Bad to Worse

Jim Brown
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The commodity decline due to negative global economics continues to worsen with crude prices falling to nine-month lows. While this will be good for the U.S. consumer it has translated into a serious decline in energy equity prices.

Nothing has changed. We need to keep that in focus. The exploration companies are still going to drill as much at $87 oil today as they would have at $95 oil a week ago. The only thing that changed was the long-term outlook for earnings and the market's view of the future.

The negative economics from Europe and Asia are starting to accelerate. It is like a snowball rolling down hill. It starts slow and then gains momentum and size as it rolls down hill. While I have never seen this in real life I am sure everyone has seen it depicted in cartoon form for as long as you can remember. Unfortunately life is not a cartoon. In real life when these snowballs appear they can be painful and leave a lasting scar.

The snowball forming today is fear of deflation. Despite mammoth amounts of economic stimulus all around the world the economic activity is declining. Prices are falling, activity is slowing and unemployment is rising. The U.S. is thought to be the bastion of hope but so far in April 20 of the 25 economic reports have missed estimates. We are probably going to report a GDP for Q1 slightly over +2.0% due to seasonal factors but Q2 could be ugly.

The Fed Beige Book today reported a slight moderate improvement in the various Fed regions but it also reported signs of early weakening as a result of the sequestration that went into effect on March 1st. This weakening is expected to increase in the months ahead.

The few earnings already reported for Q1 have seen 65% beat on earnings but roughly 50% beat on revenue. More than 27% of companies have missed on earnings. I don't have an actual number for guidance but at least half of those that have given guidance for Q2 have disappointed. Companies are worried about Q2 and some are REALLY worried.

China is on track to post the lowest growth in 13 years. Europe is in a recession that is worsening. Initially they were expected to rebound in Q4 but activity in Europe is accelerating to the downside. The recent events in Cyprus have poisoned the well. A financial taxation virus has been created and it is quickly spreading to other European countries. The lure of ready cash sitting in depositor accounts is too much to resist for countries with financial problems and that is the majority of the eurozone. The worry over a deposit tax is forcing businesses and individuals to take their money out of the bank and this is causing a sharp drop in spending. The end result of this virus could be a breakup of the eurozone.

This is going to weigh heavily on China where 35% of their exports go to Europe. China has significant inflation and is handicapped to some extent on how much and what kind of stimulus they can add to the system. This means commodity demand is going to slow in both Europe and China. It will mean fewer miles driven and less oil consumed.

The threat of deflation or global recession is high. This is pressuring stocks as well as commodities. The U.S. markets are struggling at the recent highs and the current earnings cycle is not helping. Top line earnings have been slightly higher than expected at roughly +4% but almost every company has credited cost cutting rather than increasing sales. You can only cut costs so far before you run out of things to cut. With 50% of companies missing on revenue that shows us that sales, and economic activity, are weak and the current QE programs are not helping the economy. They are benefitting the stock market but not the economic environment.

Crude prices declined another -2.29 today to close at $86.43. That is a nine-month low for the current contract. Prices were near $98 back on April 1st. The continuous contract has strong support in the $85 range but this time last year we traded down to $77. If we see further signs of a potential recession we could see much lower numbers. In 2009 we saw $35 oil. I don't expect that again since the circumstances of the Great Recession were one of a kind. However, there is no guarantee of future economic growth.

Add in the new terror fears and we have a witch's brew of uncertainty. That much uncertainty is normally painful for the market. Margin debt on the NYSE is near record levels. It will only take a few more points to the downside to force a liquidation of a lot of that margin. Up until now investors have been buying the dip. If they are burned again they could retreat to the sidelines.

WTI Continuous Contract Chart

Crude oil inventories declined by 1.2 million barrels last week to 387.6 million. The decline was caused by a -289,000 bpd drop in imports. Refinery utilization declined slightly and consumption of oil was basically flat. The report had no impact on prices.

