Option Investor

Weekly Newsletter, Saturday, 03/31/2007

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Table of Contents

  1. Commentary
  2. Changes in Portfolio
  3. Portfolio Listing
  4. New Plays
  5. Existing Plays
  6. Watch List

Leaps Trader Commentary

Thank You Iran

Iran's new hostage crisis and their belligerence in the press has produced another week of gains in oil prices. Should they suddenly decide to release the hostages the price would plummet but probably only temporarily. The dice have been cast and it appears we are racing into an armed conflict between the US and Iran. Another carrier battle group is headed for the Persian Gulf and occupancy at UAE hotels has climbed past 90% due mostly to US military support personnel. Patriot missile batteries have appeared in Bahrain and American civilians are being told to leave the region. I can't conceive of a scenario where Iran backs down and loses face in the region. They would rather go out as martyrs than sit down and debate rationally.

With gasoline inventories low and refinery problems rampant and hurricane season only eight weeks away the Iran problem could not have come at a better time for prices. Considering the jump of nearly $10 from the recent lows their hostage escapade has produced an additional benefit of nearly $35 million per day in additional oil revenues. All they have to do now is keep their oil fields from being cut off from the outside world to collect that money.

On our side of the pond the refiners are printing money with the volatility in oil prices and gas prices nearing $3. The only challenge on our side is to keep drivers driving and not have them succumb to sticker shock at the pump. Consumer sentiment fell unexpectedly in late March and the price of gas was given as the primary reason.

I have decided there is an idiot born every minute and quite a few of those born 40-50 years ago were on CNBC this week. Two in particular were claiming that oil was the perfect short for the next 20 years. I kid you not that is exactly what they were suggesting. One was targeting $20-$30 again within four years. This came in the same week that the GAO released its Peak Oil report saying that Peak Oil was inevitable and nobody was doing anything about it.

The Peak Oil report was unremarkable in its lack of a consensus of opinion and remarkable in its vagueness. A form of the word "uncertain" was used 87 times and the word "could" was used 84 times. Typical bureaucratic cover your butt mentality. Read it here

A few highlights for your reading pleasure:
I paraphrased some for length. (My comments in italics)

Ethanol may be technically feasible but it is more expensive than gasoline (gets 25% less mileage as well) and will require costly investments in infrastructure before it can become widely used as fuel. Even at maximum effort key alternative technologies including ethanol could only displace 4% of annual gasoline consumption by 2015. (Gasoline consumption is expected to rise 8% by 2015 so alternative fuels are a net loss) In such circumstances, an imminent peak and sharp decline in oil production could cause a worldwide recession.

According to a 2005 report prepared for DOE, without timely preparation, a reduction in world oil production could cause transportation fuel shortages that would translate into significant economic hardship. (Duh!)

Most studies estimate that oil production will peak sometime between now and 2040. The timing of the peak depends on multiple uncertain factors including how much oil remains in the ground, how much can be extracted even at great cost and future oil demand. (Great, you spent millions of taxpayer dollars and this is the answer you provide. Any Option Investor reader could do better than that!)

According to the IEA, most countries outside OPEC have reached their peak in conventional oil production or will do so in the near future. 60% of the remaining global oil reserves are in politically unstable countries. (No argument here)

Some experts believe OPEC estimates of proven reserves to be inflated. For example, IEA reports that reserve estimates in Kuwait were unchanged from 1991 to 2002 even though Kuwait produced 8 billion bbls during that period and did not make any new discoveries. The potential unreliability of OPEC's self reported data is particularly problematic with respect to predicting a peak because OPEC holds most of the worlds current estimated reserves. According to the Oil and Gas Journal estimates in Jan-2006, of the estimated 1.1 trillion barrels of proven reserves worldwide, about 80% are located in OPEC countries. (Claimed reserves, not proven)

It is also difficult to project the timing of a peak in oil production because technological, cost and environmental challenges make it unclear how much oil can ultimately be recovered from proven reserves, hard to reach locations and non-conventional sources.

