Curves, Peaks and Dips

The Rude Awakening

Wall Street, New York

Wednesday, February 9, 2005

--- The Rude Awakening Presents ---

"Hubbert's Curve" is NOT part of the female anatomy…But it is, nevertheless, a thing of beauty to long-term crude oil investors. Here's how you profit - including three specific guidelines for crude oil speculators…

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CURVES, PEAKS AND DIPS
By Eric J. Fry

"Hubbert's Curve" is NOT part of the female anatomy…

But it is, nevertheless, a thing of beauty to long-term crude oil investors.

Back in the 1950s, Shell Oil geophysicist, M. King Hubbert, discovered a phenomenon he dubbed, "Hubbert's Curve."

The Shell geophysicist theorized that oil production from a new field would tend to rise until about half the recoverable oil had been produced, then peak and fall off sharply, all along a classic bell-shaped curve.

Furthermore, Hubbert understood that in the real world of crude oil production, the "second half" of the theoretically recoverable reserves would be relatively more difficult - and expensive - to extract, which would prompt oil companies to abandon fields before extracting all "recoverable" reserves.

Based on his theories, therefore, Hubbert predicted in 1956 that U.S. oil production would peak in the 1970s. Most of his contemporaries scoffed at the notion. But his prediction turned out to be surprisingly accurate. U.S. production did indeed peak in 1970.

"Using the same model," writes Jeremy Rifkin, author of the The Hydrogen Economy, "Hubbert estimated in 1971 that the middle 80 percent of global oil production will be produced within fifty-eight to sixty-four years, or less than one lifetime."

In other words, 80% of the world's oil would have been produced by 2035…at the latest.

"If M. King Hubbert is proven right once again, the world has either reached or will soon reach peak global production," observes Steve Belmont in a new report entitled, "The Death of Cheap Oil." (Belmont is the Senior Market Strategist for the Rutsen Meier Belmont Group LLC in Chicago).

"Hubbert's predictions for exploration are also proving to be true," Belmont continues. "Now that all the cheap sources of oil have been found, oil companies are cutting spending for new exploration. The windfall profits generated by the 3-year run-up in crude prices are not being spent on finding new oil, but on share-buybacks, dividends and/or efforts to purchase already-discovered reserves. Exploration is decreasing because today's smaller, harder-to-drill fields provide less bang for the exploration buck."

"Most geologists agree that there is still plenty of oil left to be discovered," Belmont admits, "but given the cost of extraction, it is not economically feasible at current prices. The world may not be running out of oil. It is, however, running out of cheap oil."

Even the world's largest oil producer may be running low on "cheap oil"…or any kind of oil, for that matter. Saudi Arabia pumps 13% of the world's oil and is responsible for 23% of the globe's reserves, making it the most important player on the supply side, followed by Iran with 11% of the world's reserves and Iraq with 9%.

"According to official Saudi state calculations," says Belmont, "Saudi Arabia could produce at current levels of 10 to 11 million barrels per day for 50 years. However, we view that number with a certain degree of skepticism. Matthew Simmons, chairman of Simmons and Company International - an investment bank specializing in the oil industry says the official Saudi numbers are too high and that Saudi fields are aging much faster…According to Mr. Simmons, the Saudis need to strip water out of nearly every well and this is a sign that Saudi fields are aging much faster than the industry has planned for.

"Almost every oil field sits on top of water," Belmont explains. "New oil wells draw up the crude first and have almost no water content. As a field ages, more and more water gets mixed with the crude oil. Wells that are almost dead will reach a 'water cut' of 40%. According to Nasen Saleri, manager, reservoir management at Saudi Aramco, the 'water cut' for Saudi wells in 2003 was 27%."

In other words, most of the easy-to-get stuff is gone and only the hard-to-get stuff remains.

"Consequently," Belmont's report concludes, "we may have entered an era of perpetual shock where supply and demand are balanced so precariously that the slightest disruption could send prices soaring. The world is currently using 98 percent of its producing capacity; OPEC was pumping flat out in 2004 yet prices remained stubbornly high. This was unprecedented in the short history of crude oil."

So there you have it, folks; demand is climbing and supplies are dwindling…At least CHEAP supplies are dwindling. So what's the far-sighted investor to do?

Belmont recommends call options on crude oil futures. That's his business, of course. Steve is not a stockbroker; he's an options broker on commodity futures. So naturally, he prefers this medium as a way of capitalizing on the crude oil rally he anticipates.

"Most investors think of energy stocks first," says Belmont. "However, if you own the more well-known stocks you also know that they haven't kept pace with crude oil itself. History has proven that an investment in energy stocks is not necessarily an investment in crude oil. In fact, in the recent bull market, traditional energy stocks have not returned anywhere near an investment in crude oil itself - not by a long shot."

To illustrate his point, Belmont presents the nearby chart showing "the relative performance of crude oil [versus] Chevron Texaco since early 2002, a period that encompasses most of the bull market. As of late December 2004, crude oil had gained 157%. Chevron Texaco had gained only 16%. There are numerous other examples of the same phenomenon."

