Option Investor

Still Counting

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The sting of inventory declines in crude stretched into a seventh consecutive week with a drop of -4.1 million barrels. Inventories are now 8.1% below last year's levels. Imports rose for the week to more than 10.0 mbpd but it did not help. Fog has hampered coastal deliveries for several weeks with and last week was no exception despite the higher imports. Mexico shutdown all exporting ports on Tuesday due to weather and some were still shut as of Friday morning.

Refinery utilization rose slightly to 89.4% due in part to the rise in the crack spread to $7 per barrel. It was as low as $2 in late October and spiked sharply last week. This is completely contrary to what you may have heard on CNBC late in the week. A noted option trader was bragging about being short refiners due to the shrinking crack spread. Maybe somebody was talking down his position because spreads went up, not down.

Oil prices touched $100 twice last week with the first touch on Wednesday in the pit and the second on Globex on Thursday with a trade to $100.09 before settling back on profit taking. Conoco helped push prices lower on the refiners by pre-announcing their Q4 operations. They said production was 60,000 boe per day higher than Q3 but refining revenues were expected to be lower due to the narrow spreads early in the quarter. They also warned that higher tax rates in Canada and Alaska would narrow profits. The refining portion of the announcement is what captured traders attention and refiners sold off not because margins were slim now but because they had been back in October.

OPEC members have been taking turns at the microphone to claim $100 oil is not their fault. At the same time others in OPEC warn that oil could head higher to something in the $110 level if demand does not slow. OPEC claims and rightly so that the high price of oil is due to a lack of refining capacity for lesser grades of plentiful crude. The majority of refining capacity around the world is for light sweet crude.

The Oil & Gas Journal did a survey in 2006 of the amount and type of crude reserves remaining around the world. The chart below is what they found. Only 20% of our remaining reserves are LS crude and the overwhelming majority a type of crude that most refiners cannot use in large quantities. Most refiners have some sour capability but only a small portion of their existing capacity. This means the majority of refiners are bidding against each other for the dwindling supplies of light crude.

OPEC will meet again on Feb-1st and discuss quotas and possible production hikes but by February the heavy winter demand will already be over. OPEC oil must be produced about 45 days before it is needed to allow time for transportation and refining. Oil produced after Feb-1st would not be available for use in the U.S. until April. They may decide to raise production by a token amount just to avoid the blame of $100 oil. A new report out by OPEC itself suggests OPEC will have a harder time filling the demand for oil in the years ahead. Under different scenarios the OPEC paper suggested OPEC would not be able to keep up with demand as soon as 2024. Of course that is a completely impossible date in itself but it does show they are beginning to let the world see there may be a problem ahead. They can continue to edge the date closer as time passes until suddenly we are there. OPEC immediately tried to distance itself from the report in the December issue of the OPEC Review published by the organizations Vienna-based Secretariat. OPEC's PR Director said, "We don't muzzle the opinions of others" but that publication "doesn't necessarily reflect the opinions of OPEC."

Several OPEC nations suggested the group would discuss another 500,000 bpd increase on Feb-1st but another member said, "OPEC is already pumping a near capacity" and can do nothing to curb prices" with additional production. Ah, yes, the voice of truth slipping out from the chairman of the Libyan Oil Corporation.

Indonesia said it will propose a 500,000 bpd increase to offset the declines by violence in Nigeria. Meanwhile Saudi Arabia delayed the start of production from the 500,000 bpd Khursaniyah field and said it will meet market demand with existing capacity. That is an interesting statement. The production from that field is supposed to be light sweet crude while the rest of their excess production is sour crude. Since putting more sweet crude on the market would lower prices I think it is a telling statement that they are going to withhold it. Of course since this was new production that had been promised for a couple years now it is entirely possible the field did not perform as expected, it was harder to complete or fizzled altogether. Until eventual production actually appears in some form we will not know the true reason for the announcement.

In another news release from Reuters the total OPEC 10 production for December was 410,000 bpd over November at 27.39 mbpd. When compared to the quotas that went into effect on Nov-1st calling for production of 27.25 mbpd it is obvious that they are still having trouble just making the quota. The +140,000 bpd over production in December will take a long time to make up the -270,000 bpd shortfall we saw in November. Two months to be exact. The report did not say where the additional oil was coming from.

