Option Investor

Frustration Turning Into Depression?

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My wife left the house on Thursday rather than be around me with oil prices moving over $82.50 on the expiring October contract. If I had a dog I would have been kicking it. (Just kidding) Instead I was kicking myself all over the house. It is literally unbelievable to see the expiring October contract spike $2 to $84 at the close. What the heck was everybody thinking?

Looking back in hindsight the rebound from the August 22nd low of $68.63 was nearly vertical. There were only three red candles in the entire string. This was not random momentum buying. There were only two possibilities. Some hedge fund was either short a huge number of contracts hoping for a break back at $70 or a major refiner was stocking up for a potential winter supply shock. Since the majority of the WTI crude is consumed in North America I can't construct a scenario where it was being bought by China or India for their strategic petroleum reserves. They would likely buy oil closer to home to avoid shipping costs.

I read a commentary by another analyst also scratching his head at the unexplained blowout in prices. Lately we have all been pointing at the falling dollar as a reason for rising oil prices since it takes more dollars to buy the same barrel of oil. Unfortunately oil prices rose about 5.3% over the last week when the price of the dollar only fell -1.2%. That leaves 4% unexplained. James Williams pointed out that oil is fungible and the price of WTI and Brent Light Crude, also priced in dollars, should be roughly equal minus the cost of shipping at about $1.50 per barrel. Brent only gained +1.2% for the week and almost exactly the dollar difference. Using any offshore scenario that leaves about $3 of the gain in WTI still unaccounted for. Williams also discounted the storm impact in the Gulf. Some rigs were evacuated as Tropical Depression 10 wandered from Florida to Louisiana just as a precaution but there was no material impact to oil production. Williams pointed out that if the storm was the cause of the spike the price of natural gas would have spiked even more since we depend more on gas from the Gulf than oil. Gas declined all week instead of rallied and that kills the storm excuse. Furthermore gas should be trading at $13.33 per MCF based on the value of oil at $82. Both fuels normally trade on a BTU parity basis but the recent spike in crude prices disconnected from gas/btu prices and that made it even more confusing.

There is no physical reason for the price of WTI to be so high. The EIA report last week showed falling demand in every category. Gasoline, distillates and jet fuel all were lower. Several have been lower for weeks. There is clear evidence of a slowing economy in the slowing demand for crude products. Distillates consumption has fallen -1.0% over the last four weeks. Jet fuel consumption is down -1.6% over the last four weeks. Gasoline demand was up only slightly over the same period in 2006, by 44,000 bpd or +0.5%, but the number of drivers is up by +1.3%. That suggests individual driving mileage is down and higher prices are forcing conservation. Gasoline demand is actually at a three month low.

The market is in full backwardization and that makes it unlikely refiners were the reason for the rise in crude. Why would they buy expiring October crude for $84 when they could buy November for just over $80? Answer, they would not do it. Refiners don't wait until the last minute to buy crude. They plan for months in advance and schedule their buys. If you know in advance how many barrels you are going to refine every day for months in advance you are not going to wait until a week before the contract expires to buy the oil. Refiners are very skilled in buying ahead of time in order to lock in the best price. They hedge their buys to reduce costs and know well in advance where and when their oil is coming from. The last $10 in gains on WTI did not come from some major refiner stocking up on October oil. Especially when they could have bought November for $4 less or December for $6 less. Backwardization works in favor of refiners not against them.

Crude oil supplies fell again last week by 3.9 million barrels but that was still a result of shipping disruptions and shipment planning by refineries. If you know that driving demand is going to plummet after Labor Day you won't schedule a long string of tankers full of Middle East oil to arrive in September. Imports normally fall in September. That lowers inventory on hand as refiners begin to make the switch to winter fuels. Add in the shipping disruptions from the Mexican hurricanes and you get even more dislocations. Despite the drop in supplies the current crude inventory levels are still +7.5% over the 5-year average and definitely not a cause for concern over shortages. The chart below from the EIA shows the decline in existing inventories (red line) from the decade high levels back in July to just over the five-year average range in blue. There is simply no cause for concern.

US Crude Inventory Chart

You should also note that refinery inputs in the second chart above are flat to down in August/September. There was no voracious oil appetite sucking crude off the market like it was the last cup of coffee in the morning pot. Everything was orderly and right inline with prior consumption trends.

After analyzing all the reports, listening to the various sound bites and reading every scrap of oil commentary I could find I am right back to the "somebody was short" scenario. It is the only one that makes sense and believe me hundreds of analysts and commentators have literally turned over every rock to try and find out why the October contract went vertical on August 23rd and never looked back.

Remember, the normal scenario is for a drop in crude prices beginning in late August and continuing to a bottom in late September and sometimes even early October. A major fund like Amaranth could have cornered the market in crude shorts and then been crushed when the combination of hurricane threats, OPEC moves, refinery outages, etc, kept prices artificially high. Amaranth went under trying to corner the natural gas market. We may hear next week that some other fund imploded covering their crude shorts. They would not have disclosed any news in advance since it would have pushed prices even higher as speculators crowded the market. Then again, we may never know who it was.

