Energy futures markets are in a time of change. Market fundamentals have much to offer both bulls and bears. Technical analysis offers a methodology with which to evaluate the implications of fundamental change and it can provide guidance on where prices might go.
Here we will focus on the fundamental elements now influencing markets and the various technical factors that signal market movements. And since liquid petroleum markets have different fundamentals at work than do natural gas, we’ll have something to say about each.
Historically, petroleum liquids have been seen as critically sensitive to international geopolitical events. Constrained crude oil production in Iraq, for example, could influence product prices here at home. At the same time, the United States, and more broadly, North America is developing new crude oil sources that are insulating our markets from international events.
Natural gas, on the other hand, has been treated largely as a domestic matter removed from the uncertainties of international influences. But the lure of higher values for LNG in foreign markets is raising the real prospect of a robust export trade in natural gas – and must be considered when thinking about bearish expectations that have developed from the dramatic expansion of domestic natural gas production.
Market fundamentals for petroleum liquids are mixed. Without doubt, the game changer for the foreseeable future is the advent of domestic crude oil production. Data available from the Energy Information Administration (EIA) for mid-August 2013 confirms increasing U.S. crude oil production. Output reached 7.571 million barrels daily at that time; the gain came from the lower 48 states, offsetting reductions from fields in Alaska.
The reduction in Alaskan production has largely been ignored in our new successes in the contiguous 48 states. Alaskan output ran 456,000 barrels daily during mid-August, continuing long-term slippage from more than 1 million barrels daily in October, 2003. EIA forecasts U.S. total crude oil production will average 7.4 million barrels per day in 2013 and 8.2 million barrels daily in 2014. These represent increases in EIA’s expectations.
The impact of domestic crude oil self-sufficiency has been more expansive than generally reported. One example is the improvement in our trade deficit. “America's trade deficit narrowed sharply in June, driven by record exports and a shrinking bill for oil imports, brightening the picture for domestic growth in the second quarter,” according to the Wall Street Journal. The trade deficit fell more than 22% during the month, to $34.2 billion from $44.1 billion.
Anticipation of tapering of the Federal Reserve’s low interest Quantitative Easing has been bearish. Ironically, Fed action appears now to have become entrenched in the economy and any change in the status quo has roiled energy markets. One of the major discussions now underway relates to how best to disengage from the impact of the Fed’s QE activity.
The bearish crude oil situation in North America mitigates bullish events overseas. Interference with crude oil production and export in the Middle East and North Africa (MENA) supports price.
At this writing, the geopolitical news revolves around Syria. The country has little production of its own and, in any case, economic sanctions and unrest in the country have cut into any export capability it may have had. More importantly, Syria is near pipelines and the Suez Canal that carry a great deal of crude oil. The EIA estimates that the Suez Canal carries about 800,000 barrels of crude oil and 1.4 million barrels of products daily.
Turkey, just to the north of Syria, houses the Kirkuk-Ceyhan pipeline, which carries Iraqi crude oil to the Mediterranean Sea. It also supports the Baku-Tblisi-Ceyhan route from Central Asia. Iraq, with its Northern Iraqi fields, produced three million barrels daily last year. Iraq is just to Syria’s east.
A point so central to Middle East oil distribution would be critical to crude oil security at any time. With events so fraught, the potential for disturbance is much greater.
The Arab Spring unleashed emotions and conflicts not yet resolved. Export capacity in Libya has been constrained and backed up crude oil production. There have been actual interferences already in distribution. Kirkuk-Ceyhan has been attacked; 300,000 barrels daily flow has already been reduced to a trickle. And revenue disputes between the regional government and Baghdad have cut supply from Kurdistan by 15,000 barrels per day.
The impact of these disparate activities in diverse oil producing provinces can be seen in the spread between WTI crude oil and Brent, its international counterpart.
Crude oil distribution in the United States has been designed to carry crude oil from producing regions of Louisiana and Texas to refineries in the Midcontinent. The development of crude oil in North Dakota changed the calculus of traditional oil distribution. Cushing, Okla. is the location at which WTI futures contracts are priced. WTI at Cushing had been landlocked and values depressed relative to U.S. coastal crude oils, themselves tied to Brent crude oil. There was no economic incentive to bring that crude oil to refineries on the Gulf Coast.
Increasing domestic crude oil output is putting pressure to improve transportation facilities which historically were not designed to carry crude oil from places like the Dakotas, or Cushing OK or West Texas to the Gulf Coast.
Reversal of the Seaway pipeline has been one response to this problem. A parallel Cushing-to-the-Gulf line is now under development, adding another 450,000 barrels per day to capacity. It is scheduled to come on line in the first quarter of 2014.
These lines are helping drain inventories at Cushing. Stocks at this critical location are now (late August) at 36.6 million barrels. Supplies at Cushing have declined 28.5% since reaching their high on July 19, 2013 at 51.2 million barrels. The drop, so deep so quick, offers stark testimony of the power of economic incentives to enforce price equilibrium on a market that had been badly mispriced between midcontinent and coastal crude oil values.
