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Shorts Squeezed

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A flurry of news events caused a monster short squeeze on Friday. Traders heavily short ahead of the normal March decline in demand and prices were handed the perfect storm of oil supply worries. The result was a +3.78 single day spike to close at $91.89. From a low of $86.24 on Thursday to $91.97 on Friday was nearly a $6 gain.

The biggest new story was only partially reported in the press. Shell said it was declaring force majeure on Bonny light crude from Nigeria for February and March deliveries. They halted production of 130,000 bpd due to pipeline repair problems. The press release said production could drop as much as one million barrels per day due to continued violence and maintenance problems. That sounds like a major problem and the 1 mbpd number was the number the press kept repeating. In reality production has already been cut by over 500,000 bpd for those same reasons over the last 18 months. We have seen spikes to as high as 800,000 bpd in lost production as flurries of violence caused intermittent halts. By halting 130,000 bpd that brings the current total to only 630,000 bpd but the attention getting headline was still the million-barrel claim. That would occur only if violence continued to rise. The government of Nigeria has ordered the various oil companies back to work or risk losing their leases in Nigeria.

The second problem came from a Total announcement about a shutdown of 280,000 bpd of Brent, Forties, Oseberg and Ekofisk oil grades produced in the North Sea. The shutdown will not occur until March when Total will attempt to correct a technical problem affecting that production. The news reports failed to mention that it was a planned shutdown in March and traders were left with the assumption it was happening today.

Other news impacting the shorts was a rising call by OPEC members to cut production at the March 5th meeting. Other OPEC members besides Iran and Venezuela are taking up the call after inventory levels in the U.S. jumped by 7-million barrels last week and 17 million barrels over the last four weeks. OPEC members fear that the combination of a recession in the U.S. and the March demand decline would allow inventories to build to the point that prices would decline sharply. OPEC needs to maintain the high prices in order to continue funding new exploration.

On another topic Total said it was pulling out of a Saudi exploration venture after three exploration wells turned out to be dry holes. Total will surrender its 30% stake to the other partners, Saudi Aramco and Shell. The area covered by the joint venture is 210,000 square kilometers or roughly the size of Great Britain. You would think that owning 30% of any exploration effort in Saudi Arabia would be a prize almost any oil company would sell its soul to get. Could this be a sign that we have passed the peak in Saudi and the future is one of increasing exploration failures rather than success? The EIA website showing global daily production by country shows Saudi Arabia peaked at 9.6 mbpd in Sept 2005. The same EIA website shows the global production of conventional oil peaked in May 2005 at 74.298 mbpd.  Increased liquids production since May 2005 has come from oil sands, NGLs, ethanol and bio-diesel.

There was news that a Russian field was depleting faster than originally thought and exports from Russia could drop sharply in 2008. That report was rather nonspecific and just added to the fog on Friday.

Lastly there was news that the Exxon noose around Venezuela was tightening. Exxon was kicked out of Venezuela when it refused to give up its facilities in the Orinoco oil belt in 2006. Chavez nationalized the oil fields in 2006 and Exxon chose to exit VZ and take the matter to court rather than take a minority position and let PDVSA collect all the money. Exxon has won a series of court battles and is systematically squeezing VZ for payment. Courts in England, the Netherlands and the Netherlands Antilles each froze assets worth up to $12 billion each in their respective jurisdictions. A U.S. court froze $300 million in assets in the U.S. with more to come. Venezuela claims Exxon acted improperly and resorted to judicial blackmail in pursuing the claims in the various courts. Venezuela knew the verdicts were coming and changed the way it required payment for oil. VZ now requires payment in advance rather than normal terms used by the oil industry. As an oil buyer I would be really hesitant to fork over $75-$90 million in advance for a tanker load of crude that I may never get. Chavez is losing favor at home because of mounting internal problems with the biggest a shortage of cash for social programs. He has already nationalized oil, telecoms, banks, insurance companies, television and utilities and confiscated their cash for those programs. Without the operating cash those companies are producing less revenue and it appears Chavez is choking the geese laying his golden eggs. The groups supporting the various Chavez watch sites on the Internet are giving him less than 18 months left in office before being thrown out.

The Mexican Energy Secretariat said last week that Mexico's oil production problems are going to increase in 2010 when the Ku-Maloob-Zaap (KMZ) field will begin to decline. The giant Cantarell decline is accelerating and expected to continue to lose production at more than 14% per year. Production from Cantarell fell by 101,000 bpd in 2005, 234,000 bpd in 2006 and 304,000 bpd in 2007. Pemex officials expect KMZ to peak in 2010 at 800,000 bpd and then begin a decline similar to Cantarell. Officials said a more pronounced decline is expected in fields in the northeast marine region with reductions of 40% and 20% drops in the southwest regions. The next decade is not going to be fun for Mexico.

We are a little more than a week away from the March futures expiration on Feb-20th. I think it is safe to say that volatility is going to be high over the coming week. Resistance is strong at $92 and support is strong at $86.50. Unless some new event makes the news I would expect resistance to hold ahead of the March demand decline and the massive build in U.S. inventories. We are out of all but a couple pure oil stocks and will look to reenter the sector on any March lows. Until then I am refraining from adding many new positions until the broader market finds a bottom.

The U.S. markets posted an average loss of 4.5% last week and the worst week since March 2003. Any long positions in an environment like that are going to loose ground. We have the cream of the crop in our current portfolio and as soon as the market recovers I expect to reclaim lost ground at an astounding pace. The keyword there was "recovers." We may have some more pain before any new gains.

Jim Brown


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