Editor’s Note:  Everyone, it seems, is talking about the Keystone pipeline. Recently I wrote a story on a mostly unexplored topic in the U.S gas price debate – a problem that could soon affect oil refineries and the price consumers pay for gas on America’s east and west coasts. You see, drivers on both coasts – but especially the heavily populated east coast – are increasingly vulnerable to sharp increase in gas prices, as I explain below. (I wrote this story for BusinessInsider.com – one of the top business sites in the world. A link to the full article follows my excerpt below.)

- Keith

Forget Keystone  – the U.S. Desperately Needs an East-West Pipeline

In the debate over rising gas prices, one largely overlooked issue is the lack of US oil pipeline distribution to the East Coast, where refineries that must import higher priced Brent crude are being shut down.

America has more than enough cheap domestic oil, thanks to the North Dakota Bakken and the Canadian oilsands. And it doesn’t face a refinery crisis in terms of capacity – after all, even though the US hasn’t built a new refinery since 1976, oil refining has actually increased by 2 million bopd to 17.7 million bopd since 1985 (and US refinery demand has been steady at 14.8 million bopd since 2005).

Instead, the real problem is that coastal refineries can’t source the cheaper North American crude. The Brent oil price fluctuates widely with geopolitical news. A stable, nationwide refinery system—well connected with pipelines—is one area where the US can help control price surges in local markets. Few things affect local gas prices like the shutting down of an oil refinery – and right now, the East Coast is at risk of losing three.

Politicians talk to the potential of the Keystone XL to bring cheaper Canadian crude to the Gulf Coast. But this north-south pipeline isn’t as badly needed as west-east lines that can carry cheaper American and Canadian crude from Cushing, Oklahoma to money-losing refineries on the East Coast. Today, the country’s five oil districts are not well connected by pipeline–each district must rely on its own crude supplies.

Only the Midwest and Gulf Coast refineries have access to all the new cheap crude coming out of the US shale plays and the Canadian oilsands. As a result, consumers in these regions enjoy WTI pricing – some of the lowest retail gasoline prices in the world.

*Read the rest of the article on BusinessInsider.com

For the first time since 1949, the United States is poised to become a net exporter of petroleum products, according to the Petroleum Supply Monthly report for November put out by the U.S. Energy Information Administration.

Through the first nine months of 2011, the U.S. exported 753.4 million barrels of gasoline, diesel and other oil-based fuels while only importing 689.4 million barrels.

America’s neighbors were far and away the biggest consumers of Yankee petroleum. Mexico imported more than 150 million barrels while Canada brought in slightly more than 64 million. The next closest country – Brazil – imported about 40 million barrels.

Jeremy Friesen, a commodity strategist at Societe Generale SA in Hong Kong, told Bloomberg News that part of the reason for the shift is that America’s consumption of oil has remained stagnant compared to the rest of the world.

“The U.S. has been flat or down for overall oil consumption versus the world, which continues to rise mainly due to emerging markets,” he said. “Latin American fuel demand continues to be pretty good.”

According to The Wall Street Journal, U.S. consumers used 7.7 percent less gasoline this August compared to four years prior, when usage hit its apex. In addition, the increased use of ethanol has depressed the consumption of gasoline.

While most experts are citing decreased domestic consumption as the driving force behind the reversal of the 62-year-old trend, increased domestic production is also playing a role.

According to the San Francisco Chronicle, production of domestic fuel products has gone up over the past two years in part due to the increased development of shale gas reserves.

One of the most prominent shale gas plays – the Bakken in North Dakota – saw gas production at 485 million cubic feet per day in September of this year, which is a more than three-fold increase over that figure in 2005, reports the EIA.

Expressed another way, the Bakken produced 424,000 barrels of oil equivalent per day in July, an 86 percent increase over the same month in 2009, reports the Journal.

Another domestic source of petroleum products that has taken off in recent years is the Eagle Ford shale in Texas.

According to the Railroad Commission of Texas, the first eight months of 2011 saw the play produce more than 8 million barrels of shale oil, compared to the about 3.76 million it produced in all of 2010.

Additionally, 2011 shale gas production in the Eagle Ford play through August reached 139 billion cubic feet, while the entire 2010 total was 108 billion cubic feet.

The increased production and dwindling consumption in the U.S., combined with eager international markets have worked together to put America in the position to be a net oil products exporter.

“Instead of that product backing up and depressing prices, it’s being sent to other countries,” Tom Kloza, chief oil analyst with the Oil Price Information Service, told the Chronicle.

According to some the U.S. will remain a net exporter of petroleum products for years to come, as the 900 million barrel figure the country imported in 2005 has steadily declined.

