Oil Sector Watch: On the Lookout for Puts

by: Philip Davis

Here's a nice Freakonomics article on the "efficient market hypothesis." I underlies the point I've been making on oil pricing -- that (mis)information has been used to drive up the price of oil and caused an overreaction, much like the 10% drop in the S&P after 9/11 was an overreaction.

While it has been tempting too view the post-9/11 spike in oil prices as the beginning of a long-term trend (red line on graph), it looks a lot more likely that we are in the IEA's reference (most likely) frame, in the first stage of a correction that may take us down near $50 a barrel before resuming a more reasonable uptrend.

It is very possible that even this scenario is overly pessimistic, as the there is substantial evidence that production capacity is increasing, rather than decreasing. Even the bearish IEA (the people who "forgot" to include 80M barrels of inventory in Q2 of this year, causing the speculator market to go crazy) projects that at just $28 per barrel, the incentive is enough to ramp global production up to 38B barrels a year by 2015.

This would be a substantial increase over the 30B barrels a year we currently consume, and at just $28 a barrel! How much will they be willing to produce for $40? On the same chart, you can see the answer is 60B barrels a year by 2025.

Now much is made of the IEA's assumption that we will hit peak oil production sometime around 2035, but the same prediction was famously made in 1956 about 1970 (one of the root causes of the 1970s speculation bubble and oil crisis).

The fundamental flaw in many of these assumptions is that they do not take into account the untapped potential resources available at higher prices. Also, what if oil isn't as rare as you think it is? Forget the fact that there are 2T barrels of oil locked up in U.S. shale, and another 1.5T in Canadian oil sands. But what if oil doesn't even come from dinosaurs, as we have been taught, but from a renewable geological process?

I'm no geologist, but it does occur to me that if we just found 15B barrels of oil 9,000 feet beneath the sea in the gulf, where did that biomass come from? Maybe there is some merit to crude as a common geological byproduct...

We will find out soon if the Russians are correct, because the great benefit of Russian-style government is that Putin can devote resources directly to exploration in the Caspian Sea and Siberia in order to test this hypothesis. Rather than let oil companies run their government, the Russian government takes a very hard line, justified or not, in dealing with Big Oil.

Ex-KGB-chief Putin wants to make sure the Russian Government remains firmly in control of its national recourses, and intends to make Russia a leading EXPORTER of oil in the next decade. Agree with the politics or not, the fact is that the economic might of one of the World's most powerful nations is being brought to bear on the problem of increasing global oil production (whether that is their direct intent or not).

We spoke about the OPEC conundrum earlier in the week as a production cut signals an oversupply of oil, which negates the argument that oil prices should be high due to supply constraints. The more they cut back the more cushion we have, and issues like Iran and Nigeria become non-factors in front-month oil contracts.

Here's where Adam Smith's Invisible Hand reaches out and slaps oil-producing nations who have run up the prices at such a rapid pace:

The OPEC cartel was able to effectively regulate oil pricing by calling for production cutbacks by it's members. At $15-$20 a barrel, it made economic sense for a producing country to cut back production by, say 5% in order to keep prices closer to $20 than $15.

If you assume the county produces 1M barrels per day, their revenue stream at $15 is $5.475B per year. Producing 950K barrels a day at $20 yields $6.935B, so it is in the best interest of an individual country to maintain pricing.

By allowing oil to be driven up to unrealistic levels (over $70 for 6 months, averaging over $65/barrel since last August) that same 1M barrel-a-day producer has become accustomed to collecting $23.725B a year.

A production cutback of 5% (1.5M OPEC barrels, 4M barrels if enacted globally) in order to maintain $60 per barrel pricing, would drop the net proceeds of a cooperating country to $20.805B while selling as much oil as they can, say 1.1M barrels at $55 would yield them $22.082B.

Even if you assume that the country is already producing as much as they can (and why wouldn't they) at $65 a barrel, the cutback still costs them $1.186B a year (5%) in lost revenues. Oil prices are simply too high to make cutting back production enough of a short-term benefit to entice enough members to stay under quota.

The more they succeed, the more the incentive to cheat. At $70 per barrel a country that can slip out another 100K barrels a day picks up an extra $2.555B, chump change to US -- but enough to pay for thousands of roadside bombs for others.

Without a reasonable economic incentive to cooperate, you can expect producing nations to continue to pour out as much oil as the market will bear for as long as this party (oil over $40) lasts. As we pointed out back in April, Chavez was ahead of the curve, looking to hedge his oil at $50 per barrel -- there were no takers.

If we roll our expectations forward and apply $50 oil to our friends at ExxonMobil Corp. (NYSE:XOM), ConocoPhillips (NYSE:COP), Chevron Corp. (NYSE:CVX), BP PLC (NYSE:BP) and Royal Dutch Shell (NYSE:RDS.A) (the usual suspects), we can expect earnings declines of as much as 10% next year. But as one of my posters pointed out in comments: "Oil is a commodity that gets set by supply and demand including hedge fund speculators; it is also cyclical... Now there is massive capital investment, capacity will start coming on line, the high prices will impact demand. The supply and demand curve gets out of wack the other way, and here we go on the other side of the cycle. So, when gas prices drop as they are, and get to the point that the oil companies returns are being crushed, they can only focus on squeezing costs and layoff people as they did in the 80s and 90s."

