Inventories, Copper, Schlumberger, BP, FOMC

Jim Brown
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The FOMC said there were no changes to the QE policy and reiterated the 6.5% unemployment and 2.5% inflation thresholds for future changes. This was no surprise but the dollar did decline and crude prices rose.

However, I believe the jump in WTI prices had more to do with the expiration of the April contract at the close today than any sudden move as a result of the Fed. The lack of any material change in Fed policy was expected and the dollar index only moved 12 basis points. That is hardly enough to propel WTI nearly $1 higher.

The euro is going to be the biggest driver of crude prices over the next year. Once the euro decline ends it will halt the dollar rise. Europe is in a mild recession that is expected to end in Q4. That will lift the euro once the economic reports begin to improve. However, more stupid human stunts like the Cyprus Stability Tax and the euro is never going to recover. That aborted tax proposal has riled all of Europe and there is new talk about countries leaving the eurozone.

Crude prices did rise this morning after the EIA said crude inventories fell unexpectedly by -1.31 million barrels. Analysts had expected a build of +2.0 million barrels. The biggest decline came on the West Coast where inventories fell -2.75 million barrels. This was likely the result of tanker movement rather than a glitch in the supply chain.

Refinery inputs rose by 520,000 bpd and imports declined by -218,000 bpd. Utilization rose from 81% to 83.5%. I am surprised inventories did not decline more than -1.31 million barrels.

Gasoline inventories declined by -1.5 million barrels but there were some heavy forces at work there as well. Gasoline imports fell -340,000 bpd and production dropped -396,000 bpd for a total decline in inputs of -736,000 bpd or 5.15 million barrels. This should have created a sharp decline in inventories except that gasoline demand fell -303,000 bpd or 2.1 million barrels.

The spring maintenance season coupled with unplanned outages at two refineries in California is playing havoc with the inventory trends.

Today was the first day of spring and warmer weather should help to increase demand for fuels. The winter storms should be over or at least be of reduced intensity. Increased demand should raise WTI prices and further reduce the WTI-Brent spread currently at $15. Later this year when the next pipeline upgrade to the Gulf is completed the price of WTI should gravitate towards the $100 level.

Crude inventories are 10.5% over year ago levels. Distillates are -12.3% below and gasoline -1.8% below year ago levels.

Inventory Snapshot

Crude Oil Inventory Chart

Gasoline Inventory Chart

Distillate Inventory Chart

Crude oil imports peaked in 2005 at 10.1 mbpd and then fell in six of the next seven years. In 2012 imports averaged 8.5 mbpd and the lowest since 1997. That was -444,000 bpd or -5% below the 2011 import levels. With added delivery capability from the Midwest to the Gulf Coast the average Gulf imports fell below 3.4 mbpd in March. That is the lowest level since 1992.

Landlocked producers are turning to rail cars, barges and new pipelines to deliver crude to the Gulf Coast where it can be sold at Brent prices. Brent has inherent problems associated with it including transportation, lag time for delivery and security. Once U.S. production is transported to the coast it competes with Brent prices. We don't actually use Brent crude in the U.S. but all waterborne crude is indexed to Brent even if it comes from Saudi Arabia or Nigeria.

East Coast refineries are still shackled to the waterborne crude because there is not enough pipeline capacity to get Midwest crude to the east coast. In 2012 92% of crude refined on the East Coast was imported. That is down from 99% in 2005. Several refineries have contracted to buy thousands of rail cars to take delivery of crude at the point of origin in the Bakken and other new shale plays because they can buy it cheaper and make the transportation costs worthwhile.

The U.S. imported 2.4 mbpd of crude from Canada in 2012. That is an increase of 775,000 bpd since 2005. That equates to about 28% of our crude imports. Once the Keystone XL pipeline is completed that number will rise but not by the full 800,000 bpd of pipeline capacity. Crude from the Bakken and Niobrara field in Colorado will be competing for that capacity in an effort to move to the Gulf.

The majority of our crude imports other than Canadian come from Venezuela, Mexico, Columbia, Kuwait, Brazil, Angola and Nigeria. With U.S. production expected to rise from 7.15 mbpd today to as much as 9.0 mbpd by 2020 we will be able to substantially cut imports from the Middle East. Add in another 1.0 mbpd from Canada and the potential for Mexico to end its decade long production slide and our reliance on insecure waterborne imports will drop dramatically. That is a good time to be less dependent on overseas imports with production expected to decrease by 2020. Schlumberger warned this week of declining output overseas.


In a presentation at the Howard Weil Energy Conference Schlumberger said U.S. drilling activity was below expectations and customers had reactivated fewer rigs than anticipated for the spring and summer drilling season. Drilling efficiency was improving and requiring fewer rigs. SLB had predicted 100-150 rigs would be reactivated by spring. However, Baker Hughes said last week the rig count had only grown by 13 so far in Q1. This is producing negative pricing pressure in many product lines in Q1. Growing competition in the sector is also increasing this pricing pressure. Overall they said they were standing by prior earnings estimates "if" activity improves in line with our prior expectations. That does not sound very promising since Q1 is over next week. SLB shares declined from $79 to $73 on the forecast. Other stocks in the services sector declined as well. Driller Helmerich & Payne (HP) also said the lack of increased drilling activity was pressuring rig prices.