The timing of peak oil is also difficult to estimate because new sources of oil could be increasingly more remote and costly to exploit including offshore production in deepwater and ultra deep water. (They go on to elaborate that 2.2 mbpd "could" be extracted from ultra-deepwater in the Gulf by 2016 BUT production challenges at those depths may make production unfeasible. Yes, the oil is probably there but we can't get it for any reasonable price.)

Worldwide oil sands production was 1.6 mbpd in 2005 mostly from Alberta Canada. Production is projected to climb to 3.5 mbpd by 2030. (Not even enough to offset the depletion rate in the US and Mexico over just the next 5 years) However, raising production to this level presents significant environmental challenges. Production would use very large amounts of natural gas (already in decline) which generates large amounts of greenhouse gases when burned. In addition large-scale production of ol sands requires significant quantities of water, typically produce equal quantities of contaminated water and alter the natural landscape. These challenges may ultimately limit production from this resource EVEN IF SUSTAINED HIGH OIL PRICES MAKE PRODUCTION PROFITABLE! (I have been warning that this would come to pass.)

In many countries with proven reserves, oil production could be shut down or curtailed by wars, strikes and other political events. If these events occurred repeatedly on in many different locations a peak in production may result even though proven reserves may still exist. Using a measure of political risk that assesses the likelihood that these events may take place over the next 5 years we found that four countries, Iran, Iraq, Nigeria and Venezuela, that have proven reserves of more than 10 billion bbls also face high levels of political risk. Those four countries contain nearly one-third of worldwide oil reserves. The possibility of a drop in production is very strong. In addition the loss of technical expertise due to political unrest in these countries and others is degrading the amount of oil that can be produced and ultimately recovered.

According to our analysis, 85% of the worlds proven oil reserves are in countries with medium-to-high investment risk or where foreign investment is prohibited. Over one third of the worlds proven reserves lie in only five countries - China, Iran, Iraq, Nigeria and Venezuela - all of which have a high likelihood of seeing a worsening of the investment climate.

Only three international companies, Exxon, Shell and BP, rank in the top ten companies based on production. No international companies rank in the top 10 according to reserves. Only national oil companies rank in that metric.

The IEA projects production declines from ALL non-OPEC countries by 2010. (Without significant additional OPEC production by 2010 the world will peak.)

The IEA expects global oil demand to reach 118 mbpd from the current 86 mbpd by 2030. (Unfortunately that means we have to add the equivalent production of FOUR new Saudi Arabian sized countries at 9 mbpd each in order to meet that demand. IT IS NOT GOING TO HAPPEN! The oil simply does not exist at those flow rates.)

This is the most amazing statement in the entire report:

Factors that create uncertainty about the timing of the peak also create the uncertainty about the rate of production decline after the peak. The IEA estimates this decline will be between 5% and 11% annually. Another methodology employed by the EIA assumes the rate of decline will actually be faster than the rise in production before the peak. The rate of decline after a peak is an important consideration because a decline that is more abrupt will likely have more adverse economic consequences than a decline that is less abrupt. (This is the first time I have seen hard numbers from the IEA and EIA about the depletion rate. They normally say 1-2% or ignore it altogether. A 5-11% decline rate is actually realistic and highly probable. At today's production rate of 86 mbpd that equates to nearly 7 mbpd (8% average). That means every year in the future we have to add 7 mbpd just to stay even. That is nearly the entire production of Saudi Arabia each year. I have warned about this repeatedly and now even the IEA has admitted the problem. Can you imagine a peak next year and then a 7 mbpd shortfall to follow? That is 7 supertankers of oil every day, 365 days a year. Where would prices be then?)

In the United States alternative transportation technologies have limited potential to mitigate the consequences of a peak and decline in oil production. If the peak and decline in oil production occurs before these technologies are advanced enough to substantially offset the decline the consequences could be severe. The seven alternative fuels and advanced vehicle technologies we examined will take time and significant challenges will have to be overcome. These technologies include ethanol, biodiesel, biomass gas-to-liquid, coal gas-to-liquid, natural gas vehicles, advanced vehicle technologies (??) and hydrogen fuel cell vehicles. (How many of those do you think will be ready by 2010? ZERO!!)

