Option Investor

Volatility Returns

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I mentioned last week that I expected some rocky prices to return and that is exactly what we got. We saw a high on Tuesday of $59.60 and a low on Thursday of $56.62. Friday's short covering rebound took us right back to the highs to close at $59.40. Each day this week saw ranges of a dollar or more.

Part of that volatility and especially the rebound on Friday was due to the pending expiration of the March crude contract next Tuesday. The options for heating oil, RBOB and natural gas expire next Friday. With the futures markets closed on Monday that meant the next trading day for crude was expiration day. I also noticed when writing tonight that the April crude contract closed within 45 cents of the expiring March contract. This lack of divergence suggests there is little expectation for higher prices over the next month. The reason for this is the expiration of winter as I have explained before.

NOAA, the National Oceanic & Atmospheric Administration, is forecasting warmer than normal weather for the next 10-12 days. That will take us out of February and nearly out of winter. The demand for heating oil and natural gas will begin to wane along with the price for crude assuming there are no geopolitical events. That may mean crude will just continue to remain volatile or slip into a nearly dormant state as refineries make their longest planned shutdown of the year for maintenance and switch over to summer products. Normal gasoline demand will begin to accelerate in April and the summer cycle will repeat once again.

What will cause the next move higher in prices will be the expectations for summer gasoline demand and predictions of summer hurricanes. Crude prices don't have to decline ahead of summer and we have seen many instances where they continued a positive trend higher. Comments like we saw this week from OPEC and the IEA will provide support to prices and could prevent any major support retests.

The new OPEC secretary-general said the global oil market had become more balanced as a result of the OPEC production cuts and demand was steady at 86 mbpd. He said compliance with the cuts was about 66%, which is very strong support among a cartel of cheaters. According to OPEC the actual cut is running around 1,122,000 bpd compared to the target cut of 1.7 mbpd. Independent surveys put the cuts closer to 850,000 bpd. Regardless of what the number is the result has been a balance of supply and demand and support for prices in the high $50s. OPEC also said the demand for OPEC oil would rise by 200,000 bpd above prior estimates due to failing production from non-OPEC sources. If you remember in late 2006 there were glowing expectations for a strong surge in non-OPEC production but it now appears reality is a decline of 170,000 bpd due to stalled projects and increasing depletion rates from several fields.

The IEA said the demand for oil will rise this year by 273,000 bpd more than previously expected due to rising demand from China. China demand is seen as rising from the 7.1 mbpd 2006 level to 7.6 mbpd in 2007. Vehicle sales are seen as a major driver along with strong economic growth at more than 10%. China saw a 25% jump in vehicle sales in 2006 to 7.2 million units. Despite strong controls to slow auto buying that growth rate is expected to continue in 2007.

On Wednesday the IAEA, International Atomic Energy Agency, will report to the UN Security Council on Iran's compliance with the UN demand to halt enrichment of uranium. Since there has been no compliance and Iran claims they are installing thousands more centrifuge cascades it should be a short report. The Security Council will retire to discuss new sanctions to force compliance and that should take several more weeks if the last discussions are any guide. The Wednesday event will get plenty of press but I doubt it will be material to the price of oil. It is an ongoing process and this week's update is just a chapter in the process.

Baker Hughes stunk up the services sector on Thursday after missing earnings estimates and warning that the current quarter will be short due to weakness in the North American market. BHI lost 10% on the news to $65. BHI reported $1.02 compared to analyst estimate of $1.19 and the prior quarter at 75 cents. BHI would not give long term guidance due to uncertainty in the North American markets. It guided for Q1 at $1.09 compared to analysts estimates at $1.19. For the full year BHI expects revenue to increase 18%.

For those interested Ultra Petroleum finally announced an earnings date of Feb-21st with the conference call at 11:AM.

Check your play descriptions this weekend for some new insurance suggestions and new stop losses.

Jim Brown

March Crude Chart - Daily

April Crude Chart - Daily

March Gas Futures Chart - Daily


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