“It looks like a trend that could stay in place for the rest of the decade,” Dave Ernsberger, global director of oil with Platts, told The Wall Street Journal. “The conventional wisdom is that U.S. is this giant black hole sucking in energy from around the world. This changes that dynamic. “

OGIB Portfolio Returns for 2011: 48% average gain on closed positions; 24% average gain on open positions

This chart is bullish for oil.  It shows the number of non-commercial net long crude oil positions in the NYMEX (New York Mercantile Exchange) is moving down – these are the people we all call “The Speculators”.  Getting these (politically unpopular) people out of the oil market is what I think one of the primary goals of the IEA was, when they announced a globally co-ordinated release of 60 million barrels into the market in late June.

This shows the speculators leaving the market – but the oil price is not declining.  This shows real demand is taking the place of speculators.  Now of course it could be argued that without the IEA intervention, world oil prices could be $10/barrel higher right now.

With expected demand rising up 4 million barrels a day more through the fall (this seasonal increase happens every year; it’s not a guess) it shows oil investors are going to have to see a dramatic decline in the world’s economy to keep oil lower.

Source: BMO Nesbitt Burns Research Comment July 4 2011

Want to learn more about investing in junior oil and natural gas stocks? If you have a Facebook account, just “like” this article and a hidden link to Keith’s 10 page how-to on oil and gas investing will appear:

ETFs, or Exchange Traded Funds, not only track the price of oil, but they can actually provide clues as to where the oil price is going.   I’ll show you how to read their charts, and show you the ETF that I think most accurately follows and even warns investors of oil price moves. (Hint – it’s not who you think.)

Currently Light Sweet Crude futures remain in an uptrend, over the last month price has tumbled from former highs at $114.83 in May to $95.25 currently on the July contract.  The two-year chart below, in 2-day increments, shows the course of oil prices with a continuous futures chart.

ETFs allow individual investors to partake in the price fluctuation of oil in a way very similar to simply purchasing a stock.  (For further information on ETFs, see Keith Schaefer’s report: ETF Investing in the Oil & Gas Market).

The chart below shows the price of light sweet crude in yellow/red, and two ETFs – USO-NYSE, which is the United States Oil Fund (purple), and an ETF which gets far less attention – XOP (light blue).  XOP is the symbol for the SPDR S&P Oil & Gas Exploration & Production ETF traded on the NYSEArca exchange – so it is an ETF that covers oil stocks/equities, whereas USO tries to track the commodity.

How to use ETFs to predict moves in the price of oil How to use ETFs to Predict Moves in the Price of Oil

Source: Thinkorswim

General Chart Comments

From the chart above much information can be extrapolated.  Namely we can see that at this time oil still remains in a primary uptrend, even though we have seen a sizable correction.  There are two trendlines shown on the chart – the first one is red and indicates an aggressive upward trend.

At some point all aggressive moves slow down.  The green trendline is also present which marks the more stable rise of oil prices over the last year.

If oil prices move below that red line, currently intersecting at $92 (this will change over time as the line is sloping), it indicates that oil is correcting to its primary uptrend level (green line).

The green line currently intersects at $80, but will rise over time as the line is sloping. An upward sloping trendline such as this helps a trader gauge when longer term trends are shifting.  Markets move in waves – in an uptrend, markets have progressively higher low prices and progressively higher high prices.

If oil can hold above the $92 level it indicates strength, based on this simple method derived from former price action.  On the other hand, if the commodity moves below that level we could see prices in the low$80s, where there is likely to be buying interest once again.

Using ETFs as a Form of Analysis

The ETFs shown in the chart are not only investment vehicles, but they are also analysis tools.  USO (purple on chart) has already broken below its trendline (yellow line) indicating that lower prices are likely for that security.  This provides some confirmation of the decline in oil, although XOP is a better gauge.

XOP provides valuable information.  Not only has it been the far more profitable play from rising oil prices, but also generally leads oil prices – providing a bit of a snapshot into potential moves in crude.

This occurs because XOP is an ETF that doesn’t track crude – it tracks oil exploration and production companies – which provide a large input the for the oil market as a whole and thus the price of oil.  If investors are buying these securities, which are held by a sector ETF such as XOP, it indicates that the market is anticipating rising oil prices.  The same situation applies if investors are selling these securities help by the XOP ETF in anticipation of falling oil prices.

Looking at the chart, XOP (light blue) has moved aggressively higher over the last year.  Rarely did it pull back significantly, even when oil declined.  I have highlighted a few sections of the chart for educational purposes.  The first, light blue highlighted box on the left s (#1) hows XOP making a lower price high, while oil made a higher price high (all contained within the rectangle).  This was a warning for oil prices and quickly oil prices corrected by about 15%.  This is commonly called divergence.

