Option Investor

Expiring Futures Produces Short Covering

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March crude futures cease trading on Wednesday and it appears traders did not want to go into the 3-day weekend short. The various news events prompted traders to begin to cover their spring shorts and crude hit $96.67 intraday on Friday. End of day profit taking knocked a buck off the price to close at $95.59.

The OPEC games have begun with comments out of OPEC on Friday that global demand is expected to grow by 1.23 mbpd in 2008 and that is 73,000 bpd lower than their last estimate. They refine their estimate each month so they could be off 500,000 bpd and still be dead on by year-end. The key here was a comment from OPEC that despite the rising demand the current production levels would be enough to satisfy that demand and build inventory levels at the same time. That suggests OPEC is setting us up for "no change" in production at the March 5th meeting. Iran, Venezuela and a couple other states had made comments about cutting production at the March meeting but the OPEC comments on Friday appeared designed to short circuit that production cut request. It was only a week ago that OPEC was hinting they would cut at that March meeting.

Not to be outdone the IEA lowered its global growth forecast to 1.67 mbpd or -310,000 bpd below their last estimate. The drop in demand was mainly due to a possible recession in the USA and its impact on other world economies.

Venezuela is still sticking to its claims it will not sell oil to Exxon but nobody seems to care. OPEC has said it will make up any shortfall caused by Venezuela and Secretary of Energy, Sam Bodman said the strategic petroleum was available to Exxon if they needed it. To me this sounds like OPEC is tired of putting up with Chavez and welcomes the opportunity to look like they are the good guys coming to the aid of the U.S. in the Chavez squabble. By making a public statement about covering any Chavez produced shortfall they are slapping him across the face in front of his peers. This could be one more step out on the proverbial limb for Chavez as he moves farther off the reservation. Eventually his limb is going to break and it appears there will be nobody around to catch him.

Exxon said on Friday they added 1.6 billion barrels of oil equivalent to their reserves in 2007. That would be 101% of its production for 2007 and a nice trick if they can keep it up. According to Exxon their ten-year average of reserve replacement is 112%. Were it not for confiscations by Venezuela and several divestitures it would have been 500 Mboe higher. Current proved reserves for Exxon are now quoted as 22.7 billion boe. If you add probable and possible (3P) that number rises to 72 BBOE.

There are no fundamentals supporting oil prices at this level in late February. Oil inventories have now risen for five straight weeks with more than 18 million barrels added. That comes after a downtrend in inventory that lasted from early July to the first week in January. You may remember my comments back in December that refineries would not want to inventory oil going into year-end because of the tax consequences of owning it on Dec-31st. That ten-week decline ahead of Dec-31st reduced inventories by nearly 40 million barrels from local inventories or roughly $3.5 billion in oil. Without that inventory reduction refineries would have paid property taxes on that $3.5 billion. Beginning with the very next inventory report on Jan-11th covering the first full week of the year those inventory levels began to build by an average of 3.6 million barrels per week. Coincidence? I don't think so and the inventory rebuilding is simply bringing us back into balance with normal levels. Demand for heating oil has slowed and that also increases crude levels since refiners don't want to produce a product they can't sell. The percentage of refiner runs has fallen off a cliff to only 85% utilization and nearly 10% below a normal level during the peak of the season. There is nothing in these numbers or trends that supports higher oil prices as we head into March.

At the CERA conference in Houston last week John Hess, chairman and CEO of Hess Corp, told the crowd an oil crisis was coming much sooner than people thought. "It is not only a matter of demand. It is not only a matter of supply. We need to take steps on both fronts and we need to start today," Hess told an overflow crowd on Feb-12th. "Given the long lead times of 5-10 years from discovery to production, an oil crisis is coming and sooner than most people think. Unfortunately we are behaving in ways that suggest we do not know there is a serious problem," Hess said. Hess believes the oil crisis will begin within the next ten years and the U.S. is not prepared in any way for the "calamity" ahead.

Goldman Sachs believes that the number of cars on the road will soar to 500 million in China and 600 million in India by 2050. That is an addition of 1.1 billion vehicles in two countries that had less than 20 million cars total just 5 years ago. Hess said, "global population is expected to grow from the current 6.6 billion to more than 9 billion by 2050." That will more than double the demand for oil but increasing production today by more than 10% appears to be impossible. Hess said, "Since 1980 discoveries have not replaced annual production. We need to find a new field the size of Angola every year and it is not happening. OPEC alone has the resources to increase capacity but they are not spending enough to insure sufficient capacity to meet oil needs in the next 10 years. Global demand is growing 1.5 mbpd annually. The IEA predicts global demand to average 98.5 mbpd by 2015. Based on current behavior, I do not see how we will meet this projection." Current global demand is 87.6 mbpd of which 4.5% or 3.9 mbpd is lost each year to depletion. That requires 5.4 mbpd of new production to be added each year to meet new demand.

I read a really good but very long article on Peak Oil this week that contained dozens of point why peak oil may be sooner than we think. The article documented numerous converging lines of discussion and points of reference and scared the hell out of me. I am a believer in the coming peak but this collection of facts accelerated my belief into near panic mode. I am going to try and upload it this weekend and I will send everyone a link if I am successful. Basically the world view according to peak oil experts is changing to a "peak plateau" rather than a sharp peak and sharp decline. With the benefit of hindsight and projections from the megaprojects database there is a large and growing contingent of experts that believe the actual peak will occur in 2008 and a slow decline in production of 3% per year begin in 2009. If this is true and there is a lot of evidence to suggest it is then the impacts of higher oil prices are just ahead. In the chart below the red line is the global production, black line demand and green line the price of oil. If the red/black lines are right then the green price line is too low. Once demand exceeds supply by even as little as 50,000 bpd that price line is going vertical. Based on the evidence in the article this could happen by the end of 2008 or early 2009.

Peak Oil Plateau Chart

It may sound crazy after that last paragraph but I am going to recommend we short some oil this week. I believe the rally last week was short covering on various news events that have nothing to do with reality. Inventories are rising and demand is slowing as it always does in Feb/Mar. This is just a temporary hedge against a potential decline while we maintain our long-term bias towards higher prices.

You may have noticed that natural gas prices spiked to a 3-month high last week at $8.84. This was not due to a major consumption binge or shortage of gas supplies. The hedge fund Saracen Energy got caught shorting the spread between the March and April 2009 futures and betting that spread would narrow. That spread jumped more than 50% in the prior week and Saracen was forced to cover their shorts rather than watching their position go further into the loss column. Reportedly they lost over $500 million or roughly one third of their fund value. They probably had vivid memories of Amaranth losing $6 billion in natural gas in 2006 and did not want to repeat that loss. There were rumors Saracen was forced to sell its trading book to Goldman to cover its margin calls. Goldman was also rumored to be the prime broker for Saracen. As the prime broker they would have the margin exposure for the positions and could have forced the sales if Saracen was over leveraged. We may never know the real scenario but we do know it moved the market nearly a dollar as the positions were closed.

Jim Brown

March Crude Futures Chart - Daily

March Natural Gas Futures Chart - Daily

March Gasoline Futures Chart - RBOB Daily


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