Option Investor

Do We Dare Try Again\?

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Oil hit $127.82 on Friday with expiration of the June contract on Monday. Do we dare try another short on the USO or just plan on buying the dip? I think I would rather ponder the meaning of life than try to pick a side on that trade. Oil refuses to decline and Goldman analysts have made it a personal challenge to see how high they can push prices. Obviously Goldman's trading book is heavily weighted in oil for them to continue to pound the table for higher oil prices. Do we dare go against them?

On Friday Goldman Sachs upped their forecast for the average price of oil in the second half of 2008 to $141 per barrel. That is the expected average price so there has to be higher prices for that to be an average. That suggests $150 and the bottom range of their super spike theory as the potential lower end of the upward range. Is that confusing? What I am trying to say is that Goldman expects highs of at least $150 in order to get a $141 average. Their super spike theory goes to $200 so there is plenty of room on the upside if they are right.

The new forecast sent oil prices to nearly $128 despite two other events that were ignored. Saudi Arabia announced during President Bush's visit that they had increased production by 300,000 bpd to 9.45 million barrels per day. This increase was to offset production declines by other OPEC nations. It was also just a token amount but traders ignored it completely.

The second announcement was the Energy Dept saying they were not going to contract for any SPR deliveries for six months beginning July 1st. That theoretically puts an extra 70,000 bpd back on the market. Since it is only 0.004% of our daily needs there was good reason for traders not to get excited. As I have said before the SPR deal is just pabulum for the masses and a way for lawmakers to show they really care about high gasoline prices. Don't make get me started on that rant.

It cost more to take that holiday trip next week with national gasoline prices hitting $3.787 on Friday and diesel reaching a record of $4.482 per gallon. Since prices are normally the highest around Memorial Day I think there is a very good chance we will see $4 gasoline. Now be honest. When we were discussing $4 gasoline a couple months ago at $3.25 did you really think it would happen? Better yet, did you think it would happen before the arrival of peak oil? I doubt it even the confirmed peak oil followers expected it this year.

OPEC claims there is plenty of oil in the system and yet there is not enough to go around. Why is that so? I have explained this many times in the past but not for several months. All oil is not equal. There is light sweet crude with very little sulfur that is easily refined into gasoline. There is heavy sour crude that flows slowly and has very high sulfur levels. Only a few refineries can refine this grade into gasoline because of the extra and expensive processes necessary to remove the sulfur before it becomes gasoline or diesel. There is also a variety of grades in between. A single refinery is built to process a specific kind of oil. If it is setup to refine light sweet crude then it cannot refiner heavy sour because the processes are different. That is a simple explanation but there are dozens of variants. Suffice to say that a refinery can only process certain grades of crude and no others. This is the equivalent of you pulling into a filling station for regular unleaded and all they have is diesel. You can't use it even if it was selling for 10 cents per gallon. If you don't have gasoline you can't drive. Period.

There is plenty of oil available in the world. Unfortunately there is a shortage of light sweet crude. For instance Iran is drowning in sour crude at present for what was initially thought to be a refinery down for maintenance reasons. There are tankers with more than 28 million barrels of Iranian crude parked in the Persian Gulf waiting for that refinery to restart. It turns out that may not be the problem but I will get to that later. Iran pumps 4 mbpd and exports 80% of that oil. It is heavy sour crude with few refineries capable of using it. That parked oil has increased from 20 million barrels to 28 million in just the past week. Plenty of oil but no place to go. Some analysts wonder if this excess oil is the result of U.N. sanctions finally taking hold. We found out on Friday that Iran had just contracted for another VLCC from Singapore's Tanker Pacific. Nobody really knows why this oil is just parked in the gulf and costing Iran $56,000 per day per ship to just sit there. (I will pose another scenario later.)

Venezuela's oil is also a heavy crude with very few refineries built to process it. If the U.S. suddenly cut off imports from Venezuela they would be swimming in oil very quickly with nobody to buy it.

