Option Investor

It's Not Easy Being Flat

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Take that title and sing it to the tune of Kermit the Frog and his "Not Easy Being Green" song. It is the same frustration we have been feeling for several weeks and even more so this weekend after crude teased us with a -$4 midweek dip. On Wednesday I was thinking the correction was underway and $70 oil was in our future. Then the short squeeze on Thursday erased that dip and added another couple bucks to the contract high. It's not easy being flat!

Friday's close saw a -$2 drop on end of quarter profit taking knocking crude back below $82. If I am right about the Wednesday/Thursday short squeeze as being funds dressing up their portfolios ahead of the quarter end then next week could be exciting.

Storm Tracks

As of 4:PM on Friday there were three active storms around the Gulf and none were threatening to shutdown production. Storm activity has increased several hundred percent in recent weeks but the conditions for a showstopper don't currently exist. Storm Lorenzo has blown itself out over Mexico and by midnight Friday it no longer appeared on the hurricane charts. Tropical storm Karen was still heading north several hundred miles east of Puerto Rico and appeared it would miss the Gulf and even Florida entirely. Tropical storm Melissa was well east of Karen and just coming off the western coast of Africa. It too was headed northwest and apparently going to miss the Southern United States although Melissa's track was migrating further towards the west than Karen. Either of these storms could change direction westward but neither has the intensity to do any harm in their present form. That could change if the direction changed to warmer waters but we will wait until that happens to worry. With the peak hurricane season drawing to a close the potential for a monster storm to roar through the gulf is dropping as each day passes. With that falling potential goes the potential for higher crude prices. Does that sound like a broken record?

India demanded that OPEC increase production even further or they would put their exploration for new oil and gas reserves and oil alternatives on a "war footing." India said the current prices were too high to be sustained by developing nations.

Venezuela went on the defensive last week after OPEC cut their quota to 2.47 mbpd from 3.22 mbpd. The problem stems from Venezuela's falling production. Since Chavez fired all the oil workers in 2003 and nationalized the rest of the oil fields in 2006 the rate of production has been falling. Chavez claims they can produce 3.2 mbpd but recent production levels have fallen below 2.4 mbpd. OPEC adjusted their quota to their actual output and gave the additional production to the rest of the OPEC nations that actually had spare capacity. Chavez is livid and plans to file a formal protest at the November OPEC meeting. It won't do him any good since he has been regulated to the status of loud mouth troublemaker. OPEC does not want to make waves in the global arena and Chavez is thrashing about furiously. Since he is not investing any of his oil proceeds back into production and exploration his output will eventually fall even further. He has implemented price controls on food and is rationing some items like chickens. The civilian population is becoming increasingly hostile and his reign appears doomed. His weekly TV show ran a record eight hours last Sunday and he addressed topics like prohibitions on breast implants.

Iran's production quota was also cut by 293,000 bpd as well as cut on Nigeria's of 143,000 bpd. Saudi Arabia was also cut by 156,000 bpd, which was a big surprise. OPEC claims it is making the new quotas more inline with actual production capabilities. That cut on Saudi Arabia is a real shocker. Algeria saw their quota rise by 463,000 bpd due to their increased output capability.

In the output table released by OPEC this week there are some interesting surprises. The boxes in brown are reductions in prior quotas to lower levels as of November 1st. They were reduced because they were unable to reach their old quotas. Note the difference in output in August compared to their quota. With oil over $80 per barrel every OPEC member should have been racing to pump every barrel allowed and a lot of barrels they were not authorized to pump. Seeing that these countries could not even meet their quotas at $80 oil is a reality check for the "we have plenty of oil" crowd. Note also that the entire output from the OPEC-10 was over 1 mbpd under the production target of 28 mbpd. Also note in the far right column that Saudi Arabia is the only country with any material excess capacity. On the bottom of the list Angola and Iraq do not have any quotas and can pump flat out with no restrictions. It should also be noted that OPEC relied on outside sources for actual production numbers for August. That really ticked off several nations who have constantly claimed higher output to maintain their status in the OPEC hierarchy.