Iraq said production from the northern fields had stopped because storage tanks were full at the Turkish port of Ceyhan. The tanks hold 6.8 million barrels. They are not selling the oil until it arrives on the coast in order to prevent penalties for failure to deliver due to sabotage. With the tanks full they have to sell the oil and schedule offloading before restarting production. Not exactly an efficient way to run an oil company but I understand the reasoning.

According to the director of the IEA oil prices could hit $150 due to booming demand from China and India. If the high growth scenario continued prices could rise sharply. The IEA said it would not release oil from stockpiles to relieve the price and the U.S. administration said the same thing this week. Oil in the Strategic Petroleum Reserve is not for price controls but for backup in the case of an emergency. The catch to the headline grabbing statement was a qualification that we could see $150 by 2030. We could see $1000 by 2030 but that would not be politically correct for an IEA official to utter those words in public.

The Movement for the Emancipation of the Niger Delta (MEND) vowed to cripple oil exports from the Niger Delta region by providing anti-aircraft gunships to the movement. It is no wonder Shell is looking to sell its assets in the area.

An editorial in the Financial Times called "Peak No Evil" attempted to debunk the coming of peak oil with a bunch of tired excuses like "there is plenty of oil left to find in Saudi Arabia." The author was laughed out of circulation by a barrage of facts to the editor. One fact came from a former Vice President of Saudi Aramco, Edward Price, "the idea that there are "large unexplored areas" in Saudi Arabia or anywhere else in OPEC - is simply not true. Other facts came from PFC Energy, "In OPEC as a whole there have been over 1000 discoveries since 1980, of which only 10% were larger than 130 million barrels (two days global consumption), and 50% were smaller than 8mb. The size distribution tells you that major new finds are unlikely, regardless of what the Saudis would like you to believe."

Venezuela said oil revenues fell -5.3% in 2007 despite a +16% rise in the price it received for crude. The average price of VZ crude was $65.13 per barrel compared to 56.35 in 2006. VZ crude is mostly very heavy oil and not desirable in the open market. The decline in revenues came from falling production as a result of the Chavez nationalism of the oil fields.

South Korea said it expected crude imports to increase 7.8% in 2008. South Korea is the worlds 5th largest buyer of crude. At the same time they cut their GDP forecast for 2008 to the upper 4% rate from over 5% due to the higher price of crude and the impact on growth.

Canada said the industry drilled 6,000 fewer gas wells in 2007 and they expected that number to fall by another 2,560 (38%) within the next two years. The reason given was the higher tax rate after Canada boosted rates in 2007. Oil drillers are expected to see drilling fall by 17% in 2008 in Canada.

Mexican oil company Pemex said oil output could fall by 33% in 2008 from the 3.1 mbpd average in 2007. Cantarell has fallen to 1.46 mbpd in 2007 from more than 2 mbpd and is expected to decline to only 1 mbpd by the end of 2008. By operating Pemex more like an ATM than a business the government extracted $54 billion in taxes on revenues around $100 billion. That was 35% more than the $36 billion Chavez extracted from PDVSA to pay for his social revolution and PDVSA has the same $100 billion in revenues. Mexican law prohibits outside investment in all aspects of oil production and that prevents companies like Petrobras from helping develop known reserves for a piece of the action. Pemex has $52 billion in debt and more than any other oil company and revenues are dropping like a rock. Reserves fell 30% from 2001-2006.

Gasoline could rise to average $3.75 in the U.S. by summer with prices on the west coast well over $4. Analysts think increased demand, lack of refining capacity and lack of inventory will push prices to new highs by summer.

Russia is increasing the tax on oil exports by 18% on Feb 1st. Higher gasoline prices coming to a station near you somewhere in Europe.

It was not a fun week in the markets but overall the touch of $100 by oil managed to insulate our portfolio pretty well from the declines. We saw some selling but it was not as serious as some we saw in tech stocks. FWLT lost -10 on Friday but still ended the week +3. RIMM was the biggest loser at -13 but it is still above our entry point with the Computer Electronics Show next week. I think we should be proud of the performance of our portfolio. I expected more tax selling than we got and I suspect more money is going to move into energy than out of it in the weeks ahead.

I strongly recommend you get this video and pass it around to all your friends. View trailer here.

Jim Brown

February Crude Futures Chart - Daily

February Natural Gas Futures Chart - Daily

February Gasoline Futures Chart - RBOB Daily


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