Fundamental view - worth reading

DAVID PARKINSON

Globe and Mail Update

November 14, 2008 at 6:00 AM EST

Don't say Henry Groppe didn't tell you so.

Almost a year ago, when oil prices were humming along at close to $100 (U.S.) a barrel, the 82-year-old dean of oil analysts warned his clients that the price was destined for $60 before the end of the year. When it soared above $145 this summer, he stuck to his guns.

This week, oil fell below $60 a barrel.

It's that kind of prescience that gets guys labelled “guru” – a tag Mr. Groppe long ago earned in his almost six decades predicting the oil market. The soft-spoken Texan cemented his forecasting in the early 1980s, when he foresaw the collapse of oil prices from then-record levels of $40 a barrel.

“Essentially, all forecasting, no matter what's being forecast, is a straight-line extrapolation of what has been experienced very recently,” he said in an interview in Toronto yesterday.

“All of our work is aimed at forecasting changes of direction and discontinuity, because that is the reality of the world. For the last several decades, our forecasts are nearly always this contrast with the consensus.”

Despite his two big (and correct) calls of market downturns, Mr. Groppe is hardly an oil bear. In fact, he hasn't changed his tune much from when we last talked with him two years ago – a time when, ironically, many people felt he was being overly alarmist when he talked about prices being sustainable above $60.

His view is based on a fundamental belief that global oil production has peaked, and is destined to go into a slow but steady decline. At the same time, though, he also believes those higher prices will result in demand destruction as consumers shift to alternative fuels – thus keeping a lid on prices, albeit at higher levels.

“We're in a new era … in which oil production will be irreversibly declining,” he said. “The question then is, what price trend during that period will give you the matching demand destruction?”

“Our conclusion is that, on an average annual basis, [under] normal conditions, it's something that rises slowly from about $65-$70 to about $100. We think that will provide the necessary reduction in consumption.”

He said such a change in consumption is already happening, and not just because of a global economic slowdown. (The Organization for Economic Co-operation and Development yesterday slashed its 2008 and 2009 global demand estimates, citing declining estimates for world economic growth.) Power generators and major industrial consumers have already been switching away from oil and toward cheaper coal and natural gas, and many are in the process of retooling their equipment to lower consumption and shift to cheaper fuels.

While he's skeptical that worldwide vehicular consumption can be significantly reduced over the next 10 years through the use of alternative fuels, he believes fuel substitutions already happening among industrial users will be sufficient to offset the declining global oil production and keep average annual prices in that $70-$100 range.

“That's all been set in motion,” he said, noting that even China – which many forecasters point to as a major driver for continued long-term growth in oil demand – is changing its ways.

“In China, they're rapidly substituting – coal particularly.” Thanks to substitution, he said, “China can continue to grow vehicle population and gasoline/diesel consumption for many years without any increase in total oil consumption.”

Mr. Groppe blames the short-lived record surge in oil prices earlier this year on Saudi Arabia and the OECD's International Energy Agency. He said the Saudis, believing what proved to be an incorrect IEA forecast of a coming surge in non-OPEC oil production, cut its output in late 2006 and early 2007, a move that eventually led to a shortage of supply.

Now, he fears the Saudis may be making the same mistake again – cutting production amid forecasts of a recession-driven slump in demand.

He's forecasting that prices will rebound to average $83-$84 a barrel in 2009, as the current cheaper prices rejuvenate demand while the reduced Saudi production constrains supplies.

And what about oil stocks?

While some analysts point to the sharp decline in the forward strip in oil futures as evidence that oil stock price targets need to be slashed, Mr. Groppe thinks that's looking in the wrong direction.

“The strip has been the poorest forecaster of oil prices of anything that anybody has ever thought of using, yet that's what everybody has been using,” he said. As long as people are driving prices lower based on these forward-strip commodity price assumptions, “It presents the investment opportunity of a lifetime.”

Consumer Protection from Opec-Induced Spike

Energy markets pushed to lows not seen since January 2007 last week as the dollar continued its rally amidst the global financial turmoil. Producer hedgers who took advantage of cheap downside puts when crude oil was trading in the $90 range have now begun to roll their positions down to the $30 level. WTI February American-style $30 puts are currently offered as low as $700 per 1000 barrels.

Traders may once again take more notice of Opec, as the cartel has once again called an emergency meeting, this one scheduled for November 29th in Cairo. The group is expected to announce further cuts in production, possibly as much as 1.5-2m barrels per day on top of the 1.5m barrels already announced.

