Option Investor
Commentary

Winter Returns

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With television news showing cities in the northeast shoveling out from under 100 inches of snow it would appear that winter has returned with a vengeance. Here in Colorado we had six straight weeks of snowstorms that left three feet of snow in the Denver area by mid January. It may seem like winter but it is just a cold spell not the end of global warming. After two weeks of 60-degree days the snow is disappearing at my house and the trees are starting to bud. Those people digging out their cars in New York will be seeing the same warming trend very soon. The thermostats will return to normal and home heating oil use will plummet. There may be some cold left in this winter but its days are numbered.

Fortunately for energy investors this cold spell helped produce a heat wave in energy prices. We saw a huge 3.6 million barrel drop in inventory levels for distillates, which includes home heating oil. Gasoline levels dropped -1.2 mb and crude oil fell -0.4 mb when expectations had been for a build of +1.4 mb. Supplies are expected to decline even further with this week's inventory report. Forecasters said heating oil use should be 23% above normal next week as below normal temperatures continue through Feb-23rd. Oil prices climbed past $60 as if supplies were shrinking into shortages. This could not be further from the truth. Heating oil supplies are still 8% above the 5-year average for this time of year. There is no danger of shortages and no reason for this to have any impact on prices.

This highlights the fact that oil trades on perception not the facts. The facts are that we have a glut of crude products in the America. Until normal weather patterns return possibly until a new cycle of colder winters returns we will not be in danger of heating oil shortages. That has not prevented prices from rising as sound bites showing blizzard conditions hit the airwaves. Natural gas inventories have fallen sharply since late December but the 2.347 trillion cubic feet in storage is still 19% above the 5-year average for this time of year. Last week's -224 bcf draw from inventory was very strong but it would take 10 more weeks of blizzard conditions in the Midwest and Northeast to produce any fear of shortages. This is not likely to happen this close to spring. Gas prices have returned to $8 per mcf but that is very strong resistance and a level not likely to be broken this winter. The rise in gas prices helped to power oil higher since they trade roughly in tandem on a btu basis.

Geopolitical events also combined to push prices higher. Nigeria declared Force Majeure on deliveries of light sweet crude for the rest of February and March. Production will drop -370,000 bpd for the rest of February and -260,000 bpd in March. OPEC appears to be following through on its announced production cuts for February although the EIA said only about 300,000 of the announced 500,000 bpd cuts will actually occur due to cheating by several nations. Fears of a future conflict with Iran heated up when the Iranian President announced plans to make a major nuclear announcement on Sunday to coincide with the 20th anniversary celebration of the Islamic Revolution.

Occidental said they lost fours days of 120,000 bpd production at the Elk Hills field in California after a fire damaged facilities. Production at Exxon's Hibernia field in Newfoundland will be offline for four weeks as the biggest maintenance program in five years gets underway. Production had dropped from 180,000 bpd to 120,000 after a valve failed on Jan-2nd. The remaining production will now be offline for four weeks as that problem is repaired.

On Thursday Mexico's state owned oil company PeMex said production from Cantarell, the world's 3rd largest oil field, would drop -15% in 2007 as depletion rates accelerate. Cantarell produced 1.79 mbpd in 2006 and is expected to produce only 1.53 mbpd in 2007. The rate of decline is expected to continue despite a crash drilling program to offset falling production.

Oil prices rose on the combination of all the events listed above. Unfortunately without any new events this three-week rally is going to find it tougher to move much higher. $60 is psychological resistance and $65 is major technical resistance. Without any new geopolitical event we may need to wait for the impact of the continued OPEC cuts for any further gains. We are in the sweet spot for oil prices. As long as we remain around $60 through the coming demand decline we should be primed and ready for a new move higher when summer consumption begins. Demand normally declines substantially from late February through March as heating demands diminish and summer gasoline demand has yet to increase. If we can maintain the $58 - $60 level through this period we should be set for summer. As summer demand arrives so does the threat of late summer hurricanes. I have not heard any forecasts for 2007 but they missed it so badly in 2006 that they are probably going to be conservative for 2007. Either way it all depends on how many storms appear and their impact on pricing. If the forecasters predict a bunch and they start to appear the refiners will load up on oil in advance just to be safe.

I am expecting flat and choppy prices for the next 6-9 weeks depending of course on geopolitical events. I then expect prices to rise into the summer as we head into driving season followed by hurricane season. The highs should come around September and that would be our exit point for the majority of our positions. We will buy any fall dip and repeat the process once again. Of course that assumes the perfect scenario and reality is never perfect and almost always messy. At least you know in advance what I am expecting.

Chevron was in the news on Friday over talks with Russia to buy the remaining Yukos assets worth something around $22 billion. ENI was also mentioned as a bidder. I hate to hear Chevron is venturing into the bears den in search for oil. It seems that a few CEOs are deaf to the rising problems in Russia and their total disregard for the rule of law. They have taken over every major project save one and BP will probably lose it before the year is over. You can't trust Putin and his gang and they will take your money and then a couple years from now charge you with some kind of tax evasion or environmental crime and repossess your asset. You can count on it! I am avoiding Conoco because of their $12 billion at risk investment in Lukeoil and I will avoid Chevron if they do something stupid as well. Several analysts said the same thing on Friday and warned about investing in Chevron if they do a deal. With all the nationalizing of energy assets around the world you would think the energy companies would learn. Evidently the lack of reserves available elsewhere and the lure of proven reserves in Russia is too powerful a drug to resist. Like with any other drug it may eventually prove their downfall.

Anybody that thinks the energy sector is fading needs to review the SLB and DO earnings reports. DO announced profits that doubled as demand for deepwater drilling increased. Earnings of $1.60 per share beat street expectations of $1.38. The day rate for semisubmersibles jumped from $181,000 to $253,000 and the utilization rate rose to 93% from 85%. Jackup rates spiked to $113,000 per day compared to $69,000 a year ago. No slump here!

Earnings are nearly over and the energy sector has been hit and miss. Some reported great earnings and others were hampered by price declines and dwindling reserves. Now that earnings have passed stock price movement will be more closely related to the rise and fall in oil prices. That could be rather choppy for the next nine weeks for the reasons stated above. Be prepared to be bored and hope for some event to provide a spark.

I am dropping several plays because there is no spark providing lift in their particular scenarios. I expect oil prices to slump over the next few weeks and if there stocks can't cut it after a three week rally then they will probably fail us over a 6-9 week slump.

Jim Brown


March Crude Chart - 90 min

March Crude Chart - Daily

March Gas Futures Chart - Daily

 

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