Option Investor

Weekly Newsletter, Saturday, 08/11/2007

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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

Safe Harbor In A Financial Storm

The price of oil fell to $70.10 on Friday morning, a full -$8 off its highs, and a level where support should hold for a couple more weeks. There is no subprime or credit risk in the energy sector. With the peak of hurricane season still a month away there will be underlying support and therefore most funds are seeing a move into oil as a no risk trade.

This provided a soft bottom in energy stocks and one that could last a couple weeks. That means our energy sector puts are likely to languish in a range until the broader market rebounds. Once equities in general, led by financials, begin to rebound we will see money rotate back into techs and out of oil. This will begin the next decline in oil prices.

We saw a drop in crude inventories of -4.1 million barrels last Wednesday and it should have sent prices soaring another $1-$2 but it did not happen. Crude continued to decline and that is a clear signal that the momentum investors are leaving.

We have seen dozens of funds admit they were in trouble and there are quite a few margin calls striking home for those in credit trouble. When you can't sell troubled assets like credit paper today, you have to sell whatever you have that will convert to ready cash.

Hedge funds are facing a confidence crisis with hardly a day going by without another fund confessing liquidity problems or major losses. On Wednesday August 15th they will have another crisis. That is the last day for investors to file notice of redemption for Sept 30th withdrawals. If the investors are concerned about their hedge fund investments they can give notice by August 15th and get their money back on Sept 30th. Rumors are flying that funds are receiving heavy flows of redemption requests and that is causing a cash crunch. They will have to sell any available asset to avoid being forced to sell assets that are currently under priced or illiquid.

That sets up a situation for next week where some funds are fire-selling assets while others will be looking at energy as a safe harbor in a credit storm.

Refiners were upgraded by Citigroup to a hold from sell on Friday and saw strong gains as shorts were forced to cover. Marathon was blessed with an upgrade all the way to a buy based on their announcement their participation in a deep-water discovery off the coast of Angola. MRO gained +2.62, SUN +3.87, TSO +2.30 and VLO +1.35. With the seasonal drop in gasoline prices Citigroup expects the refiners to quickly switch to heating oil and distillates to maximize profits while margins on those products are still high.

China halted construction of its many ethanol plants noting that the corn based production of ethanol was driving up food prices to an unbearable level. Unless these plants can convert to making ethanol out of something that is not a food crop they will not be completed. Finally some reason in the ethanol sector. In the US the profit margin on a gallon of ethanol including subsidies was over $1 last year but has shrunk to only 3-cents in 2007 due to higher prices for corn. In the US we avoid making the connection between high corn prices and inflation by removing food and energy numbers from the core inflation calculations. Eventually regulators will learn from the Chinese that corn prices do impact inflation and ethanol, if it is to succeed in the US, must be made from some other source.

Demand for Ethanol rose to 427,000 bpd in May and a +20% increase over May 2006. As of July 30th there were 124 ethanol plants in operation in the US with a combined output of 423,000 bpd. Ethanol production for corn has surged +300% since 2001. In 2007 over 94 million acres of corn were planted. I have been on the road for most of the summer having driven through 19 states since the end of March. I am in Florida this weekend and after passing through Kansas, Missouri, and Illinois last week I think I have seen at least half of that 94 million acres. Every piece of flat ground for 1500 miles was growing corn. Quite a few farmers are betting a lot of money this corn/ethanol relationship will continue.

Russia planted a symbolic flag on the ocean floor at the North Pole in an effort to claim all the oil and gas reserves suspected to lie from their current borders and stretch to the North Pole. Most countries, especially the US, laughed off this symbolic display as a hopeless attempt to avoid a future resource war. Nobody appeared to be concerned the Russian attempt would shut them out of any exploration. Since much of the territory is under 10,000 feet or water and covered by a huge ice pack that is subject to continuous movement the experts said it could be 10-20 years, if ever, before technology could be developed to drill in the area and even longer before any production and completion systems could be developed. For instance how do you transport oil over thousands of miles of ice pack in subzero weather?

