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June 14, 2006

Oil Shortages this Hurricane Season - Last Thing to Worry About
by Henry To

Dear Subscribers,

First of all, I would like to say "thanks" to all those who have written regarding my move to Los Angeles in mid July. As I mentioned in our last weekend's commentary, I will be staying with my current company, but will be working for the Investment Consulting group instead. Among my many professional responsibilities will be to help develop investment policy, set asset allocation, and select money managers for pension funds, foundations, and endowments. Again, subscribers who are in the West Coast should feel free to drop me a line should you wish to. As for the exact timing, we have pretty much settled on a relocation timeframe during the weekend of July 15th to 16th - which means I personally won't be able to write a commentary that weekend (which is good for those that claim - probably correctly - that I write too much). Therefore, I will most likely bring in a guest writer for that weekend, although please don't hold me to that at this point.

In last weekend's commentary ("Will We Ever See a World Awash With Oil Again?"), I stated that while the prices of most commodities (including gold and copper) have topped out for this cycle (even though they are still in a secular bull trend) - given continuing tightening liquidity from the world's central banks and a U.S. economic slowdown - this remains a different story with the price of crude oil. Since 2003, the world price of crude oil has more or less determined by the amount of (or lack thereof) spare capacity in the world's oil-producing countries - and most recently, by the amount of political and terrorist jitters in countries such as Iran, Iraq, Nigeria, and Saudi Arabia. As of today, the Energy Information Administration (EIA), estimates that remaining OPEC surplus capacity is at a mere 900,000 barrels to 1.4 million barrels per day - and these are all very heavy crudes. And while there is still 325,000 barrels per day of shut-in production remaining from the Gulf of Mexico (caused by last year's Hurricanes Katrina and Rita), chances are that this potential production won't be ready in time for the Hurricane season (which officially started June 1st). Even assuming a relatively "dull" hurricane season this year, it will take several more months for Gulf of Mexico production to return to its pre-Katrina and Rita levels of last year. Therefore, for the rest of 2006, the oil markets should remain very tight - but from 2007 and onwards, both the EIA and this author believes that new capacity coming online will significantly alleviate the current tight supply situation (again, please see last weekend's commentary for more details). In fact, the EIA estimates that: "Based on projects that are already in the pipeline, there is a strong likelihood that additions in OPEC and non-OPEC capacity will exceed demand growth between 2008 and 2010. World surplus production capacity could grow to 3 to 5 million barrels per day by 2010, substantially thickening the surplus capacity cushion, if demand projections prove accurate."

Please note, however, that the above projection of the EIA does not take into account a potential economic slowdown in the U.S. or in Asia/Europe later this year. As this author has pointed out since the beginning of this year, we're in for at least a mid-cycle slowdown for this year, and recent statistics, including the much-anticipated housing slowdown (along with the insistence of the world's central banks to keep on tightening) are signaling that U.S. GDP growth will significantly slow in the upcoming quarters. In the event that the U.S. experiences a recession (but which this author is not looking for), then world capacity could dramatically increase over the next few years - and in such a scenario, this author would not be surprised to see a crude oil price of $50 a barrel or even lower.

Okay Henry, you just said that crude oil supply should remain tight for the rest of 2006. Is there a possibility of an oil supply shortage later this year - especially during the most active part (August 1st to October 31st) of the Hurricane Season?

Of course, anything is possible. As a Houstonian, who would've thought that so many thousands would have to flee Hurricane Rita last year? Without the convenience of our radios, cell phones, and the internet, society could have quickly broken down in the midst of all the chaos. That being said, I am a numbers person and am very fond of probability at heart - and if I was to bet, I would have to bet that another evacuation by Houstonians would not be necessarily this year (or for the matter, for the next five years). Using the same probability argument, one would definitely bet that there would be no significant crude oil or natural gas disruptions during this Hurricane Season based on the current NOAA (National Oceanic and Atmospheric Administration) forecasts and the accompanying analysis from the EIA. As history has shown, it has nearly always been better/profitable to not bet on a disaster or "end of the world" scenario.

