WTI

As WTI rose over $72/barrell this morning on Norwegian strike fears and tightness in US gasoline summer supplies (see first article below), you may recall that our last analysis regarding oil carried a graph evidencing that while prices are reaching their historical high in nominal terms, oil suppliers seem unable to increase production. Our first reaction then was to think that suppliers are facing a production limitation of some kind. However, if you look at the facts, the opposite picture could emerge:

THE FACTS

1. The World SPR (Strategic petroleum reserve) is currently close to its highest value over the past 20 years: 1.4 billion barrels
2. The physical (“wet barrel”) market is awash in oil. Saudi Arabia, the world’s top exporter, had to cut production from 9.5Mbpd down to 9.1Mbpd (-400,000 barrels per day) since April-06 (see second article below and http://www.dawn.com/2006/06/25/ebr5.htm).
3. OPEC monotonously insists that supply is plentiful at every meeting since 2004: 05-28-06 05:05 PM EST. CARACAS -(Dow Jones)- OPEC’s acting secretary general, Mohammed Barkindo, said Sunday that the global oil market is well supplied. “This market is very well supplied both in terms of crude and products,” Barkindo said upon arriving in Venezuela for an OPEC ministerial meeting. Ministers of the Organization of Petroleum Exporting Countries will hold a formal meeting in Caracas on Thursday-

ONE POSSIBLE EXPLANATION

Since the late 1980s, there are two distinct markets for oil: an illiquid spot market for “wet barrels” and 2 liquid derivatives markets for so-called “paper barrels” of oil: NYMEX and ICE. Theoretically, “wet barrel” and “paper barrel” prices should be tied together by arbitrage as it happens in most commodity and stock index futures markets, but apparently not in the oil market. This is probably due to the fact that the types of crude oil traded in derivatives (West Texas Intermediate and UK Brent) represent a very small % of world’s daily oil production, e.g. WTI represents the most expensive 1% of all oil sold in the world, while Brent represents 0.4% of the world’s total oil production. Thus, paper barrel oil prices keep rising and at the same time oil producers can’t find buyers for all their oil, including light sweet crude. So, at least in the short-term, maybe the run-up in oil prices is not an indication of shortages in the physical market, but a financial phenomenon.

BOTTOM WATCHING

With the above, we are saying that maybe in the short-term, oil prices (and commodities in general) may be due for a correction. However, if this correction in fact happens, one should be prepared to acquire a position in both oil and gold, once both markets start to recover. I cannot pinpoint a date for any of this, but as a general guideline, I would follow the “8-year cycle” posed by Clif Droke (http://www.clifdroke.com/articles/jun2006/061406/art061406.mgi), who claims that we will be see all investment markets bottom in September. Take a serious look at the link provided; Droke´s explanations make a lot of sense, especially, his presidential cycle theory that revolves around the fact that US presidents must take all the hard medicine (Fed Rate increases) during their first two years in office, so they can enjoy the benefits over the last two years of their term. If oil and other commodities continue to rally during July, then I would expect Droke to be right on the money by Sepetember.

START GOOGLING FOR GHAWAR

No matter what happens over the next three months, we think the long-term potential for oil prices is drastically up. Just like Burgan (the world’s second largest field) and Cantarell (the second largest producer) peaked last November and December, respectively, we believe Ghawar, the world largest oil field is due to peak this year or next. Ghawar, found in 1948, accounts for about 60 per cent of Saudi Arabia’s oil production. 90 per cent of Saudi Arabia’s oil comes from seven super giant fields discovered between 1940 and 1972 (see 5 of them in the list below), the other 10% comes from about 300 smaller oil fields. According to Mathew Simmons (see his impressive presentation at http://www.simmonsco-intl.com/files/Energy%20Conversation.pdf), aquifers are being drained to pump oil out from ever deepening wells (9 million barrels of water/day in Ghawar); a sign that oil near the surface is exhausted in all of these fields. In fact, most of the fields listed below have already peaked and are now in depletion phase. Since they comprise over 60% of current world light-crude reserves, their peaking means the world’s peaking.

