Defeat is not the worst of failures. Not to have tried is the true failure.
George Edward Woodberry
Over the last several sessions the market has tried to push oil prices into a downside corrective pattern, but so far each attempt has resulted in shallow and short lived moves lower. However, trading volume has been well below normal…especially in up days…suggesting that the market may be running out of new buyers and/or the existing long base of buyers is mostly near the upper end of where they want to be based on the current and projected market dynamics. I know I have discussed this many times but at the moment there is no shortage of oil anyplace in the world, thus much of what is driving the market is based on a twofold perception trade.
First the evolving situation in Libya along with the potential contagion of the democracy movement spreading to the rest of North Africa and the greater Middle East is perceived to result in a much larger supply interruption that may last for an extended period of time…obviously a bullish scenario for oil prices. The second perception is global oil demand is growing faster than new supply is emerging and thus surplus capacity of crude oil is declining. Although surplus capacity is still above the lows hit back in 2007 through the middle of 2008, it is now in a declining pattern that the main holder of surplus crude oil capacity – Saudi Arabia – has begun to increase its production to offset the million barrels per day plus loss of exports from Libya. The pattern of demand outstripping supply is a longer term trend and one that is likely to continue as long as the global economic recovery does not become derailed anytime soon.
It is difficult to try to put a probability on each of the main perception drivers at the moment as in some respects the supply driver or first driver can not only result in further price surges, but if prices did increase strongly from current levels that alone could work to derail the global economic recovery and thus the second main upward price driver previously described. Without putting a probability on it, I will say I view the perception of a major supply problem beyond Libya as not as likely as the media and the current price may lead one to believe. I actually believe that the Libyan situation is likely to result in some sort of cease fire and even a possible regime change during the next several weeks. If my view is correct, that would result in the risk or fear premium for oil receding modestly (but not completely) and lay the groundwork for the demand growth outstripping supply model to remain in place and provide a slow but sustainable increase in the price of oil over the medium- to longer-term.
Thus at this juncture in the price trend the optimum strategy is twofold… both involving either being in it from the long side or not at all, as even though I am still expecting a downside correction the risk of being wrong and having a short position on is much more risky than the reward may be. For the more aggressive types that are still on the sidelines and not in the market I would suggest getting long from several different approaches. The most direct would be to just simply buy futures any time the market is even modestly lower and employ a tight, trailing stop based on what your individual risk tolerance warrants you risk on a trade that could go sour at any time. The second is to take advantage of the high volatility level of the market and enter into one of the variety of ways to get long exposure by using options. The most direct option trade is to buy at the money or out of the money calls options which would result in a predetermined monetary exposure to the trade. If the premium of this strategy is too high (which it is) one could move toward a debit call spread by also selling a further out of the money call option to offset some of the high costs of buying the previously mentioned call options resulting in a long /short call spread at two different strike prices. Finally one can also just sell some out of the money put options that are relatively short dated – May or June options – that still have a modest amount of extrinsic or time value left in the option.
For the less aggressive types and those willing to remain on the sidelines for awhile longer, wait to enter the market (via directly with futures or any of the aforementioned option trades) after the market undergoes a more significant downside correction. The risk of following this strategy is it may not happen for an extended period of time and not until prices move significantly higher from current levels. I think a cease fire in Libya could easily result in upwards of $10/bbl downside correction in a relatively short period of time – days rather than weeks. This would be a signal to enter from the long side. At this stage of the rally, when and how you enter the market from a flat price perspective will be a direct function of each of your individual risk tolerances.
Finally the May WTI/Brent spread breached the lower technical support level of minus $13/bbl (WTI below Brent)… a key support level discussed in yesterday's newsletter. If you are trading the spread you should be short WTI/long Brent. Last night's API report was mixed for the spread (see below for more details on the whole report) in that Cushing, OK stocks increased marginally while PADD 2 crude oil stocks declined strongly of the week. If the EIA report is in sync with the API report it could quickly result in a short covering rally in the spread pushing the spread level back above the minus $13/bbl old support/new resistance level and thus a short term technical signal to get out of or possibly reverse the direction of your position.
On the financial front, global equities have been relatively quiet even as China surprised the market yesterday while most participants have been waiting for the anticipated 25 basis point increase in EU short term interest rates when the ECB meets on Thursday. The Chinese Central bank surprised the market with yet another increase in its short-term interest rates as inflation fighting remains front and center in its monetary policy. China raised rates by 25 basis points today. This is the fourth increase in interest rates since China switched away from its easy money policy. Inflation still appears to be the number one worry of the Chinese government as they did not even wait for this months' round of inflation data to hit the media airwaves to raise rates. China has been trying for almost a year to throttle back the meteoric growth in its economy and eventually the main economic growth engine of the world will slow. As it slows, China's consumption of everything is likely to also slow starting with the entire energy complex including LNG, coal and oil.
