friday. Their earnings spiked +71% and their guidance was gold plated. The CEO said exploration activity worldwide remained very strong and they saw "high growth" for the rest of the decade and beyond. He said cheap energy was behind us and companies knew they had to invest more to find and produce future wells. SLB has a backlog of contracts well into the future as existing projects are scheduled and completed. This strong guidance and the +$2 bounce in oil prices helped produce strong gains across the entire sector. Gas prices jumped +8% on Friday alone on the cold weather in the northeast and the prospect for a colder February. These factors helped power the energy sector to +4.8% gains for the week and make it the best performing sector. Who would have guessed last week that energy would outperform everything else?

We have a lot of energy earnings next week but I doubt they will be as positive as SLB. The outlook for energy earnings is relatively neutral so any good news should help the sector.

Having GE buy land and offshore equipment supplier Vetco Gray for $1.9 billion did not hurt oil sentiment either. With GE buying the company it doubles the headcount at GE Oil and Gas and gives them another leg up in the competitive field. Most feel GE will make another acquisition in the sector. Possible targets are Cameron International (CAM), Dril-Quip (DRQ) and FMC Technologies (FTI). GE is also said to be looking for a deep-water driller. However, on CNBC Friday morning CEO Jeffery Immelt said they were done for the year after a multi company shopping spree over the last two weeks. Do you believe him? I would think they could be looking at a equipment manufacturer like National Oilwell Varco (NOV) or Helmerich Payne (HP). Both are relatively small compared to GE sized acquisitions and that would give GE a foothold into every company that buys those products.

The average change for all our positions last week was a gain of about a buck. This was the week when oil broke $50. 12 of our 24 current stocks closed at a new high for 2007 on Friday. All things are not as bad as it would seem on the surface. Be sure to check the play notes for those positions you currently own.

There was some confusion last week with PetroChina (PTR). The "current recommendation" line in the body of the description said this:

Current recommendation: Buy at $128.50, stop at $124

PTR blew through $128 and $124. Several readers thought that meant we were stopped out of PTR. That is not the case. That recommendation line is for new entries. This is for readers who were not in the original position. Had you entered at $128.50 you should have been stopped out at $124 on that new entry. A stop loss on the original play would look like this:

PTR - $124.50 -1.28 - PetroChina *** Stop Loss $124 ***

That format is the header line of each play description. That is where any stop loss will be listed. Readers are always asking when they should enter existing plays if they did not get into them when first profiled. Use the "current recommendation" line for new entries only.

Jim Brown

February Crude Chart - Weekly

February Gas Futures Chart - 90 min


Leaps Trader Commentary Archives