Option Investor

Iran Backed Down

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With the third carrier group steaming full speed towards the Persian Gulf and rumors of attack plans the Iranian government caved in to growing pressure to release the British hostages. Now we are hearing from Britain that they were handcuffed, stripped, blindfolded and forced to stand against a wall while Iranian soldiers cocked weapons and shouted as though they were preparing a firing squad. The sailors were threatened with seven years in jail if they did not make statements claiming to be in Iranian waters.

We are also hearing this weekend that the US offered to "scare" Iran by mounting aggressive air patrols over Revolutionary Guards bases during the hostage standoff. Britain refused to let the situation escalate into a possible military confrontation. Britain reportedly asked the US to tone down activities in the Gulf to avoid agitating Iran to even further acts of violence. At London's request the two carrier groups in the gulf changed their exercises and moved away from Iran to make them appear less confrontational.

Apparently the capture was the result of a decision by a regional commander who was not acting on orders from higher up the chain of command. The situation started out as just a challenge and then escalated into the capture as events unfolded. The regional "accidental event" grew quickly into an international incident and the Iranian administration had to back the confrontation or risk losing face for a regional mistake. With the third carrier group heading for the gulf and the recent US military exercise involving 10,000 personnel and over 100 planes it appears Iran finally decided they could not benefit from continuing the crisis and could be in serious danger from the growing threat. Officially the release was in honor of Easter, Passover, the birthday of Muhammad and the magnanimity of the Iranian people. You chose the real reason.

Iranian President Mahmoud Ahmadinejad is planning a major announcement on Monday regarding Iran's nuclear program. April 9th is Iran's nuclear technology day and marks the first anniversary of its successful enrichment of uranium. Ahmadinejad will visit the enrichment facility in the city of Natanz where he is expected to make a major announcement. He is expected to claim that Iran has completed successful installation of a cascade of 3000 centrifuges at the plant. The announcement was expected back in February but delays in the process caused a postponement. This cascade is in direct violation of repeated ultimatums from the UN Security Council. The US has repeatedly refused to rule out military action if diplomacy fails to secure a halt in the process. It appears this could be coming to a head very soon.

Oil prices declined to initial support at $64 once the hostage deal ended and that is where it has rested for the last two days. A break of $64 targets $60 but with new hurricane warnings and gasoline inventories plunging I would be surprised to see it weaken much further. Gasoline inventories fell -5 million barrels in the last inventory report on Wednesday. Much of this is due to refinery problems but gasoline demand is also rising sharply and it is not even close to the summer driving season yet. Gasoline demand rose +241,000 bpd or +2.6% over the last week. That could be due to movement in pipelines, refinery surges and report timing but the number was a definite surprise. The more stable 4-week average is also showing a +1.7% increase in demand over 2006. Gasoline inventory levels have fallen below the 5-year average and that will provide even further support for prices.

The drop in oil prices after the hostage release was even more unusual given the sharp rise in gasoline prices. Gas prices rose +8.8 cents per gallon on Wednesday's inventory report. That equates to $4 increase per bbl oil. Instead oil fell over $2 from its high for the week. That is the equivalent of oil falling -$6 in price relative to gasoline once the crisis was over. If gasoline prices continue to rise as expected the price of oil is not going to spend much time under $64. Eventually the synchronization of gas/oil will return and oil will continue higher heading into summer.

Refiners continue to print money with the crack spreads reaching as high as $21.83 per barrel last week. The crack spread is the difference between the cost of the oil and the value of the refined products. It means they are making roughly $21.83 profit for every barrel they refine. Valero is making even more because it uses the much cheaper sour crude from the Middle East. This profit picture can't last simply because the refiners will catch up with annual inventory levels once the repairs and conversion to summer blends is completed. The spreads should return to something closer to normal at $8-$10 per barrel. That assumes the recent flurry of refinery outages does not continue and demand does not increase substantially heading into late spring.

