FOMC Roils Market

Jim Brown
 
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The FOMC minutes for October were released at 2:PM and the markets immediately plunged to the lows for the week. The minutes suggested the Fed could taper QE sooner than previously expected and the market was not happy.

The minutes showed considerable discussion about how to taper QE and how to break the news to the market in a way that would not cause severe volatility. Good luck with that task since the market is already so nervous about a taper announcement that any discussion causes major volatility. For instance the FOMC minutes today knocked -100 points off the Dow in a matter of minutes and all the minutes said was that tapering could occur in the coming months. You can imagine what an actual taper announcement will do to the market.

The FOMC minutes showed discussions about lowering the current unemployment threshold from 6.5% to something even lower. The Fed believes the rapidly falling labor participation rate, showing more and more people dropping out of the workforce, is distorting the unemployment rate. Yellen has already said the 6.5% threshold could be passed without the Fed making any changes to the fed funds rate.

The FOMC discussed the potential to cut QE even if there was no evidence of a sustainable recovery. That was a shocker since the party line for the last six months has been "the QE taper decision would be data dependent." Employment would have to be sustainable over 200,000 new jobs per month for several months. Apparently the Fed is so interested in getting out of the QE program they are considering cutting it without the "sustainable recovery" evidence. The market really did not like this.

They also discussed cutting purchases of both treasuries and mortgage backed securities when they eventually taper. That was another shock since prior comments had suggested they would trim MBS purchases last to keep mortgage rates low.

They discussed announcing a QE taper calendar and assigning dates and amounts well in advance so the market would know what to expect and exactly how QE would end. While that may be a good idea it could also be market negative because interest rates would immediately spike higher once they knew the schedule. Rates are kept low by indecision and uncertainty. Remove that uncertainty and they will rocket higher.

The Fed's problem with the increased transparency instituted by Bernanke is that the market can see the Fed is confused on how and when to reduce stimulus. If the Fed is confused and uncertain on which path to follow the market will also be confused and that means additional volatility.

Because the Fed understands that any change in QE will send interest rates soaring they discussed giving additional guidance about holding rates at zero for an even longer period of time. Currently analysts don't expect a change in Fed rate policy until 2015 or even early 2016 because of the slow growth economy and the problems created by removing QE.

Let say the Fed decided to begin removing QE in March. We know from experience it will take a minimum of six months and probably at least nine months to get to zero QE. Maybe even longer if interest rates spike too sharply. That puts the end of QE at the beginning of 2015. Once QE ends they are not going to immediately raise interest rates. They will have to let the market adjust to whatever the end of QE brings and that could take a year. That means 2016 would be the earliest for rate hikes.

The Fed discussed giving the market a hard date somewhere farther out in the future in order to keep rates from spiking out of sight from the end of QE.

The market turned volatile when the minutes were released but the simple truth is that the Fed is not going to make any changes in the near future. The economics are too volatile. There is no sustainable trend. Employment is also trendless. The market will have to face the fiscal follies with the December 13th budget deadline and the return of the debt ceiling debate in late January. The Fed held a special meeting in October when the government shutdown and debt ceiling event threatened the status quo. They devised plans to offset the negative effects of a debt ceiling crash. They were obviously worried. They are not about to taper QE before the debt ceiling confrontation passes in Jan/Feb. The actual ceiling is Feb 7th but the government can use "special situations" for another month to pay the bills.

The ECB, Bank of England and the Bank of Japan are talking about increasing stimulus. The Fed is not going to cut QE while the other major banks are adding QE. The dollar would spike out of sight and the hit to the international economy would be very serious. The Fed has to keep QE going but maybe at a lesser amount until those banks begin to back off the stimulus.

All of this suggests it will be at least March or even later before the Fed actually takes action. While the market is very nervous I believe cooler heads will prevail later this week.

The weekly EIA inventory report showed a minor gain in crude levels of 400,000 barrels. After eight weeks of strong gains averaging over 4.0 million barrels per week the rate of climb may be over. Remember, refiners are taxed on the oil in storage on December 31st. This means they will try and let inventories decline into year end to minimize the tax bill.