The next box to the right (#2) shows oil correcting to the prior low yet XOP pulled back very little in comparison – oil quickly moves higher following XOP’s lead.  The next highlighted blue box (#3) shows a similar situation to the last – XOP leading oil higher.

The final box is highlighted in white (#4) and is a potential warning signal similar to our first highlighted area.  For the first time in over a year XOP made a lower high, while oil made a new high.  This was a warning signal for the correction in oil, and remains a warning signal.  XOP has shown a strong tendency to lead oil prices and now it is retreating, leading oil lower.

You will notice at the far right of the chart, which shows June 15 price action, that while oil has paused near recent lows, XOP has retreated below its recent low.  This makes further declines in oil likely, as long as XOP continues to decline or fails to rally on oil price rises.

Tying it together

Investors can use the XOP ETF to help them see the likely course the commodity will take.  XOP has been a sound indicator for the strength of oil prices.  It pointed to strong oil prices through the rise, and even when crude corrected, it indicated a correction which has come and currently it is pointing to a further correction in oil.

In the beginning of this report the low $80’s was discussed as a potential target for the oil price.

If oil continues to drop below that level, we can look to the XOP indicator as a sign of a potential bottom.  When oil makes new lows (compared to recent price action), but XOP fails to make new lows, oil prices have a high probability to begin moving higher as well.

While USO comes to mind when looking for a place to take advantage of a rise in oil prices, it has proven not to be the most efficient vehicle.  XOP, when oil prices are rising, has proven to lead oil and also generally outperform.

Investors must remember XOP will also lead on the way down, retreating fast and more aggressively than oil; therefore, a prudent exit strategy is required. XOP also lacks the trading volume that USO has (still 2-10 million shares a day), yet it functions as an excellent analytical tool for oil prices.

- Cory Mitchell, CMT

Sector Diversification: Target Oil Sands

Just about everybody on Earth ought to know by now about the oil sands are a vast and virtually limitless supply that’s going to backstop North American energy security for a century or more.

But for all the hype and hoopla, surprisingly few investors know how to play the full oil sands value chain.

The thing to remember about a massive development undertaking — a mega, mega project — is that it’s not a single homogenous entity, there’s a whole support network that has to be built around it.

Oil and gas producers are basically procurement houses that go out and buy what they need. Everything from drilling wells to building and operating pipelines — even the catering — is contracted to third parties. By entering specific points in the supply chain, it’s possible to create a surprisingly resilient portfolio that’s diversified while still taking advantage of big growth opportunities in the many, many years ahead.

The first link is the producers. For almost half a century oil sands have traditionally been a game for Majors, Everyone thinks of trucks and shovels, but more than 80 per cent of the resource is actually too deep to be mined. Most of the new production over the decade will come from specialized steam injection schemes.

The past 18 months there have been some high profile IPOs, backed with foreign capital from China. Names like Athabasca Oil Sands and MEG Energy are but two. Given China’s voracious appetite for overseas investment, there will inevitably be more IPOs to come.

On that front, the first half of this year also promises to be active, with Laricina Energy and OSUM Oil Sands hitting the street this spring. Calgary-based Peters and Co. recently did a valuation on both companies and says that they’re going to be popular issues. Laracina could fetch $37/share and OSUM $16/share on their respective IPOs. Call it informed speculation considering they’ll probably be in the underwriting syndicate, at which point they’ll be restricted.

Another bright light is Black Pearl (TSX-PXX) headed by former Black Rock Ventures guru John Festival. You might recall he sold his predecessor company to Shell a couple of years back for a few billion, little wonder the shares have tripled in less than a year.

The real key to this oil sands renaissance is horizontal drilling and steam injection. By now SAGD (Steam Assisted Gravity Drainage) is a relatively mature technology that sees pairs of parallel horizontal wells work in tandem to inject steam and bring oil back up to the surface. This is a sophisticated undertaking that requires the skills of a surgeon and some heavy iron. Enter the drillers.

The coldest winter in a decade means all of Canada’s contract drillers are really hot right now. Precision Drilling (TSX-PD) (NYSE: PDS) is up almost 20 per cent in the past two weeks alone and rivals like Trinidad Drilling (TSX-TDG) (OTC: TDGCF.PK)and Murray Edwards’ Ensign Resource Services (TSX-ESI) (OTC: ESVIF.PK) have had a good run this winter. Both have good exposure to the oilseeds, with Ensign running nearly 300 coring rigs that are used to prove up reserves, while Precision has the heavy iron need to drill the new steam assisted thermal wells.

The best performer of all is Stoneham Drilling Trust (TSX-STG.UN) (STHMF/STHMF.PK)which is fast becoming a player with its share price quadrupling since last October. It’s one of the last remaining oil and gas trusts, but that will change around Canada Day when it converts to a corp. One of the company’s biggest customers is Cenovus Energy (TSX-CVE) (NYSE: CVE)which is the industry leader in the thermal oil sands space.

