Volatility Ahead

Jim Brown
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We can expect some volatility in oil prices next week as the current WTI contract expires on Monday, the equity markets are teetering on the support cliff and there are strong rumors out this weekend that Iran is ready to embrace serious talks about ending its nuclear program.

The November WTI contract expires at the close on Monday. That may have had something to do with the $2 drop in prices on Friday. Resistance at $93 has been rock solid for the last month and anyone long in hopes of a breakout should be bailing out ASAP.

The equity markets made a round trip last week with the close at 1429 the prior Friday, a rally to resistance at 1465 and then a return to 1430 on Friday. Suddenly fundamentals appear to matter with earnings falling off a cliff. The blended earnings estimates for the S&P are now in the range of -3.7% for Q3 and significantly different from the breakeven to slightly above estimates just a few weeks ago.

I heard an interesting statistic on Thursday. More than half of the 25 companies that reported missed estimates. That included some high profile big caps and that carried over into Friday's limited earnings with GE and MCD both disappointing. Of the 116 S&P 500 companies reporting so far 58% have missed on revenue estimates. This is a huge challenge for the market but not one that can't be overcome.

Earnings per share estimates are still being beat but you can only cut cost so much without damaging your operating capability. Currency issues have also plagued international companies with GE reporting $1.1 billion in currency translation issues for the quarter.

With the indexes back at support and only eight days left in October and the fiscal year for funds we are at a critical inflection point. Managers are either going to buy the dip hard next week or hit the flush lever.

Because of the fund fiscal year end we very rarely see negative markets in the last week of October. This month is known as the bear killer month because the dips are normally bought and the last week of the month is in rally mode that carries through until Thanksgiving.

The election is the wildcard. If president Obama is perceived to be likely to be elected the markets could weaken because of his stance on business and taxes. If Romney is expected to be elected the markets could rally because of his corporate tax cut plan, the elimination of taxes on personal investments and reduced regulation. The polls after Monday's final debate will be critical for the market.

For the oil market the Iran news could prove to be a major mover. The New York Times reported on Saturday that Iran has agreed to meet one on one with the U.S. to discuss Iran's nuclear program. The article cited Obama administration officials. The only caveat was that talks could not begin until after the elections because Iran did not want to meet until they knew who would be president. The Times said the talk agreement was the result of secret exchanges between American and Iranian officials that date almost to the beginning of the Obama presidency. This would be a major win for Obama and produce a major decline in the security premium embedded in the price of oil.

HOWEVER, and you knew there had to be a catch, after a couple hours of "no comment" from the White House they finally denied the story completely. The National Security Council spokesman Tommy Vietor, said the U.S. and Iran had no such agreement. The official statement said "It is not true that the U.S. and Iran have agreed to any one-on-one talks or any meeting after the American elections. We will continue to work with the P-5+1 (the six nations in the UN security council) on a diplomatic solution and have said from the outset we would be prepared to meet bilaterally."

Even if the story is NOT true it should have an impact on oil prices on Monday. Coupled with the expiration of the WTI contract it could produce some significant volatility.

In other Iranian news the German magazine Der Spiegel said Iran was planning on creating a disaster in the Strait of Hormuz to block the strait and force the lifting of UN sanctions on Iranian oil. According to a top secret report Iran was planning on wrecking a super tanker in the strait to cause an environmental catastrophe that would force cleanup crews to block the strait to prevent oil pollution from escaping to the sea beyond. In theory the plan named "Murky Water" would force closure of the strait and would prevent oil from other Persian Gulf countries from being exported. Iran has more than 50 million barrels of oil stored in tankers outside the Persian Gulf. In the event the strait was closed that oil could be used to make up the global shortfall.

Back in 1991 Saddam Hussein dumped millions of barrels of oil into the Persian Gulf in an attempt to prevent navy ships from approaching from the sea. The Murky Water sabotage plan is thought to be pending approval by the Ayatollah Ali Khamenei.

If such a plan was able to shutdown the Strait of Hormuz for any period of time there would be an instant spike in the price of oil to $150 or more. More than 18 million barrels are shipped through the strait every day or roughly one fifth of global consumption.

Exxon Mobil (XOM) is trying to exit the flagship oil project in Iraq. The $50 billion West Qurna-1 project was to increase production of the 8.7 billion barrels of proven reserves in that field. Exxon was hoping by taking on the Qurna-1 project for almost a breakeven they could become a preferred bidder on some other projects where they could make some money. Exxon signed a deal to explore the northern Kurdish region and Baghdad threatened Exxon with the cancellation of the Qurna-1 contract if Exxon did any deals outside of Baghdad.

Later there were rumors that Iraq's Prime Minister Nuri al-Maliki had asked President Obama to force Exxon to withdraw because Exxon's presence was bad for peace. After Exxon signed the first deal with the Kurds it was not long before Chevron, Total and Gazprom Neft also signed deals with the Kurds. This angers Baghdad since they don't recognize the Kurdistan Regional Government of (KRG).