However, since Ghawar´s weight among them is so large, its own official peaking will determine the world’s peak. In other words, the only variable we need to follow from here on is Ghawar´s daily production. As you may know, this figure is heavily guarded by Saudi Arabia and will not be revealed willingly. The only thing we know for sure is that the 68 year-old gusher has already produced more than 90% of its original 1970’s estimated URR (ultimate recoverable reserves).Thus, we won’t know for sure when peak oil occurs until after the fact.  In his presentation, Simmons envisions Middle East oil production to drop by 25% by 2012 and by 50% by 2018 (see slide 44 in the above presentation link). If this were the case, we may only have the rest of 2006 to make up our mind and buy as much oil as we can safely afford before the coming spike.

ARTICLES ATTACHED:

FINANCIAL TIMES

Supply concerns for summer period send oil prices higher

By Kevin Morrison

Published: June 24 2006 03:00 | Last updated: June 24 2006 03:00

Oil prices rose this week, while metal prices fell, continuing a trend that has been in place since the sector began to fall from its highs in early May.

IPE Brent for August delivery fell 2 cents to close at $69.93 a barrel in London trade yesterday, and was up 2 per cent on the week. August West Texas Intermediate added 3 cents to settle at $70.87 a barrel in trade on the New York Mercantile Exchange, leaving it up about 1.7 per cent on the week.

Oil prices were pushed up this week mainly on concerns about tightness in US petrol supplies during the summer period when demand reaches a seasonal peak. This pushed up US gasoline futures by 4 per cent this week.

The Atlantic hurricane season also kept the market nervous with the US National Hurricane Center saying this week that a tropical storm could develop north of the Bahamas. But it added that it was unlikely to turn into a cyclone and predicted it would avoid the oil and natural gas fields in the Gulf of Mexico.

Another factor that helped support oil prices was the threat of a strike by oilfield service workers in Norway, the world’s third largest oil exporter, that could startto affect production next week.

Gold fell $4 to $577.70/$578.00 a troy ounce in late afternoon London trade. The fall was enough to stop the metal price from recording its first weekly rise in six weeks. The gold price has fallen 20 per cent since reaching a 25-year peak of $730 a troy ounce on May 12.

The gold market ignored comments this week by officials at China’s central bank that China should allocate more of its foreign exchange reserves, which are the largest in the world, to gold.

Copper prices were up $91 to $6,709 a tonne yesterday on the London Metal Exchange, but down $180 on the week. The fall in copper prices came in spite of copper inventories at warehouses registered with the LME suffering their steepest weekly drop since last October, to 95,000 tonnes, or two days of world consumption – and threats to supply in Mexico and Chile.

Striking workers at two of Grupo Mexico’s copper facilities have forced the company to forfeit supplies, while in Chile unions at BHP Billiton’s Escondida are pushing for a pay rise of up to 10 per cent.

The three-month LME aluminium contract dropped $37 to $2,448 a tonne yesterday, and was down about $120 on the week. Zinc prices dropped $80 to $2,860 a tonne, and were down 7 per cent on the week as inventories in LME warehouses recorded some rare increases this week.

The Atlantic hurricane season has also affected US orange juice futures, which mainly track the Florida orange crop. The orange juice futures for July delivery on the New York Board of Trade hit a 15 year high of $1.6615 a pound yesterday. The Florida crop was partially damaged by the hurricanes last year, and producers, consumers and investors are expecting the same to happen this year.

WALL STREET JOURNAL
Saudis Cite Market Forces
For Lower Crude Output

Kingdom Denies Any Effort
To Curb Global Oil Supply;
Stores Are Near Capacity
By BHUSHAN BAHREE
June 5, 2006; Page A3

CARACAS, Venezuela — Saudi Arabia’s oil minister confirmed that his country’s massive crude-oil output has declined in recent months, but he attributed the trend to a drop in demand and denied the kingdom is aiming to limit supply.

