Option Investor

End In Sight\?

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Is the end of the bear market for oil in sight? Oil continues to set new lows every couple days but the rate of decline has slowed. Friday's dip to $111.34 was likely the result of crude options expiring more than a continued desire to dump crude. Volume in the September contract was the lightest in the last two weeks. Of course that contract expires next Wednesday so a lot of that volume has already moved into the October contract.

On Friday afternoon tropical storm Fay was headed west just south of Cuba and the National Weather Service had it turning north and crossing over Cuba on Monday and heading up the western coast of Florida. That would pose no threat to the oil patch but part of the closing spike in oil was probably related to that storm. Some forecasters were predicting a more westerly path for Fay that could have taken the storm closer to New Orleans. I would not have wanted to be short oil over the weekend to find Fay headed for New Orleans when the futures opened Sunday night. As I update this paragraph on Saturday afternoon the NWS is now forecasting a track with a sharper move north and pretty much right up the center of Florida so it appears any concerns were unfounded.

OPEC updates its 2009 demand growth forecast on Friday and they are projecting the lowest rate of growth in seven years. They estimated growth at +1.03% but raised estimates of daily demand in 2009 by 90,000 barrels to 900,000 bpd over 2008. OPEC now believes demand for 2008 will increase only 1 mbpd over 2007 and 30,000 bpd less than their prior estimate. "Risks to the outlook for the world oil market appear to be on the downside," OPEC said in its report. "The outlook for the world economy has deteriorated further as more evidence of a global slowdown emerged. With current OPEC production well above the expected demand for OPEC crude, there is potential for a sharp build in crude inventories." This is a key statement ahead of the Sept 9th OPEC meeting on production quotas and suggests they will be talking about cuts in production again.

In the weekly Bloomberg survey of 30 analysts 63% said prices would rise through Aug-22nd. It was the most bullish response since Dec-2006. Seven analysts said oil would be unchanged and only four expected a drop in prices. Last week 37% expected a decline and 34% expected an increase.

On Friday Goldman Sachs said oil will remain supported above $105 and is likely to rebound as emerging market demand holds up and production from older fields declines. "Mounting signs of strength in oil fundamentals provide support and suggest significant upside risk to prices in the autumn," according to Goldman. Goldman predicts crude futures on the NYMEX will trade around $143.50 a barrel within three months, at $148.10 within six months and around $147 a year from now.

BP said on Friday they don't know when the BTC pipeline will reopen because they have not finished assessing the damage and cannot predict the time needed to make repairs. This pipeline is capable of moving 1 mbpd but recently has only had volumes of 850,000 bpd. The second pipeline in the area remains offline due to security concerns from the Russian/Georgia conflict. There are some really strange comments coming out of Russia regarding the pipeline. An adviser to the Russian parliament claimed the closed BTC pipeline would not be opened again and declared the line "dead." "The world and countries in the region have seen that not NATO, but Russia is the only one who could secure the energy routes," Alexander Dugin, international politics advisor to the Russia's Duma, told Turkish Cumhuriyet daily. "In this context, regarding Turkey's energy politics, it should be said that the BTC is not running at the moment and it will not run again." If this is the case then we should know very soon and oil prices will rocket higher. Russia has already demonstrated they are capable of cutting off natural gas flows to Europe whenever they feel like it and taking the BTC pipeline offline would make Russian oil more valuable.

BTC/Supsa Pipeline Map

Shell said it was not making any progress on repairing the damaged pipeline in Nigeria. "Repair work is not progressing as much as we want due to security concerns. We are making no real progress," a Shell spokesman reported. Shell has claimed force majeure on output from the pipeline through the end of September. This is a light crude pipeline and continued outage will eventually impact global inventory levels of light crude.

It appears to me we are setting up for a rebound in crude from a fundamental perspective. Russia is claiming the BTC pipeline is dead. Shell is making no progress on repairing the Nigeria pipeline and OPEC is already setting us up for production cuts at the Sept 9th meeting. Demand will return with gasoline at $3.75 simply because the price shock will fade. Drivers will adjust to the new price and the cycle will repeat.

Crude prices have over corrected but they could easily correct further before this cycle ends. The super spike may be over but the oil problem has not gone away. Peak oil theory predicts an "undulating plateau" where shrinking supply growth causes higher prices before the actual peak in production is reached. Those higher prices cause slower demand "growth" and lengthens the time before demand exceeds production. Each price spike is short lived but removes some percentage of demand. Each rebound increases demand until the price spikes higher to repeat the cycle. Eventually underlying demand exceeds available production despite constantly rising prices. The production shortfall can come before the actual permanent peak in production if demand from emerging markets continues to grow at a rate faster than production grows. Peak oil theory does not predict a sudden climax spike in production as the last field comes online and then everything tanks at the same time. We could have increasing production at a very minor rate for years to come just not at a rate sufficient to keep up with rising demand. The end result is the same. Oil prices at double or triple today's prices and a rapidly declining global economy. Once cheap oil turns into expensive oil the economic explosion we have seen over the last 60 years will come to an end.

