Strong Dollar, Weak Oil

Jim Brown
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Energy stocks took it on the chin once again after the inventory reports show a large gain and the dollar rocketed to two week highs.

It has not been a good week for the energy sector or the market in general. The Fed minutes appeared to show a lot of disagreement among FOMC members on the future course of Fed monetary policy. The chances of QE3 declined significantly in the eyes of traders even though analysts only lowered estimates slightly.

The anticipation of a lack of Fed buying in the treasury market sent yields dramatically higher. Those higher yields and the Fed's comments about raising GDP estimates caused the dollar to spike dramatically as well. Since oil and gold are priced in dollars the price of each declined sharply. Gold has declined about $75 since Monday.

U.S. WTI prices declined from $105.50 on Monday to $101.50 today. Helping to push crude prices down was another supersized rise in oil inventories. The EIA showed that oil inventories rose +9.0 million barrels on top of the +7.1 million the prior week. Imports rose by 500,000 bpd or an additional +3.5 million for the week. Imports were 1.55 mbpd more than they were just two weeks ago. That is a huge amount of incoming oil but we need to remember that refineries build up inventories this time of year ahead of the summer driving season. This is a big jump and it puts the inventories at the top end of the five year range but they are still following the seasonal pattern.

You may remember two weeks ago there was an auto accident that shutdown a leg of the pipeline from Canada to Illinois and to Cushing. Oil flow was halted while repairs were made. That pipeline has been restarted and I am sure they are running it at near capacity to lower the backlog levels from the shutdown. That oil can't just accumulate in the storage tanks at the northern end or eventually the producers would have to halt production for lack of storage space. Pipeline operators have to flush that storage as quickly as possible because they never know when the next pipeline outage is going to require that storage.

Refinery demand also rose +300,000 bpd and refinery utilization rose to 85.7% and the highest level in months. U.S. production also rose by 203,000 bpd to 6.05 mbpd. That is also a major jump and the highest level in more than a decade.

Gasoline demand rose to 8.78 mbpd and also the highest level in months. If the economy is truly improving then gasoline demand and oil demand should continue to improve. Gasoline imports rose by a whopping 321,000 bpd.

Inventory Snapshot

Crude Oil Inventory Chart

Gasoline Inventory Chart

Distillate Inventory Chart

WTI crude prices declined to solid support at the 100-day average at just under $102 while Brent prices held over support at $122 after trading over $125 on Tuesday. Helping to support Brent is a number of supply outages in the overseas export market including the shutdown of multiple production platforms in the North Sea for maintenance and leaks. At least seven tanker cargoes of oil from the North Sea have been canceled or delayed as a result of the production problems.

Saudi Arabia tried to pile onto the price decline by saying even if IEA countries released supplies from their strategic reserves. Saudi also said it would not seek to attract more buyers by discounting its oil.

Also supporting Brent was news that the E.U. oil embargo against Iran was increasing. Japan and South Korea had been lobbying for exemptions to the embargo but insurance and shipping executives say a complete ban now looks likely. Japanese insurers are following the lead of European insurers in halting insurance on oil cargoes picked up from Iran. All of the major insurers and reinsurers have now halted writing that insurance and that will stop the purchase of oil because no purchaser wants to be liable for a major spill that costs tens of billions of dollars.

The EIA also said the emptying of the Seaway Pipeline in preparation for its reversal added 2.2 million barrels to storage in Cushing in March. That accounted for 20% of the inventory gains at Cushing. The pipeline is being reversed to transport oil from Cushing to the Gulf refineries and will open in June at 150,000 bpd and ramp up to 400,000 bpd in 2013 and 850,000 bpd in 2014.

Note the sharp increase in inventories at Cushing in 2012 compared to the five year average. Once the north to south pipeline is opened the inventory levels should decline as traders take advantage of the cheap Midwest oil by shipping it to the Gulf where it can be sold at Brent prices.

Cushing Inventory Chart

In stock news Transocean and Chevron were sued by Brazil for another $11 billion for a second leak in the Frade field. The first oil leaked through several cracks in the seafloor within 160 feet of the well. Chevron said the underground pressure was higher than expected and lead to the seepage. Brazilian prosecutors went nuts at the possibility of a windfall profit and sued the companies for $11 billion. Chevron immediately said Transocean had no responsibility in the leak and it was Chevron's engineering error. Less than 4,000 barrels were leaked.

The prosecutor was not making any progress on the case so he filed criminal charges against 17 Chevron and Transocean company executives accusing them of environmental crimes, misleading Brazil's oil regulator about safety plans and not providing accurate information in the wake of the spill.

