Bear Market in Energy

Jim Brown
 
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While stock traders are moaning about the -9% drop in the broader markets the energy sector is in a bear market with more than 20% declines in some cases.

It is never calm in the energy markets. Crude prices tend to move swiftly when times are good and accelerate even faster when times are bad. Crude futures are a highly liquid market and very prone to speculation and hedging. When traders and investors need money fast they can always sell their futures. When the market swoons and equity margin calls show up in your account the fastest way to raise money is to sell any futures positions.

Hedge funds, large commodity funds and ETFs maintain huge long positions in the futures market. When a series of headlines appear that change the sentiment on a particular commodity the dumping commences almost immediately. Because of the margin involved you could say futures traders are a very nervous breed. The leverage is great when the trade is going in your direction but extremely painful when the trade is going against you.

This makes the market very "trendy." It tends to move in one direction until a headline appears and then reverse instantly. When multiple headlines appear over the course of several days the liquidation of positions can become intense.

Numerous analysts believe we saw a liquidation event last week with Wednesday's selling a likely capitulation event. WTI prices fell under $80 temporarily before saner minds saw the opportunity and bought the dip.

There were multiple headlines causing indigestion for investors. There were multiple economic reports coming out of Europe that had Fed heads suggesting we may need another round of QE to avoid being sucked into the coming European recession.

Saudi Arabia and Iran were in the early stages of a price war with each discounting their oil to Asia to the lowest levels since 2008 and multiple OPEC nations saying they had no plans to cut production. The last time there was a price war with Saudi Arabia was 1998 and crude prices fell to $10 a barrel. That would be so disastrous today that it isn't even in the realm of possibilities but oil traders remember the carnage that followed. Active rigs drilling for oil fell to 488, down from a high of 4,530 in 1981. Thousands of rigs were stacked in fields and left to rust and never reactivated again. An entire generation of oil well workers disappeared into other industries. When the oil industry restarted there was an extreme shortage of workers for more than a decade.

Analysts were warning last week that a prolonged decline in prices would reduce the amount of drilling in the U.S. and slow production growth. Given the current oil boom that is almost inconceivable to many investors. Goldman said the drop in oil prices was unreasonable and based on a potential scenario that had not come to pass. In theory crude prices were dropping because there was "going to be" a glut of oil because Europe was falling back into a triple dip recession and possible even a depression. China was also in the mix because GDP growth in Q3 had declined to 7.2% or at least that was the forecast.

People forget that 200,000 people per day turn 19 and join the workforce worldwide. They become consumers of oil for the next 50 years. The IEA announcement that demand growth estimates had been cut for 2014 and 2015 was met with an implosion of prices. Traders forget that they revise their forecast every month and next month they could raise it again. It is a constantly moving target. The IEA still expects demand to rise by 650,000 bpd in 2014 and another 1.1 mbpd in 2015. That is hardly a decline in demand.

The key word in the report is demand "growth." They said growth in demand would slow not that demand is slowing. Traders react to the headlines each month like it was gospel and we should shut a couple refineries because they were no longer needed.

Another culprit last week was the weekly inventory numbers. Crude inventories rose a whopping 8.9 million barrels. Immediately the investing public ran for the exits. That is because most of those investors don't understand that refineries shutdown in October to switch over to winter blend fuels and to do seasonal maintenance. They don't consume oil while they are undergoing maintenance so inventories surge in October and November. They then decline sharply into yearend so the refiners don't have to pay taxes on oil in inventory on December 31st. In the EIA chart below note the historic inventory pattern on the far right of the chart. The shaded area is the five-year range in inventory levels and the blue line is the current inventory. The current trend is exactly in line with the historic Oct/Nov range.


For investors not aware of the seasonal trends this sudden rise in inventories can be rather disconcerting. Add in all the economic headlines and the sharp declines in the broader market and you get a liquidation event. Fund managers cut crude net long positions -8.1% last week. Short positions rose to the highest level in 22 months.