I profiled the new production coming online in 2009 in a LEAPs newsletter a couple weeks ago. That surge in production should begin in the fourth quarter. If Russia is determined to take the BTC pipeline out of service then the new production will only offset the lost production from the Caspian that flows through that pipeline. In 2009 when the new Saudi field comes online there is no guarantee it will come to market. OPEC has tasted $145 oil and that makes $113 oil today a bitter pill to swallow. If they actually start planning production cuts at the September meeting then I would not expect the new Saudi production to make any difference. They are going to manage the price of oil as they always have and I don't see any prolonged dips under $110. Barron's was predicting $50 oil last week and I think we can all agree that writer was on drugs when he penned that piece.

I hesitate to add any new oil plays with oil still falling. Even though I think we are very close to a bottom I thought that at $122 as well. It may be different this time thanks to Russia and the coming OPEC meeting but we need to see the trend change rather than anticipate it. I doubt we are going to see another spike this year contrary to what Goldman is predicting. I believe prices will remain high, possibly in the $120-$130 range but I would not be surprised to see that bottom number as low as $110. We need to remember that $110 oil is still expensive oil. The oil companies are still going to be making piles of money and the drillers are still going to be backlogged for years to come. Once the shock of the price drop has eased there will be a new wave of investment into energy companies. No other sector will have as reliable a source of income as energy. We just need for that price drop shock to pass before conditions normalize and investing can begin again.

Jim Brown

Readers Write:

Well, there has been a nice little pullback in the price of natural gas. When reading the transcripts of conference calls with the major natural gas producers, there seems to be a difference of opinion as to how much gas and how fast the new areas of discovery will generate. The market has obviously concluded: A lot!

I am focused on another point. There seems to be general agreement that about 30-40% of gas produced has come from wells that are "new." They also seem to agree that the depletion rate of some of these newer wells is close to 40%. This is what I call a self-governing gas price principle. At $8.00, sharp reduction in wildcatting and combined with 40% depletion means a lot less gas. Correct? Len

Len, you are absolutely correct. We are seeing an explosion of new gas today with the Haynesville Shale starting to be drilled and other shale plays starting to be explored. The very high depletion rate for new wells makes this seem like a sudden abundance of supply but as I have pointed out in the past it is only a temporary condition.

One of my sons works on a gas rig drilling in western Colorado. Every 26 days they complete a new 12,000 ft hole. He has a new "walking" rig that moves around on the pad and they can drill up to 20 horizontal wells without taking down the rig and moving to a new location. When the rig does move and the production crews move in to complete the wells and connect them to the pipeline the initial production is huge. All of these new wells come online at once and there is an immense burst of new gas. Multiply this by the 1,586 working gas rigs in the U.S. and the amount of new gas is huge. Obviously only a few are the new walking rigs but even with a single well rig the concept is the same. BHI said there were 395 working oil rigs last week in addition to those gas rigs. On a side note the total active U.S. rigs was 1,990. That is still a far cry from the peak of 4,350 in 1981.

For every gas well that drops 40% in the first year another one needs to be drilled to offset that drop. Remember demand is rising faster than ever and with the new push by Boone Pickens to switch to nat gas for autos it will grow even faster a couple years from now. Basically the gas sector is enjoying an embarrassment of riches right now with the new shale plays. Everybody has heard about the Barnett Shale in Dallas/Ft. Worth for years. That play is already coming to an end. They will still be drilling wells there for years to come but not at the current pace. Every new gas play is a flash in the pan as they used to say. Sudden discovery, rapid acquisition of leases, even more rapid drill out and then on to the next play. 50% of the gas in a new field is produced in the first five years and then the long depletion cycle settles in for the rest of the deposit. The advent of horizontal drilling and multiple wells from the same pad only helps to produce the new gas faster and accelerate the depletion curve.

I listen to the various gas companies like Chesapeake and marvel at the sudden boom in production. What you don't hear in the news is the construction of new utility plants. They seem to go unnoticed except for the city they are serving. The new shale plays appear to have reversed the decline in North American production. Previously the peak in gas for North America was thought to be in 2004. Well counts had doubled in the last five years but production continued to decrease. That may have changed today with a new peak date ahead but the future outcome has not changed. Gas will continue to be a fuel with rapidly expanding demand and eventually the depletion monster will win the battle. We are already seeing declining crude production targets in the Canadian oil sands because they are running out of natural gas to run the plants. The Canadians claim burning the remaining supplies of gas to produce oil is like burning $100 bills to produce $60 oil. The marginal cost of a barrel of oil sands crude is $60.

The U.S. natural gas drilling sector is hot and it is a victim of its own success. Produce more gas in record amounts and the price of gas declines along with profits. They are drilling more and enjoying it less. Falling gas prices increases demand and the cycle repeats until eventually the final peak appears and the drillers have nowhere else to drill. That may not be for 5-7 years in the U.S. but like night follows day the peak will come.

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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