Option Investor

Volatility With A Capital V

Printer friendly version

Wow, what a whipsaw ride! Crude fell from 99.10 on Monday to close at 88.65 on Friday. It was far from a straight drop. On Wednesday there was spike in the downtrend to 95.22 followed by a $5 dip to 90.34 and a quick spike back to 95.17. Yes, -5, +5 in the same day only to be followed by a gut-wrenching drop from 95.17 to 88.52 (-6.65) by the next morning. The loss for the week was the largest single week drop in over two years.

The comments out of OPEC early in the week about discussing new production hikes got the ball rolling. That meeting is next Wednesday and with an $11 drop in crude prices that production hike is probably just wishful thinking today. The price hawks Iran and Venezuela will be screaming for production to stay the same and no self-respecting OPEC minister is going to vote to push prices lower. I expect plenty of whining about plenty of oil in the market and speculators causing the volatility in prices. Surely they will not want us to believe it is OPEC's fault!

The Saudi Oil Minister Ali Al-Nuaimi was adamant on Wednesday that the world oil market was well supplied and that high prices did not properly reflect the supply-demand situation. "There is no relationship between the fundamentals today and the high price of oil. Fundamentals do not support high oil prices," he said in a speech. He refused to discuss the potential for a production hike saying the ministers would first have to look at the data. The Libyan minister said no increase was necessary and the Kuwait minister said they would vote for a hike only if the data required it. I would not hold my breath. If Saudi does not want an increase it probably will not happen.

OPEC president, Mohammad al-Hamli said on Wednesday the cartel would invest more than $150 billion by 2012 on more than 120 projects including large refineries to expand output. This should be a clue they are stressing at current production levels. Would you invest $150 billion over the next five years if you had plenty of production available? You would probably invest the money but probably not in a crash program.

On Thursday that big price spike was due to an explosion and fire at the main Enbridge Canada-to-U.S. pipeline in Minnesota. The pipeline system can carry about 1.8 mbpd of Canadian crude into the U.S. market. The explosion in the largest line killed two workers and shutdown three lines for some time. Originally it was expected to take weeks to restore production but Enbridge was quick to jump on the problem and 80% of production was already restored by Friday. The rest was expected to be restored over the weekend or early next week at the latest. As John Kilduff said we went from losing all the Canadian production for weeks to having it fixed in a day. That produced the $5 spike and drop on Thursday.

Hurricane season is officially over with only one hurricane hitting U.S. shores. That hurricane was Humberto, which hit Texas and Louisiana with peak winds of 90 mph. Damage was light and estimated at $50 million. There were 14 named storms of which six became hurricanes. Only two, Dean and Felix, rose to category 3 or higher. That is two years in a row without a major hurricane making landfall or worse ripping through the oil patch. What are the odds of stretching that to three?

Alaska got five proposals to build a massive natural gas pipeline from Alaska's north slope to the U.S. markets. The proposals were submitted under the Alaska Gasline Inducement Act passed by the legislature earlier this year. Friday was the deadline for submissions. The cost of the pipeline has been rising yearly as various companies and state agencies argued on how and where to build it. Conoco submitted a plan calling for a $42 billion investment to build it. Alaska has had problems getting oil companies to want to build it given the volatility in gas prices. At $4 it would not be profitable in our lifetime and nobody wanted to take that risk. The North Slope reportedly has over 35 tcf of gas reserves and most analysts think that number will grow once actual production begins and reserves can be more accurately determined. Some believe the additional reserves could be several times bigger than the 35 tcf estimate. The pipeline is expected to transport around 4 bcf to the U.S. every day or roughly $28 million in gas every day.

When OPEC met to discuss goals in November they issued a statement that said many things but most of all they want to maintain stabilized prices. When oil prices go up demand goes down. Some analysts expect the current high prices to depress demand by 3 mbpd by next summer. I am not in that camp but I do expect prices to slow demand growth. OPEC is focused on increasing spare capacity so short-term problems in any one or two OPEC members can be made up by the rest. They are reportedly trying to raise capacity by 1 mbpd every year for the next five years. I wish them luck. The table below compares capacity and production from just 5-years ago with capacity and production today. Overall capacity has fallen roughly 500,000 bpd. Production has increased 3.245 mbpd and spare capacity, the component that matters most, fell by 3.74 mbpd. The squeeze is on and OPEC is struggling to maintain its outward appearances while racing to try and create more capacity. By the table below it looks like they are losing the race. The spare capacity total for July 2007 is 2.395 mbpd but we have seen in recent months that OPEC could not even meet its scheduled production goals do to problems in multiple countries.

OPEC Capacity Table

According to Baker Hughes (BHI) the number of active rigs in the U.S. rose by 50 last week to 1,823. Of the rigs actively drilling nationwide 1,463 were exploring for natural gas and 354 for oil. Six were listed as miscellaneous. The rig count for the same period in 2006 was 1,171. The all time high was 4,530 in 1981 during the post OPEC embargo oil boom. The record lows were 488 in 1999 when oil declined to $10 a barrel on Saudi Arabia's glut play. Rigs were being cut up for scrap steel rather than pay storage on them. Amazing how times change from one decade to the next.

Last week we were stopped out on several plays and one was Canadian Natural Resources (CNQ). I did not have a stop on the play description but there was one listed on the portfolio listing. That was a bookkeeping error on my part and I took the exit even though it was in error. I also sent an email alert suggesting a reentry the following day.

The refiners were hit hard and that took us out of VLO and MRO. Ironically cheaper oil will help return them to profitability by increasing the crack spread. The last two days they have risen on that prospect.

Transocean (RIG) completed its merger with Global SanteFe (GSF) on Tuesday and the stock did not sell off as expected. The RIG symbol was retained and the merged company was forced to sell to overseas rigs to comply with EU terms. RIG is now the dominant offshore driller worldwide and should be able to raise its rates in the absence of credible competition. I want to be in RIG but with oil correcting I am still hoping for a lower price.

I am looking for crude to test $85 but if OPEC fails to hike production I think it will rally again. The normal price cycle is broken this year and the winter demand months are already upon us in terms of buying oil to produce heating oil. The next cycle would normally be a drop in price in March/April then a rebound into summer. December and January have historical volatility due to the tax window on Dec-31st. The ideal scenario for us today would be for OPEC to not raise production and put a floor under prices into the pre-summer rally.

I am adding a new feature this weekend. I continually get requests for my top three stocks or the best five to enter on a dip or if I could only buy 10 who would they be. Those are good questions and I know it is a daunting task to pick out a handful of plays from the current list of more than 20 recommended positions. To make this easier I am going to add a top ten list and potential entry prices. If you are looking to add a position that would be the best place to look. You need to pick a LEAP strike that corresponds with the entry point you choose. The newsletter will continue to track its initial position and not any subsequent top ten entry points.

Jim Brown

January Crude Futures Chart - Daily

January Natural Gas Futures Chart - Daily

December Gasoline Futures Chart - RBOB Daily


Leaps Trader Commentary Archives