Option Investor

Really, We Are Going To Cut

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OPEC just can't get any respect. They claim they are going to cut another 2.2 million barrels of production but nobody believes them. Maybe it is because they have 20+ years of history where cheating was the norm?

The problem with OPEC is compliance with quotas. It always has and more than likely always will be. Public data shows compliance with the 1.5 mbpd cut which took place in November is showing a 52% to 63% rate. Saudi Oil Minister al-Naimi said it was 85% when he made his announcement last week. Analysts theorize he avoided the real facts because Saudi did not want to publicize the cheating while they are trying to put a bottom under prices. In the table below the various organizations that track OPEC production are pretty uniform in showing an average of only 847,000 bpd was actually cut in November. Cheating was alive and well.

Actual OPEC cuts from November
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In the announcement last week OPEC specifically said production would be cut 4.2 mbpd from the actual September production of 29.045 mbpd and starting on Jan 1st. We are assuming the cuts will be prorated across the entire group. In the table below you can see their production rate in September, which served as the base rate for the production quota changes in November. The center column is the actual percentage rate the countries lowered their production in November. Note that Angola and Ecuador actually increased production. Now compare the last column and see how much everyone will have to cut production on Jan 1st. Note that the numbers are more than twice as large in some cases. What are the odds these cuts will be made? Zero. This is why OPEC has a public relations problem. This also why the price of oil is likely to continue down until some real action is taken OR the recession ends.

OPEC Quota Chart
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The price of oil did not drop -27% last week to $32.40 because of the prospects for cheating. The price of oil was crushed because OPEC did not present a uniform front to the press and the cut was not large enough to satisfy the whisper number. Many analysts thought they needed to cut by at least 4 mbpd to reduce the stress on rising levels of oil in storage.

Crude prices were crushed because traders had been long January oil in expectations for a big cut and a big spike in prices. When it did not occur traders jammed the exits with only 2 days left in the expiring January contract. Add in the full storage tanks at Cushing Oklahoma and the price of oil hit a 4-year low. Cushing is the delivery point for crude futures contracts and they are running out of storage. When storage is in short supply the price of storage rises sharply. Anyone long oil is faced with selling it cheaper to offset the increase in storage fees. The bottom line to the story is still an OPEC meeting two days before futures expiration. It was a recipe for disaster.

The other monthly contracts for 2009 are trading sharply higher than the January contract. The February contract was trading at nearly $9 over the January price. This is an obscene example of contango. That is when future prices are higher than current prices. This suggests traders are confident prices are going to rise in 2009. In the short term I would bet on the February contract taking a steep hit next week as prices normalize and the February holders start worrying about storage.

2009 Futures Contracts
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After watching the price of January crude dive I was planning on adding some crude futures to the list but after seeing the monster prices I am going to pass until February's expiration cycle. (Jan 20th) By then we should have a better idea of how the oil market and the stock market is going to act in the first quarter.

These price drops are killing Venezuela, Russia, Iran and even Brazil. They all live on their oil revenues and that revenue has been slashed to the bone. Russia is already starting to see some signs of unrest. Iran and Venezuela depend on oil to pay for their social programs so the rulers can stay in power. Brazil is facing the expenditure of $500 billion to produce their new offshore finds but at $40 a barrel that money will be tough to find and slow development down by several years. That slows revenue and Brazil had already started budgeting for their windfall profits. Back to the drawing board for them.

Solar saw a massive win last week. First Solar has arrived at grid parity with its products. That is where electricity produced by solar is the same price as that produced conventionally. This is the Holy Grail for solar companies and evidently First Solar actually achieved without subsidies a $0.075 per KWH yield in Nevada where conventional power costs $0.09 per KWH. This means organizations looking for cheap power are no longer tied to the conventional grid. This vastly broadens the market for solar and that will lower the price even further. This is the dawning of a new day for the solar sector. FSLR was up +26 for the week.

I am not adding any plays this week. I believe we will see some additional minor gains into the holidays but after next weekend we could see some sharp declines going into January. I will add some watch list plays next week in anticipation of that decline. We missed being triggered on that NXY play by 3 cents on the spike higher and now it has returned to support. Whew! I would much rather get the breakdown entry.

Check out the end of year renewal special. There is another crude oil video and two special reports on energy.

Click here for the full package description

Jim Brown

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