Mexico's oil production is falling so fast and investment in new exploration by Pemex is happening so slow that Mexico could become an importer of oil within 6-8 years. That is a reduction of more than 2 mbpd to overall supply. Iran is also expected to become a net importer of oil within the next 10 years. Growth in Iran is exploding even under the current administration. Once they become accustomed to paying market rates for gasoline the country could shift the billions per year they are now paying in gasoline subsidies to building business infrastructure to accelerate that growth. This would remove another 2-3 mbpd from global supplies. With the sharp words being traded this week over Iraq we could see their gasoline demand drop sharply very soon if hostilities erupt.

Venezuela refineries are running behind rising demand for gasoline in that country. Chavez had pledged to build three new refineries to increase supply but construction has not started due to lack of funds. With oil exports falling and Chavez confiscating every possible dollar from any profitable enterprise unlucky enough to do business in Venezuela to pay for social programs it does not appear those refineries will break ground any time soon. Chavez has tried to get Russia and China to fund new refineries but to date they have declined. North Korea, your phone is about to ring as the last member of the axis of evil Chavez has not called on for a loan.

The ASPO newsletter this week included two quotes I thought were very key to the current energy discussion.

"Supply is going no place and demand is rising 2.5% per year." Economist Phillip Verleger

"US natural gas production is declining despite a 400% increase in the number of wells. The US natural gas peak was at 22TCF/a in 1973 with 100,000 wells. 2005 production was only 19 TCF/a with over 400,000 wells." Jean LaHerrere, ASPO-France

Like oil all the big gas fields have been tapped and new production can't outrun depletion. Gas wells deplete much faster than oil wells with the majority of production in the first 3-5 years of life. If your home is heated by gas you might consider moving in the next 3-5 years because your gas bill is going a lot higher.

Next week should be another week of patient waiting for a hurricane to show with continued volatility in the broader market putting pressure on energy stocks as well. The only wild card here is the appearance of a hurricane to rejuvenate prices. Until that happens prices should continue to erode slowly.

Jim Brown

September Crude Futures Chart - Daily

September Natural Gas Futures Chart - Daily

September Gasoline Futures Chart - RBOB Daily


Changes in Portfolio

New Plays

See Watch List

Dropped Plays


New Watch List Plays Triggered
$110.70 Bear Stearns *** Stop Loss $97 ***

Portfolio Listing & Top Picks

New Plays

Most Recent Plays

BSC $110.70 - Bear Stearns *** Stop Loss $97 ***

Monday's opening drop hit our $100 target on BSC and the following bounce took it back up to $124 before the continuing credit crunch came back to haunt us. Eventually this crunch will end and the Fed entering the market three times on Friday should be a sign that it is about over. I am going to place a stop just under our entry point just in case more bad news breaks.

Company Info:

The Bear Stearns Companies Inc. is primarily a holding company that through its broker-dealer and international bank subsidiaries, principally Bear, Stearns & Co. Inc. (Bear Stearns), Bear, Stearns Securities Corp. (BSSC), Bear, Stearns International Limited (BSIL) and Bear Stearns Bank plc (BSB) is an investment banking, securities and derivatives trading, clearance and brokerage firm serving corporations, governments, institutional and individual investors worldwide. The Company operates as a securities broker and dealer in three principal segments: Capital Markets, Global Clearing Services and Wealth Management. In February 2007, the Company completed the acquisition of the subprime mortgage banking platform of ECC Capital Corporation's subsidiary, Encore Credit Corp. Encore Credit will retain its brand name and operate as a separate division of the Company's mortgage bank subsidiary, Bear Stearns Residential Mortgage Corporation.

Breakdown target $100 hit 8/06/07

Position: 2010 $120 LEAP Call YBO-AD @ $25.60


Play Updates

Existing Plays

CVX - $83.42 +2.40 - Chevron Put *** Stop loss $88.00 ***

Profit stop: $75

Chevron got a boost on the Citigroup refiner upgrade. Strong resistance at $86. No change in the play.

For initial commentary see the July 22nd newsletter.

7/23/07 Position: Dec $90 Put CVX-XR @ $4.70


TSO - $49.30 +3.88 Tesoro Put *** Stop Loss $53 ***

Profit stop: $37.50

Tesoro also got a boost from Citigroup. No change in the play with strong resistance at $50-$52. Maintain the stop at $53.

For initial commentary see the July 22nd newsletter.