Because development and widespread adoption of these technologies to replace oil will take time and effort an imminent peak and sharp decline in production could have severe consequences. The technologies we examined currently account for less than 1% of consumption and could only achieve a 4% equivalent by 2015. If a peak and decline occurs before 2015 competition among consumers for increasingly scarce oil resources would cause oil prices to sharply increase. Ultimately, consequences of a peak and permanent decline in oil production could be even more prolonged and severe than those of past oil shocks. Because the decline would be neither temporary nor reversible the effects would continue until alternative transportation technologies to displace oil became available in sufficient quantities at comparable costs. Furthermore, because oil supplies would decline even more year by year after a peak the amount of replacement technologies would have to also increase year by year.

Federal agencies do not have a coordinated strategy to address peak oil issues. Federal agencies have many programs and activities related to peak oil issues but peak oil is not the main focus of these efforts. (In other words, if peak oil appears over the next several years it will be a monstrous debacle.)

Report Conclusion:

The prospect of a peak in oil production presents problems of global proportions whose consequences will depend critically in our preparedness. The consequences would be "MOST DIRE" if a peak occurred soon, without warnings, and were followed by a sharp decline in oil production because alternative energy sources, particularly for transportation, are not yet available in large quantities. Such a peak would require sharp reductions in oil consumption and the competition for increasingly scarce energy would drive up prices possibly to unprecedented levels causing severe economic damage. While these consequences would be felt globally, the United States, as the largest consumer of oil and one of the nations most dependent on oil for transportation, may be especially vulnerable among the industrialized nations of the world. (In other words, the bigger we are the harder we will fall.)

The committee warned that peak oil could come at any time and consequences would be severe. Because they also said it could come as late as 2040 it will be ignored. It is always easier to put off until tomorrow an unpleasant task you don't want to face today.

This is not the same report as we are expecting from the National Petroleum Council to be completed in June. That one may be a tad more detailed as to a target date.

We saw more consolidation in the oil patch last week with US Steel (X) buying Lone Star Technology (LSS) for $2.1 billion. This will make the combined company the largest North American producer of tubular steel. That was a 39% premium to the $48.45 closing price on LSS before the announcement.

For the rest of the oil sector the highly volatile oil prices produced some volatility in the stock prices with profit taking hitting some pretty hard on Friday. It is just a symptom of the current market and we will have to live with it until a longer term trend appears. Today everybody is thinking we should see some profit taking before the next rally but without a hostage release by Iran it would be short and new highs are still ahead.

Jim Brown

May Crude Futures Chart - Daily

May Gas Futures Chart - Daily

April Gasoline Chart - Daily


Changes in Portfolio

New Energy Plays

None - See watch list

New Non-Energy Plays
BZH $29.02 Beazer Homes

** LEAP PUT **

Dropped Plays


New Watch List Plays Triggered


Portfolio Listing & Top Picks

New Plays

Most Recent Plays

BZH - $29.02 - Beazer Homes ** LEAP PUT **

The legal problems are mounting for Beazer and the quantity makes it highly probable they are going to find some charges filed in the near future. Some of the things they are being accused of doing could actually put them out of business if charged and found guilty. With the housing sector already out of favor the odds of Beazer falling substantially from here are pretty good without a sudden miracle to rescue them from the alphabet soup guys.

Company Info:

Beazer Homes USA, Inc. designs, sells and builds primarily single-family homes in various locations within the United States. The Company's segments comprise the locations, in which it operates, and these include West (Arizona, California, Nevada and New Mexico); Mid-Atlantic (Delaware, Maryland, New Jersey, New York, Pennsylvania, Virginia and West Virginia); Florida; Southeast (Georgia, Nashville, North Carolina and South Carolina), and Other (Colorado, Indiana, Kentucky, Memphis, Ohio and Texas). The Company offers homes at various price points to appeal to homebuyers across various demographic segments. Its homebuilding and marketing activities are conducted under the name of Beazer Homes in each of its markets. The Company's products are offered in categories, such as Economy, Value and Style. It also offers mortgage services to its homebuyers through its subsidiary, Beazer Mortgage Corporation.

