Option Investor

Somebody Please Wake Me

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I am having this terrible nightmare that oil is trading at $40 and gasoline retails for less than $1.50. Millions of barrels of current and future production are being taken offline for not being cost effective. Surely this is a nightmare and not reality.

Unfortunately it is reality and I want to buy oil stocks and futures so bad I can taste it but oil company CEOs are on TV saying it could go to $25. I feel like I have stepped through a time portal to 1998 all over again. Crude was $10 a barrel and production was being shut in all over the world. We know now what havoc that caused over the last eight years but it appears we are doomed to make the same mistake twice.

I am going to reprint three paragraphs from my market wrap this weekend for the benefit of those readers who don't get that newsletter. Just skip three paragraphs if you read it there.

The most amazing statistic from last week came from the energy sector. The price of oil closed at $55.19 on Friday before last Saturday's OPEC meeting. This Friday it traded as low as $40.50 for a -26.6% drop. Given the prior $100 drop over the last few months this additional $15 drop in one week is nothing short of amazing. Actually it is incredible. OPEC did not act but made it clear they would in two weeks at the Dec-17th meeting. Unfortunately that is not the problem. We are still seeing massive liquidation by funds and institutions. Complicated hedges are being unwound on a daily basis as analysts talk about $25 oil and $1 gasoline. The world has gone mad as the fear of the recession has surpassed the actual impact of the recession. Just like every bubble is built on irrational expectations and greed, every crash is based on irrational expectations and fear. Every prediction by a major analyst is repeated thousands of times until another analyst jumps in the spotlight with something even more bearish and the actions are repeated. It is a massive game of whispers, gossip and unknowns. Nobody knows what demand will be in six months. Heck, nobody really knows what demand is now. Everyone is afraid the soaring unemployment will result in bread lines around the world and people will be living in their cars not driving them. All of this crap is simply not true. Even if demand temporarily fell another million or even two million barrels a day it is not the end of the world.

All of this hysteria over falling oil prices is doing much more harm than good. Projects are being cancelled or put on hold all over the world because the current price of oil does not support new projects to produce $50, $60 or even $75 oil. Every project that goes inactive adds several years to the date when it will eventually produce oil. We are already talking about projects that total over 3 mbpd of potential production. That production is what would have delayed the onset Peak Oil. By putting them on hold the world is becoming increasingly at risk of even higher oil prices. The recession will be over in 6-9 months and demand will explode at these low prices. Unfortunately when a project is cancelled or mothballed the workers move on to other jobs. The equipment is sent to other locations and pipe and supplies are diverted elsewhere to be used on other projects. When the decision is made to reactivate the project all those assets will need to be acquired again and that could take years in the case of rigs and workers.

The current drop in oil prices is the worst thing that could happen to the energy sector. We are duplicating exactly what happened 10-years ago this month. The price of oil crashed because of a political battle inside OPEC and Saudi Arabia flooded the market and pushed the price down to $10 a barrel to force other OPEC nations to face reality. Around the world rigs were mothballed by the thousands and eventually cut up for scrap steel. Tens of thousands of experienced oil field workers were laid off and either retired or went into other professions. These were experienced workers that could not be replaced. When the price of oil eventually began to rise again those workers were no longer available. The rigs had been scrapped and there was nobody left to man them even if they were still around. This led to a boom in the oil equipment sector where companies ended up with multiyear backlogs for new rigs. Day rates for existing rigs exploded. New workers had to be hired and trained at great expense. The result of the oil crash meant every new rig and crew now cost up to ten times as much to operate as the older rigs and hands. This meant the cost of producing a barrel of oil soared to levels today of $50, $60 or even $75 a barrel. Those fields cannot be produced today because they are not profitable and will eventually be shut in if prices do not change quickly. In 1998 thousands of producing wells were plugged because they were not profitable. Most were not reopened even at $145 a barrel simply because there was no time or money to do it. We lost millions of barrels of production because of low prices. The same thing is happening today. This oil crash will eventually turn around and when it does the moves are going to be dramatic. Enjoy your $1.50 gasoline today because it is not going to last forever.

There are so many oil stocks I want to buy but their charts are diving so fast I could lose fingers trying to catch them. Eventually this will turn around but we have to let it play out first. We know the integrated oils like Conoco, Exxon, etc, are going to report monster drops in profit over the next quarter because of the drop in oil prices. Those stocks should get cheaper.

Until then I am going to continue to focus on what I would call fringe plays. I added a combination play and two more stock plays. It is hard to resist a $2 stock with a bright future. There is no time decay and no expiration date. If you would rather I not profile these low priced stocks send me an email using the link on this page and I will quit. Majority rules. I believe this is a once in a decade opportunity and we should profit from it. Buy them in your IRA and forget them.

I am close to finalizing the EOY special and hopefully it will be ready by next weekend.

Jim Brown

January Crude Futures Chart - Daily
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January Natural Gas Futures Chart - Daily
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January Gasoline Chart - Daily
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