Option Investor
Commentary

Fundamentals Don't Matter

HAVING TROUBLE PRINTING?
Printer friendly version

I heard one trader on Friday claiming that fundamentals don't matter when a chart is in breakout mode. That is apparently true in the case of oil with it hitting a new high of $103.05 on Thursday. Fundamentals are so far out of range it is laughable. Crude inventories have risen for seven consecutive weeks for a total of 25.8 million barrels and nearly a 10% increase. Crude consumption in February was down 511,000 bpd or -2.4% from 2007 levels.

Gasoline inventories have risen for 19 consecutive weeks for a total increase of 38.3 million barrels or a 20% increase. Gasoline inventories are at levels not seen since 1994. Inventory levels are significantly over the 5-year average. Gasoline demand has fallen nearly 100,000 bpd below last year's levels.

EIA Gasoline Inventory Chart

Nothing in the news supports the continued ignoring of the fundamentals. OPEC meets on Wednesday and all indications are for no change in production levels assuming oil prices stay at current levels. The current production quota is 29.67 mbpd not including Iraq. OPEC is worried that a recession in America could soften demand and allow inventories to build into a glut. Given the already high levels and decreasing demand they appear to have plenty to worry about. OPEC is in a box. With oil prices over $100 they would undergo extreme harassment if they cut production to offset this build in inventories. If they bowed to global pressure and increased production even as inventories are rising and demand slowing then they would be shooting themselves in the foot once it became evident that inventories were way too high. Prices would plummet and while the world would cheer OPEC members would be faced with much lower income. The only thing they can do is keep production level and hope summer demand comes early to deplete the excess inventory.

Why have prices disconnected from supply? There are several thousand traders who would pay dearly for that information. There are several schools of thought. One idea is oil as a hedge against the dollar. Since oil is even more liquid than gold (pun not intended) hedge funds, pension funds, sovereign funds or anybody that holds assets denominated in dollars can buy oil and feel pretty sure that it will continue going higher as long as the dollar is going lower. They can liquidate in an instant and if they hold long term they can be pretty sure of a nice profit as we approach peak oil. Since those same funds can't invest in bonds in the current environment there is little else available that will provide liquidity, return and relative safety.

Another idea is the proverbial short squeeze. Historically oil prices decline in the spring as inventories build. Quite a few traders were short heading into February and even though they were repeatedly stopped out they continued to short each new high thinking this insanity had to end somewhere. As we have seen many times in the past the market can remain irrational far longer than we can remain liquid. Our own short on the USO was stopped at $80.50 on Thursday.

One factor supporting oil on Thursday was news that the U.N. could vote on a third round of sanctions against Iran on the nuclear issue. Even Russia has agreed to support this round of sanctions and given the anti U.S. moves of late this is surprising and worrisome. If Russia thinks Iran, a major trading partner, could be a threat then trouble is brewing.

There was a brief shutdown of 50,000 bpd in a spur pipeline in Nigeria and a 400,000 bpd shutdown in Ecuador due to landslides. Petroecuador said it would use other routes to bring the oil to the export facility. They said there was no need to call a force majeure.

China's January crude imports rose to 3.3 mbpd. This was a 1.8% increase from 2007. Japanese imports rose for a 4th consecutive month with a gain of 8.6%.

A fellow trader sent me the following chart on Friday. I don't know where it came from originally but the question that accompanied it was interesting to say the least. The question was this: "If a stock completes a measured move such as the one from $70 to $100 would the consolidation breakout at the top equal the measured move?" In plain English, would the breakout target be $30 over the $30 move or $130? According to technical theory that could be correct. In reality I can't conceive the price could run that much farther ahead of the fundamentals. Demand would have to begin ramping sharply or Saudi Arabia suddenly announces a field had run dry. Stranger things have happened but never say never.

$WTIC Chart

At home the future of ethanol is starting to look bleak. Cargill announced it was scrapping plans for a $200 million plant in Topeka Kansas. In Canton IL, a bankruptcy judge approved the sale of an unfinished plant. Plans for as many as 50 new ethanol plants have been scrapped according to Credit Suisse. The problem is the number of new plants started over the last two years and the price of corn. Corn has spiked from below $2 per bushel to more than $5.25 and the inflated prices have made corn ethanol even less profitable than it was just two years ago. Without government subsidies many of the plants would never have been built. Without subsidies most plants will never turn a profit and those subsidies are dwindling. Verasun (VSE) reported that gross margins fell from 37% in Q2 to only 12% in Q3 and corn was only $3.32 per bushel in Q3. Ethanol prices rose 30% over the same period. According to Credit Suisse ethanol producers were only netting 3 cents per gallon when oil was $60 and corn $2 a bushel compared to $1.04 in 2006 when corn was cheap and subsidies heavy.

Ethanol produces less bang for the buck when used as a transportation fuel and from 15% to 25% less mileage than a comparable gasoline vehicle. It needs to sell at retail for less than $2 per gallon to be viable even with oil at $103. Ethanol will eventually find a home once peak oil arrives because having fuel will be more important than walking and price will no longer be a decision factor. Those plants that can hang on a couple more years may actually have a profitable future. Archer Daniels (ADM) is still favored by analysts as the eventual survivor in the ethanol sector. They build 200 million gallon plants, some fired by coal and cheaper than the natural gas plants used by their competitors. Their plants are 4-10 times the size of their competitors and gives them the advantage of scale and buying power. I personally think the sector needs to get past the current growing pains and into the peak oil period before it is worth an investment.

