China, Flooding and the CME

Jim Brown
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Crude prices are starting to make a habit of monster intraday moves thanks to the CME and their attempts to decrease volatility. Add in the rising inflation in China and the threat of flooding for 900,000 bpd of refinery capacity in Louisiana and those big moves just keep coming.

China's industrial growth slowed more than expected in April and inflation only declined to 5.3% from a 32-month high of 5.4%. Analysts are worried that China will have to take additional action to further slow the economy to combat that high inflation rate. Slowing the economy has a related impact of slowing demand for crude products.

I personally believe this worry over slowing demand in China is overdone. China's manufacturing output and GDP may slow slightly but the move to mobility by China's masses is only going to accelerate. They are expanding auto production at a record rate and auto sales from brands shipping into China are also at record rates. China's exports are moving higher and manufacturing will continue to require petroleum products.

In the grand scheme of things it will not make any difference to global oil demand if China's imports rise by 190,000 bpd instead 200,000. This fear over slowing demand in China is just an excuse made by people who don't know why oil prices are falling.

A bigger factor in the oil price decline was the rise in crude inventory levels in the USA as reported by the EIA on Wednesday. The EIA said crude levels rose +3.8 million barrels to 370.3 million. That is a new post recession high. However, crude oil levels are normally high this time of year while refiners are slowing production and switching from winter blends to summer blends and performing equipment maintenance before the high demand summer driving season. I view that level of inventory as immaterial even though it is slightly over the five-year average.

Crude Oil Inventory Chart

A bigger inventory challenge was the minor rise in gasoline level by 1.3 million barrels. That was the first gain in the last 12 weeks. It is also not a material spike and it is the time of year when gasoline levels should begin to rise. The fly in the ointment was the decline in demand of 107,000 barrels per day. This is due drivers in a weak economy making choices to limit driving when gasoline is around $4 per gallon. It does not mean they are going to stop driving, only they are driving less. As the price moderates and the economy gains speed the gasoline demand will increase. I don't think we reached a tipping point back into recession. We were getting close but I think it is still ahead.

Another reason for the decline in gasoline prices was the passing of the crisis in Louisiana. The flood levels have crested and are receding. There will be no material loss of any of the 900,000 bpd of refinery capacity in Louisiana as a result of the flood. Speculation that several refineries could have been knocked offline for weeks has passed and the speculation premium in gasoline has evaporated.

The real reason for the volatility in crude is still the CME. The drop at the open this morning came after traders who were not paying attention received a margin call in their accounts from the new margin rates that went into effect on Tuesday night. To make matters worse the CME announced on Wednesday they were raising rates again today by another 21% on gasoline futures. This caused a -7% decline in gasoline today. The decline was so rapid as traders raced to the exits that the limit down level on gasoline was hit and trading in oil, gasoline and heating oil was halted for five minutes. When trading resumed the CME changed the limits to $20 on oil and 50-cents on gasoline to allow even more volatility as traders raced to unload positions. The CME did not want a situation where traders were locked into contracts where margins were expanding because the futures could not trade due to limit halts.

The CME has apparently appointed themselves as guardians of volatility and they are trying to slow future volatility by eliminating weaker traders and limiting positions of stronger traders. In doing so they had to shake up the markets by repeatedly changing the rules and causing bouts of historically high volatility in the process.

In the end the result will be the same. Oil demand will eventually meet and exceed supply and no amount of margin games will be able to reduce prices. This is a political move by the CME more than a real change in the future outcome. It is the equivalent of changing from a brown basketball to a blue basketball in the championship game. The difference in the outcome at the buzzer will not be related to the color of the ball.

In the short term the margin changes will cause some traders to exit the market and we will lose some liquidity because of it. We will also lose some weak holders but new ones will appear to take their place. Nothing changes but the short-term volatility.

Jim Brown

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