Option Investor

Gasoline Induced High

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No, I am not sniffing gasoline fumes to obtain a very deadly high. The shortage of gasoline fumes in refiners tanks is a major reason oil prices have rebounded so strongly and may even reach a new high soon. In Wednesday's inventory report gasoline levels declined by 5.5 million barrels to 199.7 million barrels. This is nearly 10 mb under the 5-year average for this period and represents a -27 mb decline over recent weeks.

The reason for the decline is two fold. The first is a series of refinery outages due to fires, breakdowns or maintenance that have caused a significant drop in gasoline production. The second reason is a +2.5% increase in year over year demand over the last four weeks. Sounds like the perfect storm for gasoline prices. As refiners comeback online they are hesitant to buy oil at the current price of $63.63 on hopes it will decline over the next couple weeks. They do not want to go into full production and fill their tanks with expensive oil that translates into expensive gas. They would rather roll the dice and try to buy the next dip to capitalize on the high crack spreads as we edge closer to summer. Crack spreads have only been this high three times before. Those occurred in the spring of 2004 and 2006 and the post hurricane spike in Sept 2005.

The refinery problems have created a storage glut at the Cushing Oklahoma terminal. When the Valero Sunray refinery shutdown in mid-February oil began backing up in the pipelines. Sunray can process 170,000 bpd or 1.2 mb per week. That equates to nearly 8 million barrels of unused crude backing up in pipelines and storage levels upstream from Sunray. Storage facilities at Cushing are at maximum levels and there is no place to put incoming pipeline deliveries. This is creating a spot glut and depressing prices in Oklahoma. The price of Brent crude which normally trades at a discount to our West Texas Intermediate (WTI) crude is currently selling for $5 over the price for WTI. This is an extremely rare occurrence. The decline in US prices due to the Cushing glut pushed WTI down to $61.35 earlier in the week. An astute trader could have purchased oil for under $62 and sold an August futures contract for $68. The catch is the cost to store the oil until delivery. Tank farms don't store oil for free and that cost of storage has to be taken into account in the case of Cushing. Suppliers desperate to move oil down the pipe may discount their price to make it attractive for users to take their oil now. The alternative for the supplier is to pay for storage and wait for the refineries to recover. Unfortunately there is no more storage at Cushing so suppliers are caught between discounting their oil or shutting down the wells until the pipeline can accept more oil.

Refiners and suppliers could just import more gasoline until the problems are corrected but imported gasoline is priced based on Brent Crude. With Brent $5 over WTI that means the gasoline is expensive compared to gasoline produced here. Suppliers don't want to load up on high priced gasoline only to have prices fall when the refiners return to full speed. Gasoline imports normally run about 1.1 mbpd but fell to 953,000 bpd last week for this very reason. Driving season is still six weeks away and everyone is hoping for the situations to be resolved before then. This will continue to pressure WTI prices until the Cushing storage glut has been relieved. Bottom line; expect more volatility in the price of oil over the next six weeks.

Why are natural gas prices so high in the middle of spring? Because spring was put on hold for a continuing series of blizzards. Cold fronts, snow, freezing rain and very high winds have returned to most of the US east of the Rockies. A winter storm warning was issued for this weekend for quite a few states east of Chicago. Gas consumption continues to be high as heating demand continues. Helping keep gas prices high is the normal nuclear plant refueling cycle. Nuclear plants plan to refuel during spring when the weather is nice and electricity demand is low. These are complicated procedures and they can't be postponed for the next lull in the weather. They are scheduled long in advance and the return of cold weather just happened to coincide with the refueling process. This causes gas and coal fired electric generation plants to run near full capacity supplying power to the grid to offset the nuclear plant downtime.

Natural gas supplies have fallen from their historically high levels last fall to -7.1% below April 2006 levels. Currently 1,592 BCF is in storage and even though that is +22.7% over the 5-year average it is depleting to levels that cause mild concern. If the cold front set to hit the eastern US this weekend lingers we could see another drop in levels next week. If the summer turns as hot as some have predicted even more gas will be used for electrical cooling. This prospect and the continued winter demand rate has rescued gas from returning to $7. We are also headed into hurricane season and they would like to get as much gas into storage as possible in case of another prolonged hurricane induced outage.

AAs earnings season gets underway the rest of the market will be paying close attention to companies like Yahoo or Google. Our earnings cycle is normally 2-3 weeks behind the rest of the market. We will see a scattered few report over the next couple weeks headed by SLB next Friday but we are going to have to be patient for the majority of earnings to appear. With oil prices hovering around $60 for most of Q1 we should see decent earnings from most companies. The ones we need to be worried about are the service companies. We heard last quarter that gas drilling had slowed due to high storage levels and lower gas prices. This warning came from the service companies who were at risk for lower revenue from a pause in the drilling cycle. Specifically HAL and NBR. We want to hear how that has progressed with gas prices hovering just under $8.

Weatherford International (WFT), a $17 billion service company operating in 100 countries, spiked over the last couple days on rumors of a pending buyout. Halliburton was the rumored acquirer. Option activity was huge and could indicate the rumor had some basis in fact. Normal option volume is around 3,000 contracts per day. Call volume on Friday in the April/May strikes was more than 29,300 contracts or 10 times normal. Weatherford said last week that conditions in North America were improving and would continue to improve the rest of the year. It will be interesting to see if HAL wants to pickup WFT's business and positive outlook.

The Wall Street Journal, long an opponent of Peak Oil, ran a front page story last week that laid out all the signs of peak oil without ever mentioning those two words. Some of the important points from the WSJ article follow. The demise of Mexico's Cantarell field means that Mexico may be an importer of oil within eight years. They go on to say, "The demise of Cantarell highlights a global issue: Nearly a quarter of the world's daily oil output of 85 mbpd is pumped from the biggest 20 fields and many of those fields, discovered decades ago, could soon follow in Cantarell's footsteps." "Two decades ago about a dozen fields produced more than a million barrels per day. Now there are only four and one of them is Cantarell." "The future of two others discovered more than 50 years ago, Saudi Arabia's Ghawar and Kuwait's Burgan, are showing signs of maturity." Evidently some of Peak Oil's harshest critics, including the WSJ, are starting to crack.

The heads of Shell and Total both said last week that "the days of so called easy oil are over making it harder to meet demand without complicated and expensive projects. Shell produced twice as much oil as it found last year.

A recent report from the European based Energy Watch Group believes that Peak coal will be reached within two decades. Since America has been called the Saudi Arabia of coal I read this review with great interest. According to their research the US peaked in high-quality coal production in 1990. Production of subbituminous coal in Wyoming more than compensated for this decline in terms of volume and the trend can continue for another 15 years. However, due to the lower energy content it requires more coal to provide the same BTU output and the trend is continuing to decline. Large reserves of coal in states of decreasing production may never be mined. Like stranded oil it requires far too much energy and effort to extract them than they are worth. These reserves are being carried on the books and give a false estimate of total available reserves. The group predicts volume coal production in the US will peak between 2020 and 2030. This is the first research I have read on coal depletion in the US that did not assume we had a century of supply remaining. I will have to dig into this and see how it compares to other estimates. It is definitely controversial at this point!

In the truth is stranger than fiction department uranium jumped +$13 a pound this week to $130. Cameco lost -$2 on the news.

May crude futures terminate trading on April 20th so expect some additional volatility.

Jim Brown

May Crude Futures Chart - Daily

May Gas Futures Chart - Daily

May Gasoline Chart - Daily


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