Option Investor

Starting Over

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That makes three weeks in a row that we have been wiped out and had to start over. If I could take back all those entries as oil was falling I would gladly do it. However, buying dips is a tried and true strategy in any market. Unfortunately our dip has gone from $147.90 to $115.15 in almost a straight line. That 22% drop of -$32.75 into bear market territory was unprecedented in dollar terms in the history of crude futures. Today it appears it will continue to at least $110 if not $100. The 200-day average is $107.50.

Fortunately the equity analysts are already starting to pound the table on energy stocks even though they expect crude to fall further. While you can't tell they are turning bullish from the declining prices on the stocks the tide may be starting to turn. Nobody is going to drill less for oil at $110 than $140. That is still a major payday and before they can get production on a well planned today it will be worth well more than $150 when it hits the market.

I was struck this week by the devastation not only in the oil stocks but gas, metals, fertilizers, etc. This is truly a bursting commodity bubble and the two-week rally in the dollar has hastened that explosion.

It is even more surprising that oil continued its decline despite the continuing fire on the BTC pipeline knocking 850,000 bpd offline and the war in Georgia. BP claims the Russian fighting has not disrupted crude flows but analysts are bracing for a shutdown. Cutting off the oil would be one way to fight Georgia and have the added benefit of boosting oil prices for Russia. Even given these events the price of oil dropped $5 on Friday.

The drillers and oil field service companies are trading as though there was a glut of oil and rigs. This is definitely not true as evidenced by recent news. So far this year Brazil has deployed 29 rigs, the most in 21 years and India ordered 28 according to Baker Hughes. Those two countries accounted for 18% of the offshore rig fleet. Asia Pacific and Latin America deployed 211 rigs last month or about 68% of all global offshore equipment excluding the U.S. and Canada. Increased exploration has tripled rig rates and has the offshore fleet almost entirely booked for the next two years. Transocean said rental of their most advanced rigs increased 35% from 2007 rates to $390,400 a day. When RIG announced earnings they announced $6.45 billion in contract extensions from Reliance Industries (India) and Petrobras. $3.05 billion of that was a Petrobras contract for four rigs through 2016.

Petrobras announced another light oil discovery offshore in the same general area as those announced several months ago. The well is 230 KM off the coast of Rio de Janerio in 2,230 meters of water. The Noble rig Paul Wolff is continuing to drill the well in hopes of deeper prospects. The light oil was discovered at a depth of 5,600 meters. Petrobras definitely has an embarrassment of riches.

The IEA will release its monthly oil report next Tuesday. Expectations are for revisions to prior production estimates and a decrease in future demand estimates. The Chatham House, a British think tank, released a report last week saying a supply crunch within the next 5-10 years would produce $200 oil or higher. They claim a supply crunch will occur around 2013 even allowing for some increases in capacity over the next couple of years. The report assumes Saudi production will remain flat at 12.5 mbpd if they actually reach that level in 2009 and that the capacity of the other OPEC countries remains flat after 2008. With several of them already in decline that is a reasonable assumption that the others cannot produce enough extra to actually overcome that decline. The report claims there is enough discovered oil to overcome the shortage for years into the future but that resource nationalism and insufficient investment into national oilfields were preventing that oil from being produced.

The drop to $115 last week reloaded the portfolio with a few more energy stocks and most entries were Mon/Tue with declines muted for the rest of the week. RIG was an exception. RIG fell $4.22 on Friday to $127 after holding above $130 for most of the week. When great companies making billions of dollars with backlogs out to 2016 are being knocked for major losses it is not rational trading. It is another prime example of funds being forced to sell whatever has value to make up for falling prices elsewhere. If you were a hedge fund manager amassing a fortune in crude futures over the last year as weekly estimates of higher and higher prices propelled those futures higher you were a happy camper. Now that the trend has reversed it is panic time as margin calls from those declining contracts eat into your other investments. Multiply this by several thousand funds in varying degrees. The volume on the crude futures has rocketed higher over the last several weeks as amassed portfolios have been dumped. Eventually every market will become oversold just as much as it was overbought before. We just have to wait out the change in direction and the pain at the fund rather than the pain at the pump.

