Be Careful What You Ask For

Jim Brown
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Investors wanted some clarification from Ben Bernanke on when the QE would end but once they got it they wish they had not asked. Treasury yields and the dollar exploded higher and the equity markets collapsed.

Bernanke said QE tapering should begin later this year and decline to zero by mid 2014. Analysts believe "later this year" in the context of Bernanke's economic comments would be an announcement at the September meeting for a decline in purchases in October.

The FOMC statement said:

Economic activity has been expanding at a moderate pace.

Labor market conditions have shown further improvement, on balance, but the unemployment rate remains elevated.

Household spending and business fixed investment advanced and the housing sector has strengthened further but fiscal policy is restraining economic growth.

The committee sees the downside risks to the economic outlook and the labor market as having diminished since the fall.

QE purchases will continue until there is a substantial improvement in employment or inflation reaches unacceptable levels.

The key point in those statements is the "downside risks have diminished" phrase. That is about as weak an upgrade to the economic outlook as you could craft. Outside of that the statement was only marginally different from the May statement.

Since the economy was only slightly improved the analysts were somewhat surprised that Bernanke said they would begin to cut QE purchases later this year if the improvement continued. To be fair Bernanke did emphasize that they were data dependent. If the data did not continue to improve or worsen the QE purchases would continue and possibly increase. I just don't think analysts paid any attention to that last part. They are focused on wanting to hear a date for the first cut and that is all they heard.

It would appear the Fed has lowered its threshold for ending QE even though their official growth targets have not materially changed. Everyone confuses the 6.5% unemployment and 2.5% inflation with the halt of QE. That is not correct. That is the threshold for the end of low rates which Bernanke said today could be mid 2015 or even 2016.

The market appears to believe QE will begin to decline after the September meeting. Since the market looks ahead six months that is in the six-month window and hair trigger investors started dumping positions or at least taking profits from the last rebound.

Another factor hitting the market is the triple witching option expiration on Friday. Investors that took positions ahead of the Fed meeting in expectations for a continued rally now only have two days to exit those positions.

Despite the severity of the market decline with the Dow losing -206 points the indexes are nowhere near recent support. We could easily see S&P decline to 1618 and the 50-day average after closing at 1629 and there would be no change in the trend.

So far this is just profit taking. If the S&P declines below the 50-day the next support is 1600 and we were at that level recently on June 6th. Any decline under 1600 is going to be traumatic and that would trigger a significant number of stop losses.

Inventory Report

The EIA inventory report was a nonevent. Inventories barely changed across all categories. Crude inventories rose +300,000 barrels. Gasoline inventories rose +200,000 barrels and distillates fell -500,000 barrels. The market was not impressed as traders were more focused on the FOMC meeting and press conference.

The biggest change was the spike in refinery utilization from 87.5% to 89.3% and the high for the year. A jump of nearly +2% is significant. This created an increase in demand for crude oil of +294,000 bpd. Domestic crude production declined by -95,000 bpd to 7.13 mbpd and that is the lowest level in many weeks. This allowed inventories at Cushing to decline from 49.3 million barrels to 48.6 million. That is also a multi-month low. Refiners are accelerating their acquisition of Midwestern crude and transporting on railcars to the coastal refineries. This is also relieving pressure on pipeline deliveries to Cushing.

Imports soared by +586,000 bpd to 8.44 mbpd or a gain of 4.1 million barrels for the week. This prevented inventories from declining significantly due to the sharp increase in refinery utilization.

Oil inventories remain near historic highs but should not move higher as refineries churn out the gasoline for summer driving.

(Inventory Snapshot guide: Green squares are multiyear highs. Yellow is multiyear low. Orange is multi month high. Pink is multi-week highs. The number of active gas rigs at 350 is an 18 year low. Oil rigs at 1,412 is an eight-month high. Crude oil at 397.6 mb is the highest since 1931.)

Inventory Snapshot

Crude Oil Inventory Chart

Gasoline Inventory Chart

Distillate Inventory Chart

Natural gas prices completed their third day of gains to close at $3.96. The demand picture has not changed and tomorrow's inventory report should show another large injection. I am starting to believe we are not going to see a material decline unless it happens very soon. Gas demand will begin to rise once we are into July and the summer cooling season begins.

Natural Gas Chart

The EIA published a report this week claiming global technically recoverable shale oil resources equaled 345 billion barrels. If that is true that is an amazing number. It is especially amazing since as recently as ten years ago nobody was producing any meaningful amount from any shale resource.

There were a few companies that were trying to produce shale oil with vertical wells but the payout was so bad there was very little production. With the arrival of horizontal drilling and high capacity fracturing a new sector in the oil and gas industry was formed.

There is a qualification on the "recoverable" claim. The EIA says he oil can be recovered using existing technology but without reference to economic profitability. That means you may be able to produce it but it might cost you $250 a barrel. Obviously a large portion will be commercially profitable today and the rest will become profitable in the decades ahead as conventional oil supplies dwindle and prices rise. U.S. companies quickly found out that having an abundance of shale gas that can be produced cheaply may not actually be a profitable exercise. Nobody doubts the eventual value of the gas but it is today's value that companies use to determine whether they are going to drill.

Factors influencing the commercial potential of a shale reserve varies significantly from country to country. The number one factor that makes it possible in the USA is the private ownership of the land and the mineral deposits. Many foreign countries don't allow private ownership of mineral rights. Those same countries have large government owned energy companies that don't have to make a profit. As long as there is plenty of gas today they have no incentive to mount massive drilling programs.

Infrastructure is also a problem. The U.S. has a large pipeline system that is growing larger every day. Most other countries don't have that luxury so getting gas from a remote shale field is a costly proposition. Vast amounts of water are also required for fracturing. Several million gallons per well and the water can't be released back into the environment when the job is done because it has harsh chemicals and toxins. With daily drinking water a problem in more than 50% of the world there is not enough water to waste it by drilling thousands of wells.

The U.S. got 29% of its oil production from shale wells in 2012. That is up from about 2% in 2002. Because of the conditions I described above we really can't apply U.S. production values to estimating recoverable shale reserves in the rest of the world. Some countries could follow suit but it varies by country, location, geography and climate.

The chart below shows known shale resources in 42 countries. Russia has the most recoverable resources at 75 billion barrels followed by the U.S. at 58 billion and China at 32 billion.

Click here for larger map

EIA shale reserves map


There is a very good chance the S&P will decline to retest its 50-day average at 1618 this week. There is a smaller chance it will retest 1600 but it is still possible. This is a triple witching expiration cycle and that should produce additional volatility.

Historically the week in June after the triple witch expiration is negative. That is followed by the Russell Index rebalance on June 28th and then the first week in July is typically bullish. After that the historical trends tend to fade until August when the dog days of summer see the indexes begin to fade after the Q2 earnings reports.

S&P-500 Chart

We are heading into the summer doldrums where traders are absent from the market and spending time with their families. Be patient and we will use any declines later in the summer as a buying opportunity.

Jim Brown

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