Option Investor

Safe Harbor In A Financial Storm

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The price of oil fell to $70.10 on Friday morning, a full -$8 off its highs, and a level where support should hold for a couple more weeks. There is no subprime or credit risk in the energy sector. With the peak of hurricane season still a month away there will be underlying support and therefore most funds are seeing a move into oil as a no risk trade.

This provided a soft bottom in energy stocks and one that could last a couple weeks. That means our energy sector puts are likely to languish in a range until the broader market rebounds. Once equities in general, led by financials, begin to rebound we will see money rotate back into techs and out of oil. This will begin the next decline in oil prices.

We saw a drop in crude inventories of -4.1 million barrels last Wednesday and it should have sent prices soaring another $1-$2 but it did not happen. Crude continued to decline and that is a clear signal that the momentum investors are leaving.

We have seen dozens of funds admit they were in trouble and there are quite a few margin calls striking home for those in credit trouble. When you can't sell troubled assets like credit paper today, you have to sell whatever you have that will convert to ready cash.

Hedge funds are facing a confidence crisis with hardly a day going by without another fund confessing liquidity problems or major losses. On Wednesday August 15th they will have another crisis. That is the last day for investors to file notice of redemption for Sept 30th withdrawals. If the investors are concerned about their hedge fund investments they can give notice by August 15th and get their money back on Sept 30th. Rumors are flying that funds are receiving heavy flows of redemption requests and that is causing a cash crunch. They will have to sell any available asset to avoid being forced to sell assets that are currently under priced or illiquid.

That sets up a situation for next week where some funds are fire-selling assets while others will be looking at energy as a safe harbor in a credit storm.

Refiners were upgraded by Citigroup to a hold from sell on Friday and saw strong gains as shorts were forced to cover. Marathon was blessed with an upgrade all the way to a buy based on their announcement their participation in a deep-water discovery off the coast of Angola. MRO gained +2.62, SUN +3.87, TSO +2.30 and VLO +1.35. With the seasonal drop in gasoline prices Citigroup expects the refiners to quickly switch to heating oil and distillates to maximize profits while margins on those products are still high.

China halted construction of its many ethanol plants noting that the corn based production of ethanol was driving up food prices to an unbearable level. Unless these plants can convert to making ethanol out of something that is not a food crop they will not be completed. Finally some reason in the ethanol sector. In the US the profit margin on a gallon of ethanol including subsidies was over $1 last year but has shrunk to only 3-cents in 2007 due to higher prices for corn. In the US we avoid making the connection between high corn prices and inflation by removing food and energy numbers from the core inflation calculations. Eventually regulators will learn from the Chinese that corn prices do impact inflation and ethanol, if it is to succeed in the US, must be made from some other source.

Demand for Ethanol rose to 427,000 bpd in May and a +20% increase over May 2006. As of July 30th there were 124 ethanol plants in operation in the US with a combined output of 423,000 bpd. Ethanol production for corn has surged +300% since 2001. In 2007 over 94 million acres of corn were planted. I have been on the road for most of the summer having driven through 19 states since the end of March. I am in Florida this weekend and after passing through Kansas, Missouri, and Illinois last week I think I have seen at least half of that 94 million acres. Every piece of flat ground for 1500 miles was growing corn. Quite a few farmers are betting a lot of money this corn/ethanol relationship will continue.

Russia planted a symbolic flag on the ocean floor at the North Pole in an effort to claim all the oil and gas reserves suspected to lie from their current borders and stretch to the North Pole. Most countries, especially the US, laughed off this symbolic display as a hopeless attempt to avoid a future resource war. Nobody appeared to be concerned the Russian attempt would shut them out of any exploration. Since much of the territory is under 10,000 feet or water and covered by a huge ice pack that is subject to continuous movement the experts said it could be 10-20 years, if ever, before technology could be developed to drill in the area and even longer before any production and completion systems could be developed. For instance how do you transport oil over thousands of miles of ice pack in subzero weather?

Mexico's oil production is falling so fast and investment in new exploration by Pemex is happening so slow that Mexico could become an importer of oil within 6-8 years. That is a reduction of more than 2 mbpd to overall supply. Iran is also expected to become a net importer of oil within the next 10 years. Growth in Iran is exploding even under the current administration. Once they become accustomed to paying market rates for gasoline the country could shift the billions per year they are now paying in gasoline subsidies to building business infrastructure to accelerate that growth. This would remove another 2-3 mbpd from global supplies. With the sharp words being traded this week over Iraq we could see their gasoline demand drop sharply very soon if hostilities erupt.

Venezuela refineries are running behind rising demand for gasoline in that country. Chavez had pledged to build three new refineries to increase supply but construction has not started due to lack of funds. With oil exports falling and Chavez confiscating every possible dollar from any profitable enterprise unlucky enough to do business in Venezuela to pay for social programs it does not appear those refineries will break ground any time soon. Chavez has tried to get Russia and China to fund new refineries but to date they have declined. North Korea, your phone is about to ring as the last member of the axis of evil Chavez has not called on for a loan.

The ASPO newsletter this week included two quotes I thought were very key to the current energy discussion.

"Supply is going no place and demand is rising 2.5% per year." Economist Phillip Verleger

"US natural gas production is declining despite a 400% increase in the number of wells. The US natural gas peak was at 22TCF/a in 1973 with 100,000 wells. 2005 production was only 19 TCF/a with over 400,000 wells." Jean LaHerrere, ASPO-France

Like oil all the big gas fields have been tapped and new production can't outrun depletion. Gas wells deplete much faster than oil wells with the majority of production in the first 3-5 years of life. If your home is heated by gas you might consider moving in the next 3-5 years because your gas bill is going a lot higher.

Next week should be another week of patient waiting for a hurricane to show with continued volatility in the broader market putting pressure on energy stocks as well. The only wild card here is the appearance of a hurricane to rejuvenate prices. Until that happens prices should continue to erode slowly.

Jim Brown

September Crude Futures Chart - Daily

September Natural Gas Futures Chart - Daily

September Gasoline Futures Chart - RBOB Daily


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