Option Investor

Selling Over?

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After eleven days of selling the bears rested. From $147.90 to $120.42 it was the biggest dollar drop ever in the history of the futures contract. In the three days since the plunge ended there have been some serious bouts of volatility but $122 appears to be holding as support. This is where we expected support to appear but the sellers are still with us. Three times in three days the contract has rallied to $127 but all three times it was sold hard and pushed back to support.

The normal news items don't seem to be having the same impact as they did over the last three months. Violence in Nigeria has had no impact on prices even though Shell had to declare force majeure on August and September deliveries of Bonny light crude. Mexico told Valero it would be delivering 15% less crude to the Texas refinery for the rest of 2008 and probably even less for 2009 and nobody even blinked.

The one news event that is having an impact on prices is the increasing tensions surrounding Iran. Iran's president said on Saturday, the deadline for giving the U.S. group an answer on halting nuclear enrichment, that "Iran would not retreat one iota from its nuclear rights." Syrian president Bashar al-Assad arrived in Tehran on Saturday for talks with Ahmadinejad including a plea to halt the nuclear program.

Israel warned on Friday that Iran was reaching a critical point in the nuclear process where they could have weapons potential by 2010. The comments while the market was open on Friday caused a $5 spike in crude. As the U.N. deadline passed on Saturday several of the spokesmen for the P5 countries were quick to play down the missed deadline saying we don't care if they take a few more days, the important thing is that they agree to halt. I guess my question would be why give them a deadline if you are not going to stick by it? That just gives Iran more leeway to stall for time on future deadlines.

In the U.S. the "Stop War on Iran" coalition of activist groups staged rallies around the country in an effort to stop what they called was escalating moves by the Bush administration and Congress to promote war against Iran. One of the measures they want to block is House Resolution 362, which they claim would call on the president to blockade Iran by air and water to force them to halt enrichment without going to war. Nine cities were targeted by the group.

Protestors near Times Square on Saturday

The bottom line on Iran is the increasing news surrounding the latest U.N. deadline and the potential next move for the P5 group. One option being considered is a blockade of gasoline being imported into Iran. Iran imports a large portion of their gasoline due to a lack of refining capacity. If gasoline supplies were cutoff it would cause a significant problem very quickly. Iran may retaliate to any gasoline blockade by cutting off oil exports. Iran exports 2.4 million barrels per day. It remains to be seen if they can afford to lose the income from a halt in exports.

There were increasing comments in the news over the weekend about the coming OPEC meeting in September. Several OPEC member countries want OPEC to enforce the quotas and force those countries currently over producing to cut back on production. For countries that cannot meet their current quotas or are currently at their quota the excess production by others is forcing prices lower. Saudi Arabia would be the biggest offender and one of the biggest reasons for the recent drop in oil. I would be hostile if oil sales were my main source of revenue and I was limited in my production while other members of my elite group were flooding the market with excess oil to push prices lower. I can see where this could cause some hostility among the members. I would expect this to become a bigger story as we get closer to the September meeting and any story about enforcing quotas should support prices. Saudi has always said the current excess production was just temporary so I would expect it to be cut before the September meeting.

After researching the various views on the direction of oil next week I could build an equal case for either direction. When I look at the chart there is very strong support around $122 but it is also clear we have had a super spike in crude and even the $27 drop over the last two weeks may not have been enough to compensate for the gains. While I want to see support at $122 it may only be wishful thinking. Several analysts were calling for a dip to $110 soon with that level being a potential bottom. I believe if $122 breaks we will see $100 rather than stop at $110. As a consumer a drop to $100 would be great and I would love to see gasoline back at $3.50. As an investor I would not complain either because of the great entry points it would produce ahead of winter. It would stop us out of every play we own and that would be painful.

On the fundamental side we have seen a substantial decline in demand due to the high prices. This is to be expected as each price plateau is reached regardless of how high we go. We have seen in the past at levels a lot lower than $3.50 gasoline that consumers have pulled back on every price spike. Eventually they become accustomed to the higher prices and demand returns. It is just like a vaccination. Every spike followed by a dip inoculates consumers for the next spike.

Peak Oil analysts have long expected the peak to be more like a plateau rather than an inverted V. As ultimate production slows prices increase and demand slows. This lengthens the onset of the peak by diminishing demand at the same time production is slowing. People don't understand that peak oil is different from excess demand. We could still see oil production climb over the next two years but at a rate slower than that of increasing demand. If demand outstrips supply we could have peak oil conditions before production actually peaks. The closer demand is to supply the higher the price regardless of the reason.

The plateau crowd suggests that higher fuel prices will slow demand and create an "undulating plateau" where rising prices and rising demand are constantly changing as consumers come to grips with their fossil fuel future. Every price spike produces lower demand but increasing demand from other sources rapidly absorbs every dip in prices. Eventually it will all end the same. Once peak production passes the price spikes will become more severe and demand will begin a permanent decline due to rapidly rising prices. The ever-increasing demand cycle will be broken once and for all by price. John and Jane Doe will be forced to take public transportation or move closer to their jobs. Teenagers will no longer be able to afford the automobile as a right of passage. How much will you and your kids be driving if gasoline was double where it is today? It will double within months of reaching peak oil. The current target date for peak oil is 2010. Time is running out to make plans in advance of the event. Where will you live when gasoline is $10 a gallon? What and where will you be driving?