Exxon has grown tired of the endless layers of red tape and constant squabbles inside the Iraqi government. They are looking for someone to buy their 60% stake in the West Qurna-1 project. If Exxon is willing to pass up on 8.7 billion barrels of reserves because of the political situation and security on the ground then how many other contractors are also ready to bail? What will happen to the grandiose plans to boost production to 10.0 mbpd by 2020, up from the 3.2 mbpd today? The state dept suggested Russian and Chinese firms might move in to take up a major position. The Chinese would want to do it in order to secure supplies in the decades to come.

In Poland the government has decided to raise taxes on oil and gas production to 40% starting in 2015. Poland said this was part of creating a stable investment framework designed to attract investment in the country's shale gas reserves. It sounds like an investment killer to me. They are creating a 5% extraction tax on gas and 10% tax on oil extracted. On top of that there will be a 25% tax on the surplus of revenue over expenses. These taxes are on top of a 19% CIT or "company tax" and real estate taxes. The new law will create a state owned operator that will supervise the exploration industry and will receive priority in buying exploration licenses. That means any good blocks that come up for sale will automatically go to the state owned company.

Poland buys more than half its gas from Russia's Gazprom and Russia has used access to that gas as a weapon in the past. They can raise prices at will and then cut off the gas if Poland does not pay.

Diamond Offshore and Noble Corp both reported earnings last week and as part of their earnings they provided guidance and fleet updates. Both companies said deepwater rig demand is very strong and prices are rising sharply. Diamond's CEO said the deepwater fleet in the Gulf of Mexico was back at its post Horizon level of 31 and would rise to 40 in 2013.

The average contract term for leasing a deepwater rig had doubled to about four years compared to the first six months of 2012. Companies are signing longer leases in order to lock in the availability and price for years to come. The Diamond CEO said there were 34 deepwater rigs currently under construction and 85 jackups to be built by 2015.

Murphy Oil (MUR) announced last week it will spin off its downstream subsidiary, Murphy Oil USA, into an independent and separately traded company. They are following the lead of Conoco in spinning off the Phillips 66 refining arm (PSX). The refining and marketing arm has 1,100 service stations, seven product distribution terminals and two ethanol production facilities. The spinoff will be completed in 2013.

Murphy also declared a special dividend of $2.50 and a $1 billion share buyback. The dividend is payable Dec 3rd to holders on Nov 16th.

Natural gas prices rallied to a ten month high on Friday at $3.647. Gas injection into storage last week was only 51 Bcf and well below the 71 Bcf average for this time of year. However, gas in storage is 181 Bcf higher than last year and 249 Bcf above the five year average. Last year saw record levels of gas in storage and this year is shaping up to be even higher. There are hundreds of wells already drilled and completed and waiting on connections to pipelines. This is especially true in the Marcellus Shale. There are several new pipelines being completed in the area and analysts believe production from the region could increase by 2.0 Bcf per day just from the completion of the pipelines. Gas exploration is down -34% in the Marcellus and down -54.6% across the entire nation. Power companies are using 6.0 Bcf per day more than the five year average so demand is up and production is down. The real unknown here is how many wells are waiting to be connected and how many are waiting to be completed. At one time there was thought to be as many as 1,000 wells already drilled but not completed because of the expense of completing them. The wells are in inventory waiting for the price of gas to rise and make completion worthwhile.

Nat Gas Chart

Nat Gas Storage Chart

Schlumberger (SLB) reported earnings of $1.08 that was 2 cents above estimates but rose +9.5%. Revenue rose +3.7% to $10.61 billion but was just a little under estimates of $10.68 billion. International sales drove revenue with North American markets weak. The decline in pressure pumping revenues in the U.S. was a material factor in limiting profits. Overall it was a decent report since everyone knows the U.S. shale gas market has been declining for more than a year.

Earnings in the energy sector appear to be coming in better than expected. S&P was expecting a -24% decline in earnings but we have not seen anything close to that as yet. Chevron was the exception with a major decline in production due to various problems outside the USA.

Next week is a big week for energy earnings. This is the most prolific week in Q3 for energy earnings. If companies continue to report "less bad" results we could see a rebound in the sector. However, if the Iran talks story gains any traction we could see crude prices back in the mid $80s very quickly. Initial support is now $88 but if there is any truth to the Iran story we could see support at $85 tested.

Earnings Calendar - Dates in green are this week

I am anticipating the seasonal rebound in the fall as the winter demand season increases prices. If crude prices do implode on a perceived softening of the Iranian stance then we will get another chance to buy equities even lower. The support factors are the improving economics in China, the improved consumer sentiment in the U.S. and improving housing market.

Jim Brown

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