Option Investor

Not Having Fun

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A lot happened since last week and none of it was fun. The global implosion in equities of more than 10% on many exchanges cast a dark spell over the market. Strong stocks as well as weak ones were slammed hard and on no material change in fundamentals. If you read my Option Investor commentary this weekend you know that much of the decline was related to the Societe Generale $100 billion futures fraud. That flush of 1.5 million Eurostoxx 50 and DAX futures contracts sank not only Europe but indexes around the world.

When a global meltdown of 10% occurs overnight the fundamentals go out the window. Panic sets in and anything with profit is sold to protect that profit and anything with a trailing stop is taken out as well.

This knocked oil prices back to $85 despite no material change in the outlook. It was simply panic selling at the time on what was called recession fears. Now that we know the real reason it does not help ease the pain of losses.

We only lost three positions due to stops last week, CNQ, CVX and DNR. The Tuesday dip allowed us to get back in to VLO, CAM, PBR and a new position in FLS.

On the energy front OPEC meets on Feb-1st to discuss production levels but the outcome has already been decided. The dip to $85 and two weeks of inventory gains in the U.S. is all OPEC needs to justify not raising production ahead of the normal demand decline in Feb/Mar. Adding to their reluctance to boost production was news out of Iraq that production had risen +400,000 bpd to 2.3 mbpd and the highest level since the war began. They expect another 400,000 bpd increase in 2008. Iraq is an OPEC member but currently does not have any production quota. Offsetting the Iraq gains is a continued drop in Nigerian production. March output is expected to fall -420,000 bpd due to continued problems.

Next week is energy earnings week with XOM, CVX, OXY and dozens of smaller companies reporting. Conoco reported last Tuesday with a 37% boost in profits despite lower production levels. Conoco earned $4.37 billion or $2.71 per share compared to $1.91 in the comparison quarter. Conoco is rapidly going private having bought back $7 billion in shares in 2007 and approving a $15 billion buyback for 2008. The major oil companies have to buy back millions of shares to keep their numbers positive as production levels fall. If it were not for the much higher prices for oil the earnings per share would be lower. You can't produce less every year and continue to increase earnings per share without the buybacks and benefit of record prices.

Coal was back in the news last week as rolling blackouts made the news in South Africa. Coal had been depressed on the bad rap for greenhouse emissions but the news of power shortages in Africa, India and China produced a sudden interest in owning coal companies. BTU, FDG and CNX spiked sharply off multi week lows to set new highs in the case of FDG and CNX. There is no use chasing them today and I believe the bounce will fade as winter ends. A normal winter returned this year with significant cold spells in the northern hemisphere. Cold weather set new energy consumption records in France and Spain and December was the coldest month since 2000. China reported the coldest, snowiest winter in decades and halted coal exports as the country struggled to meet power needs. The government ordered the railroads to make coal a priority. Ocean shippers were told to stop loading coal for export and divert other shipments to China. State officials said last week there is only enough coal for eight days of power. 70% of coal deliveries in China are made by road and severe snowfalls and icy roads are hampering delivery. In January it snowed in Iraq and Saudi Arabia, something that has not happened in more than 20 years.

China's oil demand soared in December to the highest growth rate in seven months. For all of 2007 China's consumption rose by 3.5% with December consumption at 7.2 mbpd. They are the second largest consumer behind the U.S. at 22 mbpd.

Natural gas drilling in the U.S. broke records in 2007 with an estimated 52,731 total oil/gas wells drilled. Gas wells were estimated to be 30,625. There was a 20-year high on completions in Q4 of 13,737 wells. Unfortunately, total North American gas production continues to fall.

Shell Oil issued a memo to its employees saying the energy outlook was changing rapidly. The memo said by 2015 there would not be enough oil supply to keep up with demand. Shell offered several scenarios as possibilities as we approach the peak in production. In their "scramble" scenario nations rush to secure energy resources for themselves, fearing that energy security is a zero-sum game with clear winners and losers. I have been preaching this scenario for three years. Their second scenario called "blueprints" suggested there would be numerous broad coalitions joining together for the common good. I wrote about this recently and the potential for countries to barter with each other for things like minerals, defense and technology in exchange for oil supplies. Regardless of what scenario or combination of scenarios appear the world after 2010 is going to be a much different place. Shell as well as the other oil majors are slowly moving their dates for peak production closer to reality. They do not want to alarm everyone by saying the end is near but like the frog in a pot of warm water they keep turning up the heat slowly.

The crash in prices last week may have altered the normal Feb/Mar price drop as winter demand slows and summer demand has not yet started. In theory we want to enter new energy positions in Feb/Mar to capitalize on the lower price but it remains to be seen if that normal cycle was altered by the high volume of early sellers last week. Support is still in the $86-$88 range and we will need to monitor it to see if the pattern has been broken.

Jim Brown

March Crude Futures Chart - Daily

February Natural Gas Futures Chart - Daily

February Gasoline Futures Chart - RBOB Daily


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