The EMI Global Equity Index is holding its gains for the week (so far) as shown in the following table. The EMI Index is higher by another 0.1% since New York's close on Tuesday with Japan now the only bourse in the Index in negative territory and likely to stay in negative territory for the foreseeable future. However, the Japanese Central Bank is in the middle of its normal monthly meeting with many expecting the Central Bank to announce an aggressive stimulus program like quantitative easing as this country struggles to recover from one of its worst disasters in history. The US Dow remains in the top spot in the winner's column with China's Shanghai A shares closing the gap to just 0.2% below the US Dow. Equities remain an upward price driver for oil.
Late yesterday afternoon the API released their latest inventory assessment. The API report was mixed and modestly biased to the bullish side. The API reported a crude oil inventory draw of about 2.8 million barrels as refinery utilization rates increased by 0.7% to 84% of capacity. The API reported a small increase in crude oil imports which did little to offset the large increase in refinery run rates. PADD 2 stocks declined strongly by about 3.7 million barrels after the previous API report showed a large build in stocks in that region. They also showed a modest build in gasoline stocks of about 0.6 million barrels while distillate fuel stocks declined by only 1 million (as colder than normal temperatures were still in place last week). The results of the API report are summarized in the following table. So far the reaction to the API report has been mildly bullish for everything other than gasoline. If Wednesday’s EIA report is in sync with the API report I would view it as neutral to biased to the bullish side.
My projections for this week’s inventory reports are summarized in the following table. I am expecting a somewhat bearish report with modest across the board builds in total commercial stocks of crude oil and in refined products inventories as refinery runs are likely to increase marginally on the week. I am expecting crude oil stocks to build by about 1.7 million barrels. If the actual numbers are in sync with my projections, the year-over-year surplus of crude oil would widen marginally to 1.2 million barrels while the overhang versus the five-year average for the same week will also widen to 14.9 million barrels.
With runs expected to increase by about 0.2% and with imports expected to hold steady I am expecting a modest build in gasoline stocks. Gasoline stocks are expected to build by about 0.5 million barrels which would result in the gasoline year-over-year deficit narrowing to 4.8 million barrels while the surplus versus the five-year average for the same week will widen to 3.8 million barrels.
Distillate fuel is projected to increase modestly by 0.9 million barrels on a combination of minimal weather demand as well as an increase in production. The latest NOAA forecast is projecting above normal temperatures across the eastern half of the US for the next several weeks thus reducing any hopes for a continuation of atypical spring heating related consumption. The forecasts are a negative for heating oil, especially after the last several weeks of bullish weather reports. If the actual EIA data is in sync with my distillate fuel projection inventories versus last year will likely now be about 8.5 million barrels above last year while the overhang versus the five-year average will be around 28.6 million barrels. With the beginning of the inventory injection season about to start for heating oil and with total distillate fuel inventories already at very comfortable levels there is not likely to be any supply issues anytime soon.
Net result the US continues to remain well supplied of just about everything in the oil complex and stocks are not yet in a sustained destocking pattern in general. The major wild card for distillate fuel over the next three to six months will be how much additional diesel fuel is going to be required by Japan. It is likely that Japan's import requirements for diesel fuel will increase strongly once the nuclear situation is stabilized and the country enters into the rebuilding and reconstruction phase especially with a large percentage of the refining capacity in Japan shut in.
As usual do not overreact to the API data as the EIA report will be released today. The API report more often than not is not in line with the more widely followed EIA data. If the EIA report is within the projections I would expect the market to view the results as neutral as total commercial stocks of crude oil and refined products combined are likely to have decreased only marginally. If the EIA data is more in line with the API data, the market will likely also view it as neutral biased to the bullish side from a macro overview and a mild positive for the WTI versus Brent spread. Whether or not the market reacts at all to the inventory report will be dependent on what is going on in North Africa and the Middle East and how much the macro issues will offset any of the individual micro drivers like supply & demand.
My individual market view is detailed in the table at the beginning of the newsletter. I am maintaining my bias at cautiously bullish as the market is still focused on the geopolitics of North Africa and the Middle East. I am leaving my view at neutral for the moment as a short term correction is overdue.
I am maintaining both my Nat Gas view and bias at neutral as prices are once again likely to remain mired in a range for the foreseeable future.
Currently asset classes are mixed as shown in the EMI Price Board table below.
Best Regards,
Dominick A. Chirichella