Gasoline inventories fell by 633,000 barrels and that was also impacted by a sharp drop in imports of -270,000 bpd. Gasoline demand fell slightly by -94,000 bpd but that was not a factor because production rose +141,000 bpd. Gasoline inventories rose unexpectedly by +1.7 million barrels last week and this week returned to the historical trend of declining levels as winter blends are sold off.

Distillate inventories rose by 2.4 million barrels after demand fell by -226,000 bpd or 1.6 million barrels for the week. That was a material decline and coupled with imports rising +198,000 bpd we got an unexpected build. Distillates inventories are -10.7% below their year ago level but that is a significant improvement over the -14.5% reading in the prior week.

Inventory levels at Cushing rose by one million barrels to 51.1 million. That is only 800,000 barrels below the record high of 51.9 million set back on January 11th. The current May contract expires next Monday so this could be impacting levels.

The green square is a 22 year high. The yellow square is a 13 year low.

Inventory Snapshot

Crude Oil Inventory Chart

Gasoline Inventory Chart

Distillate Inventory Chart

Gasoline prices fell for the seventh consecutive week to $3.54 per gallon. That is 38 cents below year ago levels. Just eight weeks ago gasoline prices were at record highs for that time of year. Diesel prices declined -4 cents to $3.94 per gallon. There have been some refinery problems on the West Coast that have kept fuel prices higher. Most of those have been resolved and prices should be coming down. With the sharp drop in crude prices they should be coming down a lot. I would expect to see gasoline under $3 in some states in the weeks ahead. I paid $3.36 in Denver this week and I am looking forward to even lower prices.

Gasoline demand is at a 16-year low.

Pushing oil prices lower was the downgrade of the global economic outlook by the IMF on Tuesday. The IMF said global growth in 2013 was now expected to be +3.3%, down from the prior estimate of +3.5%. They cut expectations for U.S. growth from +2.1% to +1.9%. The eurozone is expected to decline -0.3%.

China reported its GDP for Q1 declined to +7.7%. The official Chinese estimate for the full year is +7.5% growth but analysts had been hoping for something closer to 8% once the new government launched new growth programs.

Brent crude fell to close under $100 for the first time since July on worries over demand growth or more likely demand decline in Europe and China. The key now will be the OPEC response. OPEC has in the past pledged to support the $100 level which they claim is a fair price for oil. They could support the price by cutting back on their current over production. This would be done by Saudi Arabia since they are currently exporting more than 9.0 mbpd.

OPEC is scheduled to meet on May 31st to discuss production quotas. The Iranian oil minister said OPEC may hold emergency talks before the May 31st date if Brent prices remain under $100. Ghasemi said, "We don't regard a fall in the oil price below $100 as reasonable."

Brent Crude Chart

Another factor hitting oil prices today was the sharp spike in the dollar. The dollar index spiked more than 1% to lift the dollar from a two month low to a seven day high. A rising dollar depresses commodity prices since it takes fewer dollars to buy the same quantity of a commodity.

Dollar Index Chart


For the third time in three days the Dow posted a triple digit move. The decline back to 14,600 is the same support level that held the decline on Monday. This is uptrend support and a breakdown here could quickly retest 14,400. A breakdown there would be ugly with 14,000 the next major support level.

Dow Chart

Tech stocks were sold hard after an Apple chip supplier issued a major earnings warning. This knocked Apple back to $400 after a brief dip to $398. This is a new 52-week low.

The real key is the Russell 2000 with a nearly -2% decline to 900. This is a two month low and the Russell was the weakest index other than the Semiconductor Index. The Russell appears on track to test prior support at 895 or lower. Fund managers are dumping small caps and trying to capture the first quarter gains before they disappear.

Russell 2000 Chart

The U.S. markets are starting to pay attention to fundamentals once again. The QE has not ended but investors are starting to realize it is not solving the fiscal problems or adding to employment.

If Europe continues to decline and I can't imagine it will recover soon, then the future is clearly negative for our markets.

Jim Brown

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