Will the Fed double down?

If at first you don't succeed, try, try again! It’s Fed Day and the global energy markets are waiting to find out whether or not the Fed is going to boost the markets with another shot of quantitative easing.

Speculation is swirling that the Fed, desperate to knock the malaise out of the economy, will double down on its policy and flood the economy with even more printed money. This is a far cry from expectations just a few weeks ago when the Fed was widely expected to reduce their balance sheet as they were set to collect $100 to $180 billion in profit from its Mortgage Backed Securities (MBS) it took over in the heat of the financial crisis. Instead of putting that money back in their coffers and reducing the money supply, the fearful Fed may just pump that cash back out there and buy more MBS or bonds to try to inspire some economic activity and maybe even some job creation.

In fact data out of China overnight might even put more pressure on the Fed to act. Chinese imports came in much weaker than expected in July causing a big selloff in the Shanghai composite index. The index dropped 2.9% which was its worst percentage fall since June 29 when the shares fell 3.3%. This disappointing number in China led to selling in commodities across the board more notably copper and oil has raised concerns about global demand for those growth related commodities. A slowing China does not bode well for the global economy.

The Fed also fears falling commodity prices. The Fed fears deflation and if commodity prices fall that means demand is faltering and if demand is faltering that means economy is faltering. And with a faltering economy job creation will not be happening.

Two tropical waves that bear watching! One storm is in the Gulf of Mexico and has about a 50% chance of becoming a cyclone. Still is the market overplaying storm threats? John Kemp at Reuters News seems to think so. Mr. Kemp says that prices for crude oil and products may have been boosted by the existence of a "hurricane premium," according to some analysts, helping keep the market buoyant despite rising reported inventories of crude oil and refined products in the United States. The market is still haunted by the memory of the unusually active and damaging 2005 season, when hurricanes Katrina (August 2005) and Rita (September 2005) caused extensive damage to offshore oil and gas installations and onshore refineries on the Gulf Coast. Long positions in crude and gasoline contracts expiring between September and December 2010 are essentially call options on the possibility of a hurricane taking out offshore platforms ad pipelines or onshore refineries, triggering a substantial loss of production and a price spike. Even the fear of a hurricane tracking into the danger area might be enough to propel prices higher and create substantial profits.

Mr. Kemp says that the U.S. National Oceanic and Atmospheric Administration (NOAA) has predicted an unusually active hurricane season this year, which has made explicit or implicit optionality in these positions more valuable than normal. NOAA is currently forecasting 14-20 named storms this year (with top winds of 39 miles per hour or more); including 8-12 at hurricane force (74 miles per hour or higher); of which 4-6 could be the most destructive type of Category 3-5 Major Hurricanes (at least 111 miles per hour). The forecast includes the three storms that have already occurred (Alex, Bonnie and Colin). The number of storms has been cut slightly from NOAA's previous forecast issued in May. At the time NOAA Administrator Jane Lubchenko warned it could be one of the most active on record. But it is still more active than usual. On average, the season has seen just 11 named storms, 6 reaching hurricane force, and only 2 major hurricanes.

The main Atlantic hurricane season runs from June to November, with activity peaking between late August and early October. Like any option, the hurricane season calls have an effective expiry (October) and become less valuable the closer to expiry they come without a major hurricane forming and heading in towards the Gulf Coast. If a hurricane premium has propped up crude oil and products prices in recent weeks, the effect will start to reverse and put downward pressure on prices from mid-September onward as the call option approaches towards expiry, unless a major hurricane strikes or threatens the coastal areas in the meantime. The hurricane premium should lose a small amount of "time value" each day between now and the end of the season a major storm does not strike. While the daily loss of time value will be quite small at present, it will accelerate in the second half of September as the peak of the season passes if no hurricane has hit.

The second key issue is whether the market is accurately assessing the probability of a damaging hurricane strike. While tropical storms and hurricanes are common, only a few enter the central and western parts of the U.S. Gulf. Only a very few of those reach the devastating intensity of a major hurricane (Categories 3-5) that poses severe danger to the petroleum complex. The NOAA forecasts are for all tropical storms and hurricanes forming in the Atlantic Basin. Only a few of these will make landfall in the United States, and only a minority of those will strike or threaten the central and western U.S. Gulf areas and refineries along the Texas and Louisiana coast. Mr. Kemp points out that in the 25 years up to and including 2005, only 17 major hurricanes made landfall in the United States. Of those only 8 menaced the central/western U.S. Gulf: Alica (1983); Elena (1985); Andrew (1992); possibly Opal (1995); Ivan (2004); and finally Dennis, Katrina and Rita (all 2005). We should add to the total major hurricanes Gustav and Ike (August and September 2008). The point remains that hurricanes at Category 3 or above and hitting the right area to damage oil and refining infrastructure are quite infrequent.

The probability of a major hurricane hitting the oil relevant part of the U.S. Gulf is higher in an active season than a quiet one. Even so, the market may be giving too much weight to the experience of 2005 and 2008, which were unusual years, rather than the other 27 years in the 1981-2009 distribution. Is this another example of investors and some traders focusing too much on the tails of the distribution rather than the central tendency? If a hurricane did form in the right area and track towards the central or western Gulf, oil prices would spike higher because hurricane tracks are subject to so much uncertainty more than 24 hours ahead, even a distant hurricane can have an impact. But any rally might not last long and be quickly reversed if there are a lot of options already built into the market and eager to take profits before the storm passes. A great read! Now add to that that according to Global TC Activity remains at 30-year lows at least -- The last 24-months of ACE at 1090 represents a decrease from the previous months and a return to the levels of September 2009...Since Hurricane Katrina (August 2005) and the publication of high-profile papers in Nature and Science, global tropical cyclone has collapsed in half. This continues the now 4-consecutive years global crash in tropical cyclone activity. While the Atlantic on average makes up about 10% of the global, yearly hurricane activity, the other 90% deserves attention and has been significantly depressed since 2007. Northern Hemisphere year-to-date ACE is nearing 50% below normal. The Western North Pacific is at 17% of normal (or the past 30-year average).

Phil Flynn is senior energy analyst for PFGBest Research and a Fox Business Network contributor. He can be reached at (800) 935-6487 or at pflynn@pfgbest.com

About the Author
Phil Flynn

Senior energy analyst at The PRICE Futures Group and a Fox Business Network contributor. He is one of the world's leading market analysts, providing individual investors, professional traders, and institutions with up-to-the-minute investment and risk management insight into global petroleum, gasoline, and energy markets. His precise and timely forecasts have come to be in great demand by industry and media worldwide and his impressive career goes back almost three decades, gaining attention with his market calls and energetic personality as writer of The Energy Report. You can contact Phil by phone at (888) 264-5665 or by email at pflynn@pricegroup.com. Learn even more on our website at www.pricegroup.com.

 

Futures and options trading involves substantial risk of loss and may not be suitable for everyone. The information presented by The PRICE Futures Group is from sources believed to be reliable and all information reported is subject to change without notice.


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