Schlumberger did say "Outside North America, several non-OPEC countries show disappointing production trends with their output dropping year-on-year as a result of project delays and challenges in overcoming production declines. This will leave the call on OPEC production almost unchanged at a level above the group's production target of 30 mbpd. As a result the oil market is expected to remain tight and this will continue to support oil prices in the band that we have now seen since 2011." Oil demand is expected to grow +900,000 bpd in 2013 and Chinese demand will account for more than half of that amount. Chinese oil demand is expected to rise by roughly 500,000 bpd or more each year from now on. That equates to the need for 5.0 mbpd of new supply every decade. Good luck with that.


Copper declined to a seven month low on Tuesday at $3.388 per pound on the doomed Stability Tax in Cyprus. The worries over a failing eurozone and the potential for a system wide bank disaster and corresponding drop in the European economy reduced demand expectations.

On Wednesday Morgan Stanley said China's demand was increasing and supply chain inventories in China are very low. Morgan Stanley said manufacturers were being forced to buy copper for inventory after allowing inventories to decline ahead of the transfer of power in the Chinese government. The weeklong New Year celebration in February is typically a turning point for manufacturing in China.

China has increased approvals for wind-farms. The Copper Development Association says the generator in a 5-megawatt wind turbine needs 3.4 metric tons of copper to generate electricity.

Morgan said inventories tracked by the London Metal Exchange climbed for a 25th session to 550,825 tons. Orders to move the metals from warehouses surged 77% to 64.875 tons and the most since December 2011.

The global economy cannot improve without copper demand increasing. It is only a matter of time but it may not improve significantly until late 2013 and early 2014. The new government in China is starting to make changes but the rest of the global economy has to improve before the consumption of Chinese goods improves.

BP Trial

The Deepwater Horizon liability trial is continuing and it BP's outlook is deteriorating. BP stands to lose another $17.6 billion in Clean Water Act fines if the company is found to be guilty of gross negligence.

Steve Newman, CEO of Transocean said on Tuesday that Transocean employees "should have done more" to prevent the 2010 explosion. On the surface that sounds bad for Transocean but there was a qualification. "They should have done more. They should not have accepted the assessment of the BP well site leaders." The BP crew including the managers on duty were in a hurry to get done and they told the Transocean crew to ignore the bad readings on the pressure test. On a well site the "company man" is king and that was a BP crew leader. What he says is law.

Newman admitted Transocean employees made mistakes but the investigation found no systemic problems that caused the disaster. "We had no management failures within the management system in place." Newman testified that Transocean employees had no financial incentives to cut corners or sacrifice safety for profits. Transocean gets paid by the day and if anything they had a vested interest in slowing down the project for safety reasons.

Halliburton (HAL) confirmed the cement samples for the Macondo well were "destroyed" despite court orders requiring they be preserved. BP claims the cement seal failed because the formula was too weak. A Halliburton employee, Tim Quirk, testified a colleague, Ronnie Faul asked Quirk to run tests on the cement "off to the side" and not formal tests in the laboratory. Faul asked him not to write an official report but "just phone the results to him." Quirk acknowledged the request was "a little unusual." Once the tests were complete Quirk discarded the notes because he didn't have to write a report and was not "aware of any preservation order." Not having the cement samples or the notes covering the tests is a "fortunate" sequence of events for Halliburton. It is tough to prove the cement was bad when there is no evidence.

I am surprised BP has not settled this out of court. The longer the nonjury trial goes the more likely a smoking gun will appear that pushes the judge towards a gross negligence verdict. I suspect the government lawyers feel they have a pretty good case and therefore they are proposing a huge settlement fee that BP is not willing to pay and feels the risk is worth the trial.


The FOMC announcement and press conference was no surprise. The majority of analysts do not expect QE to change until 2014. However, there are some that believe the Fed could decrease the amount in Q4 of 2013. That is not likely unless the economy catches fire. As part of the quarterly FOMC process the Fed produces forecasts for the economy, employment and inflation. The FOMC projects that unemployment will not decline to 6.5% until 2015. They expect inflation to remain in the 1.5-2.0% range in 2015 and 1.7-2.0% range in 2015. NEITHER of those parameters suggest the unemployment threshold of 6.5% and inflation ceiling at 2.5% will be hit in 2013 or 2014 so the odds of a change in QE are exceedingly slim despite the analyst commentary to the contrary.

That means the QE process should continue at $85 billion a month for the rest of 2013 and beyond if the Fed does not change their parameters.

If you take and average the various economic reports for January and February the average is BELOW the average for Q4. The spike in new jobs for February is expected to be only temporary. Moody's expects new jobs to average 135,000 per month for the next six months as a result of the sequestration process.

Q1 earnings will begin in two weeks. S&P Capital IQ is expecting earnings growth to be a very anemic 0.58%. We saw major earnings misses from FedEx and Oracle on Wednesday. Oracle lowered guidance significantly.

All of these events are not suggesting the economy is accelerating. We are at the mercy of the Fed's QE program and the stupidity in Europe.

The markets rallied after the FOMC meeting but they continue to have trouble at the new high levels where they failed last week. In theory we should see gains into quarter end as hedge funds try to recover lost ground from earlier in the quarter. After the quarter ends I am worried we are going to see the market begin to weaken. The "sell in May" process this year could be especially painful.

I would be extremely cautious about adding new positions over the next week.

Jim Brown

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