Option Investor

Weekly Newsletter, Saturday, 04/12/2008

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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

Gasoline $3.37 and Rising

Consumer sentiment fell to a 26 year low last week and rising gasoline prices were a strong component of that drop. Crude oil hit a new intraday record of $112.20 and that pushed national gasoline prices to a new record high on Friday of $3.365 per gallon according to AAA.

Eventually this upward move has to end at least temporarily but there seems to be no end in sight. I sent an email to everyone last week about the new production coming online in Saudi Arabia. They are finishing development on the 500,000 bpd Khursaniyah field. It will start production at 300,000 bpd within a month and rise to 500,000 by years end. Saudi will add another 250,000 bpd when it completes the 500,000 bpd Shaybah field in December. Other new projects include the 900,000 bpd Manifa field and the 1.2 mbpd Khurais project. Both scheduled to complete over the next 18 months. Adding this production cost Saudi Arabia $90 billion over a 5-year period.

This sounds like a tremendous amount of oil coming online and to the uninitiated probably like the end of the peak oil talk. Unfortunately it is not the end. It is a lot of oil but it is oil that has been scheduled to come online for 3-4 years. Meanwhile the 6% depletion rate of older fields is causing a loss of production of 5.2 mbpd each year. If you took all those Saudi fields above at face value of 2.8 mbpd that is still only one-half of the new production required for just one year to overcome the loss from depletion. Those Saudi fields are coming online over a 3-year period or roughly the addition of only 1 mbpd per year at face value. It remains to be seen if they will actually come online at those stated numbers and some of that production has already started so that dilutes the impact of the announcement.

Still, the Saudi announcement should have weakened the price of oil and it didn't. There was barely a blip in the price and that is because most serious oil investors already take into account those points I listed above. The rest are just momentum traders speculating on higher highs ahead. There was also news that Nigeria was slowly bringing production back online that was shut in due to the violence. Over 1 mbpd of light sweet crude is still offline but hostilities are easing and that could be back by years end.

The weekly EIA inventory report was bullish for prices with strong drops in every category. The strong +7.3 million barrel gain in crude the prior week was offset by a -3.1 mb drop this week. The last four weeks have been impacted by blips in imports either with a drop in deliveries or a sharp spike. This is just a routine randomization of crude deliveries. Depending on where in the world the oil is loaded it could take a week or up to six weeks from loading to delivery. The oil is contracted well in advance but delays in the loading port, equipment malfunctions, storms, harbor traffic on both ends and any number of other reasons can delay scheduled shipments for weeks. There may be weeks where ships line up outside the Houston ship channel waiting for a slot and other weeks where they just sail right in. Fog can shut down the harbors for days at a time. The tankers pile up in massive traffic jams waiting for the harbor to clear. Those ships already unloaded can be stuck in the harbors waiting for the fog to ease. The U.S. imports about 10.4 million barrels per day and that is delivered in tankers of every size including the VLCC class with 1 million barrels of crude per tanker. Just keeping roughly 30 tankers per day moving in and out of the various U.S. ports from loading docks around the world is a daunting challenge. It is a wonder the average barrels delivered per day is not more volatile. Last week imports fell an average of 1.4 mbpd. The prior week imports were up 1.4 mbpd. The week prior to that imports were only 8.9 mbpd and the lowest level in two years. All of this volatility is just tanker flow not a change in oil buying or availability. The volatility in price from these flows is simply hysteria by traders who don't understand the mechanics involved.

Weekly Oil Inventories

On Friday the International Energy Agency (IEA) revised down its overall forecast of global oil demand due to the current economic decline. The IEA said demand would now be 87.2 mbpd, down -310,000 from their last forecast of 87.5 mbpd only a month ago. The current forecast still calls for demand growth of 1.27 mbpd in 2008. Cutting demand growth estimates is not the same as cutting demand. It just means new consumption is growing slower than expected but still growing. This month's cut of -310,000 bpd in demand growth was the largest since the agency cut its estimates in July 2001 by 509,000 bpd.

The agency also noted that global supply fell by -100,000 bpd in March. They also see a surplus of supply in April and May. The demand cuts came after the IMF cut its global GDP forecast with the U.S. estimate now only +0.5% compared to +1.5% in the last IMF forecast. The IMF said growth in emerging economies like India, China and Brazil remained robust and demand should continue to grow. The IEA said it appears oil prices have decoupled from the U.S. economic woes for the first time. Normally a downturn in the U.S. creates a global slowdown.

