Option Investor

Surprise, Surprise!

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Who would have thought that oil prices would rebound +2.50 from the lows on an increase in supply and no hurricane damage. It is truly the power of imagination that drives markets. Some traders see two refinery outages for loss of approximately 250,000 bpd of refining capacity as bullish for oil. It should be exactly the opposite since a drop in refining means more oil backing up in the pipeline. Prices were also helped by stronger than expected economic reports suggesting demand would continue at a record pace. We also had some short covering after prices failed to implode in the aftermath of Dean.

I believe this is just a blip on the chart as we await the peak of hurricane season on September 10th. Hurricanes can still form after the 10th but once we are on the backside of the curve they are quickly forgotten.

I received an email on Friday telling me to forget the current entry points because all our candidates were running away from us. I agree they are moving in the opposite direction but once oil prices reverse to the downside so will the stocks. We may not get all our entries but the ones we do should be profitable. Be patient.

I attended the 12th annual Enercom Energy Conference in Denver last week and listened to 75 companies try to convince fund managers to invest in their stock. There were CEO's that could have been used car salesmen with their polished pitch attempting to sell the dream. There were 75 companies what presented and I told you on Tuesday night I would post the best ten in this newsletter. Unfortunately I only found 9 to recommend. This was a tough year. Increasing production is becoming increasingly hard and many of the small players are struggling to really add significant numbers. Costs are rising and competition for rigs and leases remains tight.

Chesapeake and Core Labs both made a point of saying the land grab was over. The majority of leases covering the remaining production in non-hostile areas have already been snapped up. For instance Chesapeake has over 12.2 million acres under lease in the United States. Apache has more than 46 million acres. To accumulate that many acres they had to expand their search to Australia, Canada and Egypt. Basically if you don't own it today you are going to have to pony up the big bucks to pry it out of your competitors portfolio. Sector consolidation is about to ramp up furiously. Rather than just dry up and blow away it is better to be acquired. Those companies with money are in the faced with many opportunities to pick up the stragglers with diverse portfolios and insufficient assets to develop them.

There is a new trend developing in the natural gas sector that suggests prices are going a lot higher over the next couple of years. The weather has been unseasonably warm over the winter and that has led to massive amounts of gas in storage and a backup into the pipelines leading to lower gas prices. December-06 and January-07 were the two warmest months in the U.S. since meteorological records have been kept starting 112 years ago. This slowed demand and allowed storage levels to remain high. Eventually normal winters will return and there is not enough gas storage in the U.S. to accommodate a normal winter. In a normal winter gas storage must be filled to capacity during the summer and fall and full production must be continued throughout the winter to avoid shortages. The problem with this scenario is the falling gas production in North America. You could not see the problem by just looking at current gas prices. Current prices have been skewed by the warmer weather.

Calyon Securities gave an update on gas price projections at the conference and the new trend is higher finding and development costs. Because gas wells are going progressively deeper to produce shrinking volumes of gas this raises the cost of the well and therefore the cost of the gas for the producer. The average cost per MCF today has risen to about $4.67 per MCF. Gas prices closed on Friday at $5.51 per MCF. Prices are not going much lower because producers will shut in production rather than produce it for a loss. This is going to impact profits at those companies that have a high cost of acquisition while benefiting those that have a low cost like Ultra (UPL) where costs are more in the $1.50 range. Over the coming years the price of gas must rise to allow the funding of future drilling. We have already seen drilling in North America slow as gas prices fell over the last 2-years. This supply/demand cycle will only move prices higher once demand returns with fewer new wells supplying gas.

The normal life cycle of a gas well is very high production in the first 12-18 months where 35% to 65% of the gas in place is produced. This is followed by a sharp decline in production rates until the well goes dry. That decline period can be from 5-20 years with the rate of flow only a fraction of the initial production. This means new wells must be constantly drilled in order to get that burst of initial production just to keep overall production flat. New production comes on very fast but drops sharply as shown in the Ultra chart below.

Ultra Petroleum Individual Well Decline Chart

Rig Count VS Gas Production

More rigs are producing less gas. In May of 2000 the Baker Hughes rig count showed just over 600 rigs drilling for gas in the United States. Production was just over 53,000 MMCF per day. Today there are over 1400 gas rigs and over 150,000 more wells and production has fallen to just over 51,000 MMCF per day. The gas production effort has more than doubled and production is still falling. This trend is going to end badly. We can't put enough wells in the ground to offset the sharp decline curve now that the easy gas has been produced. The massive conventional plays have been exhausted and the current shale plays are labor intensive with shorter life spans. Gas prices are going up, just not next week.

