Option Investor
Commentary

Sometimes You Feel Like A Nut

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For some reason I found myself repeating that Almond Joy/Mounds jingle to myself all day on Friday as oil prices climbed to nearly $74.50 on a combination of circumstances. Ahh, but the second line to that jingle says, "Sometimes you don't." I don't because I am still confident our plan will work and we will get a majority of our watch list entries when oil prices subside.

Let's review why oil prices rose this week. Concern over high driving demand for the last week of summer and four refineries down for much of the prior week had traders watching the Wednesday inventory reports even more so than normal. Would gasoline drop, would there be enough for the holiday driving, does the Easter bunny exist? Had to throw that in the mix just to see if you were paying attention. Traders may have been watching for the inventory report but they were NOT paying attention.

Oil inventories dropped "unexpectedly" by -3.5 million barrels and gasoline stocks fell by -3.7 million barrels in the prior week. Dang! The world must be coming to an end. Buy some oil futures quick. Aunt Martha and uncle Bill may not have enough gas to get back from their Labor Day trip. What are we going to do? There is only enough gasoline for 20 days of supply according to the EIA. Break out the ration cards we are going to need them.

Let's reconstruct the events and see why inventory levels fell "unexpectedly" last week. If you are a tanker driver bringing a million bbls of oil from Saudi Arabia, Nigeria or Venezuela and saw this hurricane probability chart for Dean as you headed for the east coast of the U.S. what would you do? I doubt it would be "damn the storm, full speed ahead" and plunge right through a category 5 hurricane to the refineries in Texas and Louisiana. No, you will dial back on the engines and put yourself in a parking orbit somewhere east of the Bahamas and wait for it to blow over. With several tankers a day carrying from 500,000 to a million barrels each it probably looked like a tanker farm trapped in the Bermuda triangle before the week was out.

Hurricane Dean Wind Chart

The rigs in the Gulf were shutting down and evacuating personnel in case Dean turned north and Pemex was shuttering production in Mexico. All of this reduced the flow of oil into the refineries several of which had also slowed production and shuttered non-essential output until the storm passed.

Once the storm turned into Mexico and everyone realized it would not impact the Gulf the tankers began sprinting west and lining up to offload their cargo. We import an average of nearly 11 mbpd of oil from various countries including Mexico and Canada. That oil not coming from our neighbors has to come by tanker. Imports were down 993,000 barrels per "day" last week or 6,951,000 barrels for the week. Personally I think it was amazing inventory levels were only down -3.5 million barrels for the week according to the EIA numbers. That should tell you something about how much extra oil is floating around in the system. Our oil inventories are just below the decade highs set back in July but still more than 10.9% over the 5-year average high for this time of year. Definitely no shortage of crude despite the -3.5 mb drop.

Gasoline fell -3.7 million barrels for a multitude of reasons. The first one was obviously the hurricane. We import around one million barrels per day and that arrives on tankers. We also had two refineries in Texas shut down partially for the hurricane and two that were down for other reasons including the 250,000 bpd plant in Mississippi. Those Gulf refineries that did not shut down slowed production to minimize problems if the storm did turn their way. Refinery utilization fell to 90.3% from 91.6% a week earlier. Even with all the impacts to gasoline production and imports the current 20-day supply is only 1.9 days below last year at the same time without any problems. Pop quiz: What could cause all the refineries in the U.S. to quit refining gasoline at the same time? Nothing but a life ending comet strike on North America. Every refinery stands alone and gets its crude from different sources. That 20-day supply assumes all refining activity halted tomorrow. It is not going to happen.

If you think about it the "unexpected" drop in oil and gasoline levels was not all that unexpected. You just have to put your brain in gear for 30 second or so and consider the facts. Obviously many traders failed to pass the test and clicked the mouse in panic instead.

Next week I guess the headline will read "unexpected increase" in crude inventory levels surprises analysts. Duh, it just means the tankers lined up in the Gulf dumped their loads are steaming east again at full speed to try and recover lost time.

Thanks to that unexpected drop in inventory we were triggered on the XLE put on Friday as it rose to our entry point. I love it when a plan comes together!