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They Don’t Make Fracking. They Make Fracking Better (and More Profitable)

This small energy services company’s patent-pending fracking technology is changing EVERYTHING.

Rest assured, it is a profit opportunity not to be missed. (It’s my # 1 trade of the year.)

Get every last detail on this company, its revolutionary fracking process, and what it could mean for your portfolio… here in my new video.

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Keeping those rigs turning requires a whole support network of its own – where do you go when a reamer or a winch goes down in the middle of the night? That’s where CE Franklin comes in. (TSX-CFT) (NASDAQ: CFK) is the Canadian Tire of the oil patch, supplying literally thousands of products like valves, flanges and drill pipe that are essential to support field operations. The company’s web site boasts that it can fix everything from quads and pick-up trucks to full blown drilling rigs.

In February, the company reported that oil sands accounts for about 15 per cent, or $11.5 million of its fourth quarter sales revenue and the company said it is committed to leveraging its presence in the Fort McMurray area to capture a bigger slice of this pie.

Although it’s firmly rooted in the oil and gas industry, the company’s operating metrics have a retail character, like the oil patch version of Walmart. IROC (TSX-ISC) is another new entrant that has managed to post impressive share price gains while remaining affordable. Higher drilling levels will inevitably translate to higher sales revenue for everybody in the space and IROC is positioned for growth.

In its most recent operational update, the company said its Canada Tech division hopes to start realizing positive returns from a series of products and solutions designed specifically for steam assisted gravity drainage projects in the oil sands.

Up until now we’ve been talking about upstream production. But selling all that oil to American — and possibly Asian — markets is the key to true diversification for investors and oil companies alike. The downstream is the one area where your interests are truly aligned with industry.

Led by pipelines, it’s a whole parallel universe of support services that connect producers with refineries and trading hubs. Canada’s pipes are in an exciting growth period, and we’re talking about some extremely ambitious projects: namely Enbridge’s proposed Gateway to the West Coast and TransCanada’s Keystone to the Gulf of Mexico. When completed, the projects will move more than 1.5 million barrels of oil sands crude for export. To put it in perspective, Libya — an OPEC member — was only exporting 1.5 million barrels a day before it came unhinged.

TransCanada’s (TSX-TRP) (NYSE: TRP) Keystone is banking on the U.S. to get over its fixation with “dirty” oil, but rival Enbridge (TSX-ENB) (NYSE: ENB) has been looking to the West Coast and threatening to break-out to Asia. Both are taking bold steps that will allow Canadian production to get the full world price and open new markets.

Both have had good share price appreciation and it’s hard not to like the steady returns offered by owning a high-yielding dividend. They are also a lot less exposed to volatile commodity prices. Due to the way they’re financed, pipelines are considered lower risk lower reward, but both companies have been showing good near and long-term growth.

Either one is a good hold or place to park when the market turns south. Enbridge will be splitting its shares later this spring, which will make them more affordable to own.

Finally, it’s one thing to throw a bunch of steel into the ground but quite another to keep it up and running. Sometime in the next year or two, the amount of money required to maintain all these pots and pans is going to surpass the amount of new capital investment, which is estimated at around $18 billion this year, according to the Oilsands Review magazine.

Put another way that means almost half of all the spending in the oil patch will go to keeping these oil sands projects going — it’s a staggering sum.

On that front, Flint Energy Services (TSX-FES) (OTC: FESVF.PK)is probably the best positioned to capitalize. Last November it announced a $450-million contract with Suncor to keep its oil sands projects — some of which have been operating for 40 years — in tip-top shape.

Company representatives told the OSR it expects revenue from its oilsands maintenance unit to equal and surpass its oil sands construction division in the next five years.

There you have it, a long and rather exhaustive look at the oil sands value chain. By picking spots along each length of the chain it’s possible to actually diversify within the sector and profit on what will likely prove to be the last big oil rush on Earth, providing even the humblest investor with a steady stream of profits for decades to come.

- The OGIB Research Team

Editor’s Note:  In my last story I explained how lower gas prices could affect reserves, as reserve reporting season is underway.  Below, here’s a look at how some junior oil companies might fare.
- Keith

Part 3 of a 3-part Series

Reserves redux:

Last time we talked about reserve reports and how natural gas producers could have their credit lines and valuations cut because of the low carrying value of their reserves.

This time we’re going to talk about how the same phenomenon is going to have the entirely opposite effect for oil producers, especially heavy oil that makes up the majority of the crude stream coming out of Western Canada.

If you’ll recall, we talked about how oil and gas companies have to file an inventory statement effective Dec. 31 that details the net present value of their reserves based on future projected cash flows (which in turn are based on independent price assumptions for the next 12 to 24 months).