All we can hope is that the closing +$2 spike on the October contract was the last desperate act of hedge fund bleeding dollars from a failed bet. Making their pain worse was the constant shorting by thousands of investors and other funds thinking that at any moment the price was going to crack and drop $5 in a massive expiration sell off. I know I contributed thousands of my own dollars shorting every spike only to be stopped out on the next move higher. We shorts fed the rally and tortured any trader that was short in large quantities. The final closing spike could have been the punctuation mark of a failed career or a failing fund. Time will tell.

October Crude Oil Chart - 30 min

While this crude price scenario may have been causing some funds some serious pain the only material pain for us was watching our potential entry points get farther and farther away from reality as each day passed. We can't turn back the clock and we can't undo the gains some of these stocks have seen. We can rest assured that once the artificial support to prices is gone there will be a correction in crude prices and in energy stocks. Whether those stocks will come back to our entry targets is unknown.

I do know we do not want to chase them higher. Every bubble eventually bursts and we know from experience the resulting free fall can be painful. The current price of oil cannot continue without any material decrease in supplies somewhere in the world. On the contrary, the supplies of oil will be growing as OPEC opens the spigots to capture every dollar of this artificial spike they can. The basket of OPEC crude rose to a record price of $75.78 on Friday. The OPEC basket is based on the prices of different oil types from all 12 OPEC nations. If this price surge were to continue eventually Saudi Arabia and OPEC would act to lower prices. Continued price hikes will eventually curb demand and cause the price to fall much further than OPEC would like. They love the high prices but they can't afford to let this upward spiral continue. It produces more drilling around the globe, conservation, alternative fuels and ill will. Every cycle in the past 100 years has always ended badly when the price shot up out of control. The last price war in the late 1990s sent oil to $10 a barrel and caused severe disruptions in the financial affairs of the OPEC nations. Since then slow and steady wins the race for OPEC and this is not slow and steady. The various oil ministers for several OPEC countries made comments on Friday that this spike was unsustainable and not supported by fundamentals. This is true but somebody was supporting it artificially and regardless of how deep their pockets were the OPEC countries have far more oil than any hedge fund has money.

The end is near.

While the current price of oil is artificial the actual end of the age of cheap oil is very near. The proverbial peak in oil production may be a couple years away but the potential for oil demand to exceed oil production is much closer.

Late Friday China said oil consumption would climb by +5% per year through 2015 to reach 10.5 mbpd. Since it has already grown by +4.5% in 2007 just through June the odds are very good that estimate is too low. In 2005 China's rate of consumption was 6.5 mbpd and growing by +7.5% per year. If we extrapolate their growth by a more reasonable 7.5% per year that translates to 13.5 mbpd in 2015. China expects automobiles to surpass the 100 million mark in China by 2015. That is up from barely 2 million only a decade ago.

India is also on a strong growth path but several years behind China's feverish pace. The OPEC countries are also growing consumption at a fever pace accounting for 22% of the growth in consumption since 2000 and expected to consume an additional 400,000 bpd in 2007. Gasoline prices are heavily subsidized in most OPEC countries with some selling it for as little as 40 cents per liter. This encourages rampant consumption and rampant growth in these fledgling economies.

If we take the estimated maximum production for 2007Q4 of 86 mbpd and extrapolate these growth trends we get an alarming number. Demand in Q4 is expected to reach 88 mbpd for a short time according to the EIA. Since there are plenty of supplies in storage this is not an insurmountable problem at least this year. However, it will eventually be a major problem. With OPEC (Saudi Arabia really) spending billions of dollars to increase their production from 9.5 mbpd to 12 mbpd by 2010 and another $50 billion to increase it to 15 mbpd by 2020 that sounds like a lot of new production. If they are able to accomplish it this would be a miracle.

Now, take the 86 mbpd maximum production today. Add the 7 mbpd increase in China's demand by 2015, OPEC's 4.0 mbpd increase in demand through 2015, India's 3 mbpd increase and throw in a couple million more for the rest of the world and you have total demand by 2015 of +16 mbpd or 102 mbpd of real daily demand by 2015. To calculate the added production we can give Saudi full credit for jumping to 12.5 mbpd by 2010 or a +3 mbpd increase. Angola can probably add another 1 mbpd and maybe all the rest of the OPEC 12 could manage another 1 mbpd. That is +5 mbpd total and we have not taken anything into account for depletion at the annual 4% historical world average as claimed by BHI, XTO, APA, BP, XOM, etc. Ignoring depletion we need +16 mbpd of new production by 2015 and can only target +5 mbpd from the OPEC 12 by 2010-2012. Obviously we can't ignore depletion (-3 mbpd per year) and we can't ignore falling production in 7 of the OPEC 12 countries. Any way you add it up there is going to be more demand than we have oil production very soon.

Boone Pickens was on CNBC several times this week and he mentioned the 88 mbpd Q4 demand if we have a normal winter and the maximum of 86 mbpd in supply. These are IEA/EIA numbers not his but his point was simple. The countdown has begun to $100 oil and while it is probably not in 2007 it could easily be in 2008.

We may have missed the entry targets we wanted back in early September but we are still early enough in the overall cycle to continue to capitalize on future dips. The future of oil prices is already etched in stone and we should not worry about the week-to-week fluctuations. We will get some entries before the Q4 rally and we will make money. Be patient and the cycle will always reassert itself even if only at a higher level.

November Crude Futures Chart - Daily

October Natural Gas Futures Chart - Daily

October Gasoline Futures Chart - RBOB Daily


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