In the IEA report, there were some interesting charts. Demand from the 30 country Organization for Economic Co-operation and Development (OECD) group is tracking along seasonal norms although the chart is only current through January. Note that there is a large seasonal demand drop in April/May.

OECD Demand Chart

Demand in North America was at the high range of normal in January. Note also that there is far less demand decline in the North American chart in April than the OECD chart.

North American Demand Chart

This next chart is where the rubber meets the road. Note that the demand for oil products in the U.S. has dropped significantly from January to February and is already well under the 5-year average and under the 4-year range. This demand drop in the largest consuming nation on earth is a direct relation to the price of gasoline and the current recession. If these conditions continue we should see an early bottom in the seasonal cycle and a bottom that could last longer.

US Oil Demand Chart

If you use that link above to download the IEA report you should look at the chart on page 19 regarding OPEC spare capacity. It was a large chart that will not fit in this commentary. It shows the OPEC spare capacity dating back to 2001 and how the nearly 9 mbpd of spare capacity fell to less than 1 mbpd in 2004. They have rebuilt it to some extent in the last three years but since early 2007 that capacity has been declining again.

One of the most revealing charts (page 23) and accompanying discussion concerns depletion of the major non-OPEC producers. You have heard me discuss this over and over for years. The accepted rate of decline for these discussions has increased about 1% per year over the last 4 years. Instead of using the 3% depletion rate that was common 4-years ago the new "accepted" depletion rate is now 7.7% per year. This is a monumental change and it represents the difference between losing 2.64 million barrels of production per year to depletion and lowing 6.77 million barrels! This is a major change for the IEA, an agency, which has always been extremely optimistic about existing and future production. This is for non-OPEC production since OPEC does not release any data. We can however extrapolate that their mature fields would follow the historical rate seen in the rest of the world. OPEC, specifically Saudi Arabia, has fields that have not yet been commercially developed and they can use those new fields to offset the decline in their old fields.

Non-OPEC Decline Rate Chart

You have also seen me write about the extreme imbalance in U.S. gasoline inventories. In the IEA chart below the black line is the build in gasoline inventories well above the normal ranges. This has decreased slightly after four consecutive weeks of declines totaling 14.6 million barrels to 221.3 mb last week. It is still well above the normal range. This is entirely due to falling demand as prices exploded well over $3 per gallon. With the excess inventories the crack spread, the difference between the cost of a barrel of crude and the value of the refined products, for U.S. refiners is nearly zero. Until that spread returns we can expect refiner utilization to remain low.

US Gasoline Chart

Oil research is a complicated field. There are thousands of variables not to mention the intentional misinformation from OPEC countries. About the only thing we can count on is the amount of product in inventory and the current demand rates. In the week ended on April-4th gasoline demand fell to 9.286 million barrels per day compared to 9.472 mbpd in 2007. This represents a 2% drop in demand or -186,000 bpd. As long as crude prices keep climbing the demand for gasoline will continue to fall.

A couple analysts I believe are credible suggest we could continue to see a momentum rise in oil to $120 a barrel over the next month. Given the seasonal decline in demand in April and May $120 seems like an impossible number. However, we have seen over the last few months that fundamentals don't seem to matter any more and until commodities lose their allure we just need to watch as the volatility increases. After May there should be a rise into hurricane season especially since we have escaped any damage for two consecutive years. Our luck will eventually run out. You may have noticed that oil stocks have not followed crude higher. There is a strong reluctance to "buy the top" and the integrated oils like XOM, COP, BP and CVX are wandering aimlessly on the charts. Most of the service companies are following the same pattern. Until we get a correction in oil prices we need to avoid loading up on oil positions. With the winter over the same is true with gas stocks. They should also begin to weaken through the spring. We have a very small portfolio right now and with the broader market direction in doubt there is no need to add positions just to be adding positions. Cash is a position.

Nymex crude options expire next Thursday and May crude futures expire on April 22nd. Both events should cause additional volatility. You may remember last months expiration cycle when there was significantly more open interest than normal going into expiration. The result was a sharp drop in prices. This month the open interest is closer to normal but still elevated. That could provide another dip to buy back in the vicinity of $100. Time will tell.