Then we talked about how any drastic change in the valuation of those reserves was akin to lowering (or increasing) the net worth of your house against the balance of the mortgage on your home. We also talked about how a 20 per cent decline in the price of natural gas was going to bite into the NAVs of several high profile gas producers and possibly send them scrambling to shore up balance sheets, by jettisoning unprofitable assets, selling equity and paying down debt — or else.

The good news is that oil-weighted producers are going through the same exercise with a different conclusion. The really good news is that most of them are going to see their net asset values and credit lines increased, given where crude prices have been for the past 12 months and given where they’re likely to stay thanks to all the trouble in places like Libya and Egypt.

And the best news of all is that it means we’re probably looking at a round of upgrades — and higher stock prices — for the entire sector. This, even though the rising Canadian dollar essentially wiped out any oil price gains in 2010; Canadian-denominated crude prices were actually down about two per cent year over year.

But nobody wants to hear us crash the oil price party with mundane things like currency valuations. Much better to party like it’s 1992 — the last time the Middle East looked like it was set to explode. Back then, if you’ll recall, Saddam Hussein had oil prices pushing the then unheard-of heights of $75 with George the Elder banging at his door in Desert Storm I.

Then, as now: peace sells. The problem is that nobody’s buying.

According to a recent report by Peters and Co., the oil-weighted guys are going to be flush with cash which will drive consolidation within the junior heavy oil space. The start-up of Keystone into the U.S. Gull is going to change the market no matter what happens in places like Cairo or Tripoli.

The North American market is too localized to really be affected. The upshot is that tensions in far off places like Libya and Egypt only increase the role for Canadian oil, as the U.S. tries to diminish its dependence on Middle East crude.

Based on geography alone, Canadian producers hold an almost insurmountable advantage.

But before we go any further, a note of caution. The geopolitical risk trade is the worst trade you’ll ever make. Just because the world seems to be going up in a hand basket doesn’t mean oil is going to hit $150 any time soon. Or stay there for more than a few weeks if it does. Don’t get sucked into what MIGHT happen. More often than not, it doesn’t happen and you’ll be left holding the bag.

Think about WHAT’s going to happen when everything settles down.

Take some time, dig into the financial statements and look for that reserve report. Then take the forecast price of oil used in the financial statements, and knock it down 15 or even 20 per cent.

Anybody that’s showing profits at $50 a barrel is going to be doing just fine at $70 or even $80. Assuming prices do spike above $100 you’ll be in a good spot to reap big rewards — just don’t be banking on the sky to fall for it to happen.

A couple names to consider: Black Pearl Resources (PXX-TSX). Here you’re getting proven management in addition to oil price exposure. These were the guys behind Blackrock Ventures before it was sold to Shell for mega-billions a couple years ago.

Black Pearl is a new stage entrant, but they’ve got some good production history — 7,700 barrels a day and rising — and a lot of expertise working their main assets near Peace River. But a big chunk of their meteoric rise in stock price over the last few months is vastly (and fastly) growing reserves (sense a theme emerging?).

In January, the company released its 2010 reserve reconciliation showing they added 7.5 million boe in reserves, but added almost 750 million barrels in a more risky category – contingent resources – and about 98 per cent of it oil. That’s a staggering sum; we’re talking resources to production of almost 300 years at current rates.  Most of these resources come from its Blackrod SAGD heavy oil project (Steam Assisted Gravity Drainage).

As CEO John Festival said in the news release: “Our objective over the next few years is to get these barrels reclassified from the resource category to reserves.”

In doing so, the company will be adding real value that will inevitably translate into higher share price multiples. Think about what that family room addition will do to the resale value of your house.  And like I said, this management team has sold a company before for a lot of money.

Likewise, consider Twin Butte Energy (TBE-TSX). They started off as a gas company but quickly shifted to oil around 2006 when it became clear the Katrina Premium on gas prices was just a figment of the imagination.

Earlier this month the company reported a23 per cent increase in total proved plus probable oil and gas reserves, which rose by 6.9 million barrels of oil equivalent to 37.5 million boe.  That reserve addition was nearly quadruple 2010 reserves it produced.

Finding, development and acquisition (FD&A) including future development costs came in at $10.48 per boe on a proved plus probable basis and $14.28 per boe on a proved basis, which is right up the fairway and a chip shot to the green as far as industry-wide performance goes.

In other words, these guys will do quite well even if oil prices come down from current levels — which they probably will, if past events like the first Gulf War are any guide.

But the increase in reserves combined with the low operating and development costs will ensure a steady stream of cash and higher valuations for you, dear investor, dictators be damned.

It may be the end of the world as we know it, but as long as you’re long on oil, we’ll all be fine.