The same is true in the oil fields. Discoveries peaked back in the 1960s and have declined sharply for decades. All the big fields have been found and production is well along the decline curve. It is thought that between 1.9 and 2.4 trillion barrels can ultimately be produced. We are approaching that midpoint where the remaining oil in the fields must be coaxed out of the ground by enhanced recovery techniques. These are costly, time consuming and produce at a much slower rate. The chart below shows the discovery decline curve and the production curves. If you can't find new oil you can't produce it. Therefore the production curve for known discoveries can be plotted fairly accurately. In the chart below the production curve is shown to be peaking now if you use the 1.9 TB ultimate production number. Using the 2.4 TB ultimate production forecast the peak would occur around 2010. Existing fields are declining at a rate between 2.5% and 7.5% per year depending on the life cycle the field. If a field has been producing for 10 years it will have a slower decline rate than one that has been producing for 40 years. Most of the 4000 fields around the globe have been producing for more than 20 years, some 50 years, and are approaching their end of life. An oil well has the same general peak and decline characteristics as the gas well illustrated above only the initial decline rate is slower.

Discovery Decline Chart - Sources- EIA, BP, Colin Campbell

This energy scenario has not changed since I began reporting on the coming energy crisis several years ago. We are just a little farther down the road and closer to the peak. Wells are becoming harder to drill, in harsher locations and requiring more technical expertise. This diagram from the Talisman presentation shows how drillers have to resort to more and more horizontal wells to obtain smaller amounts of oil. By going horizontal the well bore remains in the producing zone for thousands of feet rather than a couple of hundred feet with only a vertical well. This allows for a greater volume of oil to be recovered but it also shortens the life of the well by recovering the available oil more quickly.

Talisman Horizontal Well Diagram

Core Labs (CLB) is active in reservoir management in 900 of the worlds 4000 fields with most of the largest fields under management. They have probably the best grasp of the actual decline rates of those fields and the potential for future production. The various agencies that predict demand growth, EIA, IEA, etc, are currently targeting +1.5% to +2.0% through 2011. Demand is expected to reach 88 mbpd in 2008, up from the 86 mbpd in 2007. Core Labs questions if the world will ever produce more than 88-89 mbpd due to current decline factors in existing fields. They believe a global decline rate closer to -5% to -7% is the harsh reality and when coupled with the current rise in demand this produces a startling divergence.

World Demand Growth Forecast - Source: Talisman

World Decline Forecast - Source: Talisman

The punch line for those two charts is the world is very close to peak oil. Adding +32 MBPD of oil by 2011 is technically impossible. That is the equivalent to adding three times the current production of Saudi Arabia. In order to add 32 mbpd those new fields would have to have been discovered over the last five years. It takes 5-9 years to go from a discovery to full production and 20-40 years to extract the oil. There have been no major discoveries since 1970 large enough to produce even a 2 mbpd increase in production. We consume 30 billion barrels per year and have averaged finding only 5 billion since 1995. Technically it is impossible to increase production from existing fields by more than 3-4 mbpd per year over the next five years. Assuming we achieved the nearly impossible global production increase of 4 mbpd per year that would still leave us short by 12 mbpd in 2011.

The world is headed for a train wreck of monumental proportions and there is nothing we can do to stop it. No amount of conservation, ethanol switch or bio-fuels can cut demand by -5 mbpd over the next five years. The momentum of oil dependency is too great. The world will only switch to alternative fuels when forced to switch by astronomical prices at the pump. Today there is nothing to switch to. If a global edict appeared tomorrow demanding everyone switch to an alternative fuel it would be years before enough vehicles and fuel could be produced to make any material dent in oil demand. Prepare yourself for the coming disaster.

The best way to prepare is to invest in energy stocks. I promised to show the ten best presenters from the 75 I saw last week but I could only come up with nine I am comfortable recommending. Times are getting tougher in the oil patch and I believe we need to focus only on the cream of the crop for our invested dollars.

I have run out of time and space today so I am only going to give you the companies and the link to their Enercom presentation so you can see it yourself. I will expound on these companies in future newsletters. Click the links below for the audio and video presentation. (The slides must be advanced manually. Expand your browser to view the slides.)

HP - Helmerich & Payne
CLB - Core Lab
UPL - Ultra Petroleum
CHK - Chesapeake Energy
APA - Apache Corporation
SWN - Southwestern Energy
CNQ - Canadian Natural Res
HERO- Hercules Offshore
GLBL- Global Industries (no audio)

Link to all 75 conference presentations

October Crude Futures Chart - Daily

September Natural Gas Futures Chart - Daily

September Gasoline Futures Chart - RBOB Daily


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