Why not play crude oil directly, Belmont asks?

"NYMEX crude oil futures and options allow investors to make bets on the movements of crude oil directly," he says, "offering the cleanest possible play on this most essential of all commodities. Crude oil futures are extremely volatile, so we would not recommend trading them directly for most investors. Crude oil call options are another story. Crude oil call options trade on the New York Mercantile Exchange or NYMEX…

"Each NYMEX crude oil call option," Belmont explains, "gives the buyer of the call the right but not the obligation to be long a futures contract covering 1,000 barrels of light, sweet West Texas Intermediate grade crude oil at a specific price known in option jargon as the 'strike price.'…For example, as we write this report, the spot (front) contract West Texas Intermediate crude oil futures are trading at roughly $45 per barrel. Long-dated, December 2006 $50 crude oil call options are going for roughly $2.30. Multiply times the 1,000-barrel contract size to get a total cost of $2,300 per option.

"At $60 per barrel, a $50 call would be worth at least $10,000. Why? Because the holder of a $50 call could simply exercise the right to be long at $50 per barrel and then turn right around and sell his 1,000 barrels into the market for the going rate of $60 per barrel. Multiplying the $10 per barrel difference times the contract size of 1,000 barrels yields a gross profit of $10,000 per option. Since our hypothetical option holder paid a premium of $2,300 for the right to be long, the net profit on this position would be the $10,000 gain minus $2,300 or $7,700."

Of course, options buyers should not forget that a DROP in the oil price would render a $50 call option worthless.

Your editors at the Rude Awakening are prohibited from revealing the exact option Belmont recommends currently. But we can share his rules for buying options on crude oil:

1) Buy NYMEX calls with at least 15 months until expiration.

2) Buy calls with strike prices no higher than 10% above the spot crude price.

3) Pay no more than $2,500 for each option.

Lastly, Belmont advises, "Consider buying NYMEX crude calls in multiples of two, holding one for the long term and using the other as a trading position."

Your New York editor contacted Steve yesterday to find out how Rude Awakening readers could reach him, in the event that they wished to do so. "Well, I'll be skiing this week," Steve said sheepishly. "So they should contact my colleague in Chicago, Sue Rutsen, at 800-345-7026."

"Thanks, Steve."

[Ed. Note: This is part II of a two-part essay on crude oil. Part I concentrates on crude oil demand…it was called In Memoriam: Cheap Oil. Here's the link…

In Memoriam
http://www.dailyreckoning.com/RudeAwake/Articles/inmemoriamcheapoil.html

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Did You Notice…?

By Eric J. Fry

Faithful readers of the Rude Awakening will recall that we have twice before noted short-term divergences between the price of crude oil and the shares of oil companies.

On October 26, 2004 we remarked: "The XOI Index of oil stocks has merely marked time since the end of August, even though the oil price has continued to race higher…How should investors interpret the diverging price trends between the XOI and crude oil? We suspect that…the oil share market is 'saying' that the rally in crude oil is running on fumes, at least for the short term…If forced to guess," we concluded, "we'd say that the price of crude oil will revisit $50, before climbing to $60."

And so it came to pass…

Then in Mid-December, we noted: "Oil shares are climbing, while the commodity itself is falling. This 'bullish divergence' suggests that crude oil is more likely to resume its rally than to continue slumping."

On cue, the oil price rallied into the New Year.

Now, once again, oil stocks and crude oil are heading in opposite directions, as the chart below clearly shows. But who's leading whom this time? It's true that the shares have run way ahead of the oil price, making them vulnerable to a reversal. But typically, the shares lead the price of crude, rather than follow.

So we turned for guidance to Kevin Kerr, editor of the Resource Trader Alert. "What's it all mean, Kevin?" we asked him yesterday.

"The recent divergence probably doesn't mean much," Kevin replied. "Most likely, the shares are simply getting a strong boost from all of the positive earnings and numbers they have been putting out, while oil is feeling the brunt of relative calm, slower seasonal demand, and a silence from OPEC on a production cut.

"I think we will see a resumption in oil demand as we head into the second quarter, as well as OPEC stepping in and cutting production. This will drive up prices throughout the second quarter. In my opinion the futures need a bit of a pullback and anything below $42 will be a good buy. Meanwhile, the oil company shares will likely take a bit of a breather too after such phenomenal gains, but then quickly continue to rise."

"Thanks Kevin."

[Ed. Note: Kevin recommends specific option plays to his readers on a regular basis. He covers the whole commodity arena, and his track record is exemplary.

But in the energy sector, he hasn't put a foot wrong. In fact, his worst energy trade since July 2004 was a 72% gain in natural gas!

Here's a link for more information on Kevin's technique, including his track record and his background…

Market Wizard Kevin Kerr
http://www.agora-inc.com/reports/RTA/WRTAF105

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