The criminal charges have repeatedly made headlines over the last month but it is old news. A judge still has to decide if the environmental case will go to trial and that would be a lengthy process. The prosecutor was hoping to make a landmark case out of a monster fine but it has not worked out in his favor. The Brazilian regulators have repeatedly said the leak was not a big deal and it was just an accident.

The second leak in the same field was also seepage from existing cracks in the seafloor. Filing a new suit for another $11 billion is another headline grab and nothing more. Officials expect the suits to be settled with a minor fine, compared to the $22 billion face amount, and a slap on the wrist. Brazil can't afford to antagonize the entire deepwater drilling industry because most of the players are currently working offshore Brazil. It is not like the different companies are just going to pull up anchor and go home but facing the risk of an out of control legal system has to be factored into bids and the cost of doing business with Brazil will go up.

Unfortunately Transocean shares hit a four week low today after new headlines about the second suit. Even though a trial is likely to show that Transocean had no part in the process they still have to undergo the trial by headline until the case is resolved.

The energy sector was one of the worst performing sectors in the first quarter thanks to the decline in natural gas prices. Suddenly it appears analysts have discovered the underperforming sector and recommendations are flying. With crude prices likely to remain high and natural gas prices not likely to go more than 20-cents lower before summer the value light is lit and strong buys are starting to appear.

I would not expect new buy recommendations on BHI, SLB, etc until after the quarter ends. The major service stocks with a pressure pumping component (fracking) have warned the rig shift from gas fields to oil fields is causing a reallocation of pumping resources and some higher costs in the business. However, those companies with the majority of their production in oil should begin to garner upgrades.

We have also seen the EPA begin to drop suits and investigations on fracking contamination of ground water. Apparently they are finding it hard to prove the contamination resulted from fracking and they are dropping various actions against drillers. The EPA withdrew an administrative order against Range Resources accusing it of polluting water wells in Texas. This was the third time in recent months the EPA has dropped cases. The EPA said it was shifting its focus away from litigation and towards a joint effort on the science and safety of energy extraction. That sounds like a feel good cover-your-but headline to extract themselves from the various cases by taking the high ground in an election year.

If the EPA is pulling away from fracking problems it should be good for the industry. The Marcellus Shale in the Northeast has seen outright bans on fracking so any withdrawal of public agencies from the fray should be beneficial. It is far too early to start buying gas stocks on hopes the fracking bans will be lifted because there is still the problem of too much natural gas.

The market had an opportunity today for a major selloff and ended up with a small bout of profit taking instead. The Dow was down more than -170 at the lows but ended with a -124 loss. Support at 13,000 was not tested. However, prior dip lows from late March were tested and held. If these support lows failed along with Dow 13,000 then it would set the stage for a major decline.

Dow Chart

The S&P-500 also declined to "uptrend" support. The trend on the S&P is higher highs and higher lows. Until that trend breaks with a break below 1388 the uptrend is still intact.

S&P Chart

Even the big cap tech stocks cracked today, with the exception of Priceline. Apple, Amazon and Google all posted declines but Apple held at $620 support. The Russell lost -1.7% but it also held at support at 820.

Despite all the gloom and doom in the news we simply have not gotten to that point yet. One more day like Wednesday would throw all the major indexes into correction mode but as of tonight it was just a dip. The concern over the FOMC minutes is way overdone and the dollar strength should begin to fade without further headlines for support.

I am frustrated the energy sector is suffering from both gas pains and dollar pains at the same time but the gas problem has been significantly over analyzed in past weeks. While we may not be at the bottom for nat gas prices we should be close. A dip under $2 should be the starters bell for analysts to start recommending oversold gas stocks. That could happen in the next two weeks. Even if it does not happen we should see the summer cooling season begin on May 1st and gas demand will increase. Odds are good we are going to have a very hot summer. Either way the bottom in gas prices should be right around the corner in the $2 range. That is below cost for many producers so they will be forced to curtail production.

With the Iranian oil embargo gaining speed and commitment the price of crude should remain supported through July. Any dip to the low $100 range is a buying opportunity until Iran relents and I don't see that in the near future.

We need to be patient because the long term fundamentals remain firmly positive. Remember, oil prices are still in the $105-$125 range and not $65-$75. The long term trend is still up.

Our biggest risk is that high gasoline prices will push the U.S. back into a recession. We will have to watch the economic numbers closely over the next 60-days to see if the trend is changing.

Jim Brown

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