Option Investor
Commentary

Against All Odds

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The price of crude continues to rise despite all the fundamentals being stacked against it. Two category 5 hurricanes have failed to enter the gulf leaving all oil platforms operating normally. Monday is the peak of hurricane season and storm frequency normally declines sharply after that date passes. Crude inventory levels remain near 10-year highs even after two weeks of big drawdowns. Gasoline prices have stalled at $2 and with driving season over it should begin to decline soon. Gasoline inventory levels declined by -1.5 million barrels last week but that was the smallest decline in 3-weeks and inventories should build from here. Refinery utilization spiked unexpectedly to 92.1% from 90.3% the prior week. This jump in utilization came after a week where six refineries were down due to various problems. The spike in utilization allowed distillate stocks to rise by +2.3 million barrels. Gasoline stocks should follow that rise next week.

All the factors except one say that oil prices should be falling instead of rising. That one is the falling dollar. With the dollar dropping in value every day it takes more dollars to buy oil. This is keeping the pressure on prices but that too may have run its course. Once the inventory reports show that gasoline levels are rising there will be more downward pressure on oil prices than upward pressure from the falling dollar.

OPEC meets on Tuesday and there is a battle being fought in the press between OPEC members. Oil ministers for Algeria, Iran, Libya, Qatar and Venezuela said in the past week they support keeping the quota at its present 25.845 million barrels per day until December. Of course those are countries without any excess production so raising the quota would not help them and oil prices would fall. I would vote the same way if I were in their position. It is widely believed that OPEC has unofficially raised its target price for crude to $70 according to Claude Mandil, director of the IEA, which advises 26 of the largest oil consuming nations. They won't officially say that for fear of bringing reprisals but they are definitely acting as if that is the new base. The 10 OPEC members with quotas are pumping more than their quota now by about a million barrels per day at 26.71 mbpd but they will not admit it publicly since it would drive the price down. That number came from the IEA and was gathered from individual production shipments. Iraq and Angola have no current quota and are allowed to pump as much as they can. Production from all 12 OPEC nations was 30.33 mbpd in August. OPEC leaders claim an increase in production is not necessary because the subprime problem in the U.S. is going to push us into a recession and reduce demand.

Exxon's CEO jumped right in the middle of the OPEC word war with his "oil over valued" claims on Friday. Rex Tillerson said there was no fundamental justification for oil over $70. In fact he said the fundamentals support something much less than $70. So now we have the IEA claiming the world will be short two million barrels per day in the 4th quarter and OPEC claiming that oil supplies are sufficient so they can keep prices over $70. We have Rex saying that $70 is not justified. Who is right?

They are all right. No, I have not completely lost it. OPEC is talking about all the grades of oil they produce when they discuss daily production and inventory levels. Using that yardstick the world does have more oil than it can currently use. It is just no in the form we need for gasoline. There is a shortage of light sweet crude and that is the grade that is quoted in the press when they say oil prices hit $XX today. OPEC claims it is not an oil shortage but a refinery shortage that is keeping prices high and they are right. If we had more refineries capable of processing the heavy sour crude into gasoline the price of oil would be lower because demand for light sweet crude would slow. That is not going to happen any time soon. It takes a long time to build a refinery and although several are under construction in the Middle East it will be a couple years before they have any impact. By then demand will have risen by double or triple the capacity being added so the problem will still exist. If you add 500,000 bpd of sour refining capacity per year and crude demand rises by 1.5-2.3 mbpd per year we are still behind the curve. The IEA is right, the demand is rising and we will consume more oil in Q4 but we have plenty in inventory and OPEC cheating will fill in the gaps. Rex Tillerson is right that current fundamentals don't support oil at $70 because of the excess inventory levels around the globe. Everybody is in hoard mode thanks to OPEC's production cutback and oil is building up in storage just in case a problem arises like a gulf hurricane, Nigerian violence, an Israeli attack on Syria, a U.S. attack on Iran or a 9/11 anniversary event. Nobody wants to get caught short if something happens. The problem here is shrinking levels of available storage. A million barrels of oil takes up a lot of room and it has to be easily accessible to be of any use. That limits how much more oil can be stored around the world.

All the factors point to an eventual short-term decline in oil prices that could begin at any time. Of course we have been waiting for it for several weeks now. The hurricanes provided additional buying and the threat of another storm is keeping the price high. Once we are past the Sept-10th hurricane season peak and the Sept-11th OPEC meeting we should see increasing pressure on prices. Until then we just have to be patient.

I should remind everyone that these are just short-term cycles and the long-term outlook is still for much higher oil prices as demand increases beyond our capacity to produce oil. It is a guaranteed event only the date is unknown. The various demand forces ebb and flow with the annual cycles but the total demand always moves up along with the increase in global population growth. Production increases are becoming harder to find and maintain and depletion rates are increasing. There is no way out of this scenario and all we can do is sit on the sidelines and wait for the fat lady to sing.

Friday's employment report caused the markets to retreat and that included energy stocks even though oil prices were moving higher. I believe a crack in support for oil will hasten the decline in oil stocks. With the market likely to be weak for the next 8 days until the Fed meets it is a perfect setup for a drop in the oil sector. I am not changing the entry points on the majority of the watch list because I still believe the prices will come back to us as long as the hurricanes stay away.

The XLE Put play was not stopped out on Thursday. There was a bad tick at the open and the high for the day showed as $72.25 but the XLE never traded there. You can check on any intraday chart and see the actual opening high was $71.98. Just in case there was any confusion I sent everyone an email Thursday afternoon affirming that we wanted to keep the XLE put and anyone who exited on the bad tick should consider reentering the play.


October Crude Futures Chart - Daily

October Natural Gas Futures Chart - Daily

October Gasoline Futures Chart - RBOB Daily

 

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