Before I dive deeper into the subject, let me give you a little bit of a background. Per the EIA, the Gulf of Mexico is a very important source of both crude oil and natural gas for the United States. During 2004, crude oil production accounted for 27% while natural gas production from the region accounted for 20% of total U.S. production. That is why so many commentators and analysts are concerned about any adverse impact that severe weather may cause in the region during the 2006 Hurricane Season. Based on (both long-term and recent) history and current forecasts, however, the chances of similar disruptions this year is next-to-impossible (but again, this is subject to revision), as I will now outline.

As discussed in the latest "This Week in Petroleum" publication from the EIA: "In May of each year, the National Oceanic and Atmospheric Administration (NOAA) produces an outlook for the upcoming hurricane season in the Atlantic basin, which includes the Caribbean Sea and the Gulf of Mexico. As the season progresses, NOAA fine-tunes its projections. Those projections are driven primarily by their forecasts of the seasonal Accumulated Cyclone Energy (ACE) index, which measures the collective intensity and duration of all tropical named storms and hurricanes in the Atlantic. For 2006, NOAA currently expects the seasonal Atlantic ACE index to range from 118 to 179 (135 percent to 205 percent of the normal level), corresponding to an 80 percent chance of an above-normal hurricane season in 2006. Although that forecast predicts a very active hurricane season, it is considerably lower than the Atlantic activity observed last year, which had an ACE index about 280 percent of the normal level. In addition to the ACE projections, for the 2006 north Atlantic hurricane season, NOAA predicts 13 to16 named tropical cyclones, with 8 to10 becoming hurricanes, of which 4 to 6 could become major hurricanes (Category 3 or higher)."

While both NOAA and the EIA will revise their predictions later this August, the above forecast is encouraging, since even if the ACE index turned out to be at the high-end of its range (179), it is still lower than the ACE index exhibited during the 1995 (227.2), 1998 (181.6) and 2004 (224.6) hurricane seasons. As a matter of fact, an ACE index of 179 is still comparable to the ACE index exhibited during the 1999 (176.1) and 2003 (174.5) hurricane seasons - two hurricane seasons which were not accompanied by any crude oil or natural gas disruptions in the Gulf of Mexico. Following is a chart from the most recent EIA publication ("The Impact of Tropical Cyclones on Gulf of Mexico Crude Oil and Natural Gas Production") showing the North Atlantic ACE Index vs. the number of tropical cyclones for each hurricane season from 1950 to 2005:

Looking at the above chart, it is obvious even to the untrained eye that 2005, with an ACE Index of 247.8, was an outliner. Compared to the current high-end (an ACE Index of 179) of NOAA's estimates, the upcoming Hurricane Season should be relatively muted and should not cause any significant disruptions to Gulf oil or natural gas supplies. More importantly, however, even an ACE Index of 220 or over has only historically resulted in temporary disruptions - as "near-normal" production usually returned the following month after the hurricane. From the EIA: "[The following] Figure 4 shows the production of oil and natural gas in the Gulf OCS for 1995-2005 with the effects of various Gulf of Mexico tropical storms and hurricanes highlighted. There have been 6 major hurricanes during the past decade that have caused significant disruption in oil and natural gas production: Opal (1995), Georges (1998), Lili (2002), Ivan (2004) and Katrina/Rita (2005). However, with the exception of Ivan (which shut in about 25 percent of monthly production) and Katrina/Rita (which shut in about 70 percent of monthly production), most disruptions have been temporary with near-normal production returning the following month. In fact, most Gulf tropical cyclones only shut in production for a few days. For example, in 1997 Hurricane Danny passed within 50 miles of the center of OCS production, yet it registered a barely perceptible drop in daily production rates, shutting in about 2 percent of that month's oil and natural gas production. Hurricane Bret (1999) with 125 mile per hour winds slightly impacted crude oil production but had almost no effect on the trend in natural gas production."