The largest publicly traded oil companies plan to invest $97 billion this year to find and produce new oil. Unfortunately based on recent news reports about drops in currently producing fields and problems in Nigeria that investment may not succeed in increasing the daily production of oil.

Production from Mexico's Cantarell field fell to 1.57 mbpd in February from 1.57 mbpd in January. Only a year ago the field was producing over 2 mbpd. Production in 2007 is expected to average only 1.53 mbpd but continued sharp declines could put that number in jeopardy.

Gasoline in southern California has risen to within 20 cents of an all time high. Los Angeles rates are averaging $3.20 while unleaded in San Francisco is said to be selling as high as $3.75.

A proposal to build nuclear plants to supply electricity and steam to Alberta oil sands projects has run into problems in committee. A Canadian parliamentary committee advised that nearly 20 nuclear reactors would be needed to meet planned oil sands production growth through 2015. Why do they need so many plants? Because the natural gas they currently use to heat the sands is rapidly dwindling. The very ambitious oil production targets (mostly to be imported into the US) are being called into question by the shrinking supplies of natural gas. Billions of cubic feet are burned each month just to heat the sand until the oil liquefies and separates from the sand. I have reported on this impending shortage many times and the potential for future oil production targets to be missed. I seriously doubt 20 nuclear plants are going to be built even if the costs could be contained. The best answer is to find a way to burn some of the oil being produced as fuel for continuing production. Unfortunately it appears it would require burning almost as much oil as is produced making the process economically unfeasible. Once natural gas production in Canada declines to a point where prices and availability make it unfeasible to use for oil sands the entire oil sands project will stagnate at then current levels and future production targets will be erased. As oil prices continue to rise they will find other ways to create the energy needed to continue production but that could require oil at $100 a barrel or even higher.

You may have noticed that Cameco (CCJ) has taken off like a rocket. This is due to recent studies about future supply shortages and the rising price of uranium. Uranium has risen from $21 a pound to more than $95 in just the last three years. Recent comments from insiders suggest the price could double or triple again by 2010. Another uranium company taking off is Energy Metals. (EMU - no options) They began trading on the NYSE in November and seem to have taken off with the price of uranium.

Arch Coal said this week they were looking for acquisitions. Since the coal sector contains relatively few players that is a very small group of potential acquisition targets. Other coal companies include CNX, FCL, MEE, ARLP, ANR, JRCC, WLB, WLT, NRP, NCOC and EEE. I put together the sector list below to illustrate the potential targets. The only way to profit in these takeover targets is to own the stocks outright or own in the money calls. Buying an out of the money LEAP is a losing proposition since any eventual purchase removes the upside risk and LEAP premiums will implode. We already own Peabody and they are the largest and least susceptible to a buyout attempt. In related news the winter storm that dropped 2 feet of snow in Wyoming last week prevented more than 160 trains from being loaded and Union Pacific said it could take two weeks to recover from the storm. Burlington Northern would not say how many trains it missed loading.

Coal Sector List

You may have noticed the metals stocks also accelerating sharply. We have been unable to get an entry in ATI and I definitely do not want to chase it given the inflation in the LEAP premiums. As an alternative you may consider Rio Narcea Gold Mines (RNG $5) or Idaho Gen Mines (GMO $5). Both are gaining ground on the sharp jump in the price of nickel. Nickel is a commodity where supplies are shrinking and demand is booming. It is used in making steel with less corrosion properties. Neither have options but the price of the stock is less than the cost of a comparable LEAP.

Oil prices over the coming weeks are going to be pegged to the price of gasoline and subject to future hurricane forecast updates. I expect it to be lackluster until the next advance begins. With strong resistance at $67 we are likely to trade in a range from $64-$67 until something appears to produce a breakout.

Jim Brown

May Crude Futures Chart - Daily

May Gas Futures Chart - Daily

April Gasoline Chart - Daily


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