Option Investor

Running Out of Adjectives

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What do you say about oil when it continues week after week to astound and amaze with almost zero fundamental support? Amazing, incredible, astounding? It is all of those things and more. The Goldman Sachs forecast last week built a fire under crude that was still burning at the $126 close on Friday.

There were two news items credited with some of the hysteria. The Iran backed Hezbollah takeover in Lebanon created fears of reprisals against Iran and Syria and a threat to oil supplies.

The Wall Street Journal printed an article saying they had reviewed computer files captured in Columbia that implicated Hugo Chavez in a terrorism for hire scheme in that country.

Chavez reportedly offered the FARC terrorists in Columbia rocket-propelled grenades and ground to air missiles to shoot down U.S. and Columbian aircraft. That kind of rockets enabled Afghan tribesmen to chase Soviet troops out of their country in 1989. Chavez also offered port access for Russian arms shipments in Maracaibo for FARC's jungle bases. He offered FARC rest and recreational bases in Venezuela and state medical care. He offered the terrorists a $250 million loan payable upon the overthrow of Columbia's government. There were also records of payments of nearly $300 million to the rebels from Chavez.

Mexico and Peru are also coming under attack by FARC terrorists. In Mexico City the chief of Mexico's national police was gunned down on Thursday by FARC terrorists. The raid where the computer files were captured also provided evidence that Mexican's were being trained in Columbia to blow up oil pipelines which supply oil to America.

The goal by Chavez is to control the southern hemisphere and as long as he has nearly unlimited oil money to use as his personal piggy bank he can eventually make his dream come true.

The U.S. will likely be forced to declare Venezuela a state sponsor of terrorism and impose trade restrictions that will prevent him from exporting oil to America. Venezuela currently accounts for 12% of our imported oil. That oil would probably end up being sold to middlemen who would attempt to resell it to U.S. refiners. It is unclear if that would be allowed. It is not a choice the U.S. is going to want to make but given the more than 10,000 pages of evidence it is not one the U.S. can likely avoid. The U.S. must kill his cash cow and so he can no longer fund terror outside his borders. A side benefit could be an internal revolution that takes him out of power when he can't fund his social giveaways. Interpol is going to publish its official findings next week so time is growing short for action.

The press has been calling for Bush to quit adding oil to the strategic petroleum reserve and to start using the oil in the reserve to bring down prices. This is utter lunacy if you take the time to think through the process. The SPR is just that, a "strategic reserve" and not an oil deposit that can be tapped at will. With the potential for a stop in Venezuelan imports and a military strike on Iran there is every possibility that oil supplies could be cut drastically at some point. Bush knows this and is continuing to add to the reserve even at these high prices because NOT having oil in a time of war is worse than paying high gasoline prices. There are simply too many global powder kegs with smoldering fuses to be draining our strategic reserve. The current fill rate of 70,000 bpd is a trickle compared to the 22 million barrels per day we consume. The oil going into the reserve is a payment in kind transaction where offshore production companies allocate a fraction of the oil they produce to the SPR in lieu of royalties they would normally have to pay in cash. The government is not exactly paying $125 per barrel but giving those companies credit against their taxes.

The oil inventories this week showed a gain of 5.7 million barrels for the week ended May-2nd. This was more than three times what analysts had expected. It was the third consecutive weekly gain. You would have thought this would have slowed the spike in prices but traders ignored it.

Crude Inventories

National gasoline prices hit $3.67 on Friday and you can bet that $3.75 is not far away. Reports of gasoline over $4 are filtering in from all over the country as prices continue to rise.

As I mentioned in the Option Investor commentary this weekend you would expect oil stocks to be exploding given the high price of crude. With only a few exceptions that is not happening. Apparently investors are in shock over the spike in crude and don't want to buy the top with a "correction" due any day. Quite a few people have been in that correction camp for weeks and it never arrives.

I received an email this week with a very good analysis of oil prices based on current demand curves and future supply coming to market. This is not going to be a pleasant commentary so skip to the plays if you don't want to be depressed. This gentleman is an engineer in the energy sector. In 2006 when oil was $60 he predicted oil would cross $100 in early 2008. Numerous people told him he was crazy because an oil shock like that would cripple the economy similar to the oil shock of the 1970s. As we all know now oil hit $100 in Jan-2008. With an additional two years of data and several hundred people feeding him reservoir data and flow rates he has produced a long-term oil price forecast. He has allowed for things like demand destruction due to price. For instance a Chinese consumer cannot afford to pay as much per gallon as an American consumer so as prices rise demand in those lower income countries will slow or even decline. He has also taken into account the greater potential for governments to exercise greater control over oil reserves once the full impact of peak oil is realized. Governments will try to hoard and lockup supplies once they realize there is a limited supply. All things I have been preaching for years. He calculated that all remaining oil reserves would be locked up by country by 2030. That means very little if any remaining exports. I personally believe it will happen by 2020.

He broke down demand by sector and by country covering things like personal transport, public transportation, heating, industry, shipping, air transport, military use, power generation and crude products. Obviously he had a lot of time on his hands. It has taken him two years to develop this model. The bottom line for all these calculations is the chart below.

Oil Price Forecast Chart

I actually think he is being too optimistic. I expect $200 oil in 2010 but he is the one with all the data. I believe the hysteria factor will appear once it becomes apparent that peak oil was not a myth and has become a reality. This should produce a sharper ascent from 2010 forward and level off somewhat in the 2015 range after the government confiscation events begin to unfold. The average consumer regardless of country will not be using $10 gasoline like they do $3.67 gasoline today. Driving habits are going to change dramatically. Economies are going to fall into a global recession and that will depress demand and prices. All the data in the world today will not tell us how irrationally mankind will act in just a couple years when peak oil arrives. That chart is just a guesstimate based on reams of data but a very good guess in my opinion. Sure makes me want to sell everything I own and buy some long-term crude futures on every dip.

Speaking of futures the options on the June contract expire on Thursday and the June contract expires on the following Monday.

There was some amazing news late Friday. Petrobras is expected to issue letters of intent to acquire as many as 17 new offshore rigs. These will be new drillships and semisubmersibles. The news came from investment bankers, Simmons and Co. UBS estimated last week that it would take $600 billion, that is BILLION, to develop the Tupi and Carioca fields. This is a massive windfall for service companies. Petrobras received 35 bids for the rigs. Norway's SeaDrill (SDRL.OL) won a $4.1 billion contract last month and Noble (NE) also won a $4 billion deal. These are in addition to the 17 rigs discussed above.

Jim Brown

Sign of the times cartoon

June Crude Futures Chart - Daily

June Natural Gas Futures Chart - Daily

June Gasoline Futures Chart - RBOB Daily


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