Option Investor

Bad Inventory, Nice Bounce

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Crude oil inventory levels fell -7.6 million barrels last week and distillates fell -2.1 million barrels. Gasoline rose +3 million barrels. The price reaction to the news was delayed but eventually rose to the high for the week at Friday's close. We knew oil inventories were going to fall because the Houston ship channel had been fogged in for most of the week. No ships equals no imports. This will probably be corrected next week when all those ships backed up in the Gulf manage to get in and unload their cargo.

Catching up on the shipping backlog is only a temporary fix. In just the last three weeks inventories have fallen -17.8 million barrels and -57.1 mb since the highs last summer. Oil inventories are now 8.8% lower than their year ago levels and at the lowest level since early 2005. The four-week moving average of imports has fallen from 10.6 mbpd in May to 9.7 mbpd. This drop has continued even after OPEC supposedly raised exports on Nov-1st. OPEC ministers are already talking about raising production quotas again when they meet in February.

The biggest boost to prices came with the Personal Income and Spending data out on Friday. Spending rose 1.1% for the biggest increase since July-2005. Fears of a consumer recession immediately dissipated. Consumers apparently are getting used to $3 gasoline and demand, even though lower than in the same period in 2006 is still strong. Once past the holiday season prices are expected to rise again. This is a vicious cycle of price hikes then a plateau while consumers recover from sticker shock and become accustomed to the higher levels then the next price hike appears. I believe we will see $4 gas in 2008 and $5 gas in 2009. Would that change your driving habits?

Brian Hicks, manager of the Global Resources Fund just raised his forecast for average oil prices in 2008 to $85, up from $70 in 2007. Goldman Sachs just raised their estimates for all of 2008 to $95 from $85 and expects demand in the second half of 2008 to accelerate faster than OPEC supplies will increase. Even the EIA is getting with the current view and just raised their estimates to $84.93 for 2008. That is up from $80 just a month ago. All of these firms believe we will see peak prices over $100 in 2008. The consensus for a peak is somewhere in the $120 range, higher if we have a bad hurricane season or a geopolitical event. Eric Bolling, a major energy trader at the Nymex said conditions that led to a record-breaking year will likely persist over the next 12 months at least. A weak dollar, strong global economy and China growing at 13%. It is the perfect storm for crude demand. Eric sees prices hitting $120 or even $130 on any specific event. He thinks $4 gasoline by summer driving season is very possible. Stephen Leeb of Leeb Capital Management also expects oil over $100 saying, "OPEC did not hike at the December meeting because they don't have much more capacity to sell. OPEC has become accustomed to high prices and they will not let prices fall even if they had additional production to sell.

The IEA just raised their estimates for demand growth in 2008 to an increase of 2.1 mbpd. This upward revision was based on the increased need for petrochemical feedstocks in the Middle East and Asia. It also INCLUDES the possibility of recession problems in the U.S. and over OECD countries. If no recession appears the demand would be even higher. The OPEC economists are more bearish due to predictions of harsher economic problems in North America. They are only expecting an increase in global demand of 1.3 mbpd. It should be noted that these are "politically correct" forecasts reflecting the goals and biases of those organizations.

The IEA said global oil production increased in November by 55,000 bpd to 86.5 mbpd because of increased production in Mexico, China and Brazil. The agency also said OPEC production fell by 180,000 bpd. Remember, OPEC was supposed to raise production in November by 500,000 bpd. Platts disagreed with the IEA decline case saying that OPEC managed to hold production level with October while showing only a slight increase and nowhere near the 500 Kbpd expected. We already know that the UAE suffered a drop of 400,000 bpd due to maintenance problems. That was only temporary and they are back online now. The IEA said OECD inventories fell by 22.5 million barrels in October.

With the UAE back online and a surprising increase in production from Iraq we should have enough oil temporarily without an OPEC increase in February. The improving security situation in Iraq has led to an increase of 400,000 bpd in production. Iraq, with no OPEC quota is now producing nearly 2.5 mbpd according to Baghdad officials. Of that production they are exporting around 2 mbpd. If there was suddenly a unified peace in Iraq they could easily increase production to 5 mbpd within 5-7 years. They have the reserves but not the atmosphere to encourage outside firms to come in and drill the wells and build infrastructure.

Syria has gone from exporter and is now a net importer of oil. Unfortunately like many other countries it subsidizes the public consumption of fuel and is now paying a huge sum to keep fuel products cheap. Syria, like others caught in the same trap, is afraid that removing the subsidies will fuel inflation and spark discontent among people used to cheap oil products. China, Iran, Iraq and many others all face the same problem. As oil prices continue to rise these countries are going to be forced to raise prices and face the internal upheaval it will cause.

The airline industry cut its profit forecasts for 2008 by a third due to soaring prices for jet fuel. At least they will be able to get it in 2008. Wait until 2011 and fuel will be rationed to those flying the most needed routes.

Oil tanker rates have quadrupled over the last month as demand for safer tankers rose after the South Korea tanker collision. Exxon is still fighting to have the $5 billion fine reversed from the Exxon Valdez spill 18 years ago. Nobody wants that kind of exposure today.

Saudi Arabia is spending $600 billion to diversify their economy with many projects underway. Those projects include building aluminum, chemical and plastics plants and those will consume large quantities of oil. How much Saudi exports will drop once this building binge is over remains to be seen but analysts expect it to be a large amount. Lehman expects new oil demand in Saudi Arabia, Kuwait, UAE and Qatar will increase by more than 200,000 bpd in 2008. That means either a drop in exports or significant new production that will never leave home.

The Mexican Oil Ministry said oil exports would decline to around 289,000 by 2016, from their 1.7 mbpd today, if there was not a significant increase in funds for exploration. The Ministry said Mexico had insufficient funds to invest in exploration and production. Mexico relies on oil exports for 40% of its budget. Falling production has crimped that budget and the country has to decide if they are going to cut social programs and explore for oil or continue to siphon off more funds as supplies dwindle.

Greenspan may be seeing the light. In a speech last week regarding the rise in energy costs part of his explanation was "the global oil supply is peaking lower and sooner than had been contemplated earlier." Maybe he was paying attention to the real world.

Another person finally seeing the light was Rodney Andrews, Executive Director of Kentucky's Center for Applied Energy Research. While addressing Kentucky lawmakers last week he said, "What we need to realize is whether peak oil production is here or is comingisn't really the question. The problem is that our share of what's available is going to continue to decrease because the rest of the world is demanding more and is willing to pay more for it or at least more than we ever have."

For the end of year renewal effort I have written a 100-page update to my ongoing peak oil view. In addition to that effort we located a professionally produced video explaining the peak oil problem and we are giving that away free with a renewal. I strongly recommend you get this video and pass it around to all your friends. View trailer here: http://tinyurl.com/yryu6s

Jim Brown

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