Jim Brown

May Crude Futures Chart - Daily

May Natural Gas Futures Chart - Daily

May Gasoline Futures Chart - RBOB Daily


Changes in Portfolio

New Energy Plays
USO United States Oil Fund *** Short ***

New Non-Energy Plays
EBAY Ebay Inc *** Earnings Short ***

Dropped Plays
TOL Toll Brothers *** Closed ***

New Watch List Plays Triggered


Portfolio Listing & Top Picks

Top Picks

If you are looking to add another position these are my top picks for this week. The target prices listed would be the ideal entry points for these stocks today. There is no assurance any stock will ever return to these support levels and you will need to make your own decision about an entry point above these levels. I believe these stocks have the best potential this week. The list will change from week to week based on technicals, fundamentals, crude prices and market action. The list is not sorted in any particular order.


New Plays

Most Recent Plays

New Energy Plays

USO - United States Oil Fund *** Short ***

This play is based on the potential for selling in the oil futures as Nymex crude options expire next Thursday and Crude Futures expire the following Tuesday.

There is a trigger on this play. Do not enter unless the USO trades at $87.25 or touches $90.

Company Info:

United States Oil Fund, LP (USOF) is a commodity pool that issues limited partnership interests or units that may be purchased and sold on the American Stock Exchange (the AMEX). The Company invests in futures contracts for light, sweet crude oil and other types of crude oil, heating oil, gasoline, natural gas and other petroleum-based fuels that are traded on the New York Mercantile Exchange (NYMEX), International Currency Exchange (ICE) Futures or other United States and foreign exchanges (collectively, Oil Futures Contracts). It holds interests in other oil-related investments such as cash-settled options on Oil Futures Contracts, forward oil contracts, and oil-based over-the-counter transactions. As of December 31, 2007, USOF held 4,754 Oil Futures Contracts traded on the NYMEX and 300 Oil Futures Contracts traded on the ICE Futures. The Company operates under full management control of its sole General Partner, Victoria Bay Asset Management, LLC (the General Partner).

Breakdown trigger: $87.25

Buy May $85 PUT UNA-QG currently $2.65

Upside trigger: $90.00

Buy May $87 PUT UNA-QI currently $3.70

New Non-Energy Plays

EBAY - Ebay Inc *** Earnings Short ***

Ebay has a seriously bad habit of declining after their earnings announcement. They have ramped into earnings this quarter with a +$7 bounce from the March lows. A negative surprise here could be ugly. This is a short-term play with a minor risk of only $1.30.

Company Info:

eBay Inc. (eBay) provides online marketplaces for the sale of goods and services, as well as other online commerce, or ecommerce, platforms, online payments services and online communications offerings to a diverse community of individuals and businesses. The Company has three business segments: Marketplaces, Payments and Communications. Its Marketplaces segment enables online commerce through a variety of platforms, including the traditional eBay.com platform and eBays other online platforms, such as its classifieds Websites, as well as Half.com, Rent.com, Shopping.com and StubHub. eBays Payments segment, which consists of PayPal, enables individuals and businesses to send and receive payments online. Its Communications segment, which consists of Skype Technologies S.A. (Skype), enables voice over Internet protocol (VoIP) communications between Skype users and provides low-cost connectivity to traditional fixed-line and mobile telephones.

Buy May $30 PUT XBA-QF currently $1.30


Play Updates

Existing Plays

MDR - $56.00 -2.18 McDermott Intl ** No Stop **

McDermott had news of new contract awards but that is a weekly occurrence. They did announce they would report earnings on May 12th. McDermott and others in the group were down slightly after Shaw (SGR) missed earnings slightly.

Breakout trigger: $51.00 (hit 3/24)

LEAP Call Spread
Long 2009 $55 LEAP Call OYZ-AK @ $8.28
Shrt 2009 $75 LEAP Call OYZ-AO @ $3.10


TS $50.63 -.37 - Tenaris *** Stop Loss $47 ***

Tenaris said it completed the sale of its Hydril pressure control business to GE for $1.115 billion. Other than that there was little news. TS declined slightly into Friday but remains above prior resistance at $50. I raised the stop just in case trouble arrives.

Breakdown trigger: $46.00 hit 3/19

Position: SEP $50 Call TSW-IJ @ $3.40


HP $51.62 +2.21 Helmerich & Payne *** Stop Loss $41 ***

HP continued to move higher hitting a new high at $52.30 on Friday. There is no weakness here! HP announced its earnings date of May 1st.