Buy Jan-08 $25 PUT WZF-ME currently $3.10

No stop loss

Play Updates

Existing Plays

The current format of the Play Updates has changed. Only the pertinent data that has changed from the prior week will be shown in an effort to concentrate more on new commentary on new plays rather than restating existing positions. Each play has a link back to either its last full commentary or its initial description.


BHP - $48.45 +1.20 - BHP Billiton

Only 30 cents off a ten-month high on no news. All we need is one more round of metals gains and we should be off to the races on short covering.

To see the initial commentary on this position click here

Breakout target $43.50 hit March 12th

Position: JAN-09 $50 LEAP Call ZPK-AJ @ $6.00


CCJ - $40.94 +0.86 - Cameco

No news but we got a new three-month high at Friday's close. Strong resistance from here to $42 but uranium prices are still climbing.

To see the initial commentary on this position click here

Breakout trigger: $37.50 Hit March 7th

Position: JAN-09 $40 LEAP Call ZBK-AH @ $7.80


PTR - $117.09 +4.69 - Petrochina

PetroChina said it made the biggest discovery in a decade in the Bohai Bay area with oil in place of as much as 2.2 billion bbls. Recoverable would be something in the 700 million barrel range and it is light crude. This could add 20% to the total reserves for PTR. The news sent PTR to a new 6-week high. No change in play.

To see the initial commentary on this position click here

Breakdown targets:
$110 1/2 position - hit Mar-5th
$105 1/2 position - not yet triggered

Position: JAN-09 $120 LEAP Call ZJK-AD @ $10.70

Cost reduction play:
Position: Short June $105 Put PTR-RA @ $3.40, stop $100


SNP - $84.48 +1.29 - Sinopec

After last weeks +$7 gain any gain this week would have been outstanding. We saw a new six-week high on Thursday on news that Exxon and Saudi Aramco had partnered with SNP to build a major refinery in China. The cost to Saudi Aramco and Exxon rose to $5 billion in the latest announcement and well over the $3.5 billion estimate when the deal was first discussed in 2005. Part of the increase was to add 750 filling stations and a network of terminals. No change in play.

To see the initial commentary on this position click here

Breakdown target $82.50 hit on 2/27

Position: OCT $85 Call SNP-JQ @ $7.00


CHK $30.88 +.12 - Chesapeake Energy ** Stop loss $28.50 **

CEO McClendon bought another $6.4 million in stock last week and raised his stake to about 5.9%. He also hold options for another 500,000 shares. McClendon founded the company in 1989 and grew it into one of the world's largest gas producers. It appears he wished he had it back in private hands again. He has spent $226 million to buy CHK stock over the last 30 months. McClendon also sold 1300 short puts obligating him to buy another 130,000 shares at $27.50 if the price falls. No change in play.

To see the initial commentary on this position click here

Earnings: Feb-23rd, 90 cents vs est 76 cents.

Current recommendation: Hold

Position: 2009 $35 LEAP VEC-AG @ $5.30

Insurance put: none


MRO $98.83 -2.29 - Marathon Oil

Profit taking hit MRO on Friday giving us a loss for the week but still a strong gain after the $7 rise last week. No news and no change in play.

To see the initial commentary on this position click here

Earnings: Feb-1st 3.06 vs 3.43 (Q4/05) $1.08 billion profit

Current recommendation: Buy at $85

Position 2009 $100 LEAP Call VXM-AT @ $12.60
Cost update: Expired March put +65 cents to $13.25

Insurance put: 2/18/07
Position: March $85 PUT MRO-OQ @ 65 cents. expired


HES - $55.47 -.51 - Hess Corporation
(Formerly (AHC))

Hess hit a rough spot on Friday after setting a new 52-week high on Thursday. It was simple profit taking after a $5 gain last week. Hess set an earnings date of April 25th. Definitely no complaints and no change in play.

