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Opec Blackmail

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We saw one of the stranger things I can remember last week. It was widely reported that OPEC threatened to send oil prices through the roof if the U.S. and others continued their quest towards volume production of biodiesel. I was shocked speechless when the first quote hit the wires. I could not believe OPEC would say such a thing in public. They may want to see it happen but they would never admit it publicly. The press had a field day with the news.

What was actually said was a lot different. Abdalla El-Badri, Secretary General of OPEC, said the cartel was considering cutting its rate of investment in exploration and production if the demand for oil was going to slow due to the increase in biofuels. Currently OPEC members are spending about $130 billion to raise production by about 4 mbpd by 2012. The next step higher is rumored to have a price tag of as much as $230 billion to increase production to meet demand by 2020.

Badri basically said OPEC nations would consider cutting back on exploration if biofuels were going to increase substantially. The reduced oil demand would not require the same level of investment. The press saw a threat when Badri warned that unsustainable production of biofuels could lead to a greater demand for oil and OPEC would not be prepared if they cut back on exploration. Badri warned that biofuel production may be difficult to maintain given the added cost to the food chain as corn and other crops were sold into fuel production.

It is a catch 22. We want to know that OPEC will continue to increase production to meet demand and allow us to live our energy rich life style. OPEC wants us to continue using all the oil they can produce to maintain an upward trend on prices. We want oil security while they want demand security. Badri warned, "If we are unable to see security of demandwe may revisit investment in the long term."

Demands on the food crops for ethanol production is the primary reason for what could be the largest annual increase in food prices in over 30 years.

OPEC has always been skeptical of alternative fuels and rightly so since they are hard to produce in volume and relatively costly. Oil is the only cheap source of energy that can be tapped with a drill bit in Saudi Arabia, flow up the pipe under its own pressure, be transported by pipeline to waiting tankers, cross oceans in days, be offloaded at refineries, refined, shipped by pipeline and truck all across the country to eventually be used in our cars for a trip to the mall. Throughout the entire process the oil is never touched or seen by humans and it sells for 1/6th the price of bottled water produced here in the U.S. They constantly complain about windfall profits made by the oil companies but the costs and risks to that entire supply chain are unimaginable to the average person. You never hear anyone claiming Pepsi or Coke are making windfall profits selling 20 ounces of bottled water for $1.79 a bottle ($11.46 a gallon) with minimal risks and negligible costs.

I doubt OPEC has anything to worry about any time soon. Bush has pledged to cut oil demand by 20% by 2020 but that is about how much demand will grow if left unchecked. By cutting 20% we will just be maintaining the status quo. We will have reached the end of cheap oil long before then so the entire conversation is mute.

Oil prices surged to $67.42 on Thursday on news that Turkish troops had crossed into Iraq. The situation never escalated and they were back home by dark. At the same time Typhoon Guno blew itself out and withered into a drenching rainstorm over Iran with no material damage to any oil installation. Oil inventory levels remained flat for the week while gasoline levels rose +3.5mb with the addition coming from imports. Refinery utilization fell to 89.6% and well under the 94% level needed to keep supplies level over the summer driving season. The jump in inventory levels pushed prices lower but I suspect it was a delivery anomaly rather than a sharp increase in production. According to the DOE refiners only added 60,000 bpd over the prior week. Imports surged to a near record of 1.6 mbpd. The U.S. imports gasoline from 36 different nations and the Virgin Islands. The biggest exporters of gasoline to us are the UK 15,908,000 bpm (barrels per month) Virgin Islands 11,802,000 bpm and France 7,678,000 bpm. The rest of the majors in declining order are Netherlands, Norway, Italy, Germany, Canada, Spain, Russia, Belgium, Brazil, South Korea and Finland to round out the top 15. You may remember that the Colonial Pipeline was shutdown for six days in the prior week for a leak in an undisclosed location. The pipeline transports 1.3 mbpd of gasoline from the Gulf Coast to customers along the East Coast. A six-day shutdown suggests nearly 7 million barrels of gasoline did not flow and backed up in refiner inventories giving us the unexpected jump in inventory levels.

Venezuela continued its program of oil export diversification and signed an agreement with Vietnam to produce heavy crude and build a refinery in Vietnam. Chavez is trying to find anybody possible to sell oil to other than the U.S. Fortunately it appears the wheels are about to come off the Chavez regime. He is running out of money to fund his massive spending programs that kept him in power. The natives are growing restless and he new management by decree program is causing problems at the grass roots level. Analysts give him 12-18 months before being removed from office.

Oil production at major fields around the world continues to decline. I have reported on the sharp drop in Mexico's Canatrell field several times as the decline continues to accelerate. This week we heard that production from the UK sector of the North Sea fell -5% month over month to 1.4 mbpd. That is a 14% drop over the same period last year. Gas output also declined -3% M-O-M and -6% Y-O-Y.

I expect oil prices to continue to trade in a range from $63-$68 while we wait on the hurricanes to appear. The longer we hold at these levels the better chance of a new spike higher on any news. Oil producers are making money by the barrel at these levels and profits for Q2 should be outstanding.

Lehman raised it target price for oil in 2006 by $1.90 per bbl to $62. They also raised 2007 earnings estimates for integrated oil companies by +9% and refiners by +17%. They also raised their estimates for 2008 by 13% for integrated and 4% for refiners.

The individual recaps this weekend are going to be short since they are all the same. The market drop and the drop in oil prices knocked a couple dollars off several positions with the biggest drop in TSO. There was no major news in the sector that impacted our positions. I view the dip as a buying opportunity.

The dates for the two major energy conferences I attend each year were announced this week. The World Oil Conference sponsored by ASPO will be in Houston on Oct 17-20 with all the major speakers you would want to hear including Boone Pickens, Matthew Simmons and many others. This conference focuses on the study of Peak Oil and features oil experts from around the world giving their views on when it is likely to arrive.

The other is EnerCom's 12th Annual Oil and Gas Conference to be held in Denver on August 19-23rd. Over 70 exploration and production companies will make presentations about their current operations and future outlook including XTO, APA, CHK, ECA, UPL and HP to name just a few. It is an excellent conference if you really want to know who is on track to improve production and increase earnings with a focus on growing small cap firms. This conference is tailored for high net worth individual investors, funds and institutional investors.

Jim Brown


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