Consumer hedgers looking to protect against an Opec-inspired price spike should look to the WTI December Asian-style $65/85 call spread, currently offered at about $2,250 per 1000 barrels. That's $2,250 of maximum risk with a possible payout of $17,750. The buyer of the call spread would profit on a short-term price spike- thus providing cheap protection against a near-term bounce higher.

Singapore, 16:00

Vol implosion in products

Vols in the front months for products are down significantly. RB Dec down 15 vols to 69, HO dec vol down 8 vols to 57. Crude remains fairly well bid only down 1-2 vols in the front and about .5 in the back.

Volatility is so high that these moves are not that surprising. Directional plays are best served with spreads if the strategy is to hold through expiry. Those trading opportunistically with options have to be careful of swings.

Again, the crude market was largely affected by equity markets. We know demand is softer, and supply reductions are not yet significant enough to send us higher. However, back month crude has strengthened, indicating plenty of buyers for longer dated energy futures.

New York, 345pm.

HCE - hedge update (Crude Inventory)

Given the strong sell off, volatility remains extremely firm (81.5% in Jan WTI). With this in mind, long put spread strategies or 3-way strategies using a short call are attractive for inventory hedgers.

For those with long physical inventory, consider the 45-55 put spread in Dec WTI (Asian) which is currently valued at $2.60/bbl. This offers good leverage for low up front premium.

For those that can tolerate margin swings, consider the same put spread with a short 69 call for zero cost. This three way position captures the high volatility and offers some downside protection while creating a short position $9 higher than the current market.

Near-Term Bearish Momentum

Energy traders continued last week to focus on the global economic slowdown and its effect on consumer demand. Front-month WTI crude oil had declined by almost 10% on the week by the end of trading on Friday despite warnings from the International Energy Agency that long-term global trends in energy supply and consumption were unsustainable. The current (relatively) low crude prices have resulted in alternative energy supplies such as Canada's oil sands and finds off the coast of West Africa to be given lower priorities. State-run oil giants are also being forced to shoulder larger economic burdens, resulting in less re-investing in declining fields. The WTI future's curve serves as a striking reminder of where prices are expected to trade as the economic turmoil dies down. December 2008 is currently trading around $61.00 vs December 2010 trading close to $78.00.

Despite long-term calls for crude oil to push higher, the short-term picture remains fundamentally bearish. To capitalize on the downward momentum, traders and producer hedgers have been using Asian options to buy up cheap near-dated vertical spreads such as the December $50/60 put spread, trading around only $3,400 per 1000bbls. The put spread can be purchased for Zero Cost by selling the December $70 call. This trade puts no premium at risk at or below $70 in WTI crude oil and the December Asian options do not expire until the end of the 2008 calendar year.

Singapore, 23:00

Market unable to sustain rally

Whether we call it more of a range bound market or not, we have not been able to sustain a rally. The equity markets Wednesday were bearish following the news of President-elect Obama, and some negative earnings surprises. Energies did not respond well to apparently bullish inventory data, which tends to spell a potential for downside here overnight. However, we see a trading range forming with consumer hedgers increasingly locking in 2009 value when we reach the low 60s. That said, volatility remains remarkably strong overall. The best near term strategy is to roll crude spreads forward, avoiding too much long volatility. We continue to recommend long call spreads or long call 3-way strategies for consumers. Long inventory players would be better to opt for put spreads or longer dated (at least Jan) crude puts that are not subject to too much value erosion over the next week. Note that December American crude options expire on a Monday, which is bad for option owners.

New York 17h20

Cheap Protection Highlighted Against Volatile Markets

Traders yesterday turned their focus to announcements from Saudi Arabia, the world's largest oil producer, that the country would begin cutting production and exports to customers in the US and Europe. Opec is desperate to put a floor in the volatile and declining oil price, hence the large cut, to the tune of about 5%. However, the price jump is seen by many as an opportunity to lock in higher prices as the market continues to trend towards $50. The underlying trend lower is supported by weak demand fundamentals in the current economic turmoil.

The $7 rally in WTI crude yesterday highlights the need for hedging strategies with limited loss potential- the market is too volatile to simply enter the market by selling or buying swaps. Cheap option strategies are available which provide unlimited gains with only limited loss potential. Using Average Price Options, the December $55/70 put spread is currently trading around $5.00. That's $5,000 of maximum loss potential (yesterday's rally would have resulted in more than $7,000 of losses by selling swaps) with a potential payout of $10,000. For unlimited downside protection, producer hedgers can buy the December $60 put for only about $2.80. That's $2,800 of maximum loss potential against unlimited gains should crude oil continue lower in the current economic turmoil.

Singapore, 08:00