Option Investor

Gasoline $3.37 and Rising

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Consumer sentiment fell to a 26 year low last week and rising gasoline prices were a strong component of that drop. Crude oil hit a new intraday record of $112.20 and that pushed national gasoline prices to a new record high on Friday of $3.365 per gallon according to AAA.

Eventually this upward move has to end at least temporarily but there seems to be no end in sight. I sent an email to everyone last week about the new production coming online in Saudi Arabia. They are finishing development on the 500,000 bpd Khursaniyah field. It will start production at 300,000 bpd within a month and rise to 500,000 by years end. Saudi will add another 250,000 bpd when it completes the 500,000 bpd Shaybah field in December. Other new projects include the 900,000 bpd Manifa field and the 1.2 mbpd Khurais project. Both scheduled to complete over the next 18 months. Adding this production cost Saudi Arabia $90 billion over a 5-year period.

This sounds like a tremendous amount of oil coming online and to the uninitiated probably like the end of the peak oil talk. Unfortunately it is not the end. It is a lot of oil but it is oil that has been scheduled to come online for 3-4 years. Meanwhile the 6% depletion rate of older fields is causing a loss of production of 5.2 mbpd each year. If you took all those Saudi fields above at face value of 2.8 mbpd that is still only one-half of the new production required for just one year to overcome the loss from depletion. Those Saudi fields are coming online over a 3-year period or roughly the addition of only 1 mbpd per year at face value. It remains to be seen if they will actually come online at those stated numbers and some of that production has already started so that dilutes the impact of the announcement.

Still, the Saudi announcement should have weakened the price of oil and it didn't. There was barely a blip in the price and that is because most serious oil investors already take into account those points I listed above. The rest are just momentum traders speculating on higher highs ahead. There was also news that Nigeria was slowly bringing production back online that was shut in due to the violence. Over 1 mbpd of light sweet crude is still offline but hostilities are easing and that could be back by years end.

The weekly EIA inventory report was bullish for prices with strong drops in every category. The strong +7.3 million barrel gain in crude the prior week was offset by a -3.1 mb drop this week. The last four weeks have been impacted by blips in imports either with a drop in deliveries or a sharp spike. This is just a routine randomization of crude deliveries. Depending on where in the world the oil is loaded it could take a week or up to six weeks from loading to delivery. The oil is contracted well in advance but delays in the loading port, equipment malfunctions, storms, harbor traffic on both ends and any number of other reasons can delay scheduled shipments for weeks. There may be weeks where ships line up outside the Houston ship channel waiting for a slot and other weeks where they just sail right in. Fog can shut down the harbors for days at a time. The tankers pile up in massive traffic jams waiting for the harbor to clear. Those ships already unloaded can be stuck in the harbors waiting for the fog to ease. The U.S. imports about 10.4 million barrels per day and that is delivered in tankers of every size including the VLCC class with 1 million barrels of crude per tanker. Just keeping roughly 30 tankers per day moving in and out of the various U.S. ports from loading docks around the world is a daunting challenge. It is a wonder the average barrels delivered per day is not more volatile. Last week imports fell an average of 1.4 mbpd. The prior week imports were up 1.4 mbpd. The week prior to that imports were only 8.9 mbpd and the lowest level in two years. All of this volatility is just tanker flow not a change in oil buying or availability. The volatility in price from these flows is simply hysteria by traders who don't understand the mechanics involved.

Weekly Oil Inventories

On Friday the International Energy Agency (IEA) revised down its overall forecast of global oil demand due to the current economic decline. The IEA said demand would now be 87.2 mbpd, down -310,000 from their last forecast of 87.5 mbpd only a month ago. The current forecast still calls for demand growth of 1.27 mbpd in 2008. Cutting demand growth estimates is not the same as cutting demand. It just means new consumption is growing slower than expected but still growing. This month's cut of -310,000 bpd in demand growth was the largest since the agency cut its estimates in July 2001 by 509,000 bpd.

The agency also noted that global supply fell by -100,000 bpd in March. They also see a surplus of supply in April and May. The demand cuts came after the IMF cut its global GDP forecast with the U.S. estimate now only +0.5% compared to +1.5% in the last IMF forecast. The IMF said growth in emerging economies like India, China and Brazil remained robust and demand should continue to grow. The IEA said it appears oil prices have decoupled from the U.S. economic woes for the first time. Normally a downturn in the U.S. creates a global slowdown.