In an interview after a meeting here of the Organization of Petroleum Exporting Countries, Ali Naimi said other cartel members are having trouble finding buyers for all the crude they are producing, at a time when global stores are near full and many refiners have closed facilities for routine maintenance. One Saudi official said an estimated three million barrels a day of refining capacity is out of action and unable to process crude, at a time when the world is using some 84 million barrels a day of oil products like gasoline and jet fuel.

“It’s not just heavy oil. Even light oil is having problems” finding buyers, Mr. Naimi said, referring to premium grades of crude known as light crude that are highly prized by refiners because they have high gasoline yields.

Asked if the kingdom was easing up on supply because of concern about the buildup of inventories in the U.S. and other importing countries, Mr. Naimi rejected such a motive, replying: “At $70 a barrel?” Mr. Naimi suggested that producers will sell all the oil they can at such high prices.

The implication of Mr. Naimi’s remarks is that Saudi Arabia would again open its oil spigots when buyers ask for more oil. For the past two years, the Saudis say, their policy has been to sell as much oil as buyers want, to the limit of the kingdom’s production capacity.

U.S. benchmark crude for July delivery settled at $72.33 a barrel, up $1.99, on the New York Mercantile Exchange Friday. So far in 2006, crude oil is up $11.29 a barrel, or 18%, and the price has more than doubled since the end of 2003 due to rising global demand and supply constraints.

The Saudi minister said the kingdom’s oil output fell to 9.1 million barrels a day in April, the most recent figures available. Saudi output averaged nearly 9.5 million barrels a day in the first quarter, according to data compiled by the International Energy Agency.

The Saudi oil czar shrugged off concerns about large inventories, a trend that some in OPEC have cited as warranting a cutback in production. Mr. Naimi said producers must focus not only on stockpiles but also on spare oil-pumping capacity world-wide. Because there is little extra oil that exporters can produce, oil held in inventories can act as a cushion against supply disruptions.

But he ruled out the idea of Saudi Arabia discounting its oil to sell more barrels. “We will not leave money on the table” for others, Mr. Naimi said.

Saudi Arabia prices its oil according to a formula that takes into account prevailing prices on futures markets and on refinery margins — or the difference between the price of crude and the price of crude-based fuels — in different regions. It adjusts prices monthly for America, Europe and Asia. Many other exporting countries follow the kingdom’s lead. OPEC’s members assert that by basing prices on futures markets and on refining margins, they in effect let markets set the price of their oil.

With prices near a nominal high — though still shy of highs reached in the early 1980s when adjusted for inflation — OPEC’s ministers on Thursday brushed aside a proposal by Venezuela to trim output and decided to maintain current output quotas totaling 28 million barrels a day, excluding Iraq.

OPEC and industry officials say the cartel’s output is currently below that. In part that is because of supply shortfalls in Nigeria, whose production has been hobbled by political violence. But cartel officials say the production shortfall is also because Saudi Arabia and others in the cartel are encountering problems selling oil. Buyers have cut back purchases from other exporters, including Iran and the United Arab Emirates.

Iran’s response has been to keep pumping oil and storing it, some of it in tankers, while it looks for buyers on the spot market. Some industry estimates put the oil Iran has stored in the past six weeks or so at more than 20 million barrels.

A senior Iranian oil official attending the OPEC meeting confirmed that his country, OPEC’s second-largest oil producer after Saudi Arabia, was having trouble selling heavy oil and was storing it. But he didn’t specify the volumes involved.

In contrast, Saudi Arabia has reduced output to match demand for its crude. Saudi Arabia sells oil exclusively under long-term contracts with buyers that have some latitude in deciding how much crude to take every month at the prices specified by the kingdom. “We don’t sell on the spot market,” Mr. Naimi said.

Write to Bhushan Bahree at bhushan.bahree@wsj.com