Earnings: Jan-31st $1.02

Position: Jan 2009 $35 LEAP Call ZQA-AG @ $4.50

Insurance put:
Position: Nov $30 HP-WF. @ .50, expired

Non-Energy Positions

SPWR $87.76 -2.64 - SunPower

After a +$16 week I am very happy with only a -2 pullback. Wells Fargo boosted SunPower's credit line from $50 million to $150 million through July-2012. Other chipmakers trying to capitalize on the solar trend, AMAT and MEMC, were cut last week by Goldman and Credit Suisse. At the same time First Solar (FSLR) was mentioned kindly. Eventually we are going to see the winners double and triple and the laggards will fall by the wayside.

Breakout trigger: $66 (hit 3/24)

LEAP Call Spread
Long 2010 $80 LEAP Call LMO-AP @ $20.00
Shrt 2010 $130 LEAP Call LMO-AW @ $8.70


CY 26.29 -0.39 - Cypress Semi *** Stop Loss $21.50 ***

+$3 last week, -.39 this week, I will take it every time. Simtek (SMTK) rejected an offer by Cypress to buy the company for $2.20 per share. SMTK was trading at $2.55 on Friday. Cypress owns 19.3% of SMTK already. Counting the shares they don't own the $2.20 offer represents about $28 million. Just going out to the market and buying the rest at $2.55 would only increase the buy to $32 million. Looks like a no brainer to me. Just put in a bid at $2.40 and keep your mouth shut. Odds are good you will end up with a controlling interest very quickly. SMTK was trading at $1.86 when CY made the $2.20 offer. Withdraw the formal offer and it could be $1.86 again very quickly.

Breakout trigger: $21.50 (hit 3/24)

Position 2010 $25 LEAP Call WSY-AE @ $4.90


TOL $22.47 -2.00 - Toll Brothers *** Closed ***

Toll is starting to look weak again along with the sector. It may be just too early to play the homebuilders. I am going to take the $1.30 loss and abandon the play. Fitch warned on Friday that declining prices, tighter lending standards and deepening recession would keep the pressure on builders into 2009.

Breakout trigger: $25

Position: 2010 $30 LEAP Call YKW-AF @ $5.40, exit 4.10, -1.30


C $23.36 -0.72 - Citigroup *** Stop Loss $22.50 **

Citi is holding the high ground but earnings are next Friday. With 6-8 other financials reporting before Citi I am concerned that we could be stopped on volatility before they ever report. I raised the stop to $22.50 rather than give back any gains. I would rather exit flat and reenter again next week if everything still looks ok.

Position: 2010 $25 LEAP Call WRV-AE @ $4.00

Position: June $17.50 Put C-RR @ $1.25

Covered LEAP Calls

AAPL $147.14 -5.94 Apple Inc *** Covered LEAP Call ***

Apple gave back $7 on Friday and erased all the gains for the week. There was no specific news producing the decline and it appeared to be simply profit taking.

Long: AAPL @ open of $177.52 (Jan-14th open)
Short: 2009 $150 LEAP Call VAA-AW @ $20.80
Breakeven: AAPL @ $136.12

Position changes:
Closed $200 LEAP Short @ $9.40 ($30.00 - 9.40 = gain +20.60)
Replaced with $150 LEAP short @ $20.80
AAPL cost basis $177.52 - $41.40 (20.60 + 20.80) = 136.12
Breakeven: AAPL @ $136.12


RIMM $115.85 -4.14 Research in Motion

RIMM was looking good going into Thursday's close but the market weakness and probably some expiring options activity knocked -4.83 off the price on Friday. It is still very close to a 3-month high set on April 3rd and a long way from the $80 level we suffered through in January.

I looked at closing the RIMM play because we are capped on the upside by the short LEAP. We adjusted down from the $150 leap when the stock dropped from $100 to $80. That gave us a $9.10 profit on the closed leap and let us get into the $110 leap for $18.30.

If we exit right now our profit is $13.90 because we have to buy back the $110 leap for more than we got for it.

If we continue holding the position until January and let it get called away your profit will be $34.80 when the stock is called away for $110. The difference is not having to buy back the $110 LEAP.

Alert entry 11/12 @ $102.60

Covered LEAP Call:

LONG RIMM @ $102.60 (cost $102.60 -9.10 $150 LEAP = 93.50)
SHORT 2009 $110 LEAP Call VHO-AB @ $18.30 on 1/14/08

Closed: 1/14
SHORT 2009 $150 LEAP Call XTB-AJ @ $18.50, close $9.40 +9.10

Leaps Trader Watch List

Dropped Entries


New Watch List Entries
FLS Flowserve
UPL Ultra Petroleum

Current Watch List

PBR - Petrobras

This company has everything going for it and there is no reason for this decline other than sector rotation. If we see $90 on a dip we need to be buyers.

