Pivotal Market Day

Jim Brown
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The Dow rose +155 intraday before collapsing to lose -110 before ending with a -80 point loss. This outside day indicator typically indicates a change in market direction. We are due for a correction but one day does not make a trend.

Conflicting messages from the Federal Reserve on their plans for ending QE3 were to blame for the market reversal. The market opened strongly positive after existing home sales rose +0.6% in March to 4.97 million and the fastest pace since late 2009. Listings declined -14% over year ago levels. The Dow rallied +155 to 15,542 before the Bernanke testimony.

Bernanke gave what appeared to be dovish initial remarks in his prepared testimony but then contradicted himself in the Q&A portion. Initially he said if the labor market continued to improve the FOMC could possibly change the pace of QE purchases in the "next few months." The timing of the change is dependent on a continued improvement in the data and purchases could also go up. It was a dovish position. In the Q&A he was pressed for details and his "next few months" seemed to shrink under pressure from the senators but he maintained an essentially dovish stance.

When the FOMC minutes came out at 2:PM the market perception changed. The minutes said "a number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting." The word "number" is key since they also use the adjectives "some and several" in prior statements. That seems to indicate a growing number but not yet a majority supported a reduction in QE. There is also the qualification by saying "participants" instead of "members." Participants include nonvoting members of the FOMC, Fed presidents and support staff. Investors were left to parse the language in the minutes as viewed through the filter of the Bernanke comments earlier in the day.

There was one dissent to the May decision to do nothing. Ester George wanted to halt some purchases at the May meeting. Another member wanted to increase monetary stimulus because of the slow growth of the economy. Clearly there is a lot of indecision.

It appears the market is starting to expect a change in QE sooner rather than later even though the Fed's May statement emphasized that QE could be adjusted higher as well if the economic data continued to decline. The market always has selective hearing and this time they are only hearing the "as early as the June meeting" comment.

After the FOMC minutes the market imploded to lose -110 points intraday before closing with a -80 point loss. While the intraday range was huge at almost 300 Dow points the close at 15,307 did not represent a material dip given our recent gains. Traders will probably buy the dip.

The EIA inventory report showed crude levels declined -300,000 barrels for the second consecutive weekly loss. That suggests crude demand was actually strong since imports increased by a whopping 507,000 bpd. That is an increase in imports of 3.5 million barrels for the week but inventory declined.

Gasoline inventories jumped by +3.0 million barrels for the second week of strong increases. Gasoline should be climbing this time of year so that is in line with expectations and a reason why crude levels declined. Gasoline inventories are now almost 10% over year ago levels so production will likely slow slightly until we get closer to summer. With weak demand refiners will not want to flood the system or prices will decline. Refinery utilization declined slightly from 88.0% to 87.3%.

Distillate inventories declined by -1.1 million barrels. There was an abnormal surge in demand of 643,000 bpd or 4.5 million barrels. I am surprised inventories did not decline further. Distillate inventories are only fractionally higher than year ago levels.

The increased demand for distillates and gasoline put their consumption levels at eight-week highs.

Green squares are multiyear highs. Yellow is multiyear low. Orange is multi month high. Pinks is multi-week highs. The number of active gas rigs rose +4 from the 18 year low at 350 the prior week.

Inventory Snapshot

Crude Inventory Chart

Gasoline Inventory Chart

Distillate Inventory Chart

The combination of the existing home sales and expectations for declining QE pushed the dollar index to a new two-year high. Gold moved in a $60 range from $1353 to $1413 and closed at $1368. If the economy is improving and the Fed is tapering soon then the Armageddon trade for gold is over and gold prices could fade. However, the offset to the Fed exit should be higher interest rates and higher inflation and that will support gold prices.

Gold is close to a double bottom according to some analysts while others believe that bottom will fail. The last several days have seen traders buying the dip but there is no follow through as you would expect from a real bottom rebound. You can blame that on the dollar and the urge to take money out of gold and invest it into equities. If the equity market finally corrects that money will flow back into gold at least temporarily.

Gold Chart

Dollar Index Chart

The yield on the ten-year treasury moved over 2% on expectations for an eventual end to Fed stimulus. I think it is premature but markets look six months into the future and I suspect the Fed will have made some stimulus changes in that period. As treasuries decline and yields rise we could see acceleration in the rotation out of bonds and into equities.

