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Crude oil: buy put options

The world markets were absolutely horrified by the murder of six Westerners in Yanbu, the kingdom's Red Sea petrochemical complex so soon after the blast at the Riyadh HQ of the intelligence directorate and a shootout in Jeddah. The prospect of a terrorist attack shutting down Saudi oil exports is a new risk for the oil market, a risk that is only reinforced by the violence and anarchy in Iraq. After all, Saudi Arabia's ability and willingness to act as a swing producer during past Mideast crises and wars preempted the Armageddon scenario in crude oil. Saudi Arabia alone has the spare capacity to both restrain the price hawks in Opec or boost production to ease the supply/demand equation. This is the reason that the Saudis did a policy U-turn, calling for a production increase in Opec when they had called for a cut only three months ago.

Like central banks intervening in the foreign exchange markets, Saudi Arabia will wait until the speculators and hedge funds in crude oil have taken the markets to extremes at 42-44 before announcing a "shock value" production rise. This will cause oil prices to plunge, please the White House and Wall Street, boost George Bush's election chances, help the kingdom's friends in Asia and Europe, reduce the inflation risk to global growth and win political brownie points for the House of Saud all over the West. It is naturally in the Saudi interest to act to dampen oil price shock and reduce the $8 risk premium in black gold. Will the Saudi move next week? If they do, Treasury bonds and US stocks could both skyrocket.

It is significant that oil is rising even though the dollar has risen significantly against both the Japanese Yen and the Euro. Moreover, inflation adjusted oil is still only half its level of 1979, when the Shah lost his throne and Iran's oil fields were crippled by strikes, sabotage and revolution. Even more ominous, five year futures on crude oil have now risen to $27, after a $18-20 range in the past decade. The impact of oil prices is now showing up in America's economic heartbeat - there was an oil deficit of $12.5 billion in the shocking March trade deficit. The Saudis will act to get oil lower - neither Riyadh nor Washington will allow a bunch of hedge funds to take crude oil to $50 a barrel. Something is brewing in the oil markets and a climatic top in the June West Texas Intermediate futures contract is imminent. The June contract front end premium has also vanished, meaning oil is near a peak and put options on crude oil could rise tenfold I am right that prices will fall to $36-38 by the end of May.

I am extremely bullish on energy shares, a view that has been vindicated in the past month as oil shares have soared. Exxon (XOM) is a bit rich at 43 even though it has Big Oil's best balance sheet, global reserves/ production growth and chemicals/refining exposure. Still, I believe the optimal range for Exxon is 40-47. There is no doubt that world oil reserves were wildly overstated. The Shell fiasco and China's scramble for secure oil supplies proves the point. After all, Saudis Ghawar, the world's largest oilfield, is 45 years old and there have been no elephant oilfield strikes since North Sea and Alaska a generation ago. The 2003-2004 oil panic is like the overture in a Wagner opera, a preview to the Real Thing. The era of Big Oil mergers, whose impetus was to buy reserves, is now over after the Conoco, Philips deal. So, it is obvious to me that we are on the verge of a global drilling boom, particularly in nasty but lucrative areas like offshore West Africa, the South China Sea, Russia.

So I would take a long hard look at Nabors (NBR) at 42, the worlds leading driller of oil and natural gas land drilling. Nabors has a beautiful franchise in North American drilling, particularly in the Rocky Mountains and Canada. The US Congress, anxious to end energy dependence on imported Arab oil, will not hinder domestic land drilling. This drilling boom will continue even if oil and natural gas prices were to fall 20 per cent. This will prove a profit bonanza for Nabors, which also has valuable drilling contracts in Saudi Arabia, Yemen, Vietnam, Algeria. Rig counts and capacity are rising, as are day rates by 30 per cent in the next twelve months. Its valuation multiple at 21 is far below its historical median P/E of 30. I believe Nabors could well hit 58-60 in the next twelve months as Mr. Market quantifies the gold rush in the Oil Patch drilling plays.

Another clear trend will be the insatiable Chinese, Japanese, Indian, Korean and Taiwanese demand for imported crude oil. This leads me to Teekay Shipping, owner of the worlds largest tanker fleet. They transport 10 per cent of the world crude. Their fleet is running at full capacity and there is a tonnage ceiling as the worlds shipyards cannot ramp up production. The demand for LNG tanker rates for longest haul (Gulf oil terminals are rising). A new era in energy is struggling to be born. There is serious money to be made here.

The author is Executive Vice President (Investments) of Eastern Trust, Dubai. Email : eastrust@emirates.net.ae

(The opinions expressed in the above article are those of Matein Khalid alone and Khaleej Times is not responsible for any loss that any reader may incur because of investment decisions made on the basis of this article.)