- Keith Schaefer
Publisher, the Oil & Gas Investments Bulletin

Editor’s Note:  Ever wonder how companies can estimate tens of billions of barrels of oil on their property before they drill it?  I explore that here in this report: How Big Shale Formations Get Estimated – All Over the World.

The first two parts of the above series:

Part 1: How To Use the ‘Recycle Ratio’ To Invest in Oil & Gas
Part 2: Unconventional Oil & Gas Plays: What I Look for in the “Reserve Report”

I have been actively buying and selling in the portfolio last week, and informing subscribers of new investment ideas has kept me away from the blog more than usual.  But a chart I follow caught my attention this weekend and I think it could help investors determine the next move in the global oil price.

I keep waiting for the 3 year chart on Exxon Mobil (XOM-NYSE) to break out or break down.  I have been following it since I started my blog earlier this year.  I noticed that oil bad become the market’s favourite derivative on the overall market, and I think that continues today.  At times, the market moves the global oil price; at other times oil moves the market.  Their relationship changes, but investors are definitely linking them.

And if equities lead commodity pricing, then should be XOM one of the bellwether stocks that investors should follow.  However, it has NOT benefited from the run up in the NYSE this year.  In fact, it has been strangely silent on forecasting market direction or oil price direction for the last six months.  But its 3 year chart tells me that is about to change. 

I am not a specialist chart reader.  But when long term wedges come to a head like this, it presages a big move one way or the other. 

I see a couple bullish signs from this chart

1. For the most part, the up moves had bigger volume than the down moves. 
2. This type of chart is called a wedge or pennant formation, which are normally “continuation” patterns – they are just pauses in the dominant trend.  However, the longer a chart consolidates in its wedge or pennant, the more likely it is to be a trend reversal, and not a continuation.  This Exxon chart has consolidated a long time, but is it long enough?
3. The five year chart actually looks like a bullish declining wedge chart.

In my next article, I will give a portfolio update and what new subscribers can expect in the next full length Oil and Gas Investments Bulletin.

Millions of consumers and investors in North America are wondering how the global oil price and the price of gasoline at the pumps can be going up in the face of rising global oil inventories and no significant increase in demand for anything in the US.

According to Philip Treick, Managing Partner of Thermopolis Partners,  a large part of the reason oil and copper have been strong is because the Chinese have re-pegged their currency, the Yuan, to the dollar, since July 2008.

Without a peg, the Yuan would naturally rise against the US dollar, attracting capital as one of the few growing economies in the world (as the Yuan did when it floated up between 2005 – July 2008). But an increasing Yuan was causing China to lose manufacturing jobs to other countries and cause social unrest.

Simplistically, in order to maintain that peg – which means forcing the Yuan down – the Chinese must print Yuan out of thin air (just like the Americans) to buy US dollars.  This increases their money supply.  To offset that, they then need to sell Yuan via debt – create an obligation that is an offset to that new increase in money supply.  But a couple of their debt auctions have failed recently, greatly increasing the monetary base in China. 

This has had the effect of flooding the Chinese banking system with capital, which has gone into new lending by banks, the stock market…and hard assets like oil, driving up growth and prices in an otherwise contracting global economy.  And Treick isn’t the only person thinking this…Ambrose Evans Pritchard, Int’l Business Editor of the Telegraph newspaper in London England, mentions it here, in this story  tinyurl.com/krqo4o.

Maintaining the peg is straining the Chinese economy – if and when something breaks, what will that mean for the oil price?  It should be good for investors in oil if the thing that breaks is the peg.

QUICK HISTORY

China pegged its currency to the US dollar up until 2005.  Bowing to international but mostly US pressure, the Chinese began a slow but steady upward revaluing of the Yuan from 2005 to July 17, 2008.

As this was a controlled rise, with very low volatility, investors and speculators poured billions of dollars into the Yuan to gain from its appreciation.  Borrow from a declining US dollar, invest in a rising Yuan, and make 10-15% of low risk money. That’s called a “carry-trade”.

Understand that the international community wanted the Yuan to rise to make Chinese goods more expensive, and hopefully other nations could get back some of the tens of millions of manufacturing jobs that had been lost to China.

But as the Yuan rose, China started losing jobs to other countries, mostly in Southeast Asia.  By July 2008, so many factories had been closed and jobs lost that the Chinese government made an un-announced policy decision to re-peg the Yuan to the dollar.

There would be no more appreciation of the Yuan against the US dollar.  THE CARRY TRADE WAS OVER. Speculators short the dollar were forced to cover as the US dollar started to soar as this trade was unwound.

(Now, the end of the carry trade was well reported, but most media credit it to the subprime crisis in the US.  But the mortgage crisis started in 2006 – the credit contraction started then.  The crash of October 2008 was a full two years later – only weeks after the Yuan was pegged again.)

