Option Investor

Last Dip Before Summer?

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Crude prices returned to $60 on Friday in what may be the last dip before the summer escalation begins. We have seen a tight range form between $60 and $62.50 and money flow shows increasing amounts of buying on every dip. Gasoline futures broke out to a new six-month high last week at $1.94 and only retraced a couple of cents on Friday's dip. This is normally the low point of the spring for gasoline prices and instead they are breaking out to new highs. This should be a clue for investors that oil prices will follow.

We have seen very poor refinery utilization, which fell to 85.8% last week due to maintenance work and a continuing rash of accidents a numerous installations. This low utilization has impacted gasoline and distillate inventory levels with distillates down 20 million barrels since mid January and gasoline down 15 mb in the same period according to the American Petroleum Institute. Last week's inventory report saw crude stocks fall -4.8 mb, distillates -1.3 mb and gasoline a whopping -3.8 mb and this is not even driving season yet. The API showed even worse numbers with crude falling -6.6 mb and gasoline -7.4 mb. Crude imports fell 650,000 bpd for the reporting week. Gasoline inventory levels are now 3.9% below the same period in 2006 with crude inventory 5.1% below 2006.

Driving this drop in inventories is a surge in demand for gasoline of +3% in February. Remember February was blanketed by blizzards and severe winter weather and should not have seen much additional driving but demand was still up +3%. Retail gasoline prices rose +20 cents in February and the sharpest February increase in over a decade. Gas prices are expected to rise through the summer and $3 gas will likely return.

OPEC meets for the 144th time this week and nothing is expected to change. Prices are holding above $60 and the increased summer demand is just ahead. Of the 1.7 mbpd in announced production cuts it appears they actually cut 1.2 mbpd according to recent reports. These cuts have helped bring inventory levels back in line with demand and has provided them a firm base price at $60 heading into summer demand AND the summer hurricane season. The stage is set and all the players are ready.

The big news this week was from Exxon. You did not think it was the Bush anti-Chavez goodwill tour did you? Exxon said it would bump its capital spending to about $20 billion a year for the next 3 years to try and add to current reserves. Exxon hopes to add 1 mbpd to its production by 2010 by developing 20 new global projects. Exxon only spent $2.2 billion in 2005 but upped that to $20 billion in 2006. Exxon averaged production of 2.7 mbpd in Q4. Exxon also bought back $25 billion in stock (12%) in 2006. A Citigroup analyst said as long as oil remains over $50 Exxon can continue buying back stock at the rate of $25-$28 billion a year and maintain its $20 billion capex effort. Exxon posted record profits of $39.5 billion in 2006.

However, Exxon is in trouble long term. Exxon may have produced 2.7 mbpd in Q4 but it refined 5.5 mbpd. Half of its refinery production came from other oil producers. Of the 2.7 mbpd it actually produced about half was produced in countries with varying degrees of political instability. Exxon announced last week it had reluctantly agreed to turn over its last group of assets in Venezuela to Venezuelan control. Chevron and Conoco also quietly agreed to the takeover of their facilities. It was either agree and salvage a small portion of future production or be kicked out of the country and lose it all. Exxon has said for years that there is plenty of oil. Unfortunately they have been unable to find and produce it in a timely manner. The extra oil is all in unfriendly countries. The announcement that they are going on a crash exploration and development binge is a clue that there is trouble brewing. Exxon is not one to charge off and produce a lot of small projects. Their sheer size makes tackling small projects expensive and less rewarding. They need big projects but unfortunately there are none. Production from the 20 global projects they announced was expected to be 1 mbpd when completed. That means each project averages only 50,000 bpd. Counting the sharp increase in capex in 2006 to $20 billion and extending that through 2010 as they announced means they are spending $100 billion to produce an additional 1 mbpd. Don't get me wrong that is a good investment if they can maintain that production for at least 5 years. 1 mbpd @ $60 equals $60,000,000 per day in crude or $21 billion a year in revenue. Assuming those projects continue producing even at a lesser rate for another 10 years it is a good deal for Exxon. It is not a windfall and not a cash cow that will continue forever. They will be forced to continue investing at those levels to maintain production through the next decade. I fear the sudden spike in capex from $2 billion a year to $20 billion was not brought on by greed and high oil prices. I fear it was inspired from declining production rates on existing projects. The new CEO, Rex Tillerson, realized that the future was theirs to lose or control and he elected to take on nearly two dozen smaller projects rather than sit back and wait for that major find that may never come. I am afraid the next round of capex may be even higher as the cost of finding and producing oil from increasingly harsh environments rises. All the easy money has been made and every year that passes Tillerson's task will grow harder.

Monday's drop finally stopped us out of Tesoro at $89. The end of week rebound saw TSO climb to a new high at $95.55 but we can't complain. The exit on the option at $29.70 provided a $22.00 profit. Now we need to see a crack in the refiners to reenter the position with a different strike. Unfortunately with refiners hot right now that may not come soon. On the bright side we have $29.70 to invest in other possibilities while we wait.

Jim Brown

April Crude Chart - Daily

April Gas Futures Chart - Daily


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