When OPEC says there is plenty of oil in the system and they can't find buyers for all of their supplies they are actually telling the truth. They are just not telling the whole truth. There is a surplus of sour crude and a shortage of sweet crude. When you see us talk about the price of oil that is the price of sweet crude, which is the benchmark for oil prices. Everything else is priced at a discount to light sweet crude. OPEC has complained for years that there is not enough refining capacity around the world to take advantage of all the crude available. They are completely correct. If there were a dozen more refineries capable of processing sour crude then there would be no oil shortage today. In a couple years definitely but not today.

So how do we capitalize on this fact. Normally I would say buy Valero because they have the largest sour crude refinery capacity in the states but with oil prices so high even they are having trouble making money.

Short of trading oil futures the next best thing is to buy the USO on dips and continue to invest in the deepwater drilling sector and service companies. The majority of oil found in the Gulf is sweet crude however some of the deeper discoveries have been heavy crude. Regardless of the type of oil found the only politically free zone left to explore is the oceans. Countries are going to be forced to rely on the drillers to explore offshore because the countries of the world simply do not have the technology to do it themselves. Mexico just spent $150 million to drill a dry hole in 3,000 ft of water and that is the extent of their technology. Over 3,000 ft and they are out of their league. Petrobras is launching a monster spending spree to enable them to drill hundreds of wells to 26000-30000 feet in 7000 feet of water over their new discoveries. The beneficiaries are going to be RIG, NE, DO, SeaDrill and others in the sector regardless of whether they get a Petrobras contract or not. Whatever equipment Petrobras ties up for the next ten years of drilling will not be available for other projects. It will cause a tremendous ripple down effect in the sector.

When do we invest more? Historically gasoline prices decline after Memorial Day. Nobody knows if that cycle will appear this year or not but there should be some traders trying to speculate on that trend. If gasoline falls so will crude. It may only be temporary but this suggests we should be ready to buy the dip when and if it comes.

Following the dip in May the price of crude typically rises into hurricane season, which begins on June 1st. I know you are probably saying what dip? Picking direction in today's volatile market is a crapshoot. Personally I think we should try to short the USO one more time at Monday's close. Then we need to target a dip to get long again for the summer in both the USO and some more energy stocks. If you do not want to take the risk in the short then don't do it. You are in control. I lay out the potential plays and you decide which to bet on.

I regret to inform you that Fluor (FLR) did not trigger our watch list entry before spiking +$30 on their blowout earnings report. Actually if I had put a breakout trigger on FLR it would have been ugly. We would have been filled at the absolute high on a $30 gap open. From my perspective here missed money is better than lost money. We did get a good entry on FWLT off the Fluor news so all was not lost.

Iran musings: Iran now has 28 million barrels of crude parked in the Persian Gulf. Why? Here is where the plot thickens. You may remember Iran threatened to cut production last week and that sent oil prices soaring before the claim was softened. Is Iran just waiting for oil prices to go higher to get a better price for their oil? Was the production cut rumor a way to jack up prices even higher? Surely they would not take this big of a gamble worth billions of dollars with a plan to bluff prices higher. Absolutely they would! They tried this exact strategy in 2006 and failed. Beginning in March of 2006 Iran started making threats that they were going to cut production while storing 20 million barrels of crude in tankers parked in the gulf. Unfortunately for Iran instead of paying Iran's higher price for crude there was enough oil on the market then for traders to just buy elsewhere. Iran's bluff did not work and they ended up selling it at a huge discount to Shell and India's Reliance. It appears Mahmoud Ahmadinejad is so desperate for money to keep his regime alive that he is trying the same trick and with Saudi willing to pump more of a higher quality oil it appears Iran is going to lose money again. Iran is in economic trouble with 45% of the population kept inline only by heavy subsidies and military force. The other 55% are ethnic Persians. Iran is extremely vulnerable right now. If the U.S. was able to pressure Iran's primary oil buyers (Japan, China, South Korea and Italy) to look elsewhere for another month or so then Iran would really be in trouble and the regime could fail. 80% of Iran's revenues come from oil and for whatever reason it is not selling. Now might be the time to tighten the noose.

Jim Brown

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