You can see the relationship between the Yuan peg and the oil price in the following chart: Initially, the peg caused the oil price to collapse by being responsible for the rise in the US dollar in the fall of 2008.  But times have changed… 

WHERE WE ARE NOW

Fast forward to today.  We see a rising oil price – usually a sign the economy is greatly improving – at a time when the world’s largest economy, the US, is still mired in deep recession.

How can that be? Because the Chinese are creating billions of new Yuan to keep the Yuan low, keep it pegged to the US dollar, and some of that money must be buying oil, says Treick.

See how the money supply in China has grown since they re-pegged.  This chart is from financial newsletter writer Steve Saville (www.speculative-investor.com-(I am a subscriber of his and enjoy his perspective))

Treick suggests as long as the Chinese hold the Yuan-dollar peg, billions in new Yuan will continue to be created, with much of that money flow going into hard assets like oil to hedge against inflation. This means that small, brief pullbacks in the global oil price are going to be just that – small and brief. 

 That, Mr. and Mrs. Smith in America, is why the global oil price and your price at the pumps are going to stay high in the face of high oil inventories.  Let’s not even start on the huge Strategic Petroleum Reserve (SPR) China is creating.

I humbly suggest this means investors who trade oil and oil stocks strictly on the supply-demand fundamentals of the oil market – which are bearish now – will miss out on a lot of profits if they are not watching China.

So how does this situation play out moving forward? Because a higher oil price is also problematic for the Chinese.  They don’t want higher oil prices to kill their economic recovery.  Economic unrest has already meant riots in the street in several Chinese cities.

China has run a trade surplus with most of the world for many years, so they have a big enough foreign exchange reserve to subsidize the price of oil, keeping demand high in that country – which analysts say would be very bullish for the global oil price. 

Their other option is break the peg, which would cause the Yuan to rise quickly, making oil cheaper in Yuan.  This would increase the oil price in dollars – increasing profits and stock valuations for investors.

 And keep the price at the gas pump high.  Sorry Mr. & Mrs. Smith.

The breakeven price for oil and gas companies in 2008 was US$87.24 per barrel of oil equivalent (boe), BMO Nesbitt Burns said in their annual Global Cost Study released July 21. 

The three year average for the industry’s breakeven price is US$73.60.  They estimate the 2009 breakeven price will fall roughly 20% to close to US$70.  It has risen steadily since 1999 when it was $16.96

BMO Nesbitt Burns is one of the largest Canadian brokerage firms.  Their survey included 118 companies that produced 19 million barrels of oil per day (bopd) and 85 billion cubic feet of gas per day (bcf/d).  These numbers encompass all costs, or what the industry calls full cycle costs, and include a 10% return on capital for the producer.

(This is an important distinction as many investors get confused on costs.  When companies report break-even costs on wells or production, they are often referring to operating costs, or what the industry calls half-cycle costs.  Energy companies can say they can produce oil or gas at $X, but that may be on an operating basis, and not include items like land acquisition (this is especially true for the new shale gas plays).)

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BMO says the rise in the breakeven price is caused by two factors:

1) Operating costs have gone from US$4.50 per boe in 1999 to almost $16 in 2008

2) Rising Finding & Development Costs (F&D). This is the big jump – from US$3.88 in 1999 to $23.16 in 2008. This is the cost for replacing reserves. If a company has 10 million boe in reserves in Year 1, but produced 1 million boe that year, it now only has 9 million boe in reserves. The cost of replenishing that 1 million boe lost to production has increased dramatically.

I’ll highlight several points that I think investors would find interesting:

F&D costs in 2008 rose 56%, a huge jump.  BMO said this was because many companies actually showed negative reserve growth in 2008, despite $323 billion being spent on exploration by these 118 companies.

This is because costs were still reflecting the highly inflated cost structure of 2005-2008, while the year end oil price collapsed.  Companies must report their reserves based on the year end oil price.  They spent their exploration money throughout the year finding oil reserves based on $100 oil, but it ended up just over $44.

In North America, BMO reports reserve additions cost more than US$41/boe, almost double their global average.  (However, North American accounting provisions could just be tougher – but I’m not sure about that.)

Return on capital for energy producers has decreased since 2005, as government have taken a larger chunk of the profits, and the quality of crude has declined. So profit per barrel has declined and the cost of finding a barrel has increased, despite over $1.2 trillion spent on exploration in the last five years, BMO reports.

There are a couple issues that would indicate higher oil prices are here to stay:

-historically, there is still a small surplus capacity in the global system, even with the global recession.  BMO’s charts show it to be under 5 million boe, vs. over 20 million in the 1980s and early 1990s.

-a shortage in skilled labour within the industry remains – geologists, engineers etc.