Now, to complicate the scenario for next week we have a new tropical storm forming south of Puerto Rico and headed right along the same path Dean took. It was not even a named storm yet when I started writing this commentary and was only called tropical storm Felix. As of 5:AM Saturday morning it now has a name, Felix. It is expected to hit the Honduras, Guatemala and the Yucatan on Wednesday if the course does not change. That would take it out of harms way other than to produce a lot of wind and rain on those Pemex fields northwest of the Yucatan in Campeche Bay. The obvious fear is that it will turn north, pick up intensity over the warm water and head into the gulf. Currently it only has winds of 30 knots but that could change at any time.

Tropical Storm Felix

The reason we are seeing storms form now is due to the peak of the season just ahead. September 10th is the normal peak of hurricane season and then storm frequency declines sharply. As an example Katrina and Rita formed very near the peak of the season in 2005.

Hurricane Season

Another challenge to prices will come with the OPEC meeting on September 11th. The two most hawkish OPEC members, Iran and Venezuela, have already called for OPEC to maintain current production levels. This is contrary to their normal call to reduce production. Since neither can even make their reduced quotas they would benefit from other OPEC members being curtailed even more. Since Q3 is a very heavy demand season around the globe the idea of cutting production even further is ridiculous. By calling for OPEC to maintain production they hope to limit any increases to meet that demand.

Depending on whom you listen to demand in Q3 is expected to increase by 1.5-2.0 mbpd as refineries gear up for winter heating oil production. Assuming no hurricanes to slow progress in the Gulf non-OPEC production around the world could grow by +600,000 bpd. That means OPEC will have to increase production to 31.3 mbpd to accommodate increased demand. Based on their current posted production numbers that would be about 800,000 to 1.2 mbpd more than they are currently producing. That assumes everything proceeds according to plan with the various non-OPEC projects scheduled to come online in the next 3-months. Since nothing ever runs on schedule it is a pretty sure bet OPEC will need to increase production by 1.5 mbpd to keep supplies level. This would be right at their maximum output level of roughly 32 mbpd. They make a lot of noise about being able to produce more but demand growth keeps sucking it up just as fast as they can increase production.

Regardless of what eventually happens to demand and supply in Q3/Q4 the OPEC meeting on the 11th will be a critical focal point and could have a serious impact on prices. They could claim only a minimal increase to keep prices high and then actually produce all they can to capture the high prices. They could also agree to produce the required amount but stair step it to keep prices high. You never know which way they will move.

What we do know is gasoline consumption will fall off a cliff next week. Summer is over, school has started and vacations are behind us. Weather will turn cooler and overall crude demand in the U.S. will slow. That will begin to push inventories higher as refineries begin to schedule fall maintenance cycles and the conversion from gasoline to heating oil. Historically this pressures prices and we get the lows around the 1st of October.

I use the terms historically and normally but there is no normal in the current oil sector. With demand running so close to production and depletion rates rising we will continue to see volatility in crude prices. I only hope that Felix will fizzle like Dean and our plan will come together culminating in a drop in crude prices and give us out winter position entries.

Natural gas producers are in the middle of a perfect storm for gas prices. A futures roll over last week provided some temporary relief from selling but the new October co0ntract was crushed on Friday to close at $5.46. This gave us our anticipated entry in Ultra Petroleum that we have been waiting for two months to arrive. Natural gas storage is at record levels going into fall and without a blizzard a week it is going to be a very bleak winter for prices. With plans to try and maximize storage levels to as much as 4 tcf there is still a little room for production but we are already at 3 tcf and +12% over the 5-year average. Without a hurricane crippling gulf production for months there are sure to be curtailments all across the producing spectrum. Eventually a real winter will return and the cycles return to normal. Gas production has fallen for the last three years but so has demand due to extremely warm winters.

If OPEC plays games with Q3 production and Felix turns into the gulf then we are going to miss quite a few entries heading into fall. That will require some new targets in other sectors rather than chase oil prices higher. We have about two weeks to watch before making any drastic changes. We should know how the production cycle is going to play out by the FOMC meeting on Sept 18th. All the wildcards should be played by then and we can setup for a Q4 rally.

If you did not get a chance to listen to some of those energy conference presentations I strongly suggest you retrieve last week's newsletter and follow the links. It is very educational.


October Crude Futures Chart - Daily

October Natural Gas Futures Chart - Daily

September Gasoline Futures Chart - RBOB Daily

 

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