Option Investor

Ready To Expire

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It was another crazy week in the energy pits with intraday volatility making it almost impossible to trade. $5 moves are common with major reversals appearing daily. You can tell we are closing in on expiration. The crude options expire on Tuesday and July crude futures cease trading next Friday. That alone would be enough to create volatility without the weekly inventory reports.

Wednesday's inventory report showed crude inventories falling another -4.6 million barrels to extend the decline to four weeks and -23.6 million barrels. This pushed inventory levels to 13.5% below 2007 and a -7% drop in only four weeks. Imports were relatively unchanged which suggests the current level is too low to support current demand. Refinery utilization fell a point to 88.6% from the prior week's 89.7%. I believe the refiners are reluctant to add to inventories at the current price. They don't want to be stuck holding millions of barrels of high priced oil if a correction suddenly appears. They want to be able to buy any dips rather than inventory at the top.

Weekly Inventory Table

Prices close the week at $135 with gasoline prices at a new record of $4.07. It will take at least $4.15 to compensate for $135 oil and possibly $4.25 by July 4th. Ironically the EIA report showed that gasoline demand rose to its highest level since Dec-21st, 2007. This number was skewed by the Memorial day traffic patterns but suffice to say there has not been as much demand destruction due to price as everyone thought.

The weekly MasterCard Spending Pulse Survey has been pegging gasoline sales at about 4.5% below the same period in 2007 but I believe that is due to more cash purchases of gasoline. Consumer credit cards are maxed out and $75 fill ups are causing many to resort to paying cash.

Nigeria took control of the joint venture with Shell in hopes of avoiding some of the anti-oil violence. Analysts said this could cause a further drop in supply since Nigerian workers did not have the same skill level as the displaced Shell workers. Also providing volatility to prices were fears of a strike on June 18th by Nigerian workers. If the Pengassan workers walked out it could cut production by another 350,000 bpd.

The Financial Times ran an article on June 12th suggesting that speculators were not to blame for high prices. Refiners are paying record prices for the high quality oil they use to produce diesel and gasoline. This is a sign of strong demand in the physical oil market and calls into question the claims that speculators are causing the problem.

Refiners are paying a premium of up to $5-$6 per barrel on top of the current price to secure high-grade oil. This is double the premium from a year ago. The price of physical oil has gone largely untracked since reporters typically report on the futures. While refiners are paying a high premium for light crude they are also getting a huge discount for low-grade oil.

The premium for Nigeria's high-grade Bonny light oil has surged to $4 per barrel, up from $2.50 a year ago. In the same period the discount for low-grade Iranian heavy oil has widened to $13 from $7 last year.

The split in actual price for light compared to heavy explains OPEC's reluctance to boost production since most of the OPEC oil is the low-quality oil. It also highlights the lack of refinery capacity for heavy oil, low-quality oil. It is tougher to refine into low sulfur products like gasoline and diesel. The shortfall in Nigerian production over the last year has complicated the refining market. Nigeria oil is light crude and is in high demand. Unfortunately rising amounts have been taken off the market due to MEND violence.

I have given this example many times but for the sake of new readers I will repeat it. Different refineries gear up for different types of oil. Some can only process the light sweet crude and some can process the heavier grades. Refining the heavy crude from Venezuela requires a different process than the heavy crude from Saudi Arabia. Each field has a specific characteristic and the refiners must create a process for that specific oil. This means they need to have a steady supply of that oil before they are willing to make the investment.

A refinery that can only process light crude physically can't use a heavy sour crude. They simply do not have the proper equipment to process it. It is the equivalent of pulling into a filling station for unleaded and all they have is diesel. Your car simple cannot use diesel regardless of the quantity and price. It could be 20-cents a gallon and you could not use it. This is the same way with the different refiners and different grades of crude.

This is also why there is such a premium on light crude. This is the lowest common denominator for oil. Almost any can process light crude but very few can process heavy crude. Light sells at a premium and heavy at a big discount. If the global price of oil was set by the cost of Arabian heavy crude we would be talking an entirely different price range because there is plenty of extra heavy crude. There is a shortage of light crude and unfortunately that is the benchmark product.

Volatility is telling. I believe that the current volatility is telling us that we may be near the top in price without some news event to power us higher like a gulf hurricane. When prices swing so much intraday it is because there is a wide difference of opinion and major players are entering/exiting the market. However, the chart is showing us a pennant continuation pattern that fits in very well with the Morgan Stanley $150 by July 4th prediction. A breakout of the pennant to the upside targets $148.

With all the commentary about futures regulation for speculators and putting rules in place on the ICE futures exchange and the Saudi Arabia meeting on crude there is plenty of reason to find another commodity to trade. If you are just a trader then corn or gold is just as profitable as oil. Granted the fundamental basis for oil was a market mover but we are moving into an 18-month period where there will be a lot of new production coming to market. It is after 2009 when serious shortages are going to develop.

There are no hurricanes on the horizon and we still have a week before the Saudi oil meeting. Unless there is a sudden news event next week it will be up to the options/futures expiration to provide motivation to trade. Remember Morgan Stanley predicted $150 by July 4th. It will be interesting to see if that comes true given the current calendar of events.

Don't forget the Association for the Study of Peak Oil (ASPO) is holding their annual conference in Sacramento on Sept 21-23rd. This is a full 2.5 days of intensive, as in 8:AM to 9:PM information overload from dozens of experts from around the world on the status of Peak Oil. The cost is minimal at $325 because they are a non-profit and make no money on the event. Follow the link below to register and join me there. We can discuss each presentation and plan trades for the coming year. Put my name in the "how did you hear" box so they can group us together for the meetings. Go here to register:

I am removing the Apple/RIMM covered calls from the newsletter after today. We are at max profits on both and baring a complete meltdown on Apple due to Steve Jobs health we should stay that way until expiration. There is no reason to continue the coverage for the few people who own the position.

Jim Brown

July Crude Futures Chart - Daily

July Natural Gas Futures Chart - Daily

July Gasoline Futures Chart - RBOB Daily


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