To see the initial commentary on this position click here

Earnings schedule: April 25th

Earnings: Jan 31st, $1.13, vs $1.44 in Q4/05, 230% replacement

Current recommendation: Buy at $47

11/05/06 2009 $50 LEAP Call VHS-AJ @ $6.80
Cost adjustment put exit +1.60, cost = $8.40

Insurance Put: Triggered Jan-3rd @ $49
01/03/07 May $45 put HES-QI @ $2.60, exit 1/26 $1.00

Insurance Put: 2/26/07
MAY $50 PUT IGG-QJ @ $1.35, profit stop $46


BTU - $40.24 -0.60 - Peabody Energy

Minor profit taking after strong gains in the prior week. Merrill said coal prices were poised to rise with Japan and China competing for available supplies. Japan wants to pay $60 a ton but China consumers are willing to pay up to $80. This has Japan out shopping for supplies. No other news.

SELL JAN-08 $30 PUT LLW-MF is BTU touches $35

To see the initial commentary on this position click here

Earnings: Jan-25th +42% including special items.

Current recommendation: Buy at $35

10/22/06 Jan-2009 $50 LEAP Call ZZT-AJ @ $8.70
02/05/07 March put stopped -$1.00, cost = $9.70

Insurance put: Triggered with drop through $39
01/03/07 March $35 Put BTU-OG at $1.15, stopped @ $42.50


SLB $69.10 +0.00 Schlumberger

SLB finished dead even for the week after hitting a new 52-week high on Thursday. SLB set its earnings report for April 20th. No change in play.

SELL JAN $55 PUT WUB-MK on a touch of $60 by SLB

To see the last full commentary on this position click here

Earnings schedule: April 20th.

Earnings: Jan 19th, +71% to $1.13 billion

Current recommendation: Buy at $60, stop at $55

LEAP Position:
1/2 9/11/06 @ $8.60
1/2 9/12/06 @ $8.00
Position: 2009 $70 LEAP Call VWY-AN @ $8.30
Cost update for expired Jan put +2.00 = $10.30

Insurance Put: 9/18
Position: Jan $50 Put SLB-MJ @ $2.00, expired


SUN $70.44 -0.72 - Sunoco

SUN hit a new six-month high on Friday as takeover talk moved through the market. Call options saw more than 27,000 contacts trade on Friday compared to 3842 puts. This is far in excess of the normal 4000 contracts.

SELL JAN $55 PUT WUD-MK on a touch of $60 by SUN

To see the last full commentary on this position click here

Earnings: Jan-31st, -57% $1.00 vs $.96 analyst est.

Current recommendation: Buy at $60, stop at $54

LEAP Position:
9/12/06 Position: 2009 $70 LEAP Call VUN-AN @ $13.50
Cost update expired Jan put +2.40 = $15.90

Insurance Put:
Position: Jan $55 Put SUN-MK @ $2.40, expired


VLO $64.49 +0.84 - Valero Energy

Valero hit a new 7-month high again on Friday and there is no change in sight. Refiners are printing money on the rising price of gasoline and that is not expected to change. $3 gas this summer will mean golden profits for Valero. No change in play.

To see the last full commentary on this position click here

Earnings: Feb-1st

Current recommendation: Buy at $50, stop at $45

LEAP Position:
9/24/06 Position: 2009 $60 LEAP Call VHB-AL @ $7.70
Cost update expired Jan put +2.25 = $9.95

Insurance Put:
Position: 9/25 Jan $45 Put VLO-MI @ $2.25, expired


DO - $80.95 -0.45 - Diamond Offshore ** Stop $73.00 **

Almost no change in DO and it continues to hold near its two-month highs at $82.50. No news and no change in play.

To see the last full commentary on this position click here

Earnings schedule: Feb-8th

Current recommendation: Buy at $75, stop at $69

LEAP Position:
8/29/06 Position: 2009 $80 LEAP Call VCT-AP @ 14.20
Cost reduction: Oct $70 Put profit -3.15, cost now $11.05
Cost increase: Dec $60 put expired -2.40, cost now $13.45

Insurance Put:
10/08 Dec $60 Put DO-XL @ $2.40, expired

Position closed:
10/03 October $70 put DO-VN @ $1.65, exit @ $4.80, +3.15

Non-Energy Positions



Leaps Trader Watch List

Dropped Entries


New Watch List Entries

We came within a buck of being triggered on TSO. I am still holding out hope that we will see declines in all our watch list entries so no change this week.

