Option Investor

Bearish Divergence

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The price of gasoline fell -13% from the prior week's high to the Tuesday low but crude prices continued higher. This divergence can't continue and they will eventually return to trade in lock step. Since driving season is nearly over the odds are good gasoline will not rebound much higher. Once more leg down in gasoline prices is all it should take to grease the skids under the price of oil.

The price of the futures contract over the next several months is already showing what is called "backwardization." Backwardization is where futures for forward months trade at a lower price than the current contract. Normally futures trade higher on the combination of risk and time. Higher prices for future contract months is called a contango. Producers always hope for a contango so they can pre-sell their production for more than the current spot prices. In theory futures prices will always decline to meet the spot prices rather than spot prices rise to meet the futures. It does not always work like that but a contango does represent a positive profit potential for producers. A market in backwardization makes it more profitable to sell production on the spot market rather than pre-sell it into the futures market. The ranges we are seeing right now may technically be called backwardization but the difference in price is negligible. We have not seen this in many months so this is yet another sign that oil prices may be about to crack.

You would not expect a break in oil prices from looking at the September crude chart. It has been rising steadily despite crude inventories reaching 10-year highs. The fear of a hurricane disruption is thought to be the reason but there are other factors supporting the market.

OPEC always claims there is plenty of oil on the market. There probably is but there is not enough light crude on the market. I have used the analogy many times about a driver pulling his diesel car into the service station for a fill up. The station tanks could be over flowing with regular, plus and super unleaded but if they have no diesel the driver is out of luck. The world is overflowing with various grades of crude but the critical light sweet grades are the ones in high demand.

With the new emission rules most refiners need to start with a lighter grade of crude to produce the very low emission fuels. Very few refineries can produce gasoline from the heavy sour grades of crude. Valero is the main exception with the ability to process the cheaper sour crude.

The light crude problem is worse because of the problems in Nigeria and the North Sea. Nigeria is a large producer of light crude with production of more than 2.5 mbpd when they are operating at full production. Violence in their country has shutdown over 750,000 bpd of this light crude production called Bonny light.

Problems with several platforms and a pipeline in the North Sea has crimped production of Brent Light Crude by somewhere in the neighborhood of 150-300,000 bpd. This shortage of light crude on the global scale has already pushed the price of Bonny light crude over $80 since July 9th. Louisiana Light Sweet crude (LLS) hit $80 last week. The benchmark WTI crude now at $76 is likely to hit $80 next week but that could be the end of the road.

Nigeria is attempting to restart production that has been shutdown for many months. This may be a futile effort but the government must get control soon to revive the government. Nigeria is losing $1.3 billion a month due to drops in production. However, an apparent kidnapping attempt of a Lebanese ended in his death on Friday. Kidnappings from oil facilities are the favorite tactic of the militants to draw attention to their cause.

Maintenance problems in the North Sea are drawing to a close and production should be resumed shortly. That will take the pressure off the price of Brent light crude.

In the U.S. four refineries were in the process of restarting last week after being shutdown for various reasons. The Exxon Beaumont TX, Exxon Baytown TX, BP Whiting IN, and BP Carson CA were all being restarted. Successful restarts will further pressure gasoline prices through greater production.

Total S.A. terminated their force majeure declared earlier in the week on its 240,000 bpd production facility in Angola.

Saudi Arabia is expected to increase output by 240,000 bpd next week. This output had been shutdown at the Ras Tanura terminal due to a fire four weeks ago.

On the demand side the vacation-driving season has about 4-weeks left but demand hit a new record of 9,710,000 bpd of gasoline last week. China also reported that crude imports surged +12% in Q2.

Add all these facts together and stir briskly and you may get $80 oil but once gasoline prices start down again I think the high oil prices are going to crumble unless a hurricane appears.

Last week saw stock prices begin to roll over beginning with the refiners as the leading indicator that crude prices were about to weaken. We raised the stops last weekend and were rewarded with exits on several positions. I am raising stops again on those we have left and adding a couple more short-term puts.

Most news commentators don't understand the pressures futures expirations put on prices. The August crude contract terminated trading on Friday at the $75.53 close. Monday the September contract will become the current month and we could see some additional volatility as a result. I believe a lot of the upward pressure last week was short covering the expiring contract. It will be interesting to see what the new contract does next week.

I mentioned the IEA Oil Market Report last week and several readers asked for a link to the report. Your wish is my command.

Just remember that the IEA is very optimistic and has even criticized themselves recently as being overly optimistic over the last 5-years. They are making progress towards being more realistic but it may take a couple more years to bring them closer to reality.

Last week another report surfaced called "Facing the Hard Truths about Energy" and it was immediately criticized as being a whitewash for the administration. Energy Secretary Sam Bodman requested a comprehensive review of the current and future energy outlook. Dozens of "experts" and oil company officials were contracted for input. In the end the National Petroleum Council produced a report that hinted at hard truths but never clearly identified them. One commentator charged, "asking the NPC to analyze Peak Oil is like asking the tobacco industry to forecast lung cancer." The same NPC was asked to study natural gas trends in the late 1990s. Their report in 1999 predicted stable prices and soaring production. We obviously know now that exactly the opposite occurred with prices spiking to over $12 from the $2 in 1999 and production slowing for the last 5 years. I won't go into the full rebuttal but here is a link to one that is excellent.

Amazing risk of the week: Devon (DVN) said it was planning on spending $100 million to drill an exploration well 33,000 feet below the seabed near last year's Jack 2 discovery. Devon said there was about a 65% chance it would be a dry hole. They decided to take the risk because "it was only a step away from other successful wells." How you define successful would be an issue here. Nobody has decided hot to produce oil from the Jack 1 and 2 wells yet with the extreme depth the biggest issue.

Quote of the week: Boone Pickens on CNBC, "I think you are going to see $80 a barrel before I am 80." Pickens turns $80 in May 2008. Seems like a safe bet.

Long-range weather forecasts predict that a ridge of high pressure will form over the US east coast by late July. This would create the hurricane steering pattern much like the 2004 and 2005 seasons. This poses increased risk for the Gulf oil patch if it does occur. Unless it occurs soon it may not be soon enough to halt a crash in prices.

Due to reader requests I added a column to the portfolio page to show the stop losses for each position. Thanks for the suggestion Ira.

Jim Brown

August Crude Futures Chart - Weekly

August Gas Futures Chart - Daily

August Gasoline Chart - RBOB Daily


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