Finally A Breakdown in Crude

Jim Brown
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When crude bubbles burst they do it in style. WTI prices have declined -$8 to trade as low as $91.25 today on a strong bounce in inventories and bullish news from Saudi Arabia.

I would bet President Obama is pretty frustrated today with oil down -8 over the last 3 days without a release from the SPR. This decline has taken the potential for a SPR release off the table and now there is little opportunity for a political move ahead of the election.

The big decline on Monday was likely a dump of a long position by a major hedge fund because it was option expiration day for crude futures. When the ramp higher from last week fading after the QE3 announcement and no further bounce on the violence overseas the right thing to do was dump those options and take profits. The profit taking triggered thousands of stops and it was an ugly drop on no news.

Today the price of crude fell another $4 after the EIA announced a monster build in crude inventories and there was news from Saudi Arabia that OPEC was going to produce more oil to push prices lower. Actually that is to prevent the U.S. and allies from going soft on Iran but they are never going to say that.

Add in the monthly futures expiration for the current contract on Thursday and you had a recipe for a decline.

The IEA reported an 8.5 million barrel spike in oil inventories. That is a direct result of production returning from the Isaac shutdown and tanker traffic resuming into the Gulf.

Inventory Snapshot

The boost in inventories came from a whopping 1.3 million barrel per day surge in imports and the increase of 751,000 bpd in domestic production from Gulf wells coming back online. The two factors combined produced daily inflows of more than 2.0 mbpd or 14 mb for the week.

Refineries also rebounded back with an increase in utilization from 84.7% to 88.9% as power was restored and that increased the daily demand for crude by 595,000 barrels. That was not nearly enough to compensate for the surge in imports and production.

Crude levels should be back to normal now and future weeks should return to their seasonal patterns. Crude inventories are above their five year average range and refineries are going to be shutting down soon for seasonal maintenance and the switch over to winter blends. This will allow oil inventories to increase.

Oil Inventory Chart

Gasoline inventories fell -1.4 million barrels and the eighth consecutive week of declines. With seasonal driving over and refineries back in operation we should see a decent build in the next inventory report. Gasoline inventories are nearing the bottom of their five year range but that is a seasonal trend. The drop in inventories was caused by a -341,000 bpd decline in imports.

Gasoline Inventory Chart

Distillate inventories were flat with only a -300,000 barrel decline and the first decline in seven weeks. The decline was caused by a sharp increase in demand of +316,000 bpd. There was no obvious driver of that demand increase.

Distillate Inventory Chart

The big drop on Monday was reportedly caused by a large sell order by an unnamed macro hedge fund. They placed a large sell order that caused a sharp dip that triggered thousands of stop losses placed by other traders. It became a selling cascade that lasted about 30 minutes.

In the past ten weeks the open interest of long futures contracts rose by 100,000 contracts, the equivalent of 100 million barrels, in anticipation of the Fed announcing QE3. After the announcement there was a $2.50 spike in oil prices and then the bounce faded. When there was no follow through the selling began.

The October WTI futures contract expires on Thursday so those still holding some of the 100,000 contracts mentioned above are going to be in a hurry to sell. With the volume today at 195,000 contracts I would bet the worst is over. However, you never know until it is really over and the contract expires.

I don't think the longer term selling is over. A senior Gulf source said Saudi Arabia was increasing production, currently about 10.0 mbpd along with several other OPEC members, in order to push prices lower. Reportedly they want to push Brent prices down to the $100 range to avoid pushing the global economy back into recession and to reduce the amount of money Iran is receiving for their oil. The production increases will come over the next couple months.

The increased production in a period of seasonal declines in demand should push prices lower. The violence in the Middle East has faded slightly so that support is evaporating. The normal linkage between higher oil prices and QE programs may not be enough to push oil prices higher in the face of rising inventories.

The QE3 trade in general is fading. There were too many expectations priced into the markets and global economic strength is declining. FedEx warned again about slowing volume and the sharp drop in overnight services with shipping moving to ground due to a lack of necessity. Slow is apparently good enough today.

After the bell on Wednesday Norfolk Southern (NSC) warned on guidance saying earnings would now be in the range of $1.18 to $1.25 compared to prior estimates of $1.64. The CEO quoted lower shipping volumes of commodities and slowing intermodal shipments. Shares fell -$5 in after hours.

Bed Bath and Beyond (BBBY) reported earnings of 98-cents compared to estimates of $1.03. The problem was rising costs and slowing sales. Shares fell -$3 in after hours.

JC Penny (JCP) CEO, Ron Johnson, said overall the new store within a store concept was working well but sales over the last two weeks had been really tough. JCP is not the first company to voice the warning that retail sales had turned seriously negative over the last several weeks. If this trend in earnings continues we could see the market expectations begin to decline sharply.

QE programs are normally expected to boost asset prices of commodities and equities but without a fundamental basis under the market that linkage could fail. Q3 earnings estimates are growing more negative every day and we have not even gotten into the real earnings cycle yet.

My initial target for crude prices is $88.

Jim Brown

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