Ecuador is preparing to nationalize its oil industry and kick out five independent oil companies. The process has been underway for sometime but President Rafael Correa has given officials 45 days to complete the process. Several companies have already started legal proceedings to stop the nationalization or receive compensation.

Venezuelan oil byproducts exported to the U.S. fell 23.8% in 2007 to an average of 211,000 bpd. Crude oil shipments rose to 1.15 mbpd. Refinery and production problems in Venezuela were the cause for the drop in byproducts. If you don't allocate funds for repair you can't sell the products. Are you listening Mr. Chavez?

Analysts claim Mexico's national oil company PEMEX is broke and will run out of reserves within ten years. Since the majority of their oil is exported to the U.S. this is not good news. PEMEX supplied 42% of the country's budget in 2006 and 2007 and now has no funds left to increase its reserves. PEMEX was created in 1938 when Mexico kicked out British and U.S. oil companies. There have been recent calls to privatize PEMEX but the government worries that there will be outbreaks of violence if that happens. I guess the citizens would rather see it go under? Without PEMEX Mexico will go bankrupt and that will cause even more hardship. PEMEX currently produces 3.1 mbpd and exports 1.5 mbpd. The Mexican government has no other source of major revenue and it is literally killing its golden goose by skimming all the cash from production to run the country without allowing PEMEX enough money to explore for new oil. Because PEMEX has not had the cash to invest in its refineries Mexico now has to import 40% of its fuel. The Institutional Revolutionary Party (PRI), which ruled Mexico from 1929 to 2000 suggested selling shares of PEMEX on the stock exchange to raise capital for exploration. Without some autonomy from the state that plan would never work. Investors want to know that the company can continue to grow otherwise nobody will buy the stock. The current ruling party the PRD says it would take $40 billion a year to renovate PEMEX. That would require nearly a 50% cut in government payrolls across the board and require PEMEX to retain all the profits from oil sales over the next 14 months. Since those profits are now going to the state governments the odds of this happening are zero. Maybe when Mexico goes bankrupt in the not too distant future the U.S. can buy/annex them and solve the immigration problem once and for all. It would be a massive undertaking but the long-term benefits would be worth it.

Brigadier General Greg Zanetti of the New Mexico National Guard warned last week that the perfect storm for social upheaval is now brewing in Mexico and specifically in the border states with the U.S. The first storm front is the decline in crude production in the prior paragraph. The drop in funds for the Mexican budget will cut social programs to the bone. The second storm front is the U.S. and the slowing of the economy. The drop in spending and layoffs in the housing sector has cut a vital source of funds for Mexican labor both legal and illegal. Remittances back to families in Mexico have dropped substantially as construction, landscaping, remodeling and other housing related jobs have evaporated. Over a third of Mexican citizens live on money sent back to Mexico by family members in the U.S. The last storm front is food. The ethanol project has caused the price of food to skyrocket well above the level the common Mexican citizen can afford. Poverty is rampant in the border states and corn prices have tripled the cost of tortillas. Flour has gone from $12 per 50-lb bag to $58 over just the last year. American restaurants have begun to stockpile flour to avoid cost increases and to insure future supplies. The poor consumers in Mexico don't have this privilege. With income flows into Mexico slowing the social unrest is rising. The Mexican government is already having trouble maintaining order in the northern states and citizens are turning to illegal activities to make ends meet. Gangs and well armed drug cartels are having open battles with the military and zones controlled by the gangs are growing. The drug cartels are rapidly becoming the ruling power in the northern states. As the military tries to take back control the gangs flee to the U.S. side of the border to regroup, rearm and plan their return. Many Texas towns are warning residents to stay away from border areas because the lawlessness is becoming rampant. In Mexico citizens have three choices, hide, fight or flee. Most are choosing to hide in hopes the violence will subside. As conditions continue to deteriorate the flight option becomes the only one available for law abiding people and the only direction to flee is north. The debate in the U.S. over illegal immigrants is likely to take on new meaning very soon as this wave of new immigrants seeking safety rather than income becomes a flood.

James Kuntsler, author of the Long Emergency, predicted a virtual takeover of the southern states, Texas, New Mexico, Arizona and southern California by Mexicans fleeing conditions in Mexico once peak oil becomes a reality. The current recession will be a walk in the park compared to the economic problems brought on by peak oil. Mexico will go bankrupt for sure and Mexican citizens will be moving to the U.S. in record numbers just to survive. The sheer numbers will make it impossible to stanch the flow and the infrastructure in the southern states will suffer from millions of unemployed, malnourished and angry immigrants. Trouble is coming and not always from the sources you expect.

Jim Brown


April Crude Futures Chart - Daily

April Natural Gas Futures Chart - Daily


March Gasoline Futures Chart - RBOB Daily

 

Leaps Trader Commentary Archives