Pressing Our Luck

Jim Brown
 
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Crude prices continue to hold near 52-week highs but we may be expecting too much for a continued rally. With production of roughly 4.4 mbpd coming back online around the world this summer the global inventories are going to rise and prices are going to decline.

I reported on some of the field restarts over the last several issues of the newsletter so I won't repeat them here. However, the restart of oil from South Sudan, roughly 4.0 mbpd is a key factor in expecting prices to decline. Oil shipments from South Sudan was restricted when South Sudan and Sudan could not agree on border issues and the support of some rebels pestering Sudan. These issues have been resolved and South Sudan oil is in the process of restarting shipments through the pipeline across Sudan. Currently 2.2 mbpd is flowing and it should be up to the full 4.0 mbpd by the end of August. That is a lot of oil hitting an already oversupplied market. That equates to roughly 120 million barrels a month or 60 VLCC tankers full of South Sudan crude.

Adding to the oil oversupply problem is rising production in the USA and falling demand in Europe and Asia. The U.S. produced 7.4 mbpd last week and that was the highest production since 1992. That is expected to continue to rise to more than 8.0 mbpd in 2014.

Meanwhile China's economy is slowing and Europe is in a continuing recession. The European debt crisis is coming back to the headlines with Greece, Cyprus, Spain, Italy, Portugal and France in the news last week. This has the potential to push Europe deeper into recession.

In the USA the impact of the sequestration is going to be felt even more as layoffs grow. Government contractors are going to start laying off workers as contracts in force when the sequestration started begin to expire. Existing contracts may not be renewed until a new budget year begins in October. However, the debt ceiling is also going to come back to haunt us in October when current funding runs out. President Obama has vowed not to negotiate over the debt ceiling and Republicans are just as firm in saying they will only raise the limit if sufficient budget cuts are passed.

Government furloughs are increasing. Starting this week and continuing for 10 more weeks more than 650,000 defense department workers will be forced to take one day a week off without pay. That equates to a 20% cut in pay for the next 11 weeks. This will further weaken the U.S. economy and weaken gasoline demand.

Other Federal agencies are also implementing different forms of the furlough programs with hundreds of thousands of workers facing the same cuts as the defense department.

Also hitting oil prices is the sharp increase in gasoline and diesel prices. Prices rose +7 cents last week and are expected to rise another 15-20 cents in the weeks ahead. As prices rise, demand declines and inventories will build. That will eventually force oil prices lower but it is a long process. This will last through the end of driving season and then the seasonal demand decline will begin.

The bottom line for me is that crude prices will not remain at these levels. Once the situation in Egypt calms the security premium currently supporting oil will evaporate.

Crude Oil Chart Drilling activity appears to be picking up. Baker Hughes reported the weekly rig count rose by +2 to 1,759. The gains were led by a +7 rig jump in active gas rigs. Oil rigs declined by -4. This was an 11 week high for active gas rigs. Apparently the stubbornly high prices for natural gas has stimulated some additional gas drilling.

Gas injection into storage was 82 Bcf last week and well above the seasonal average of 74 Bcf. Despite the very hot weather across most of the country the injections were strong. You can chalk that up to the higher prices and producers removing constraints on some previously completed wells. Also the pipeline infrastructure system in the Marcellus is expanding rapidly and connecting hundreds of wells that were previously drilled and awaiting connection.

The total rig count for Q2 was flat with Q1 after five quarters of declines. Baker Hughes and Schlumberger both said in their Q1 earnings projections they were expecting a pickup in drilling for the summer. Up until now that drilling increase has been absent.

Baker Hughes and Schlumberger both report earnings next Friday but the clouds are already forming. Nabors (NBR) warned investors last week that earnings will be weaker than anticipated. Nabors said operating income will be in the range of $88-$91 million and analysts were expecting $118 million.

The company said a longer winter and resulting floods impacted its pressure pumping services in northern areas. They also said lackluster demand for its drilling services was also a drag. RBC Capital Markets cut earnings estimates from 16 cents to 8 cents and Simmons & Co cut estimates to 8 cents from 14 cents.

Analysts were not expecting a big quarter for energy companies. Revenues for the sector were expected to decline -17% because of high oil prices in the year ago quarter. The drop in rig counts over the last five quarters was already pressuring the service companies.

Chevron warned last week that production was lower than expected due to maintenance issues overseas and prices received for international production were down more than $8 per barrel. it is tough to exceed estimates for earnings with those kinds of metrics.

Oil prices are poised to be the next big economic shock. With crude in the $105 range it is at the point where any further gains are going to put pressure on consumer spending. Gasoline prices rose +7 cents last week and could rise another 15-20 cents over the next couple weeks. That will put it perilously close to the $4 level on the national average and guarantee $4 gas on both coasts. That is the level where consumers quit driving and stay home. This is going to be another shock to the already slowing economy.

Europe is already struggling with higher prices because of the recession. China, India and other Asian nations are faced with pressure from high prices because the governments subsidize fuel prices to keep the high prices from holding back the economy. When oil is up for an extended period the governments finally relent and raise prices slightly in order to ease the deficit pain.

Even if Egypt calms there is still unrest in multiple Middle East and Northern Africa nations. Syria has been out of the headlines the last couple weeks but they will return once Egypt goes quiet. Libya is on the brink of a civil war and is reverting back to a feudal society with more than 100 local militias exerting local rules.

If Europe accelerates into the debt spiral again the consequences could be dire. After multiple rounds of bailouts and bail-ins not working out the bottomless money pit from the EU, ECB, IMF may suddenly find a bottom. There is significant reluctance to throwing additional good money after the bad money they already spent.

Larger economies like Spain and Italy are back in the headlines and conditions are worsening. In Spain the second largest newspaper, El Mundo, says a "pre-revolutionary" mood is taking hold. The government is breaking down after repeated scandals and scorched earth austerity.

None of those events are conducive to higher oil prices. In fact they are more than likely to lead to lower equity markets around the globe. The U.S. may be the best house in a bad neighborhood but you can only put so many investors in that house before it also collapses.

Market

The major U.S. indexes all closed at new highs on Friday but earnings start in earnest this week. After multiple earnings warnings last week the outlook is not good but nobody seems to care. They are either ignoring the bad news in hopes the reality of future earnings will be better or they are simply betting on the Fed to continue QE well into the future.

Eventually fundamentals will matter again and when that happens the market is in serious danger. Multiple analysts cut Q2 GDP numbers again last week with the median estimate now in the +1% growth range. The Fed is not likely to cut QE purchases with a 1-handle or less on GDP so that pretty much suggests QE will be with us the rest of the year. The Q3 GDP is not reported until the end of October and that makes the October 30th FOMC meeting a potential turning point.

Crude prices typically decline in August-September and then rebound in the fall as winter heating oil demand increases. Investors should wait for the normal end of summer weakness to add long positions.

Jim Brown

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