Option Investor

Last Chance

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Crude prices continue to hover just over $62 on the June contract and $64 on the July contract. This may be your last chance for a buying opportunity ahead of hurricane season. The June contract expires on May 22nd, 6 days from now. That means we are likely to have further price volatility but odds are good that July contract will see some upward price pressure.

We are seeing continued production problems around the world with 100,000 bpd offline in Nigeria due to rebel attacks and another 65,000 bpd offline from shuttered Chevron facilities. Chevron is evacuating non-essential workers and shutting in production until the potential violence passes. Press reports claim Nigerian production overall is down about 700,000 bpd. We are seeing production slowdowns in Venezuela, capacity declines in Mexico and the North Sea and output from Russia is slowing because of maintenance problems due to lack of maintenance.

Locally the refinery problems continue to push gasoline prices higher with the national average 3.037 per gallon. Despite the addition of 5 million bbls of crude to inventory levels last week there was only a gain of 400,000 barrels of gasoline and that was localized to one area in California. Refinery activity is still well below average at 89% with some production offline for months to come. Gasoline supplies at the end of April were said to be at their lowest end-of-April level since 1956. At the current inventory levels we will need to add something on the order of 2 mb of gasoline to inventory each week through June to have enough on hand for the summer season.

Despite the gloom and doom the refiners are still printing money. The crack spread per barrel of oil rose to $37 last week and very close to an all time high. That means refiners are selling refined products for $37 more per barrel than oil costs them. This is an amazing number when you consider a large refinery can produce 450,000 bpd of refined products. That equates to $16 million per day in profits for a refinery of that size. Not bad work if you can get it.

Obviously those margins won't last. At least they won't last for more than a few months if conditions continue to deteriorate. The International Energy Agency said on Friday there could be a global gasoline shortage in June if production runs don't increase and OPEC raises output by 1.6 mbpd. I would say the odds are good that gasoline prices are going higher. The IEA said OPEC production in March was a two-year low and the draw down in inventory levels in Q1 had not been seen since 1999. OPEC says the market is currently "well supplied" meaning we are comfortable with the prices and inventory levels ahead of hurricane season. Inventories are low and any hurricanes will put money in OPEC's pocket. Since 58% of the worlds reserves are held by the top 5 OPEC countries they do control our future and it appears they finally found out that they can manipulate the price and get away with it. To avoid the constant production questions OPEC announced it would not meet again until September. That means no change in policy until September

In March production in Venezuela fell to 2.41 mbpd and well below their stated number of 3.2 mbpd. The 2.41 mbpd is not an official number but is derived from "secondary sources." OPEC does not even believe its own members and relies on secondary sources for reliable input. In the early 1980s Venezuelan oil production peaked at 3.4 mbpd and then declined to roughly half of that by 1985. The government realized they had to do something to rectify the problem. In 1990 they opened the oil fields to outside investment and about 44 different revenue sharing agreements were put in place with major international oil firms. By 1998 production rebounded with the help and investment of these firms to 3.4 mbpd and life was good. When Chavez came to power the problems began. There was a major strike and half of the workers walked out leaving the industry in dire straits. Chavez fired these workers and many of them were the only experienced personnel available. Chavez turned to the private oil companies again and saw production rise but most saw the writing on the wall. These companies hesitated putting additional funds into existing projects and hunkered down to await their fate. Chavez has now nationalized the industry and owns the projects under drastically reduced revenue sharing agreements. Basically, you help us produce oil and we will pay you peanuts for your services and charge you increased taxes on those peanuts. Hostility is rampant and production is falling. Only Conoco has failed to sign the new agreements although they have admitted the fields now belong to PDVSA. Conoco was the largest stakeholder in the Orinoco Heavy Oil Belt. There are rumors of Chinese companies willing to take over the existing contracts and work for Venezuela but so far they have failed to materialize and prior agreements with China have failed to produce any material results. Chavez has threatened to kick Conoco out of Venezuela and forfeit their billions in investments. Conoco has already said it might be in a stronger legal position to not sign a deal and just let Chavez kick them out. Caracas has already said it will not compensate companies in cash for the $30 billion or so in investments made over the last 15 years. In order to get around any claims by the oil companies Chavez has taken a play out of Putin's handbook. He is now threatening to sue the oil companies for undeclared back taxes, mismanaging extractions and environmental violations. He can sue them for $100 billion and they will have no defense and he can claim their properties in payment of the funds owed.