7/23/07 Position: Nov $50.00 PUT TSO-WJ @ $3.50


XLE - $67.72 +1.60 Oil SPDR Put *** Stop Loss $71.50 ***

Profit stop: $62

The XLE continued to be hammered by the broader market sell off. The refiner upgrade helped it slightly as did the 200-day average. This is a long term position and we need to get into September before any major breakdown should occur.

For initial commentary see the July 15th newsletter.

Breakdown trigger: $72, hit 7/18

7/18/07 Position: Dec $70 Put XBT-XR @ $3.00

Profit target: XLE $62


RIMM - $207.00 -11.50 - Research in Motion

RIMM support finally cracked with the major market drop. Once the broader market recovers RIMM will also recover even stronger. Plenty of time and no hurry to exit.

For initial commentary see the July 1st newsletter.

Earnings schedule: Sept 27th.

Breakdown trigger: $168.00 hit 6/25

Call spread:
Position: LONG 2009 $180 LEAP Call VHO-AP @ $32.60
Position: SHORT 2009 $230 LEAP Call VHO-AF @ $10.47


HOS - $42.71 -0.48 - Hornbeck Offshore *** Stop $39.50 ***

Hornbeck continues to fight the broader market and every dip is bought quickly. No change in play. This is the little energy stock that thinks it can!

For initial commentary see June 10th newsletter

Earnings schedule: August 2nd

Breakdown trigger: $39.00 hit 6/08

Position: 2009 $40 LEAP Call ZIG-AH @ $8.00


CHK $34.02 -1.15 - Chesapeake Energy ** Stop $29.00 **

This is an insurance put we bought really cheap several months ago when CHK was a long LEAP position. We were stopped on the LEAP but kept the put in play.

CHK dropped nearly -$3 from its high this week and despite the bounce in gas prices it failed to completely recover. Our exit may be coming soon.

Insurance put:
Oct $30 Put CHK-VF @ 90 cents. Profit stop $29

Non-Energy Positions


Leaps Trader Watch List

Dropped Entries


New Watch List Entries


Current Watch List

UPL - Ultra Petroleum

Still looking for another drop. Maintain the entry target.

This is an unbelievable opportunity in progress. For some reason UPL has fallen out of favor even though production is rising and they are the lowest cost producer in North America. Cash flow in Q1 increased +15% on a +42% increase in production to record levels. They closed 2007 with more than 10 TCF of gas reserves in Wyoming and Utah. They have a 17-year drilling program on those assets alone. They raised guidance for 2007 to 114 BCFE for a +24% increase over 2006. Estimates for 2008 are 135 BCFE and 160 BCFE for 2009. They added $250 million to a $1 billion share repurchase agreement on April 30th. This company is printing money but suddenly the stock has fallen out of favor with investors. I would love to be a buyer at $50. Falling gas prices may give us a chance.

Company Info:

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 primarily in the Green River Basin of southwest Wyoming and Bohai Bay, offshore China. As of December 31, 2006, Ultra owned interests in approximately 147,917 gross (79,566 net) acres in Wyoming covering approximately 230 square miles. The Company owns working interests in approximately 464 gross producing wells in this area and is an operator of 50% of the 464 gross wells. During the year ended December 31, 2006, domestic production was approximately 89.5% of the Company's total oil and natural gas production on a thousand cubic feet of natural gas equivalent (Mcfe) basis and 99% of the Company's estimated net proved reserves were domestic on a Mcfe basis.

Breakdown target: $50

Buy Jan 2009 $60 LEAP Call OZH-AL


BHP - BHP Billiton

We were stopped on BHP for a nice profit and I want to re-enter the position using a longer LEAP on any further price declines.

Company Info:

BHP Billiton Limited is a diversified resources group. The Company has seven business units, or Customer Sector Groups: Petroleum, which explores for, produces, processes and markets hydrocarbons, including oil, gas and liquefied natural gas; Aluminium, which explores for and mines bauxite, and processes and markets aluminium and alumina; Base Metals, which explores for, mines, processes and markets copper, silver, zinc, lead, uranium and copper by-products, including gold and molybdenum; Carbon Steel Materials, which explores for, mines, processes and markets metallurgical coal, iron ore and manganese used in the production of carbon steel; Diamonds and Specialty Products, which explores for and mines diamonds and titanium minerals; Energy Coal, which explores for, mines, processes and markets energy coal for use in electricity generation, and Stainless Steel Materials, which explores for, mines, processes and markets nickel, which is used in the production of stainless steel.