In the IEA report, there were some interesting charts. Demand from the 30 country Organization for Economic Co-operation and Development (OECD) group is tracking along seasonal norms although the chart is only current through January. Note that there is a large seasonal demand drop in April/May.

OECD Demand Chart

Demand in North America was at the high range of normal in January. Note also that there is far less demand decline in the North American chart in April than the OECD chart.

North American Demand Chart

This next chart is where the rubber meets the road. Note that the demand for oil products in the U.S. has dropped significantly from January to February and is already well under the 5-year average and under the 4-year range. This demand drop in the largest consuming nation on earth is a direct relation to the price of gasoline and the current recession. If these conditions continue we should see an early bottom in the seasonal cycle and a bottom that could last longer.

US Oil Demand Chart

If you use that link above to download the IEA report you should look at the chart on page 19 regarding OPEC spare capacity. It was a large chart that will not fit in this commentary. It shows the OPEC spare capacity dating back to 2001 and how the nearly 9 mbpd of spare capacity fell to less than 1 mbpd in 2004. They have rebuilt it to some extent in the last three years but since early 2007 that capacity has been declining again.

One of the most revealing charts (page 23) and accompanying discussion concerns depletion of the major non-OPEC producers. You have heard me discuss this over and over for years. The accepted rate of decline for these discussions has increased about 1% per year over the last 4 years. Instead of using the 3% depletion rate that was common 4-years ago the new "accepted" depletion rate is now 7.7% per year. This is a monumental change and it represents the difference between losing 2.64 million barrels of production per year to depletion and lowing 6.77 million barrels! This is a major change for the IEA, an agency, which has always been extremely optimistic about existing and future production. This is for non-OPEC production since OPEC does not release any data. We can however extrapolate that their mature fields would follow the historical rate seen in the rest of the world. OPEC, specifically Saudi Arabia, has fields that have not yet been commercially developed and they can use those new fields to offset the decline in their old fields.

Non-OPEC Decline Rate Chart

You have also seen me write about the extreme imbalance in U.S. gasoline inventories. In the IEA chart below the black line is the build in gasoline inventories well above the normal ranges. This has decreased slightly after four consecutive weeks of declines totaling 14.6 million barrels to 221.3 mb last week. It is still well above the normal range. This is entirely due to falling demand as prices exploded well over $3 per gallon. With the excess inventories the crack spread, the difference between the cost of a barrel of crude and the value of the refined products, for U.S. refiners is nearly zero. Until that spread returns we can expect refiner utilization to remain low.

US Gasoline Chart

Oil research is a complicated field. There are thousands of variables not to mention the intentional misinformation from OPEC countries. About the only thing we can count on is the amount of product in inventory and the current demand rates. In the week ended on April-4th gasoline demand fell to 9.286 million barrels per day compared to 9.472 mbpd in 2007. This represents a 2% drop in demand or -186,000 bpd. As long as crude prices keep climbing the demand for gasoline will continue to fall.

A couple analysts I believe are credible suggest we could continue to see a momentum rise in oil to $120 a barrel over the next month. Given the seasonal decline in demand in April and May $120 seems like an impossible number. However, we have seen over the last few months that fundamentals don't seem to matter any more and until commodities lose their allure we just need to watch as the volatility increases. After May there should be a rise into hurricane season especially since we have escaped any damage for two consecutive years. Our luck will eventually run out. You may have noticed that oil stocks have not followed crude higher. There is a strong reluctance to "buy the top" and the integrated oils like XOM, COP, BP and CVX are wandering aimlessly on the charts. Most of the service companies are following the same pattern. Until we get a correction in oil prices we need to avoid loading up on oil positions. With the winter over the same is true with gas stocks. They should also begin to weaken through the spring. We have a very small portfolio right now and with the broader market direction in doubt there is no need to add positions just to be adding positions. Cash is a position.

Nymex crude options expire next Thursday and May crude futures expire on April 22nd. Both events should cause additional volatility. You may remember last months expiration cycle when there was significantly more open interest than normal going into expiration. The result was a sharp drop in prices. This month the open interest is closer to normal but still elevated. That could provide another dip to buy back in the vicinity of $100. Time will tell.

Jim Brown

May Crude Futures Chart - Daily

May Natural Gas Futures Chart - Daily

May Gasoline Futures Chart - RBOB Daily


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