Option Investor

Sharp, Fast and Scary

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Those terms are usually reserved for bull market corrections. In the oil market they justly apply to those monster short squeezes like we saw on Friday. The shorts had just loaded up for a long drop from $120 on positive oil news from around the globe. Just when they had settled in to a series of three negative days lightning struck. It came in the form of new month end money buying the dip to $110 and news that Turkish jets were bombing Kurdish rebel bases in northern Iraq. Fears of an oil stoppage in the northern Iraq pipeline that crosses Turkey were almost instantaneous. The momentum players looking for a dip to buy saw the rebound and jumped back into the game. The shorts were crushed once again. A $4 single day move in crude futures is sharp, fast and scary if you are on the wrong side.

The weekly inventory report was bearish for prices despite a 7th consecutive weekly drop in gasoline inventories. Crude gained for the second week despite a strong uptick in refiner utilization. $3.60 gasoline has been a drag on consumers with demand falling -1.5% for the month. It is just temporary and once drivers get over the sticker shock the demand will pickup again. We have been through this cycle many times where gasoline spikes 50-75 cents and then declines slightly. Once the shock wears off there is another spike to a new level. Consumers need to just get used to it. On both coasts gasoline is being seen over $4 with more frequency and we are not even into the high use season yet. National gasoline prices have risen $1.40 per gallon over the last 18 months. I ran this picture in the Option Investor commentary this weekend but I am going to repeat it here.

Palo Alto California May 1st Prices

Weekly EIA Inventory Levels

There was some conflicting news out of OPEC on Friday. The OPEC president has said repeatedly that there would not be a production meeting before September. The Kuwaiti oil minister said that OPEC may hold an extraordinary meeting on oil prices before September and did not rule out higher production. However, Libya's oil minister Chukri Ghanem then repeated his claim that OPEC countries cannot pump more oil because they have no spare capacity other than Saudi Arabia's. Ghanem has been fairly vocal of late in contradicting any OPEC related speaker that talks about increasing production. He has repeatedly said it is a baseless threat and meant only to calm those in the West alarmed by high prices. Based on the news I get I believe him. The spare capacity numbers reported monthly never seem to change but the production numbers continue to decline. Since OPEC members have displayed their lack of ethics in the past by cheating on production whenever possible it would make sense they would cheat today at $120. Those that can cheat are already doing it and those that can't are watching helplessly as their production drops. Even OPEC itself has to rely on production numbers from outside OPEC to police the group. OPEC management does not trust the numbers presented by its members either.

A long time subscriber sent me the latest numbers for gasoline prices around the world. (Thanks John!) The column on the left is the top ten highest priced countries after doing the conversion from liter to gallon and allowing for currency conversions. That makes our $3.60 per gallon last week look rather cheap. However, the column on the right is the cheapest places for gas and it should come as no surprise that they are all subsidized countries. Part of their oil wealth goes back into providing cheap fuel to help grow their economy. This cheap fuel is causing another problem and that is rapidly escalating demand. The OPEC nations themselves account for nearly 600,000 bpd of 2008 demand growth. That is more than the production from the entire Shaybah field (500,000 bpd) Saudi Arabia just spent $10 billion to bring into production. At the rate of demand growth in OPEC they will need another field of that size every year. Odds of that happening are zero. They will eventually have to quit subsidizing fuel costs to slow demand and as we know from Iran the consuming public will not be happy. Civil unrest is growing daily because of it. Subsidized gasoline is a way to pacify the people with a much lower standard of living than the kings and sheiks. Eventually that will end and it will not be pretty.

We are hearing calls from aspiring politicians to remove the Federal gasoline tax, 18.4 cents for gasoline and 24.4 cents for diesel. McCain is calling it a tax holiday and suggests removing the tax between Memorial Day and Labor Day. He was the first to come out with the suggestion. Clinton jumped on the bandwagon with her own plan only she wants the oil companies to pick up the tab with a windfall profits tax. Either way it is a bad idea. Cutting the cost of fuel will only encourage extra consumption at a time when too much consumption is causing the problem. Europe went the other way years ago by heavily taxing fuel to kill demand and promote mass transit. A politician would be committing suicide to suggest raising the tax to $1.00 or $1.50 per gallon but it would be the right thing to do if you really wanted to cut consumption, force downsizing of automobiles and reduce dependence on foreign oil.

