Option Investor

Support at $109

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As unbelievable as it may seem crude has found short-term support at $109 and appears ready for another sprint higher. You may remember the prior week when oil inventories fell by 3.1 million barrels and crude prices spiked almost $6 from the day's low to close at $104. This week inventories rose +6.2 million barrels and oil spiked again from $107 to $111. If you want common sense don't search for it in the oil market.

Oil Inventory Update

In the crude futures market a single futures contract is valid for delivery of 1,000 barrels of light crude to Cushing Oklahoma during the month specified in the contract. In 2002 open interest in crude futures averaged about 400,000 contracts. Today there are over 1.4 million open futures contracts. The current month contract is April, which ceases trading on Wednesday March 19th. As of last week there were 350,000 April contracts representing the potential delivery of 350 million barrels of oil to Cushing OK. Unfortunately Cushing can only hold 18.8 million barrels. There are 18.6 times more contracts in force than Cushing can inventory. Granted oil leaves Cushing every day and new oil comes in but the same concept applies. There is no physical way for that much oil or even half as much oil to be delivered.

Futures contracts are not always bought to actually guarantee delivery of oil. They are also purchased as a hedge against oil prices. A refinery that knows it will be buying millions of barrels of oil some time in the future can buy a futures contract at today's price to lock in their price months in advance. Refineries locking in prices on the January dip to $85 for April delivery would have saved themselves $25 per barrel. They don't actually have to take delivery of the oil in the contract but can simply sell the contract at today's price of $110 and pocket the cash. The result is the same as if they had taken delivery. Actually in today's market with demand falling sharply they may by less oil than they had hedged. Basically any products refined during the hedged month had a much lower cost basis than any unhedged refiner. Lower costs equals higher profits and in today's nearly zero crack spread environment that is a big plus.

The question for next week is what will happen to those 350,000 contracts. The vast majority of them will be sold to capture the profit rather than actually require delivery. Since somebody actually sold those contracts short to open a position there are quite a few traders, speculators, producers, etc, who have zero chance of actually supplying oil so their only option is to buy those short contracts back on the open market sometime before next Wednesday. Those long the contracts are sitting in the drivers seat since they don't have to sell until the last minute of trading. The shorts that created the 350,000 contracts of open interest are in serious trouble if the speculators hold their feet to the fire and a bidding war breaks out for those contracts available for sale to cover short positions.

If everyone decided to hold their longs we could see $120 by mid-week. If all the longs suddenly decided to take profits on Monday we could see a collapse with everybody trying to exit at once. I have given up trying to predict how these expiration short squeezes will end but you can bet there will be some huge volume before the week is out. Those shorts who firmly believe there is an eventual correction in our future can just roll out to the next month by covering the April shorts and then shorting May or June to maintain a short bias. Eventually they will be right but they are sitting on $25 of pain today and on the large futures contract every penny change in crude price is a $10 change in the value of the contract. A $25 change in price is a $25,000 change in value. Being short a handful of those could ruin your whole month. Every contract of open interest (350,000 current contracts) started out as a short sale. The seller can either purchase it back later with cash or supply 1,000 barrels of oil at Cushing but the key here is the fact all those contracts are shorts of one form or another. They MUST be covered with cash or commitment to deliver oil over the next four days. I have greatly simplified this explanation but I think you get the idea. It should be interesting.

Gasoline prices rose +1.3 cents on Friday to a national average of $3.28 per gallon and another new record. That was the fourth consecutive record day. Diesel rose to a new national record at $3.938 per gallon. The Energy Dept says prices for gasoline will top out at $3.50 this spring but many analysts are saying we could see $4 soon.

In its monthly oil market report OPEC said it was pumping enough oil to keep consumers satisfied and a potential U.S. recession could mean lower demand for crude in the months ahead. OPEC said there was little risk of a rise in demand above their already decreased estimates. OPEC now expects 2008 demand to rise by 1.2 mbpd to 86.97 mbpd. OPEC said demand for OPEC crude would be 31.68 mbpd for all of 2008. That is below the 32.1 mbpd OPEC members produced in February. Global inventory levels are continuing to build and eventually fundamentals will again matter.

Deutsche Bank said oil prices would have to rise to $145 per barrel to have the same economic impact as the levels reached in 1981. According to some analysts we have already passed the inflation-adjusted price from 1981 but others claim that will not happen until crude reaches $118. The different numbers reflect different methods of calculating actual inflation and the change in the value of the dollar over the last 27 years. Deutsche Bank said the income level in America was substantially higher and fuel had not yet reached the percentage of total income as we saw in 1981.

Venezuela was in the news again with an announcement that they would begin selling oil in Euros and not dollars. They have long backed Iran's efforts to move from the dollar to Euros but OPEC has avoided that action. Now Venezuela said it will start contracting for "some" oil in Euros but would not specify how much or to whom. Venezuela exports half of its oil to the U.S. and I seriously doubt the U.S. refiner, partially owned by Venezuela, is going to agree.

I really appreciate everyone who took the time to send me an email to my reader question last week. I read each and every one and there were some interesting points and I was gratified to see how many readers are taking steps to act before peak oil arrives. I am putting all the emails up on a web page and I am going to send everyone a link this week. (names will be withheld) There were many good questions that I believe would benefit everyone not just the readers asking the question.

The bear market returned as the Tuesday and Thursday bounces collapsed and the S&P returned to its January lows. The about face on Bear Stearns and their liquidity problems and the fear the Fed will not be as lose on rates combined to take the rally out of the market. The Monday decline and some new profit taking knocked us out of six more positions. I raised the stops on almost everything last week and those stops were hit in many cases. I am not going to add anything this week. Energy stocks are not following crude higher and I can only guess it is fears of an eventual correction, fears of a recession leading to lower fuel consumption or just a feeling that the energy sector is over done but something is preventing a rally in the energy sector. We will watch for a week and see how the market reacts to Tuesday's Fed meeting. Should they NOT cut rates or only cut a quarter point we could see some lower lows.

Jim Brown

April Crude Futures Chart - Daily

April Natural Gas Futures Chart - Daily

April Gasoline Futures Chart - RBOB Daily


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