New OPEC Quotas as of Nov-1st (Source: OPEC)

The obvious question is where would the excess capacity come from if demand suddenly exceeded supply. Since five of the OPEC-10 could not even make the prior quotas due to falling production the numbers in the excess capacity column are wishful thinking at best and should not be relied upon. To put the entire chart in perspective we should assume the new Nov-1st quota numbers to be full production for everyone but Saudi Arabia. Saudi should be the only excess production that can be reasonable sure of being there when it is needed and that is also questionable. If Saudi was not even pumping at their quota in August what does that say about their claimed spare capacity? Reportedly Saudi argued for a 1-mbpd increase for OPEC on Nov-1st and the +500K increase was a compromise. Since only four OPEC members other than Saudi had any real spare capacity and that totaled only 0.446 mbpd that meant Saudi would have gotten nearly the entire +500,000 bpd of that additional increase. But they were not even pumping at quota before the meeting? This is very strange indeed. You wonder if they were only going through the motions arguing for the increase to keep up their appearance as having lots of extra capacity? We know Saudi is supposed to be bringing an additional 500,000 bpd of light crude online early in 2008 and they are spending something in the range of $20B to $50B (the numbers are all over the board) to raise production capacity to 12 mbpd by 2009. If their current claimed capacity is 10.91 mbpd that means they are spending a LOT of money to only produce a 9% increase. Several oil analysts claim that increase will only be enough to offset declines in other Saudi fields by 2009. If that is true and the excess capacity numbers for everyone else on that chart are true then we are very close to that Peak Oil event. The IEA expects crude demand to increase by 2.2 mbpd annually in 2008 and 2009. That leaves little room for error in 2008 and puts us in a deficit in 2009.

A senior OPEC official was in the news on Friday saying market fundamentals don't support $80 oil and backwardization would continue to push prices lower. Backwardization is when future month contracts for crude are selling for less than the current month contracts. This encourages refiners to use up current supplies and contract for more using cheaper future month contracts and ignore the current front month contracts with higher prices. Historically this pushes current month prices down sharply until the current month sells for less than future months. Refiners keep weeks of oil supplies on hand. According to the EIA last week there were 173 days of supply on the Gulf Coast, 52 days on the West Coast, 64 days in Midwest and 15-18 days in the Rockies, Cushing and the East Coast. That means they can contract 2-3 months out and save several dollars per barrel. In reality they contract many months in advance and only resort to the spot market when it is not in backwardization.

Crude 14 Months Out

Earlier last week Jim Ostroff, a writer for the Kiplinger Letter, was predicting that $80 oil was about to become history for 2007 and could trade in the low 60s by December if there are no hurricanes in the Gulf. While I don't believe that has a chance in hell of happening it is a view making the rounds. John Kilduff, SVP with Man Financial, said prices would come off as hedge funds reduce their exposure to energy over the next few weeks. The crack spread for refiners is shrinking rapidly and with that shrinkage is the need to buy oil cheaper. Refiners raking in the money when spreads are high can afford to pay high prices. When those spreads shrink so does the interest in buying high priced oil.

Part of the pressure on oil prices has been the fear of escalating tensions over Iran. On Friday Russia and China said they would not support further sanctions on Iran until after the IAEA report in December. That postpones any further hostility until sometime in early 2008 and removes Iran as a prop for oil prices until early 2008.

Gasoline demand continues to fall and is accelerating sharply to the downside aided by higher prices.

EIA Gasoline Demand Chart

I am going to continue avoiding buying the top in oil as I see it today. I reviewed our targets on the watch list and adjusted some but I am keeping them low and where I expect those stocks to trade in the coming months. Oil will eventually correct. Maybe not next week but it will correct. It is driven by supply and demand and we are rapidly crashing towards the fall lows in demand. Refineries will be shutting down to convert to winter fuels and crude supplies will build ahead of the winter heating oil runs. Unless we have a sudden blast of artic air that lasts for months the normal fall cycle will arrive in some fashion. Be patient.

November Crude Futures Chart - Daily

November Natural Gas Futures Chart - Daily

October Gasoline Futures Chart - RBOB Daily


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