Breakdown target: $55

Buy 2010 $70 LEAP Call LPH-AN


JEC - Jacobs Engineering Group

Jacobs has been on a very strong growth path and the recent market weakness has knocked it back into range. It has oil and gas exposure but it not an oil and gas company.

Company Info:

Jacobs Engineering Group Inc. is a professional services firm that focuses on providing a range of technical, professional and construction services. It provides project services, which include engineering, design, architectural, and similar services; process, scientific, and systems consulting services; operations and maintenance services, and construction services, which include direct-hire construction and construction management services. It concentrates its services on selected industry groups and markets, including oil and gas exploration, production and refining; programs for various federal governments; pharmaceuticals and biotechnology; chemicals and polymers; buildings, which includes projects in the fields of healthcare and education, as well as civic, governmental and other buildings; infrastructure and technology and manufacturing. In April 2006, its Canadian subsidiary acquired Techna-West Engineering Limited. In October 2006, it acquired W.H. Linder & Associates, Inc.


Breakdown target: $55

Buy JAN 2008 $60 Call JEC-AL


NOV - National Oilwell Varco

This may be wishful thinking but a major drop in crude prices over the next several months could bring NOV back into range once again.

Company Info:

National Oilwell Varco, Inc. (NOV) is a worldwide provider of equipment and components used in oil and gas drilling and production operations, oilfield services, and supply chain integration services to the upstream oil and gas industry. The Company operates in three segments: Rig Technology, Petroleum Services & Supplies, and Distribution Services. The Rig Technology segment designs, manufactures, sells and services complete systems for the drilling, completion and servicing of oil and gas wells. The Petroleum Services & Supplies segment provides a variety of consumable goods and services used to drill, complete, remediate and workover oil and gas wells, service pipelines, flowlines and other oilfield tubular goods. The Distribution Services segment provides maintenance, repair and operating supplies, and spare parts. In March 2006, NOV acquired Soil Recovery A/S. In November 2006, it acquired Rolligon Ltd. In December 2006, it acquired 87% of NQL Energy Services Inc.

Breakdown target: $100

BUY FEB $110 Calls NOV-BB


VLO - Valero Energy

Looking to buy Valero cheap on the fall dip.

Company Info:

Valero Energy Corporation owns and operates 18 refineries located in the United States, Canada and Aruba that produce refined products, such as reformulated gasoline blendstock for oxygenate blending, gasoline meeting the specifications of the California Air Resources Board (CARB), CARB diesel fuel, low-sulfur and ultra-low-sulfur diesel fuel, and oxygenates (liquid hydrocarbon compounds containing oxygen). It also produces conventional gasolines, distillates, jet fuel, asphalt, petrochemicals and other refined products. It markets branded and unbranded refined products on a wholesale basis in the United States and Canada through a bulk and rack marketing network. It sells refined products through a network of approximately 5,800 retail and wholesale branded outlets in the United States, Canada and Aruba. During the year ended December 31, 2006, it sold all of its ownership interest in Valero GP Holdings, LLC. In July 2007, the Company sold its Lima, Ohio refinery to Husky Energy Inc.

Breakdown target: $55

BUY 2010 $70 LEAP Call YPY-AN (*** LEAP CHANGED to 2010 ***)


COP - Conoco Phillips

I hesitate to add Conoco because of its Russian LUKOIL exposure but the company is doing everything else right. Now that it is out of Venezuela it should be more aggressive with other opportunities.

Company Info:

ConocoPhillips (ConocoPhillips) is an international, integrated energy company. The Company's business is organized into six segments. Exploration and Production segment primarily explores for, produces and markets crude oil, natural gas and natural gas liquids on a worldwide basis. Midstream segment gathers, processes and markets natural gas produced by ConocoPhillips and others, and fractionates and markets natural gas liquids, primarily in the United States and Trinidad. Refining and Marketing segment purchases, refines, markets and transports crude oil and petroleum products, mainly in the United States, Europe and Asia. LUKOIL Investment segment consists of its equity investment in the ordinary shares of OAO LUKOIL (LUKOIL). The Chemicals segment manufactures and markets petrochemicals and plastics on a worldwide basis. Emerging Businesses segment includes the development of new technologies and businesses outside the Company's normal scope of operations.

