Option Investor

Bear Market In Oil

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Amazing how quickly bubbles can burst. The +$11 ramp in oil prices to $111 over just the last two weeks saw a massive reversal as the April crude contract expired. I discussed last week how there were 18 times more April contracts than Cushing had storage to hold the deliveries. The vast majority of those contracts would have to be sold and settled in cash because the open interest was many times over what actual buyers in the spot market would be able to consume. Most refiners have established contracts for crude well in advance of delivery. They only go to the spot market when they need a more than they have coming contractually or when there is an interruption somewhere else. The resulting sell off in crude last week knocked -8.30 off the price with Thursday's close at $101.70 after trading as low as $98.65. That brought oil prices back to decent support at $100 and a logical place to rest. 29 of 34 analysts surveyed by Bloomberg felt that oil prices would continue to fall through March 27th.

The sector rotation out of commodities hit not only oil buy metals, grains, lumber, etc. Somebody rang the exit bell on the month long rally and it was a race for the exits. The CRB Index of 19 commodities fell -8.3% for the week and the largest weekly drop since 1956. Is it permanent? Are we going to give back all the gains for the last six months? I seriously doubt it. Global growth could easily slow by several percent and there would still be a shortage of commodities. Traders are simply taking profits after a long run and rotating into other sectors. Banks, brokerages, finance and insurance suddenly look like bargains given the recent Fed actions. Another factor feeding the sudden decline is margin calls. Michael Smith of T.K. Futures said there was a lack of liquidity in the markets and funds were selling raw-material futures to raise cash to cover margin calls. When futures contracts decline they require more money on deposit to maintain the position.

The oil inventory report on Wednesday showed oil levels stayed the same but gasoline inventories plunged for the first time in 18-weeks with a -3.4 million barrel plunge. There was such a panic sell occurring in commodities in general that the number was completely overlooked. The key point was the drop in refinery utilization to 83.8% and the lowest level since March-2006. There is so much gasoline in the system that refineries are opting to either shutdown for maintenance or cut back on runs to avoid increasing supplies above their record levels. Price at the pump is definitely having an impact on consumer buying habits. The Energy Department said gasoline demand dropped by -1% last week alone.

Weekly Oil Inventory Report

National gasoline prices slipped slightly to $3.275 per gallon but diesel continued to climb to top $4.03 per gallon and a new record. A reader reported to me this week about conditions inside a trucking company where he has connections. Reportedly with the price of diesel going up daily they are not breaking even despite the fuel surcharges. The rate of increase has been faster than the surcharges can compensate. Even worse he reported a sharp slowdown in durable and capital goods being hauled. He warned me to expect earnings problems for this quarter and next. Bill Zollars, CEO of YRC Worldwide, said on Wednesday that there was increased weakness from retail customers and the overall economy has not changed from the recent weakness. He also said that severe winter weather has hampered shipping even more than normal. YRCW stock spiked slightly on news that renewing YRC contracts for 2008 showed an uptick in expected weights to be shipped. Zollars said typically this pointed to a future economic recovery.

You may have heard that Exxon had an analyst meeting in early March. At that meeting they admitted that their global oil production would remain flat through 2012. That is astounding to me given the price of oil over $100 but it fits in perfectly with the peak oil scenario. Exxon said it was having trouble finding and producing more oil than they were losing in depletion of existing fields. This should have been front-page news but it garnered barely a mention in the press. Since 2000 Exxon's output from two of its largest regions, the U.S. and Europe, declined by 37%. That equates to about a 500,000 bpd drop. Depletion matters! Exxon said it was sizing up its investment opportunities based on what price they expected to get for the oil. They were taking the top of the list and had increased the capital budget to $25 billion from $21 billion in order to pursue the best opportunities. They will start 12 new projects this year. Exxon said it was also losing production due to new revenue sharing agreements with its country partners. More contracts are calling for royalties to be paid in oil and the higher the price of oil the more barrels the contracts call for as royalties. If Exxon produces 50,000 bpd from a field at $90 the royalty may be a diversion of 5,000 barrels. If the price moves over $110 then the contracts could call for 10,000 barrels to be diverted to the country. It is the global equivalent of a windfall profits tax. You make more per barrel and we get more barrels. Take it or leave it. Exxon still made a bundle with $40.6 billion in profits in 2007. Exxon invested $21 billion in exploration and $36 billion in stock buybacks in 2007. This increased the number of barrels owned by Exxon shareholders by 20%. Exxon is quickly buying itself back but it is not raising production. CEO Tillerson said "if we had investment opportunities we would pursue them" but the $36 billion in buybacks suggests there is far more money than opportunity.

Shell released reserve numbers last week and showed that the actual cost of getting the oil out of the ground had increased to $15 in 2007 compared to only $6 in 2003. Shell also disclosed that the "operating" cost of the Athabasca oil sands project was between $20-$25 per barrel. That is primarily the cost of natural gas to heat the sands and make the oil flow. They would not disclose the "capital" cost per barrel but that is estimated to be between $15-$20 per barrel. The Shell CEO is tough to believe. In one press conference he says demand will exceed supply by 2012. In another press event he says the idea of peak oil is ridiculous. Granted demand exceeding supply is not peak oil but it will have a similar impact on prices. He thinks we are suddenly going to unlock the estimated trillion barrels in oil shale and another trillion in oil sands that cannot be mined in the current sense. Unfortunately neither of those represent any material flows and neither will come to market within the next ten years even if the technology was discovered tomorrow.

Barclays raised its crude price forecast for 2008 to $100 a barrel and the second increase in less than a month. They blamed lowered estimates of non-OPEC supply for the increase. Merrill boosted its 2008 forecast last week to $102. Barclay's analyst said "perceptions about the sustainability of $100 per barrel" are gaining a greater level of acceptance. "Demand growth is robust and non-OPEC supply is "disappointing dramatically." Remember, Goldman said the prior week that we could see explosive rallies to $175 as political decisions on money flows, labor and technology are "substantially constraining supply growth."

Wood MacKenzie Consultants said global demand will grow by about 10 mbpd by 2012 assuming there is not a major recession. They feel OPEC will need to increase production by 3 mbpd and the rest will have to come from non-OPEC suppliers. When taken in context with the prior paragraph about non-OPEC supply "disappointing dramatically" it makes you wonder if they were on drugs when they issued the forecast.

The combination of the Monday and Wednesday drop in the broader market and the implosion in commodities and anything related completed the house cleaning in the portfolio. We were stopped out on all but one energy position. With oil prices expected to decline even further there is little reason to rush back in. I will start adding targets to the watch list but I want to be selective. Typically oil begins to climb heading into summer demand and the hurricane season but with prices and inventories so high it remains to be seen if the normal cycle will appear. We did have one new entry in Tenaris.

Jim Brown

May Crude Futures Chart - Daily

April Natural Gas Futures Chart - Daily

April Gasoline Futures Chart - RBOB Daily


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