Option Investor

Beginning of the End?

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Wednesday's +$4 spike in crude may have been the beginning of the end. Support at $88 held for over a week before the rebound appeared but I suspect it will be tested again. The spike was caused by a continued fall in crude inventories, news that the Houston ship channel had been closed for several days due to fog, shutdowns at two refineries due to fire and a dozen other minor news events. None of these factors have any long-term impact on crude prices. They are just transient events on a slow news week for the energy sector.

The biggest factor in the increased volatility is next Tuesday's expiration of the current January futures contract. Volume in the contract is slowing as institutional traders clear the decks for the holidays. They don't want to be worried about watching tens of millions in open crude positions while they are sitting with their family around Christmas dinner. With no major crude movers like OPEC meetings or other geopolitical events currently making waves the interest level crude trades is waning. Once the holidays are over that will probably change as momentum traders move back into the market. However, this move out of crude for the holidays and the resulting low volume could make any unexpected event even more volatile than normal.

There are some bearish events headed our way for oil prices. The UAE has had 600,000 bpd of production shut in due to maintenance problems for over a month and that is coming back online this week. You may remember that Saudi Arabia bumped production up by +600,000 bpd for six weeks. That was supposedly to offset the maintenance by the UAE. The real question now is whether or not Saudi continues to produce at that level or takes it back offline. Saudi reportedly argued (although weakly) to boost production by 500,000 bpd at the last OPEC meeting. Whether that was a political event meant to calm the U.S. or a real desire to boost production we will never know. They are in position to continue to produce at that higher level on an unofficial basis. It remains to be seen if they will do it in defiance of their quota.

The New York Times had an article last week warning that several major oil exporting countries would turn into importers within a decade. This is not new data and I wrote about it in my year-end oil report. Mexico is the number two source for U.S. oil imports and they could stop exporting within five years. The Times also said rising Saudi demand could consume all the 40% increase in production they feverishly working to add by 2010. The Times pointed out that internal consumption by the five biggest oil exporters, Saudi, Russia, Norway, Iran and UAE, grew by 5.9% in 2006 and are on track for a similar boost in 2007. The Times went on to say that this change in demand and production was not going to be critical since expanding production from places like Canadian oil sands and new exploration in places like Iran, Iraq and Venezuela could offset the drop. Unfortunately they did not pickup on the fact that Iran was probably going to cease being an exporter within a decade due to rapidly rising internal consumption and serious declines in their aging fields. If they did start a major drilling and infrastructure upgrade program they could bring more oil to market in 5-7 years but nobody wants to invest money in Iran until the current nuclear sanctions are removed. Venezuela has lost 500,000 bpd of production over the last three years from declines in production, equipment breakdowns and lack of money being devoted to exploration and maintenance. Chavez is taking all the cash flow to pay for social programs so he can stay in power. They have not produced to quota in over five years and OPEC just reduced their quota to better match their falling production. Iraq is about the only country that could bring significant additional production online but they have to end the daily sabotage first then spend tens of billions to renovate the oil fields, combat damaged infrastructure and begin drilling again. All of that could probably happen by 2015 but with peak oil currently targeted for 2009-2011 it will be too little, too late.

China's booming economy is undergoing a serious fuel crisis. The government has ordered state owned oil companies Sinopec, Petrochina and CNOOC, to produce as much diesel as possible. They offered additional subsidies for refiners and scrapped oil import duties. Diesel imports were 2 mbpd in November and are expected to rise to 3 mbpd in December and 3.7 mbpd in January. These increases will only relieve the most immediate shortage because passenger car sales have risen by 23% in the first 11 months of 2007. Heavy-duty truck sales have increased 600% in the last 5-years alone. 10 years ago there was barely 5 million cars and trucks in all of China. Today there are over 50 million and that number is expected to hit 200 million by 2020.

Cuba has invited Russia to explore for oil in Cuban waters in the Gulf of Mexico. Is Castro ever going to die so Cuba can return to some kind of natural relations with the U.S? Letting American companies explore those waters makes so much more sense given the close proximity of U.S. infrastructure and density of firms willing to explore.

A key rebel leader in Darfur has targeted oil installations as military targets. He especially targeted those run by Chinese oil companies.

The WSJ reported that Nigeria, Africa's largest oil producing country is planning an overhaul of its petroleum industry. The president of Nigeria proposed creating a national oil company to manage the country's oil and gas resources and limiting the influence of foreign oil companies. This is yet another nationalism move that will limit Nigeria's ability to increase production if the move comes to pass. We have seen this in country after country. Nationalized oil companies simply don't have the same goal to raise production. They take the cash out of the sector to fund social programs. Nigeria has halted about 900,000 bpd of crude production due to continuing violence in the region.

Exxon and BP agreed to comply with production restrictions imposed on Angola after OPEC set a production cap on its output.

I am looking for activity in the energy stocks to calm down over the next two weeks as holiday trading goes dormant. Without a new geopolitical event the move from the January contract to February on Tuesday could be the last major bit of volatility until the new-year. As such I do not expect anything newsworthy for the individual stocks in the portfolio. We did return to contango in the futures and that could be another indication of the decline in volatility over the next two weeks.

Jim Brown

January Crude Futures Chart - Daily

January Natural Gas Futures Chart - Daily

January Gasoline Futures Chart - RBOB Daily


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