Current Watch List

UPL - Ultra Petroleum

Ultra Petroleum Corp. (Ultra) is an oil and gas company engaged in the development, production, operation, exploration and acquisition of oil and gas properties. The Company's operations are focused primarily in the Green River Basin of southwest Wyoming and Bohai Bay, offshore China. As of December 31, 2005, Ultra owned interests in approximately 148,007 gross acres in Wyoming covering approximately 230 square miles. The Company owns working interests in approximately 330 gross productive wells in this area and is operator of 53% of the 330 gross wells. Its domestic operations are focused on developing and expanding a tight gas sand project located in the Green River Basin in southwest Wyoming. During the year ended December 31, 2005, the Company's Wyoming production was approximately 87.4% of total oil and natural gas production on a thousand cubic feet of natural gas equivalent (MCFE) basis and 98.5% of the Company's estimated net proved reserves were in Wyoming on an MCFE basis.

Breakdown target $47

Buy JAN 2009 $50 LEAP Call AZH-AJ


ATI - Allegheny Tech

Allegheny Technologies Incorporated (ATI) is a diversified specialty metals producer. The Company operates in three segments: High Performance Metals, Flat-Rolled Products and Engineered Products. The High Performance Metals segment produces, converts and distributes a range of high-performance alloys, including nickel and cobalt-based alloys and superalloys, titanium and titanium-based alloys, zirconium, hafnium, niobium, nickel-titanium and their related alloys. The Flat-Rolled Products segment produces, converts and distributes stainless steel, nickel-based alloys, and titanium and titanium-based alloys. The Engineered Products segment produces tungsten powder, tungsten heavy alloys, tungsten carbide materials and carbide cutting tools. ATI products are used in various markets. These markets include aerospace, defense, chemical process industry, oil and gas, electrical energy and medical.

Breakdown target $98.50

Call spread:
BUY JAN-09 $100 LEAP Call OYG-AA


TEX - Terex Corp

Terex Corporation (Terex) is a diversified global manufacturer of capital equipment delivering solutions for the construction, infrastructure, quarry, mining, shipping, transportation, refining and utility industries. The Company operates in five business segments: Terex Construction, Terex Cranes, Terex Aerial Work Platforms, Terex Materials Processing & Mining, and Terex Roadbuilding, Utility Products and Other. The Company's products are manufactured at plants in North America, Europe, Australia, Asia and South America, and are sold primarily through dealers and distributors worldwide. During the year ended December 31, 2005, it acquired Halco Holdings Limited and its affiliates, and Power Legend International Limited and its affiliates. It entered into a joint venture with North Hauler Joint Stock Company Limited to produce high-capacity surface mining trucks in China. It has a 50%-ownership interest in Sichuan Changjiang Engineering Crane Co., Ltd.

Breakdown target $66.00

Call spread


TSO - Tesoro

We were stopped out of our highly profitable TSO position and now we are looking to get back in with a different strike on the next dip in refiners.

Company info:

Tesoro Corporation (Tesoro) is an independent petroleum refiner and marketer with two operating segments: refining, which is engaged in refining crude oil and other feedstocks at its six refineries in the western and mid-continental United States and selling refined products in bulk and wholesale markets (refining), and retail, which is engaged in selling motor fuels and convenience products in the retail market through its 460 branded retail stations in 18 states. Through its refining segment, the Company produces refined products, primarily gasoline and gasoline blendstocks, jet fuel, diesel fuel and heavy fuel oils for sale to a variety of commercial customers in the western and mid-continental United States. Tesoro's retail segment distributes motor fuels through a network of retail stations, primarily under the Tesoro and Mirastar brands.

Breakdown target: $96

BUY 2009 $110 LEAP Call ZGC-AB


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