Option Investor

Starting to Worry

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The price of oil closed at 73.97 when trading ceased for the weekend. This was exactly one year since the prior high for oil was made on July 14th 2006. Prices stayed at that level for about three weeks before rolling over into a dive that took -$15 off the price in a very short period of time.

Almost exactly the same scenario is setting up for this July. Strong demand and promises of an active hurricane season that never appears. Unfortunately in trading we know that past repeatable events tend to be hedged by a week or two when the scenario repeats. Traders who understand the scenario don't wait until the last minute to change directions. They tend to enter earlier and earlier each time the scenario repeats. That suggests we are very close to a top assuming no hurricanes appear.

Helping to push crude prices higher in spite of decade high inventory levels has been the refinery crisis. With capacity utilization running -5% or more under normal the fear of gasoline shortages has pushed gas prices higher and crude prices followed. For most refiners gasoline production requires light WTI crude and WTI has seen the strongest demand.

Last week gasoline prices fell from Tuesday's high of $2.38 to Friday's close at $2.25 a drop of -5.5%. $2.20 is strong support but once traders decide there is enough gasoline in inventory to last the rest of the summer the dump will begin and gasoline prices will plummet. Once gasoline cracks crude will be only a heartbeat behind it and it will be ugly.

I expect the drop in crude prices to be hard and fast because current net long positions in crude futures are at record levels. OPEC has managed the price perfectly and production problems at various fields around the globe have added to the price pressure and investing interest. Without a hurricane the decade high inventory levels will begin to weigh on prices. The last time inventory levels were this high oil was under $20 a barrel.

The International Energy Agency, advisor to the worlds 26 most advanced economies, continues to repeat a call for OPEC to ramp up production to add to global inventory levels before Q4 demand arrives. The IEA trimmed its 2007 demand projections by 100,000 bpd to 86 mbpd for all of 2007. Demand for 2007 is expected to rise by 1.8% or 1.5 million barrels per day over 2006. Oil demand for 2008 is expected to rocket higher by 2.5% or an additional 2.2 mbpd to 88.2 mbpd.

The disturbing portion of this report was the cut in production expectations of 410,000 bpd from non-OPEC sources from prior estimates. The agency said "unscheduled outages" are now a part of the industrial landscape for the oil industry. They blamed this on aging infrastructure. OPEC demand is expected to rise to 32 mbpd in 2008 compared to June's 30.17 mbpd of production.

The IEA admitted it had been too optimistic in past years about new production capacity coming online and is toning down production estimates to take into consideration delays in projects and those unscheduled outages. They have yet to mention the biggest problem of all and that is depletion at existing fields. It is as if they feel if they don't mention it the problem will go away. They can just say new demand will be X and expected production additions will be Y and hope those two numbers are equal. Somehow I think reality has to enter the mix eventually and no amount of confusing press releases will help.

They also said prices over $70 a barrel would depress demand as it did in 2006. When prices passed $70 in 2006 demand growth dropped from a +2% pace to end the year at only +0.9% due to voluntary and forced restrictions on gasoline purchases. People simply drove less and global demand slowed. The IEA is expecting that to happen again in 2007 but to less extent. Each time prices dip they dip from a higher level to a higher level and consumers adjust to the new range until the next price hike begins again. As long as the world continues to produce nearly 35 million vehicles a year demand will continue to climb. Current global vehicles are thought to be in range of 730 million and are expected to hit 1 billion by 2015. That one fact alone should be enough to convince everyone that we are going to be in a world of trouble very soon. Transportation as we in America know it is about to change dramatically.

The table below is the actual demand and production numbers for 2006, 2007 and estimates for each quarter through the end of 2008. I added a line to show the difference between the actual production and the demand. You can see we have been living off oil in inventory during the high demand months and then adding to that inventory in slack months. Unfortunately the trend towards more negative quarters is growing. Note that production from Q1-2006 to Q4-2008 is expected to rise +4.3 million barrels per day. I believe that is wishful thinking and it will be tough to reach that 88.9 mbpd demand level. Remember also that the IEA has admitted their oil production estimates for the last 5-years have been too optimistic.

IEA Crude Projection Table.

Just when refiners were starting to come back online and pickup speed the BP refinery in Whiting Indiana crashed. This is a 250,000 bpd refinery and it has been offline for a week with an expected restart this weekend but it will impact the inventory numbers for next Wednesday's report. The refinery accounts for 1.4% of US refining capacity and produces 800,000 barrels of gasoline per week. It uses 1.6 million barrels of oil in the process. With this refinery offline for over a week you can see how that will impact the next inventory report. Oil levels should rise and gasoline levels should fall. Imports of gasoline increased another 30,000 bpd to 1.423 mbpd for the week.

Brent light crude closed at $77.68 on Friday with prices holding above WTI crude due to continuing problems in North Sea production. Many of these problems should be corrected over the next couple of weeks and Brent crude should begin to fall. This will be another drag on WTI prices here in the US.

Because of what could be an impending drop in crude prices I am raising the stop losses again and I am going to institute a couple hedge plays to capitalize on the drop if/when it appears.

Jim Brown

August Crude Futures Chart - Weekly

August Gas Futures Chart - Daily

August Gasoline Chart - RBOB Daily


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