Cushing inventories rose again by another +1.7 million barrels to the highest level since August 7th at 39.94 million barrels. This is the rising inventory ahead of the opening of the new pipeline to the coast. Once the pipeline is open we should see inventory levels decline somewhat. However, producers will be sending more oil to Cushing by pipeline to capture the higher prices once that pipeline is operational.

The big change in inventories came in the distillates with a -4.8 million barrel drop. I remarked last week the minimal -0.5 million barrel decline was unusual and apparently the accounting caught up with the EIA reporting. The flawed calculations could have been in the demand line. Demand dropped unexpectedly last week from 4.51 mbpd to 3.79 mbpd. That is not a normal fluctuation for this time of year. Demand this week rebounded to 4.33 mbpd. Something was flawed in those demand numbers and that probably impacted the inventory levels as well.

Gasoline demand declined about -100,000 bpd and inventories declined by a miniscule -300,000 barrels. Gasoline imports were flat and production increased only 56,000 bpd.

Refinery utilization was also flat at 88.6% declining only 0.1%. That is still high for this time of year. Analysts believe this is due to industry consolidation and the closure of several refineries over the last year. Those still working are operating at a higher capacity to make up for the decline in overall U.S. capacity. If we were to see a real economic recovery and several million people go back to work we could see a refiner pinch where any unplanned outage could send gas prices higher.


Domestic crude production was flat at 7.974 mbpd. That was just slightly below the 7.981 mbpd the prior week. I am expecting a burst of new production over the next several weeks as producers race to get all available production online by year end. Everyone has yearend goals to meet and it helps to be able to say production at year end was XXX bpd. That number will be reported as a benchmark all year.

NET Mexico, a subsidiary of NET Midstream received a "Presidential Permit" on November 8th to build a 2.1 Bcfd export pipeline from the U.S. into Mexico. The 42 inch pipeline would be supplied from the Agua Dulce Hub in Nueces County Texas. In 2012 Mexican imports increased +24% to 1.69 Bcfd. This would be a substantial increase to that export level. Gas exports from the U.S. accounted for 80% of Mexico's imports in 2012.

Devon Energy (DVN) has agreed to buy 82,000 net Eagle Ford acres with production of 53,000 Boe/d from GeoSouthern Energy for $6 billion in cash. The leases have an estimated 1,200 undrilled locations and a recoverable resource of 400 million Boe with the majority as proved reserves. Devon said they expect the production from those leases to grow by 25% per year with a peak production around 140,000 Boe/d. The company will immediately begin drilling and that drilling is self funding with the company expecting to generate $800 million annually in free cash flow by 2015.

BP said it had added two more rigs in the Gulf of Mexico to bring the total for BP to a record nine rigs. The West Auriga drillship has started development in the Mississippi Canyon's Thunder Horse field. The drillship is contracted from SeaDrill under a long term contract. The ship can drill in water depths up to 12,000 feet.

A reconstructed drilling rig was added to the Mad Dog field complex. The original rig was toppled and sank by Hurricane Ike in 2008. The Mad Dog spar began production in 2005 in 4,734 feet of water. The dates on this development illustrate how long it takes and how costly it is to drill in the Gulf. It took BP five years to reconstruct a topside rig for the Mad Dog spar after the initial rig sank.

BP said it expects to invest $4 billion a year in the Gulf over the next decade. They own more than 650 leases in the Gulf and produced an average of 214,000 boe/d in 2012. They have seven major production platforms in the Gulf and they expect to double production by the end of the decade.

Market

The Dow dropped -100 points after the FOMC minutes were released but recovered to close down only -66 points at exactly 15,900. Support is 15,800 and 15,600. The S&P lost -6 points to close at 1,781. The Nasdaq lost -10 to close at 3,921. The Nasdaq is now -80 points below the 4,000 round number it just missed hitting on Monday.

I am neutral to negative about the market for the rest of the week. I am afraid the QE conversations could make traders even more nervous about the current market level.

Jim Brown

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