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The Fuse Is Lit

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Crude oil prices rose to close at a 9-month high on rising geopolitical tensions and continued refinery problems. The conflict in Israel and Iran's vow to never give up its nuclear ambitions fueled price concerns on both sides of the globe. An unexpected drop in refinery utilization in the U.S. produced a sharp spike in crude prices at home. Apparently the refiners cannot keep them running this year with multiple outages each week and some lasting for weeks.

News that China was arming the insurgents in Iraq and the Taliban in Afghanistan with new anti-aircraft missiles, components for roadside bombs and other munitions caused another shock in Washington. While this does not directly impact oil production it does bring up the issue of what to do about it and what potential military conflicts could arise on a much larger scale. China is also arming Iran with modern anti-ship missile systems for use in the Persian Gulf. Investors have to ask themselves where this is headed. To others and myself it is clear that a conflict with China is inevitable although still years away. That conflict will impact oil production and delivery on a global scale even if the oil fields are not specifically targeted. China is preparing to fight to control the seas on its side of the globe and challenge our current undisputed rule. Presentations to congress over the last month showed that China was spending $125 billion on modernizing and improving its weapons systems with state of the art offensive capability. They have even created a cyber warfare division with the intent to break into, compromise, disrupt and jam communication systems both Internet based and satellite based. I am starting to rant here so I will end this topic but make no mistake this is going to be a major problem early next decade if not sooner.

On the current energy front the depletion monster continues to feed on existing oil fields. Norway announced that crude-oil production fell -7.4% in May from only a month earlier. They also announced that gas production was slowing. However they are developing new gas fields and will eventually become the world's second largest gas exporter.

The IEA and EIA continue to project massive new demand numbers for decades out into the future. To match this demand they project new production coming online for the next 3-5 years. Rarely does new production actually produce a material increase to overall global production. For instance they projected large amounts of new production from the Canadian oil sands. Over an 8 year period where they were projecting and tracking new expected oil sands production that production rose +500,000 bpd. Over the same period production from the North Sea alone declined -1.6 mbpd for a net loss of 1.1 mbpd despite the optimistic projections for an overall gain. Outside experts claim we have to find and produce more than 3 mbpd of new oil each year just to make up for depletion rates from existing fields. To actually increase production materially you would have to add 5 mbpd for multiple years since the depletion rate grows at a faster rate each year due to aging fields. We know how this story will end. We have only been discovering oil at the rate of 5 billion barrels per year. (7gb (gb=billion barrels) in 2004, 5gb in 2005 and 3.6gb in 2006) We are using oil at the rate of 27 gb per year. Do the math.

Uranium prices are expected to hit $200 a pound within the next two years. This is up from $35 a pound just a couple years ago. Increasing numbers of nuclear plants and shrinking supplies cannot peacefully coexist. Something must give and that means frantic exploration by the major producers. Thorium is being explored as a substitute for uranium in future plants.

Iranian drivers can only buy gasoline starting last week if they have a government electronic ration card. The plan is supposed to curb soaring gasoline use. An easier method might have been to just let the prices rise to market levels. Iranians currently pay about 11 U.S. cents per liter and that is after a recent 25% price hike. Just let the price float to global levels and demand will drop drastically. Since Iran subsidizes the price of gas at that level it would also halt a serious drain on the Iranian government's finances. Let's don't tell them about this option and let them continue to pour money into consumer gas tanks.

According to the IEA demand for OPEC crude will rise by 7.8 mbpd to 38.8 mbpd by 2015. That is the equivalent of adding the complete production of another Saudi Arabia. Unfortunately nobody in OPEC can tell us where that oil will come from. Current expansion programs are targeting an increase of roughly 3 mbpd by 2011. Also unfortunate is the fact that it takes nearly 10 years to bring new fields online from discovery to material production amounts. Any additional oil to be produced by 2015 would have to have already been discovered, infrastructure planned and production wells scheduled to be drilled. Since nobody in OPEC has any projects on the board for completion after 2011 it appears we can project Peak Oil for sometime in that range if not before.

In 2004 the Venezuelan national oil company PDVSA said they planned to produce over 5 mbpd by 2009. They were going to spend $37 billion to accomplish this feat. About half that time has passed and production should have passed 4 mbpd on its way to the 5 mbpd target in 2009. Unfortunately production has fallen instead to less than 3 mbpd and still dropping. Chavez has no capital to invest in exploration and he has nationalized all the fields and production facilities. No outside company will invest a dime at this point. Last week Chavez said, "an unnamed U.S. oil company has abandoned its oil wells in Venezuela and left the country." There is no official word on who it was but several firms are close to pulling up stakes and fleeing the disaster in progress. Chavez has 12-18 months left in power according to several political think tanks, which are projecting the downfall of his regime when he can no longer fulfill his expensive promises by nationalizing foreign assets. Political unrest is growing and the clock is ticking.

It was a banner week for our positions with several gaining multiple dollars to new highs. Definitely no complaints and the arrival of a Gulf storm will only send oil prices and stocks higher.

We had a nice entry on McDermott last week and are already up nicely on that new play. With nearly all the decent oil stocks at new highs this week I will not be adding any new plays. We want to plan our exit in existing positions for late August and that does not allow for many profits from entering at new highs today.

Jim Brown


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