Headline Wars

Jim Brown
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Crude prices have declined for two weeks as the U.S. economy weakens, the European debt crisis returns to haunt us and growth in China slows. WTI prices remain over $100 despite all the bad news. This hunt for a bottom may be about over.

China said oil imports rose only 5.3% in March. Commentators heard the "only" not the "rose 5.3%. This import pace was slower than the +8% in February. That rapid pace was a statistical abnormality due to the calendar date for the Chinese New Year and the dip in oil prices in January. China buys oil on the dips to add to their strategic reserve. The New Year celebration shut Chinese commerce down for a week. Every headline has dozens of reasons behind it but commentators never seem to make the effort to find out the "why." They are only interested in the next sound bite.

European markets are falling again as the sugar rush from the one trillion euro LTRO quantitative easing program fades. Bond yields in Italy and Spain are rising without any fresh LTRO money to grease the bond auctions. Both countries are too big to save and so far they both claim they don't need saving. Of course Greece also made the same claims until suddenly they were broke. Spain and Italy are not going to implode next week. They may never reach the status of Greece but they will monopolize the headlines for the next couple years and will probably be the recipients of bailout money in some form over the coming months.

Analysts tell us Europe will rebound in the third quarter and U.S. earnings estimates revert back to double digit growth in the third and fourth quarters on the anticipation of that growth. That may be wishful thinking. S&P earnings for Q1 are now expected to grow by +0.1%. That changes to -1.6% if you remove Apple from the mix. Two month ago analysts were expecting +3% growth and on January 1st +5% growth.

The drop in jobs, the lowered expectations for Q1 earnings, the economic news from China and the clouds forming again in Europe have depressed the U.S. market and the price of crude on expectations for lower demand.

Traders are no longer factoring in the production outages in Nigeria, Libya, Yemen, Syria, Sudan, etc or the Iranian oil embargo. For some reason they are more focused on the current economic headlines than the falling global production and the slowing exports from Iran.

This is because of the ramp up in inventories in the USA. There was a surge in inventories over the last three weeks due to the restart of a pipeline from Canada that was closed due to a traffic accident and the fog problems on the Gulf coast. Inventories tend to fluctuate a lot this time of year because up to one third of the refineries are shut down for maintenance as they switch from winter fuel blends to summer fuel blends. As I have pointed out for several weeks now the inventory accumulation curve is on the high side of the five year average but still following the trend. If the red line were to shoot out the top of the blue band then we would have an inventory problem. Currently we are only about three weeks away from the start of the inventory decline cycle as refineries begin to produce summer fuel in high volume.

Oil Inventory Chart

That ramp has not yet started because gasoline and distillate inventories both declined by more than 4.0 million barrels last week. Refiners are still in the liquidation stage where they sell down the winter fuel blends ahead of the switchover. Refiners are required to switch over to summer blends by May 1st. Service stations have to switch by June 1st. That May 1st deadline means refiners are running out of time to complete their conversions. They need to build up supplies in the distribution system before Memorial Day. Note on the chart below that gasoline supplies are also moving in the right direction.

Gasoline Inventory Chart

Distillate inventories are almost perfectly balanced in the middle of the five year range. However, the trend for distillate inventories has been down for the last two years. Inventories hit nearly a three year low this week at 131.9 million barrels. You have to go back to December 2008 for a lower inventory number. If this trend continues it will force the prices for diesel, jet fuel and heating oil even higher. Distillate demand last week at 3.932 million barrels was the highest since the week of December 16th. That suggests business activity is increasing.

Distillate Inventory Chart

Cushing inventories rose only slightly to 40.6 million barrels with futures expiration on April 20th. There is additional room at Cushing for oil storage but there is no incentive for traders to do that with the futures contracts farther out trading for only 50-cents more than the expiring contract. The hassle factor plus the storage costs would exceed the difference in the contract price.

Inventory Snapshot

Serious inventory problems exist but not in the liquid fuels. Natural gas inventories are ramping up quickly and are on track to exceed existing inventory space later this year. Nat gas futures closed today at $1.98 and more than a decade low. Gas rigs are disappearing at the rate of roughly 12 per week but it will take months for the flow of gas from newly drilled and yet to be completed wells to dissipate.

There appears to be no chance that gas inventory will not exceed storage space later this summer. That will force pipelines to curtail acceptance of gas until space becomes available and this will further depress gas prices. There may be a bounce in prices as we move into the cooling season and gas demand for electrical generation increases. However, any bounce in price may be temporary. Eventually the declining drilling and the increased demand will equalize with prices and normal commerce will return. That may not be until next year.

Natural Gas Chart

The EIA predicted the average price of gasoline in the USA would be $3.95 from April through September with a peak of $4.01 in May. The government said there was a small chance prices could hit $4.50 in June. This is due to higher prices for Brent crude as a result of the dozen or so production problems around the world and the Iranian oil embargo. The average gasoline price nationwide is $3.92 today. The higher prices will also come as a result of three major refineries closing. Those refineries fed gasoline to the east coast markets. Another refinery in Philadelphia will close July 1st if Sunoco cannot find a buyer. Delta Airlines is currently considering that purchase with the help of JP Morgan.

Diesel prices should peak at $4.25 per gallon according to the EIA. Diesel currently averages $4.16 per gallon.

I would like to proclaim we have seen the lows for oil but with the three Es of Economy, Earnings and Europe hanging over the market there is no guarantee the lows for the week will be "the" lows for this cycle. The seasonal fundamentals, production fundamentals and the Iranian oil embargo all support higher prices. This is a battle of the headlines and the last headline will always govern prices.

Energy investors need to remain 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. The drop in nonfarm payrolls may be a sign of further weakness ahead.

Jim Brown

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