As I mentioned above, Hurricanes Katrina and Rita were definitely outliers - not simply because of their intensities but because of the paths they have taken, the long-term effects of the subsequent destruction, and the fact they occurred only a month apart from each other. The following chart shows the paths taken by Hurricanes Katrina and Rita last year. Note that more than 70% of all oil and gas platforms in the Gulf of Mexico were affected by the paths of these two destructive hurricanes:

Again, based on current forecasts as well as history, the chances of similar disruptions in oil and natural gas production in the Gulf of Mexico this year is next to impossible. In fact, based on current forecasts, this author would be surprised if we get ANY significant disruptions this year. All this is not lost on the folks at the EIA, as they are currently forecasting a cumulative production loss in the range of only 0 to 35 million barrels of oil and 0 to 206 billion cubic feet due to this year's hurricane season. For comparison purposes, a cumulative 162 million barrels of oil production and 784 cubic feet of natural gas production have been lost since the 2005 hurricane season began nine months ago.

Of course, no one can predict weather-related events with accuracy - especially weather-related events that are more than two weeks out. But over the last few years, the forecasting tools that have become available have gotten much better in terms of prediction accuracy. Moreover - precisely because of last year's freak events - many oil and natural gas drillers have rebuilt their platforms and pipelines with stronger infrastructure, which should make them better able to withstand any upcoming hurricanes and storm-related events. When it comes to investing, the old adage is that you can't hedge what you can't predict - and usually, the most profitable scenario is to not do so. Given the current "evidence" and historical experience, the message of this author is to not bet on another hurricane-related spike in either crude oil or natural gas this year.

Moreover, based on our outlook of world spare capacity in last weekend's commentary, my guess is that oil will top out sometime in the next four months and will embark on a self-reinforcing decline starting later this year or early next year as both hedge funds and pension funds bail. This outlook is still being confirmed by our MarketThoughts Global Diffusion Index (MGDI). For newer subscribers, I will begin with a direct quote from our May 30, 2005 commentary outlining how we constructed this index and how useful this has been as a leading indicator. Quote: "Using the "Leading Indicators" data for the 23 countries in the Organization for Economic Co-operation and Development (OECD), we have constructed a "Global Diffusion Index" which have historically led or tracked the U.S. stock market and the CRB Index [and CRB Energy Index] pretty well ever since the fall of the Berlin Wall. This "Global Diffusion Index" is basically an advance/decline line of the OECD leading indicators - smoothed using their three-month moving averages." Following is the monthly chart showing the YoY% change in the MGDI and the rate of change in the MGDI vs. the YoY% change in the Dow Jones Industrial Average and the YoY% change in the CRB Energy Index from March 1990 to April 2006. Please note that the data for the Dow Jones Industrials and the CRB Index are updated to May 31st (the May OECD leading indicators won't be released until early July). In addition, all four of these indicators have been smoothed using their three-month moving averages:

Historically, the rate of change (second derivative) in the MGDI has lead or tracked the year-over-year change in the CRB Energy Index (and to a lesser extent, the Dow Jones Industrial Average) very closely. While the second derivative (rate of change) in the MGDI has been strong since November of last year, readers should note that ever since March 2004, the MGDI and the year-over-year change in the CRB Energy Index have embarked on a historical divergence - most probably due to the lack of world spare capacity in crude oil production and the spike in last year's natural gas prices. Given that the supply outlook is more favorable going into 2007, this author expects the CRB Energy Index to correct in due time - and thus taking down crude oil prices with it as well. While crude oil is still in a secular bull trend and remains a secular story, there is no question that it can and will correct in a big way in the short-term - most probably starting later this year and continuing into 2007 and beyond.

As an aside, this author believes that any relief in gasoline prices will come too late for GM. The final insult came last week when Yanase (a Japanese chain that sells imported autos) announced that it will be slashing the number of dealerships that will be selling GM cars in Japan, while Suzuki has confirmed that it will be stopping all GM sales in Japan. Moreover, since GM has also bet most of its turnaround on its 2007 SUV lineup, further signs of GM's ultimate demise are now evident as SUV sales in general have dramatically slowed down - with the "popularity" of SUV arson being now reported by the mainstream media. As I have mentioned before, the secular rise in oil prices will claim many casualties along the way - including the legacy airliners, SUVs, and now most probably GM and the American consumer.

More follows for subscribers...

Henry K. To, CFA
MarketThoughts.com

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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