Some observers expect stocks at Cushing to fall to 25 million barrels in the years ahead. This level is more typical of 2008 when balances still reflected the dominance of Gulf-to-Midcontinent crude oil movements.
The spread between WTI and Brent crude oil has been used to gauge the importance of foreign crude oil in pricing oils in the United States. The spread has narrowed in recent months, reflecting the expanded availability of U.S. crudes. This should continue as the transportation system carries more U.S. oil to coastal refiners.
WTI and Brent crude oil values have come together for the first time since August 2010. With parity, the impact of the cost of rail transportation from the Bakken eastward has now to be resolved.
Once parity was achieved in the spread between WTI and Brent, a widening of the difference came as no surprise. It may have reflected profit taking by traders that rode the difference down from the mid-teens. More significantly, the Brent leg of the spread was far more impacted by events in MENA. By Labor Day, the difference between WTI and Brent expanded to $6.25. The spread was $4.62 during the previous week. The added $1.63 indicates the growing independence of North American supply and perhaps somewhat greater insulation from foreign events – at least in the short run.
What do the charts say?
There are many technical aspects to the examination of price charts. One of them is that prices may reach a new high in a long series. This was the case with WTI crude oil in August. With news of possible military action in Syria, WTI rallied to $112.24, a new recent high. As the prospect of deferred action, however, WTI prices fell back, closing for the week at $107.76, near the weekly low. This suggests a possible reversal of prices.
Unusually high prices invite contrary action and crude oil producers should consider using the combination of a new high and a lower close as a signal to get short.
Another indication of a top forming can be seen in Elliott Wave patterns for WTI. The move to $112 was not surprising. Indeed, it could be seen as the culmination of a rally that has been developing since April of this year. Elliott Wave, which propounds rallies in five wave sets, suggests the new high fulfills the conditions of a five wave advance. Even if further highs may lie ahead, a consolidation may be in store. Support can be found around $103.
The shape of the forward price curve can often provide guidance for the trader. The forward price curve consists of a chart on which the price of each forward contract is plotted. On Aug. 30, WTI crude oil prices moved sharply lower through the traded months. The nearby contract, October WTI, was worth $107.65. Each subsequent month had a price just lower than the month before. By December, 2020, WTI is worth $79.60.
If, in fact, WTI is nearing a top, a spread trade opportunity may exist. Low prices in the future discourage storage. This would eventually lower crude oil supplies and support prices. One way to trade this would be to sell the relatively overpriced nearby WTI and buy the more distant month. As a spread, this trade enjoys better initial margin requirements set by the exchange.
The effect of new technologies on natural gas production has been well documented. The term “peak oil” seems to be antiquated with today’s robust natural gas industry. And even with prices well below what had been seen to be rock bottom for sustained development; natural gas continues to pick up market share from other fuels and builds a case for sustained export in the years ahead.
According to the EIA, “Proved reserves of U.S. wet natural gas rose by 31.2 trillion cubic feet in 2011 to a new record high of 348.8 trillion cubic feet. Though this increase was lower than the 33.8 trillion cubic feet (Tcf) added in 2010, it was only the second year since 1977 that natural gas net reserves additions surpassed 30 Tcf.”
Natural gas pricing peaked in May 2013, around $4.52. It subsequently moved lower, tracing a channel to $3.15 early in August. A rally over $3.55 would break the down channel, its timing coincident with a seasonal rally.
Natural gas pricing follows well behaved seasonal patterns. This commodity has two seasons and two “shoulders.” The lesser peak is generally found in June, a time leading up to summer’s heat. The greater price peak occurs in December, reflecting, of course, winter’s cold. Prices move down in February from the December peak and remain on that shoulder until April when values rally.
Prices top in June. They consolidate through the summer, starting their run up to December during September. Traders follow these patterns for short-term trades. Powerhouse’s analysis of the seasonal pattern shows the summer peak price nearly five% higher than the annual average price. December’s peak can run more than 10% over the annual average.
The forward price curve is very different from that of WTI crude oil. Nearby prices are relatively low, with the October 2013 contract at $3.58. Prices rally in more future months. By December, 2026, natural gas is worth $6.995.
A trading strategy similar to that suggested for WTI is indicated here. A trader could buy the nearby natural gas contract, selling the more distant month. As time passes, the more distant month should fall to meet current prices and since the current month is already relatively cheap, it has less price room to move adversely.
The steep carry in natural gas prices represents an opportunity for producers. A sale of more distant futures months establishes a price well above current levels in a market that is likely to be well supplied for several years.
Alan H. Levine is CEO of Powerhouse, a company offering the Power of Price Protection. Alan has served the energy industries since 1969 and focused on hedging and price risk management since 1977. He can be reached at alan@powerhouseTL.com