Historically because of the type and quantity of oil found in Venezuela it requires a minimum of 110 rigs working constantly to maintain production. After the recent wave of nationalism there were only 69 rigs in production according to Baker Hughes. In order to halt the production declines he will have to spend the money to at leas double the amount of rigs in operation. With his current attacks on the banking system, telecommunications sector, private hospitals and the cement industry and others with pledges to spend their money on projects designed to keep him in power the odds of any new money going to oil exploration are negligible. As Venezuelan oil production slows it will impact the U.S. as well as the rest of the world. We import 1.2 mbpd from Venezuela even with his threats to cut off that supply. Unless he found another buyer willing to ship his heavy oil half way around the world he can't afford to cut off shipments to us. In fact we have the hammer. If the administration wanted to play hardball they could tax his shipments or forbid them completely leaving Chavez to seek other buyers at what would surely be substantial discounts and much higher shipping costs. We have the power to cripple him and probably get him removed from power but we are slaves to oil. Nobody wants to take the step because it might cause higher prices overall and force Americans to conserve. It would be short-term pain for long-term gain in Latin America but I doubt it will happen.

Chavez suddenly announced last week that Venezuela will be leaving the International Monetary Fund (IMF) seemingly indifferent to the fact that will prompt an immediate default on $21 billion in debt and allow investors to call for an immediate payment in full on the loans. I would not hold my breath.

U.S. oil and gas drilling reached a 21-year peak in the first quarter with 11,771 wells drilled. Canadian drilling activity fell to its lowest rate since 1999 producing another sharp downward revision to well completion forecasts for 2007. 19,200 wells are expected to be drilled in 2007 and that is 18% less than 2006. Higher costs and lower volumes of gas produced are contributing to the decline.

Saudi Arabia said it might halt plans to increase oil production past 2009 because conservation and alternative energy sources could curb global consumption. No kidding that is what they said. It appears they have been breathing gas fumes way too long. Saudi Arabia expects to have production capability of 12.5 mbpd by the end of 2009, up from the 10.3 mbpd of current capacity. One has to wonder why they made this comment. Is it because they don't think they can increase production any further due to aging fields and they are planning their alibi this far in advance?

At the same time they said they may double exports to China within 3 years as demand increases and new refining capacity comes online.

Even stranger in the context of the Saudi announcements was this one. Oil Minister al-Naimi said Saudi Arabia intends to increase its oil reserves by 76% and gas reserves by 40%. "Our petroleum reserves amount to about 264 billion barrels." (It has been reported at that level for the last 20 years despite 10 mbpd of production) "All indications highlight the possibility of increasing those reserves by almost 200 billion barrels." He neglected to say where those reserves would come from and most analysts laughed at the absurdity of the statement. Apparently they are trying to cement their position at the top of the OPEC heap by increasing their bragging rights with undiscovered reserves.

The IEA said higher energy prices are having a diminishing impact on consumption. The increasing wealth of the U.S. and other developed nations are helping these countries withstand the higher energy costs. So much for the demand destruction theory.

Another week has passed and nobody has come up with a silver bullet to replace liquid fuels derived from oil. With the remaining days until peak oil measured in the hundreds or possibly thousands it is time to start thinking about what we are going to do with $8 gas and we will probably be happy just to get it. There are no material solutions in progress other than drill more holes. That is not a solution since experts believe it would take 35-50,000 wells per year in North America by 2010 just to keep current production levels from slipping. Remember that comment on how we could cripple Chavez by refusing his oil? We could be crippled even more ourselves if OPEC suddenly decided not to ship any to us. It has happened before and with the Iraq war getting worse by the day those OPEC countries in the area are not liking us any better as each day passes. It is time for us, those of us awake to the coming oil crisis, to start planning a survival strategy. I will discuss possible alternatives in coming newsletters.

We got a nice Friday bounce in Petrochina (+6.33) and Sinopec (+7.50) from the new China bank investment policy announced on Thursday. Let's hope it sticks as well!

Until next week, buy the dip!

Jim Brown

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