Another option has been getting some press and that is to sue OPEC for price manipulation. There is also talk of going after OPEC on antitrust rules through the World Trade Organization (WTO). WTO rules prohibit quotas as a method of limiting exports. While this sounds like a good idea on the surface it could have unintended consequences. If OPEC members were free to do as they wanted only a couple countries could really pump more oil but others are still constrained by capacity. If the WTO tried to breakup OPEC then countries could limit investment into new production so they could not be made to pump more. It would still produce higher prices and there would be no governing organization to police the group. The absence of OPEC quotas could actually create more volatility in prices since there would be no ruling body to level out the flows. The swings from highs and lows could be huge with seasonal demand issues left unmanaged. OPEC does provide a useful function to keep track of capacity and plan on increasing that capacity to cover growth. Spare capacity is critical to taking out the severe price fluctuations caused by various events like strikes, hurricanes, equipment malfunctions, civil unrest and wars.

Today's high prices are not a function of not enough oil in the system. It is a function of not enough light sweet crude and not enough refiners to refine other grades of crude. There is plenty of heavy, sour crude to go around. If there were 2-3 more large heavy crude refineries around the world there would the prices for all grades would be cheaper. The various OPEC countries either by themselves or in conjunction with other countries have plans in motion to build nearly 2 mbpd of new refineries over the next 5-8 years. Most of those refineries will be able to process heavy, sour crude. The key here is that demand will grow by more than 1.8 mbpd each year and those refineries will already be insufficient when they are completed. After 2010 there will not be enough oil of any type to fuel them so the entire point is mute.

It's official, Russia again pumped less oil in April than they did in March, -0.4%, and less than April 2007, -0.8%. Production fell to 9.72 mbpd due to aging oil fields, rising costs and increasingly remote new deposits. They are still the second largest global producer behind Saudi Arabia.

The major oil companies on this side of the pond are having the same problem. Chevron reported earnings and confessed that production has fallen year over year by 44,000 bpd. Exxon reported its biggest profit ever at $10.9 billion but confessed that oil and gas production fell sharply, -5.6%, from the comparison quarter. Crude production fell almost 10% as higher country taxes required a greater portion of oil to host governments. Venezuelan nationalism of its facilities also caused a drop in Exxon production. Declines in production in Canada also hurt total production. Exxon is having such a tough time finding and producing new oil that they are resorting to stock buybacks to support the stock price. Their recently announced $8 billion buyback dwarfs their $5.5 billion spending on capex and exploration. That is drawing fire from U.S. House members.

Exxon repeated its claim that current fundamentals value oil at only $60 per barrel. They are analyzing future projects with the assumption of $60 oil. BP is also using $60 oil for their project analysis. Why are the two largest private oil companies still stuck at $60? Maybe because it is politically expedient to do so. Maybe because there is the technical possibility for there to be 3 million barrels per day of excess capacity in Q4 of 2008. They are expecting prices to implode as we get closer to that new production. There are several new oil platforms coming online plus three new fields in Saudi Arabia. It will probably be early 2009 before it really happens given the normal delays in these major projects. The longer they delay the less relevant that new production becomes. Every year that passes see an increase in demand of around 1.6 mbpd and a decline in existing production due to depletion of around 4.5 mbpd. We are not finding and producing an extra 6.1 mbpd of crude each year so we know how this story ends. The new production coming online in 2008 and 2009 will be insufficient to meet demand in 2010. This is the end of the story. No amount of political wrangling or OPEC posturing will make more oil appear two years from now.

Here is the global outlook for new supply as compiled by dozens of researchers around the world for the Megaprojects database. Note the large spike in 2008-2009 mainly from the addition of the new Saudi Arabia production, Brazil, Canadian oil sands and Angola. The fate of the oil sands is in doubt given the declining supply of natural gas, which is needed to heat the sands, and the new environmental rules that could halt new production.

Percentage of new supply by country

It takes 5-7 years to bring a new field online. Sometimes as long as 7-10 years for a complicated offshore field. All the new production that should come online from 2012-2017 should already be known. Unfortunately as you can see from the megaprojects graph above the drop off in new supply after 2012 is huge. You can bet there will be some smaller fields show up later with a faster startup time but the really big ones like the new Tupi field in Brazil may not enter full production until 2017-2020. Nearly all the new major finds are in seriously unsuitable conditions. They either suffer from environmental hardships like the 6 mile deep fields off Brazil or political hardships like the nationalism purges in Russia and Venezuela or both. Either way those new finds will be slow to come to market if at all.

That is the end of my peak oil rant today. I get so fired up I can't stop typing.

The Minnesota House passed a Peak Oil resolution last week by a measure of 81-7. The resolution called for the Legislature and the Governor to draw up plans for coping with peak oil. The resolution called for the Governor to "recommend funding, give direction to state departments and develop a response plan as soon as possible." Evidently the Minnesota House has been reading unapproved material. Didn't they know anybody in office is not allowed to do their own research? How dare them actually acknowledge the situation and ask for a disaster plan ASAP. Maybe there are some people in elected office that are not asleep at their desks or completely focused on pork barrel politics.

