Option Investor
Commentary

New Two Month High

HAVING TROUBLE PRINTING?
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Can you believe it? April crude came very close to hitting $62 intraday on Friday. It appears most investors could not believe their eyes as oil stocks failed to share in the exuberance.

The early morning spike was caused by a seemingly endless parade of refinery problems with shutdowns showing up like popcorn from a hot skillet. Most were temporary but the explosion and fire at the Valero refinery in Texas could take it offline for as much as a month. That would remove 3 million bbls of gasoline and 1.5 mb of distillates like jet fuel from the market. You would think such a major outage would put a sizeable crimp in Valero's stock price. Instead it rose nearly $4 for the week. The spike in gasoline prices was the culprit. Higher gasoline prices produce higher crack spreads for refiners and therefore higher profits.

We are approaching the period where gasoline normally puts in a bottom before moving higher on expectations of summer driving demand and hurricane season. Based on the chart it appears that bottom was put in back in January and traders have decided there will be no more weakness. Gasoline broke out of its month long range of $1.66-$1.73 on the April contract and charged to hit $1.83 intraday on Friday. The March contract expires for trading on the 28th. This expiration most likely put added pressure on prices. March heating oil also expires on the 28th and natural gas on Monday.

In this week's oil inventory report there was a sharp decrease in the distillate inventory of -5.0 million bbls following declines of -3.0, -3.6 and -2.6 mb over the prior three weeks. Gasoline inventories fell -3.0 mb last week and -2.1 mb the prior week. Crude levels rose +3.7 mb. The drop in refined products is due to many refineries taking portions of production offline early in the year for seasonal maintenance. With the flurry of refinery fires over the last week we are likely to see those levels fall again over the next two reports along with a rise in crude inventories from a drop in refining capacity. How this will impact pricing is unclear but a continued drop in refined products could keep upward pressure on gasoline. What we could be seeing here is the early stages of a refining problem ahead of summer demand. If the refiners fall behind the curve it could be a race to catch up that would have them running flat out at near 100% capacity heading into summer. Whenever they run near 100% breakdowns occur further complicating the problem.

Oil production problems continue to appear around the globe. New data from Mexico suggests the super giant Canatrell field is in catastrophic decline and could deplete to meaningless production levels within 5-7 years. First production from the Kashagan field in Kazakstan has been delayed until 2011-2012. It was initially scheduled for 2005 and then revised to late 2008 and now 2011-2012. Venezuelan production currently 2.56 mbpd fell -5.5% in 2006 and is predicted to fall another 5-8% in 2007. Oil imports from Venezuela fell nearly 8% in 2006 and are expected to fall another 8% in 2007 as Chavez sends that oil to China. It takes 5 days to ship it to the US and 30+ days to ship it to China along with the additional transportation costs of several dollars per bbl. Chavez is determined to cause the US energy grief and is protecting himself in advance from us causing him pain if we suddenly halted Venezuelan imports for political reasons.

Chavez policies has cut Venezuelan production from a high of 3.5 mbpd in 1997 to its current 2.5 mbpd. Venezuela exports roughly 1.1 mbpd to the US with the rate declining. Within months Chavez will have completely nationalized all the oil facilities in Venezuela and as 60% owner under the new contracts will be responsible for funding future development. Since the goal of nationalizing the oil industry was to siphon off the cash for domestic programs aimed at keeping him in power it is not likely he will invest the billions of dollars needed to drill new wells and build infrastructure. History has proven that it takes over 100 active rigs to maintain production levels in Venezuela. Currently there are only 60 and that number is declining. Without future investment it appears Venezuelan production is doomed to a continuing drop in production as wells deplete faster than new ones are drilled. In 1998 Chavez fired 18,000 PDVSA employees for their politically incorrect behavior. Those workers represented the majority of the skilled and knowledgeable workers in the sector. Without their knowledge and decades of experience it is an almost insurmountable task to create additional production now that he has kicked out the major independent oil companies. This is not a problem that can be remedied soon or even over the next decade since Chavez has made himself virtually immune from being removed from office. The current 5% decline rate is expected to increase as wells deplete and facilities fall into disrepair from lack of funds or proper management.

Saudi on the other hand is going to invest $267 billion over the next 10 years to develop its oil, gas and chemical businesses. They quietly announced this week a new discovery well southwest of Ghawar that produced 4,000 bpd on its first test. They have several projects underway that should add 1.2 mbpd to their output capacity over the next 4 years.

Russia finally took aim at the Kovykta TNK-BP joint venture project on its east Siberian gas field. This project is 50% owned by BP or should I say "was" owned by BP. Russia told BP it was in violation of its development agreement and gave it 3-months to fix the violations or risk losing their license. This is exactly the ploy used against Shell and their $20 billion Sakhalin gas project. The attack ended with Shell losing control and becoming an operator and Gazprom became the owner. Analysts have been saying for months that BP was next on the hit list and that hit has begun.

Ironically Russia will face a natural gas shortage this year of nearly 4 billion cubic meters according to Anatoly Chubais, CEO of a large Russian gas utility company. He predicted the shortage would double next year and increase by a factor of 10 within a few more years. The shortage has halted construction of gas power plants by his company. Russia is planning a strategic play with its natural gas across all of Europe but can't keep its own fires lit as it follows the Chavez strategy of nationalizing its energy assets. Eventually these countries will understand that it is better to have a smaller piece of a bigger pie than a large piece of a shrinking pie. By then it will be too late to prevent an energy disaster.

UK oil and gas production will fall by -10% for the next three years or 250,000 bpd according to the UK Offshore Operators Association. Production from the UK Continental Shelf fell -9% in 2006 due to rising costs and increasingly harder production hurdles. Sound familiar?

China's coal exports fell 20.4% year over year in January. It was the 4th straight month of decline. China could become a net importer by the end of 2007 due to demand from new coal-fired power plants coming online and the increasing demands for power.

Last but not least a Saudi wing of al Qaeda called on attacks on suppliers of oil to the US saying targets should not be limited to the Middle East but including places like Canada, Mexico and Venezuela. I bet Chavez fell out of his chair when he heard that. Attack him for selling oil to the US. What a strange turn of events!

There are no hurricane predictions yet but historians point out that there is rarely two years of back-to-back calm with no storms. With global warming the storms are only going to get more severe so this season will be watched even more closely than 2006.

That is enough rambling for today but I am sure you get the picture. The optimistic forecasts for future production are meeting with reality and geopolitical concerns that are not easily resolved. The long-term price of oil will continue higher and there is little anyone can do to stop it. Time is on our side.

We saw some nice gains in most of the positions last week and hopefully that will continue as gasoline prices move higher into summer. I would not be surprised to see some volatility next week as the various futures contracts roll over. $58 should be support and I would look to add to positions at that level.

It may be boring not to add any new positions but this is what we waited for over the last six months. We waited for the fall dip, bought the dip and now we ride it higher. Don't worry, be happy!

Jim Brown


April Crude Chart - Daily

March Gas Futures Chart - Daily

April Gas Futures Chart - Daily

 

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