While I'm not looking for that sort of carnage in the oil sector, I do think this short-term correction still has a way to play out. As I pointed out in the Weekend Wrap-Up, oil is now 60% of the way down towards a healthy correction at $54, based on a Fibonacci retracement pattern (and ignoring all the politics etc.). I expect a pump into Wednesday's numbers, but by Thursday the natural gas build will leave oil bulls with nowhere to hide, so we will be watching the following stocks for good entry points next week

To see the extent of the change in sector sentiment, you only need to look at Veritas DGC Inc. (VTS), who received an offer of $3.1B in cash and stock from Geophysique on 9/5, valuing the company at $75 a share. VTS got a triple downgrade the next day and shares fell back to $66 over the next week despite the deal on the table.

By good entry points, for new readers, we are generally looking for options to pull back 20% to make a good entry point -- we will follow up in the daily comments for full positions, these are just research suggestions to get us ready for the week.

Today's Oil-Sector Picks:
TODCO (THE) purchased $150M of their own stock between Aug. 10 and Aug. 30, taking the stock from $32.45 to $41. In the one week since they announced the completion of the program (they paid an average of $35.51) the stock has dropped back down to $35.60. With an average volume of less than 2M shares a day during August, the company made over 10% of the entire month's purchases.

  • The company has earnings in October, but the quarter ending in September is expected to be a beat of last years numbers of 140%, but I don't see them pulling off .82 a share unless sales are far in excess of the projected $249M. We may not get earnings until early November, so I'm looking at a buy on the Dec $35 puts for $3.40 or less and selling the outrageous Oct $35 puts for $2 or more.
  • McDermott International (NYSE:MDR) is a multifaceted service company that just got a big Cheniere Energy Inc. (NYSEMKT:LNG) contract in Qatar from RDS.A. This gave the stock a nice boost, but it quickly retraced last week ,and I think that changing economics will skew the project or at least place it on hold. If they come up enough, I will be looking at the $45 puts, perhaps $2.50 or less.
  • Chevron Corp. (CVX) is taking the Alfred E. Newman approach to declining prices with a mild, $5 pullback from their August highs (whereas ConocoPhillips (COP) is down $12, ExxonMobil Corp. (XOM) $7, Sunoco Inc. (NYSE:SUN) $18, Total S.A. (NYSE:TOT) $7, BP PLC (BP) $7). Even assuming CVX is a better overall producer (they are NOT better than COP or XOM) in the past 200 days they have outperformed these peers (other than XOM) by 10%, and outperformed Sunoco by 30%. I like the majors because the options are relatively inexpensive, and the $60 puts reachable are .90.
  • XOM is on my list for the same reason, but I am counting on this manipulated piggy to come up close to $67 so I can grab the $65 puts for under $1. We advocated a spread on them earlier in the week between the $67.60 calls and the $62.50 puts, and are down 10% for our troubles so far as volatility flattened out going into options. This one may explode out of the gate one way or the other, but, as we are already 460% ahead on our original $67.50 put play, we're not exactly sweating it out. As with CVX, the stock is trading 25% above United States Oil Fund's ETF (NYSEARCA:USO) price appreciation.
  • Frontier Oil Corp. (NYSE:FTO) was at $15 last October after having fallen off a cliff in September. At $25 I think they will be hard-pressed to match this year's high expectations, nor do I think they can give a good guidance report if crude continues to slide. A 65% increase in earnings (to match the price) over last year's $2.37 would require the second half numbers to come in at $3.87, which would require a 20% increase over the first half of the year. A miss of any kind will knock this stock below $25, so I like the Jan $25 puts for $2.60 and possibly selling the current $25 puts against it for $1.30.
  • Cheniere Energy Inc. (LNG) plans to lose money this year and much, much more money next year as they work to build an infrastructure that no one may need. Revenues are off 40% from last year and the loss is only narrowed by accounting shenanigans, taking a .30 "expense recapture" in Q2 by capitalizing pipeline development costs that were previously expensed. In addition to the $12.3M accounting bonus, the well-funded company pocketed $10M in interest income and drew a $5.6M income tax benefit in Q2. Without these items, you don't even want to know what a turkey this stock is!
  • LNG's 10Q report states: "Even if successfully completed and implemented, our LNG-related business activities are not expected to begin to operate and generate significant cash flows before 2008. As a result, our business success will depend to a significant extent upon our ability to obtain the funding necessary to construct our three LNG receiving terminals and related pipelines." One has to wonder what the anticipated price point was that made this massive undertaking a viable project. With $1B in debt and $3B in projects to complete and $1.4B in assets ($800M cash), this company most reminds me of Sirius Satellite Radio Inc. (NASDAQ:SIRI) when it was at $50 back in 2000, when it was all promise and building but no actual sales or service. The Jan $30 puts are just $2.95 and the current $30 puts can be sold against them for $1.60.
  • Valero Energy Corp. (NYSE:VLO) is not done playing limbo with $50, but I'm hoping for a nice run-up to get those puts cheap.
  • XTO Energy Inc. (XTO) has a lot of fans but the Nov $35 puts are a fun trade at .45.

Let me know if you have some others; it's a big field and we're looking for unrealistic high-flyers as long as oil stays under $65!

By way of disclosure: I currently only have the ExxonMobil Corp. (XOM) puts, but I fully intend to buy whichever of the discussed plays come down in price the most next week!

Read all of Phil Davis's articles on Seeking Alpha.