Ten-year Treasury Yield Chart

Iran met with the IAEA and the P5+1 UN nations last week and was successful in getting nothing accomplished for the 10th consecutive meeting. Successfully concluding each meeting without any agreement gives Iran another two months of breathing room to continue enriching uranium.

Today, a week after the IAEA meeting, Iran announced it has increased its output of uranium and installed additional high technology centrifuges in order to enrich uranium faster. Stockpiles of medium-enriched uranium at 20% rose to 324 kilos (714 pounds) from 280 kilos it reported back in February. About 175 kilos are required to make a bomb.

The IAEA said they are continuing to try and track the usage of the enriched uranium but are "unable to provide credible assurance about the absence of undeclared nuclear material and activities in Iran." They are limited to the information Iran gives them and there is nothing to prevent Iran from secretly diverting enriched uranium to weapons testing.

The IAEA said Iran was accelerating the installation of faster and more advanced centrifuges at the Natanz facility.

The full IAEA report claiming it is "essential and urgent for Iran to engage" in the diplomatic discussions will be published on June 3rd. This should be a trigger point for decisions by Israel and the U.S. on action over the nuclear red line in Iran.

Sanford Bernstein Research said today that Chinese oil consumption will rise at an average rate of 5% to reach 12.9 mbpd in 2018 from the 9.6 mbpd pace of 2012. This is higher than the +4% rate predicted by the IEA.

Bernstein said the proportion of SUVs in the Chinese passenger fleet should double to 20% by 2020 from its current size. The total number of vehicles in China should more than double to 220 million by 2020. Chinese oil demand is shifting from industry to transportation and gasoline consumption has grown +15% year to date. Over the same period diesel consumption declined -1.8%.

China is currently a net exporter of gasoline but that will change in the years ahead to become an importer.

China is building more than 100,000 miles of roads with the emphasis on highways to enable people to move about the country. The cities are highly congested and the trend is for upwardly mobile consumers to move away from the city while the lower income consumer is moving into the city to reduce transportation time and expense as they apply for jobs. More than two million Chinese move from the farms to the city each month. As the Yuppies move farther out of the congested and smog choked cities it means they will be forced to drive farther and consume more fuel.

China and India are going to be the two main drivers of oil consumption over the next decade while the developed economies will see demand remain flat or slightly lower as the boomer generation moves into retirement.

Tanker owners are getting crushed in the current global market. Oil tanker owners are struggling because their deliveries are losing money. Earnings per day for Very Large Crude Carriers or VLCCs, which hold 2 million barrels, declined to $10,675 per day in April. Frontline, the largest tanker operator said it takes $24,200 per day to break even with operating costs. General Maritime, a New York based tanker operator filed bankruptcy in November 2011 and was followed by Overseas Shipholding Group in 2012. Economic conditions are worse now than when these companies filed bankruptcy.

Some tanker owners are now refusing to accept cargoes rather than put the ships at risk for a money losing trip. When oil reached its peak before the recession the tanker companies were rolling in the cash with high rates and a shortage of tankers. Everyone ordered new ships and oil demand declined in the recession and has not recovered. Tanker capacity increased nearly 8% since the recession but the number of cargoes has declined. With the U.S. rapidly increasing its production the number of trips to the U.S. from the Middle East will continue to decline. If the U.S. production increases by 1.0 mbpd in 2013 as expected that will reduce the number of cargoes by 52 per year.

Rates are not expected to increase materially until 2017 as older tankers are scrapped and oil demand increases. Prices are expected to rise to $15,000 per day in 2015. Tanker owners who leased their ships for long term rates, typically five years, back in 2009 are getting roughly $26,000 per day. When those leases expire in 2014 it will produce another round of losses for the tanker companies as their rates drop in half overnight.


Today's sell off was headline related. After traders have time to think about the Fed's timing and the likelihood there will be no change at the June FOMC meeting the dip will probably be bought. This was simply an overbought market running into a series of headlines that prompted a knee jerk reaction. However, we are still overextended and we are still due for a correction. With the May payroll report still two weeks away there is plenty of time for more gains. Since the payroll report will be the determining factor for the Fed decision at the June FOMC meeting that will be our biggest hurdle in the weeks ahead.

Jim Brown

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