Fortunately for next week we don't have any of those worries. Our biggest concern will be support at $122. If the Fed does not raise rates at the Tuesday meeting the recent rise in the dollar should end and that would be bullish for oil prices. Conversely if they do raise rates the dollar should get stronger and could threaten the 74.0 level on the dollar index. A breakout there would severely pressure oil prices without a geopolitical event to provide support. Oil is seen as an inflation hedge against the dollar and that relationship has lasted since the dollar began its decline back in Nov-2005. I don't give as much weight to the oil/dollar relationship as most other analysts but without any other global event supporting prices it could make the difference between support holding and collapsing.

Lawmakers failed to pass any laws regarding speculative trading before leaving for the summer and that means anyone who exited large positions just in case are now free to start over again. According to the CFTC the majority of speculative traders and commercials are now short. That means the tide had turned for sentiment but I am wondering if that pendulum could be ready to swing back into the bulls favor given the Iran problem and the talk about enforcing OPEC quotas.

On the bearish side oil prices have fallen sharply with every recession since 1974. If the U.S. economy continues to weaken we can count on lower oil prices. However, we saw the GDP strengthen in Q2 and employment has remained out of recession levels. Greenspan said last week that a recession was still very likely but his recent mental lapses has made him far less accurate as an economic barometer.

Jim Brown

Readers Write:

I just can't seem to grasp the "critical support level $122" as it applies to a "we don't have enough of it to meet demand" commodity. If you say it would go to $110 due to demand destruction, and the data around the world shows that, I understand. Otherwise, it sounds like the speculators really are propping up the market artificially.


Now you know how I feel. The problem is always the timeline. Today there is enough light crude production to meet demand. The excess production is in the heavy, sour crude variety. This is confusing to almost everyone who does not fully understand the oil market. OPEC goes to great lengths to disguise this fact by never discussing the shortage of a particular grade. The market is always "well supplied" in their view.

The spike we saw this summer was artificial. I believe there was some market manipulation involved. However, when supply and demand are so close to equal it does not take much to manipulate prices. A little truth goes a long way in a manipulated market. Personally I believe the OPEC nations always have a hand in the futures market and could have "helped" the price along.

Baring any hurricanes the next month or two is typically a declining period for prices as peak gasoline demand ends and refineries switch over to winter blends and add more heating oil. As fall arrives the price of oil should again rise but I doubt it will hit the prior highs.

Everyone needs to remember that the next 18 months will see a large inflow of new crude production. In the Megaprojects Database below (http://en.wikipedia.org/wiki/Oil_megaprojects) you can see how much new oil came to market over the last five years and how much is scheduled to come to market over the next six years. Remember it takes 5-8 years for a large project to be completed and in may cases 8-10 years. The larger the project the longer the period before it goes into full production. There are always major delays in almost every planned project. A year ago the projections for 2009 were much higher than today's 4,636,000 bpd total. Many of those projects have slipped into 2010 and boosted that year to 5,330,000 bpd. Remember also those are just estimates of production. Actual production can differ greatly from estimates and normally it is lower.

If it takes 5-8 years for a planned project to come online then we know about those projects 5-8 years in advance. That means new discoveries known today will not come online until 2013 to 2018. Notice how drastically the new production estimates drop after 2010 because of the lack of any new discoveries.

Megaprojects database

Annual depletion is running about 4.5% per year according to the recent estimates by the IEA. With current production around 87 mbpd that equates to 3.915 mbpd day per year. That means we have to add more than 3.9 mbpd in new production every year to actually increase total production. In 2008, 2009 and 2010 we will add net production 1.6 mbpd, 721 kbpd and 1.4 mbpd respectively.

As of July 1st the IEA claims "Global demand for oil products will grow by an average of 1.6% per year to 2013, from 86.9 mb/d in 2008 to 94.1 mb/d. Contrary to supply trends, demand growth will be weakest in the first two years of the period, building as global GDP growth strengthens from 2010 on." That is roughly 1.4 mbpd of demand growth.

In the table below and using the IEA projections I extrapolated the ultimate demand and production for the next six years. The decline in demand growth due to prices has pushed the theoretical arrival of peak oil into 2012-2013. Unfortunately production growth is a very elusive target. Things happen every day to delay new production and accelerate production declines. For instance Mexico began declining at 12% per year two years ago and the North Sea jumped to 10%. Venezuela production is dropping sharply due to declines in technology, expertise and equipment after nationalizing the sector. Russia entered a decline phase in Q2 after 10 years of growth. Nigeria has lost 1.3 mbpd of production due to violence. These types of problems will continue to degrade actual production from the theoretical maximum. That could easily drag the peak date back into 2010.

Now remember that the majority of excess production is heavy sour crude that very few refineries can use. How much of that crude is represented in these numbers if unknown. It is obvious that just a very small portion of 2-3 mbpd would be enough to upset the apple cart and accelerate the peak event even closer.

IEA Demand and Production Chart

So, the short answer to your question is, Yes. The market was being propped up artificially to some extent BUT there was a strong underpinning of fundamental support. We are not at peak oil today but depending on the actual ratio of light to heavy crude we could be nearing Peak Light and that would be almost as damaging as total Peak. We will not know until it happens because nobody has the exact data for an industry that has a million moving parts.


(I am going to try and make this a weekly feature. Send me your email questions and I will try to answer. Jim @ OptionInvestor.com)

September Crude Futures Chart - Daily

August Natural Gas Futures Chart - Daily

August Gasoline Futures Chart - RBOB Daily

Qcharts gasoline chart unavailable this weekend.

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