Breakdown target: $70

Buy 2010 $80 LEAP Call YRO-AP


CFC - Countrywide Financial

Best run mortgage company that should come out on top of any continued meltdown. They will be grabbing market share with both fists. CEO said they had $50 billion in available credit on 8/03.

Company Info:

Countrywide Financial Corporation (Countrywide), incorporated on February 6, 1987, through its subsidiaries, is engaged in mortgage lending and other real estate finance-related businesses, including mortgage banking, banking and mortgage warehouse lending, dealing in securities and insurance underwriting. The Company has five segments: Mortgage Banking, which originates, purchases, sells and services non-commercial mortgage loans; Banking, which takes deposits and invest in mortgage loans and home equity lines of credit; Capital Markets, which operates an institutional broker-dealer that primarily specializes in trading and underwriting mortgage-backed securities; Insurance, which offers property, casualty, life and disability insurance as an underwriter and as an insurance agency, and Global Operations, which licenses technology to mortgage lenders in the United Kingdom. During the year ended December 31, 2006, Mortgage banking accounted for 48% of the Company's pre-tax earnings.

Breakdown target $20.00

Buy 2010 $30 LEAP Call YJD-AF


CCJ - Cameco

Strong earnings, major producer, the world is consuming more uranium than is currently produced.

Company Info:

Cameco Corporation (Cameco) is primarily engaged in the exploration for and the development, mining, refining and conversion of uranium for sale as fuel for generating electricity in nuclear power reactors in Canada and other countries. The Company has a 31.6% interest in Bruce Power L.P. (BPLP), which operates the four Bruce B nuclear reactors in Ontario. The Company wholly owns Zircatec Precision Industries, Inc., whose primary business is the fabrication of nuclear fuel bundles. Cameco's 52.7% subsidiary Centerra Gold Inc. (Centerra) is involved in the exploration for and the development, mining and sale of gold. Cameco has four segments: uranium, fuel services, nuclear electricity generation and gold. In June 2006, the Company acquired a 19.5% interest in UNOR Inc, whose principal properties are 226 mineral claims in northwestern Nunavut on the Hornby Basin.

Breakdown target: $35

Buy 2010 $50 LEAP Call LTA-AJ


MRO - Marathon Oil

On July 31st Marathon announced its purchase of Western Oil Sands for $5.5 billion. This will be an immediate increase in production for Marathon of 31,000 bpd. The acquisition gives them 20% interest in the Athabasca Oil Sands Project in Alberta. The other partners are Shell 60% and Chevron 20%.

Company Info:

Marathon Oil Corporation (Marathon) is engaged in exploration, production and marketing of crude oil and natural gas worldwide. The Company operates in three segments: Exploration and Production (E&P), which explores for, produces and markets crude oil and natural gas on a worldwide basis; Refining, Marketing and Transportation (RM&T), which refines, markets and transports crude oil and petroleum products, primarily in the Midwest, the upper Great Plains and southeastern United States, and Integrated Gas (IG), which markets and transports products manufactured from natural gas, such as liquefied natural gas (LNG) and methanol, on a worldwide basis, and is developing other projects. During the year ended December 31, 2006, Marathon completed leasehold acquisitions totaling approximately 200,000 acres in the Bakken Shale oil play. In July 2006, it completed a natural gas leasehold acquisition in the Piceance Basin of Colorado, in Garfield County in the Greater Grand Valley field complex.

Breakdown target: $45

Buy 2010 $60 LEAP Call WXM-AL


SLB - Schlumberger

SLB posted blowout earnings on its global services business and had only good things to say about the future.

Company Info:

Schlumberger Limited (Schlumberger) is an oilfield service company supplying a range of technology services and solutions to the international petroleum industry. It consists of two business segments: Schlumberger Oilfield Services and WesternGeco. Schlumberger Oilfield Services is an oilfield services company supplying a range of technology services and solutions to the international oil and gas industry. WesternGeco, owned by Schlumberger and Baker Hughes, is an advanced surface seismic company. Schlumberger's products and services include the evaluation and development of oil reservoirs (controlled digging, pumping and testing services), well construction and production consulting, and sale of software programs. The Company also offers storage tank and seismic monitoring services. Schlumberger Limited is headquartered in Paris, France.

Breakdown target: $77.50

Buy 2010 $90 LEAP Call WUB-AR


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