Option Investor

$70, Going Once, Twice

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On Thursday crude prices spent a lot of time over $70 only to retreat at the close. On Friday during the cash session crude never traded under $70 with a high of $71.06. Ironically crude inventory levels are at a ten-year high. The last time crude inventories were this high was 1998 and crude was trading under $20.

Professional trades were saying a close over $70.40 on Friday was very bullish and $80 was being tossed around like it was a guaranteed target before the summer is out. That would depend mostly on the hurricane season, which so far has been devoid of any material storms. Prices are trading up on the expectations for a disruptive storm and eventually traders are going to get nervous being long if one does not show.

Over the last 100 years the peak week for storms comes around Sept-10th. There are very few until early August and they drop off quickly after mid September. Oil traders know these facts and that puts a tie limit on being long in large positions.

Hurricane Season Probability Chart

We have other factors influencing oil prices such as the problems with Iran, Nigeria, Venezuela, production from Mexico and drastically low refinery utilization. However, with oil inventory levels at 10-year highs it is the storm probability that is moving prices higher. Our strongest demand peak is in July and that is about as far as we can stretch the gains before volatility arrives. Everybody is watching the same calendar and their nervousness will increase with time and the size of their positions.

We entered most of our energy positions back last fall when the normal drop in prices arrived. That was the plan and it worked almost perfectly. The game plan today is to exit those energy positions in late July or early August if prices begin to roll over. We will enter again in the fall when prices correct. With inventory levels so high in 2007 there could easily be a correction back to $60 or even lower. It all depends on storms, Opec and intestinal fortitude of existing oil traders. If a correction appears it could be very sharp and swift like the drop we saw last January when the current August contract fell from $67 to $54 in only a matter of days. We definitely want to be out of our positions if prices start to crater again. We were stopped on four plays this week when that big downdraft occurred on Wednesday. ATI, BTU, HES and TEX. We also triggered on four entries on CNQ, GSF, NOV and RIMM.

There was a concentrated sell program across all markets on Wednesday that took all out stocks down to monthly lows. It did not seem to be related specifically to energy with miners, metals, machinery, builders, etc, all taking the same hit. This kind of volatility is typical of markets at their highs and various funds rotating out of positions even when the major indexes are having a good run. It could be a symptom of what we may face next week. Watch those stops!

I heard on Friday that 1.4 million families were planning on being on the road next week for vacations. That seems light to me but I don't track that number. Demand for the last seven weeks has been stronger than the same period in 2005 and gasoline prices are well over $3 for most of that period. Demand is not slowing despite the number of hybrids Toyota is selling.

Production from Mexico's Cantarell field, the world's 3rd largest, fell again in May to 1.58 mbpd. This was a 15% decline from the 1.86 mbpd produced in May 2006. By the end of 2008 production is expected to decline to only 1.0 mbpd. The rapid decline is a result of enhanced recovery techniques that accelerated oil output over the last decade but sacrificed longevity in the process. Multiply this problem across most of the world's fields and you will get a picture of what is ahead of us. May output from all of Mexico fell -6.6% from 2006 levels.

The worlds major oil companies failed to replace 100% of produced reserves for the third consecutive year according to Bear Stearns. Reserve replacement in 2006 was 91% compared to 92% in 2005. This is a clear indication of coming problems but nobody is listening. If you can't find as much oil in as year as the oil you produced you are going to eventually run out.

Exxon blamed consumers on the rising price of gasoline. Exxon's CEO, Rex Tillerson, said at a their recent annual meeting, "The industry is producing record amounts of gasoline but the consumer is also burning record amounts." Consumption is about 1.5% higher so far in 2007 than 2006. That is an increase of 4,334,375 barrels of gasoline per month or 144,500 bpd. That is the equivalent output of a new refinery each year.

Keep watching the weather because it is the only force that can keep prices moving higher from here. Keep watching the stops on the individual plays because we don't want to get caught wishing we had sold if a correction appears.

Jim Brown

August Crude Futures Chart - Daily

August Gas Futures Chart - Daily

July Gasoline Chart - RBOB Daily


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