Company Info:

Petroleo Brasileiro SA - Petrobras (Petrobras) is a Brazil-based holding company engaged in the exploration, production, refinement and distribution of oil and gas. The Company is involved in four business areas: Exploration and Production, Downstream, Gas & Energy and International. Petrobras has 109 production platforms and 15 refineries. It operates 31,089 kilometers of pipelines. The Company has various subsidiaries: Petrobras Quimica SA - Petroquisa, which is engaged in the production, commercialization, distribution, import and export of chemical products; Petrobras Distribuidora SA - BR, which is involved in the distribution and commercialization of oil products and natural gas, and Petrobras Netherlands BV - PNBV, which is active in the purchase, sale and rent of equipment and platforms for the production of oil and gas. Petrobras operates in Brazil, Argentina, Mexico, Portugal, the United States, Peru and Turkey, among others.

Breakdown trigger: $100

Buy 2010 $120 LEAP Call YMO-AD
Sell 2010 $140 LEAP Call YMO-AH


USO - U.S. Oil Fund

The USO fell -$8 last week to trade under $80. If we really get some margin selling in the commodities and especially oil it is possible but not probable we could see $72. If by some freak combination of circumstances we do tag that level we want to be long.

Breakdown trigger: $80 *** New trigger ***

Buy 2009 $80 LEAP Call OLL-AB *** New Strike ***
Sell 2009 $95 LEAP Call OLL-AQ


FLS - Flowserve

Flowserve was downgraded last week by Robert Baird just as it hit a new high at $118. Their price target was $120 and he felt it was fairly valued. At the same time Flowserve was upgraded by S&P and Moody's. Flowserve is expected to earn just over $5 in 2008 and $10 by 2010. Even according to Baird this is not priced into the stock. I think they should be immune to any light market selling with support at $105 but could suffer in any real downdraft.

Company Info:

Flowserve Corporation (Flowserve) is a manufacturer and aftermarket service provider of flow control systems. The Company develops and manufactures precision-engineered flow control equipment, such as pumps, valves and seals, for critical service applications. Flowserve offers a range of aftermarket equipment services, such as installation, advanced diagnostics, repair and retrofitting. The Company sells its products and services to more than 10,000 companies, including engineering and construction firms, original equipment manufacturers (OEMs), distributors and end users. The Company operates through three business segments: Flowserve Pump Division (FPD) for engineered pumps, industrial pumps and related services; Flow Control Division (FCD) for engineered and industrial valves, control valves, actuators and controls and related services, and Flow Solutions Division (FSD) for precision mechanical seals and related products and services.

Breakdown trigger: $100

Buy Oct $110 Call FLS-JB

Breakout trigger: $110

Buy OCT $120 Call FLS-JD


UPL - Ultra Petroleum

This may seem like a strange play given my thoughts that gas prices could go down this summer. The reason UPL has been rising is the new cross country pipeline to their property in Utah. Once completed they will be able to sell their gas for more money with access to the eastern markets. Ultra is on a capex program to spend $755 million in 2008 to boost production by 18-22%. They pln to boost production another 25-30% in 2009 over 2008 levels. 2008 estimates are for 135-140 BCF. They produced 117 BCF in 2007. 2009 estimates are for 170-175 BCF. 2010 estimates are for 200-205 BCF. That would be nearly double their 2007 production.

Company Info:

Ultra Petroleum Corp. (Ultra) is an independent oil and gas company engaged in the development, production, operation, exploration and acquisition of oil and natural gas properties. The Companys operations are primarily in the Green River Basin of southwest Wyoming. The Company continually evaluates other opportunities for the acquisition, exploration and development of oil and natural gas properties. As of December 31, 2007, Ultra owns interests in approximately 121,652 gross (62,756 net) acres in Wyoming covering approximately 230 square miles. The Company owns an interest in approximately 676 gross producing wells in this area and is operator of approximately 50% of the 676 gross wells. The Company owns interests in 252,629 gross acres in Pennsylvania. On October 22, 2007, the Company sold Sino-American Energy Corporation (Sino-American), which owned its Bohai Bay assets in China.

Breakout trigger: $83

Buy 2009 $90 LEAP Call OZH-AR

Breakdown trigger: $76

Buy 2009 $85 LEAP Call OZH-AQ


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