BNP Paribas and Bank of America joined Goldman Sachs in saying the decline went too far because a crude glut had not yet materialized. Goldman said they were near term bullish on crude prices but long term bearish if the demand from Europe did decline.

Here is the good news. For every 10% drop in oil prices consumption grows by 0.15% because fuel prices decline sharply. Brent's slump of almost 30% from the June peak could stimulate additional demand of 500,000 bpd according to Goldman. As if to prove the point Dubai crude prices rose as more Asian buyers entered the market as a result of the cheaper price.

The number of supertankers headed for China rose to a nine-month high, with 80 Very Large Crude Carriers (VLCC) tankers heading there from around the globe. Supertanker cargoes headed for Japan are the highest since December and those headed for South Korea and India also rose. When prices decline, demand increases.

Late Sunday crude prices rose after Iran said it was seeking to prevent further price declines. Iranian President Hassan Rouhani instructed the oil ministry to use the "oil diplomacy tool" to halt the decline. At the same time Saudi Arabia and Kuwait said they were halting production at a 300,000 bpd field for "environmental" reasons. That was seen as a way to slow production without saying "we are cutting production because the price is too low."

Oil always seems to over correct when one of these high profile declines appears. That would definitely be the case this time around. Investors should note on the chart that the major declines tend to reverse just about as fast as they fell.


Oil Inventories

Crude inventories rose +8.92 million barrels to 370.6 million. This was the largest one week gain in months. However, on the surface this appears to be another accounting irregularity. Refinery demand declined -233,000 bpd and imports rose only 28,000 bpd. If you add those numbers you only get an implied increase in inventories of 1.827 million barrels. The difference between 8.92 million and 1.8 million is nowhere to be found in the internal data. This suggests a couple of deliveries of oil were not reported in a timely fashion and "caught up" last week.

U.S. production rose +76,000 bpd to 8.95 mbpd and a 35 year high. Inventories at Cushing rose from 18.9 million to 19.6 million barrels. With refineries shutting down for maintenance I would expect the Cushing levels to rise over the next several weeks. Refinery utilization fell from 89.3% to 88.1% and an eight week low. This should continue to decline over the next couple of weeks and then ramp back up once the winter blend fuel production begins to increase.

Gasoline inventories declined -4 million barrels despite an increase in production of +380,000 bpd. Gasoline demand spiked +398,000 bpd. Those two numbers should have equaled out so there is no obvious reason why we got a -4 million barrel decline. Imports were basically flat and had no impact on the total.

Distillate inventories declined by -1.5 million barrels thanks to an increase in demand of +212,000 bpd. Imports also rose +98,000 bpd. Distillate demand at 3.71 mbpd is right in line with the weekly averages and erased the unexpected decline to 3.5 mbpd last week.

In the graphic below green represents a recent high and yellow a recent low.


Propane inventories rose 0.73 million barrels to 81.38 million. Inventories are at the highest level since October 1998. Demand declined from a four month high of 1,400,000 bpd to 1,100,000 bpd. Propane supplies are not likely to run short this winter. Last week is typically the peak inventory level for the season.


Natural gas inventories rose +94 Bcf to 3,299bcf. Inventories are still -7.5% below the five year average at 3,661 Bcf. There are only 2 weeks left in the injection season and at the current rate we may only reach 3,500 Bcf. That is still about 400 Bcf below where we need to be going into the heating season.

The blue line in the chart below shows the current inventory relative to the five year average.


There are currently no storms in the Atlantic. The hurricane season is rapidly coming to a close without a major storm. Rigs in the Gulf are safe for another year.

Market

The S&P futures are up +9 late Sunday night and without some dramatic headline overnight we should open positive on Monday. Whether we stay positive is another matter. The charts are all bearish despite the late week rebound. We need a couple more days of follow through to erase the bearish signals. This is typically the week in October where the yearend rally begins.

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Jim Brown

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