Crude Oil Chart with volume

I thought you would get a kick out of this graphic from the McCain campaign. In response to the McCain pledge to increase drilling in the U.S., Obama suggested Americans could save money on gasoline by over inflating their tires. The McCain camp was quick to jump on that comment with a promotion to get your free Obama tire gauge with a contribution to McCain.

Readers Write:

Hi Jim, You have got my curiosity peaked with a statement you made in your August 2nd 2008 Leaps Trader article. You made the statement, "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." I would be very interested in you going into some depth as to what you meant by that statement. Unless I have missed something you may have said in one of your previous articles I do not recall you ever saying that you believed that
there was any manipulation here. Also, if you believe that it may have been "helped along" by OPEC nations, could you please explain how you think that may have happened? I greatly value your opinion and truly enjoy your writing and will eagerly await any form of answering this question for me, be it in the readers write portion, or addressing it outright in the newsletter or
responding to this email. Thanks for All You Do,


Glad to try and answer that question. I wrote several months ago of a rumor circulating in the markets about OPEC countries manipulating the price of crude through the futures market. Without rehashing that entire piece the principle was simply this: OPEC produces roughly 30 million barrels of crude per day. They are active in the futures market. Maybe a little too active. They have inside knowledge of how much crude "is being produced" and when it will get to market. They know how much is headed to the U.S. and will be reported in the weekly inventory numbers. Their sovereign funds control hundreds of billions in investment dollars. The rumor making the rounds was that several sovereign funds were making buys in the futures market at the same time across different exchanges when they needed the price to move in their favor. Given the leverage in the futures market and the amount of money these funds control it would be a simple task to keep an upward pressure on the price. If you knew in advance what oil was being produced and delivered you could time the buys to coincide with the events. Add a few dropped hints here and there and comments from the Saudi king about not producing any more oil and you have an instant price spike. You continue to preach the "no more production, the market is well supplied" mantra whenever the price starts to weaken. You unload your contracts in an orderly manner and get ready to repeat the process.

Obviously there is no way to substantiate this rumor. I was curious if the CFTC was going to uncover any of these trades but given the massive amount of hedging the OPEC countries undertake, a few thousand contracts here and there would go unnoticed. That would be especially true if they were actually doing it as a conspiracy as one rumor alleged. I was ridiculed for reporting on it the first time and I am sure somebody will take offense again this time. "Surely this is not possible given the tracks in the system." Surely you jest. The system has more holes than Swiss cheese given the number of markets, players, futures instruments, options and the volume of the commodity actually traded. Do you really trust the Arabs to deal straight up? Why do you think they won't release reserve numbers? Why do you think we get 84 answers to every question from dozens of spokesman and insiders with information given anonymously? Even OPEC itself has a stated goal to maximize the price of oil at whatever the market will bear. Not what it costs them or a fair profit but at whatever level the market will bear.

I may be predisposed to believing in the rumors simply because I read so much research and recognize what a crock of crap is produced as "official" by the various OPEC countries. Heck, even OPEC has to depend on outside sources for production info because their own members lie to each other in their reports. Of course I know they would not conspire to cheat the U.S. consumer because they love us so much. They are happy as heck that we invaded Iraq and upset their applecart with a potential democratic state in their midst. I personally believe that the price of oil today has a lot to do with payback by the Persian Gulf nations for our interference. Could I see them attempting some subtle intervention in the global futures markets? Heck yes! When you already control 35% of the world's daily production it would be a simple process to manipulate prices. I am sure many readers will think I have lost my focus here but then I don't believe the high gasoline prices in the U.S. are the fault of Exxon either.

Jim Brown

(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

September Natural Gas Futures Chart - Daily

September Gasoline Futures Chart - RBOB Daily


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