You may have seen all the press the airlines received last week after EOS filed for bankruptcy and Aloha Airlines stopped its freight service just as suddenly as it stopped its passenger service last month. The airlines claim they need to raise ticket prices 25-40% to cover fuel costs. They announced their 11th rate hike for 2008 last week. They are cutting flights and estimates are for a reduction in seats by 20% by this time next year. They are parking planes, Delta 20 full size and 70 regional jets and United is parking 30 planes just to name a couple. Routes are getting slashed with all the airlines announcing cancellation of routes. These are just the start of the headlines. OPEC's president said this week that prices could go to $150 or even $200 if demand does not slow. At $150 oil you will have six U.S. airlines. At $200 you might have two survivors. Air travel will not longer be a bargain but a very expensive luxury.

The chief economist for the International Energy Agency (IEA) Faith Birol was interviewed last week. He has gone on record that oil supplies are depleting at a faster rate then previously thought and new supplies are slowing. He predicted a disaster by 2015 is something is not changed immediately. When the IEA's latest "World Energy Outlook" was released in November the world was shocked by the abrupt change in posture. The IEA has long held that there was plenty of oil through 2030 or even 2050 if sufficient investment was available to search for it. The sudden change in posture has made Birol an unpopular person. The following comments were edited from his public interview.

Astrid Schneider:
Mr. Birol, in your "World Energy Outlook" which was published in November 2007 the IEA has warned for the first time that there could be a slump in oil production and escalating prices in the time from now to 2015. The reason you give is that there has been to little investment in oil production.

Fatih Birol:
Indeed. There are three reasons why that is so. The first one is the increasing demand, mostly from China, India and the Middle Eastern countries themselves. These countries are the main reason for the increasing oil consumption. Even if there should be a recession in the USA, this would not slow those countries down much, because India and China have a strong internal economic growth, while high oil prices will help the economy in the Middle East. The demand for oil will therefore remain high.

Schneider: The second reason ...?

Birol: ... is, that we see a sharp decline in production from the existing oil fields, especially in the North Sea, the USA and many non-OPEC countries. Even here money should be invested, to slow down that decline. The third reason why we expect a risk for overall production is, that we looked at all oil exploration projects around the world: 230 altogether, in Saudi-Arabia, Venezuela, the North-Sea, everywhere. Even if all those projects which are already funded will be implemented, the overall capacity they can bring for new oil production is too little.

How much is missing?

Exactly 12.5 million barrels a day are still missing, about 15 % of the global oil demand (the current global oil consumption is 84 million barrel a day, note from the editor). This gap means that we could face a supply shortage and very high prices during the next years.

I will forward the balance of the interview in an email on Monday. It is far too lengthy to reprint in its entirety here. The comment Birol makes about a 12.5-mbpd shortage in 2015 is a clever way of NOT saying that there will be a shortage in 2010. We are not going to suddenly wake up some day and be 12.5 mbpd short. It will start with 500,000 bpd then a million then 1.5 mbpd, etc. All hell will break lose when that first shortage appears not in 2015. Actually we will have problems just getting to that first shortage due to the nature of oil supplies. As we get closer to an actual shortage we will experience intermittent tight supplies and these will get progressively worse until they become permanent.

I am asked constantly about investing in oil futures. I buy the emini contracts for trades but I can't recommend you do that for long term holds. Because futures can go against you just like they can move in your favor you have to buy at the absolute lows in order to have any kind of safety. You cannot just tough it out knowing that in 2010 oil could be $200. It could also be $80 sometime in the near future and your $110 futures would be in Warren Buffett's terms, "financial weapons of mass destruction." If you want to buy and hold futures you need to buy ONLY on sharp corrections and then be very faithful with your stop losses.

Last week's $10 drop in oil prices and some earnings misses in the energy sector knocked us out of some positions but put us into some others. I resolved after the prior correction to be faithful on keeping the stops tighter so that is the pain we must go through whenever oil corrects.

I am changing the way I list stops. I am no longer going to list them in the play description. They will only be on the portfolio listing.

I also received some questions on why I am adding so many spread trades. That is buying a LEAP close to the money and selling one well out of the money. The reason is simply risk. With oil so volatile the price of these LEAP calls is out of sight. By selling a short call against our long call we are reducing our cost in the long call by 30-50% while giving up little in potential profits. If you do not want to do the spread just buy the long call. If money is tight you may want to move out a couple of strikes to reduce the premium. Just remember those well out of the money strikes will drop like a rock in price should a correction appear.

Jim Brown

Sign of the times cartoon

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