BMO also reports that previously when there was surplus capacity, the industry was also able to discover large low cost reserves in the world that helped bring costs down.  They don’t see that on the horizon right now.  The oil sands, a new unconventional source of oil, might be able to get to all in cost of US$50.

They do point to shale gas as one such possibility. Natural gas could potentially find a breakeven price of US$5/mcf, down from $9.28. However, I have written before how the financial statements of these companies are not yet showing any significant decrease in their finding costs, as is shown on the line item “Depreciation, Depletion & Acquisition”, or DD&A.

Lastly, and this is important for the many thousands of retail investors who own the Canadian natural gas stocks, is that costs to find gas in Canada is 50% higher than in the US – >US$10/mcf vs. US$7.09.  The reason for this is that Canadian companies built up production as fast as they could over the last few years, with the hopes of being bought out by a royalty trust, and that game is now gone, or much reduced.

The Canadian producers just did not need to be as efficient in their growth as their US counterparts. (Having said that, their success rate in drilling is still very high.)  But this has resulted in high debt levels for the Canadian companies during a time of low commodity prices.  Much if not all of their cash flow growth over the coming years will be used to reduce debt, and will not flow to investors.  This means investors need to be very choosy in deciding which if any gas weighted juniors or intermediate producers.

When I first started the newsletter in January, one of my best stockbroker friends asked me – where do you think the price of oil is going to be at Christmas 2009? I said US$65 or $75.  Wow that’s high, he said, compared to all other analysts.

But research analysts base their oil price projections on fundamentals.  And like everything else in the market, the oil price is based on the psychology of what the fundamentals may look like 6-9 months ahead.  (Plus they are concerned about not being embarrassed on being wrong on a gutsy call that was well outside their peer group.  Iconoclastic newsletter editors aren’t burdened with that.)

I said to my friend – the market has shown it can take oil to $147 per barrel.  Then take it to $38 per barrel.  The market is powerful enough it can put the oil price wherever it wants.  All fundamentals do is show the barest of trends, which over the last 3 months has been optimism, and the market takes that and runs with it – hard. 

The inventory numbers on oil this week were higher than expected, and therefore bearish.  But over the last 3 months there have been several inventory statistics that were bearish and the market continued to take oil higher.  So I’m not convinced that was all the reason for the drop this week…

Here’s some conspiracy theory thinking for you.  US Treasury Secretary was in China trying to assure the Chinese that their vast US-denominated debt holdings were safe.  The US dollar was falling hard.  And the US dollar gold price was about to go up through the magic $1000 per ounce level.  It touched $990 this week.

The US government can talk all they want about the benefits of a strong dollar, but they really do want the US dollar to go as low as possible as fast as possible as long two things don’t happen:

• 1) The market doesn’t crash like it did last October
• 2) Gold doesn’t go through $1000 an ounce in a panic

As soon as gold goes through $1000, it is a major sign to the world’s investors that the US dollar is weak and getting weaker.  They want the dollar lower so they can pay off their debts more cheaply, and give less back to their debtors.  They inflate their way out of it.

So when gold got close to that magic $1000 per ounce, the government had to act.  To have gold go four digits while Geithner was in China would have been an even bigger embarrassment than being laughed off the stage by students at a Chinese school.

The dollar had to move higher to prevent gold from going higher.  So the dollar moved higher.  Which of course made the global oil price fall. 

Personally, I have a hard time with conspiracy theories. I’m always reminded of a conversation I had at an investment conference with Bob Moriarty, publisher of www.321energy.com.  Bob told me something like “Keith, conspiracy theories confer a much greater level of sophistication and intelligence upon the elites than is real, or even possible.  They’re just people.  I used to deliver planes to some of the richest men on earth for years, and trust me, they couldn’t figure out how to do all that .” That being whatever conspiracy theory we were talking about then.

Natural Gas – inventory numbers due out today, Thursday. The drop in rig counts is stalling now – Canada is up a bit lately and the pace of decline in the number of rigs is slowing.  Chesapeake (CHK-NYSE), the largest US natural gas producer, estimates there needs to be 1100-1200 rigs to keep national production steady.  Tristone Capital in Calgary recently estimated 1400 to increase production 5%.  The US rig count is now 700.  So by the experts, the natural gas price is setting itself up for a big jump.  As I wrote in an earlier column, I can smell the anticipation of buying in the market should natural gas inventories be much lower than expected on any given week.  Expect that to be a 15-20% jump for natural gas stocks that Thursday.

In the new and subdued US, I would suggest this equilibrium rig count number will be lower, but how much is a fool’s game. 

In my portfolio, I try to take the market out of the equation as much as possible by buying low cost producers with management teams who have proven they can grow their business, so I don’t have to pay too much attention to all the detailed noise.