Crude Oil: Oil Prices Continue to March Higher

Thursday Morning March 24, 2011

Quote of the Day
Faith is much better than belief. Belief is when someone else does the thinking?
Richard Fuller

The crude oil rally continued for another day driven by the geopolitics of North Africa and the Middle East. Oil prices are now back above where they were when the Japanese earthquake and tsunami hit and are quickly approaching the key technical support level of around $107/bbl as shown in the following chart of the spot Nymex WTI contract. Prices have been trading in the current trading range since February 24th with prices hitting the upper end of the range on March 8th and failing at that point. However, now that the Japanese situation seems to be marginally better than last week and the situation in North Africa and the Middle East a bit worse than last week prices are once again readying to make another pass at the high of the range. As I have been mentioning oil trading is being driven primarily by events that are causing an exceptionally high level of fear of a future supply disruption rather than the fundamentals or even the technicals. Prices will rise and fall in the short term almost exclusively based on the 30 second news snippets hitting the media airwaves on Libya and the Middle East democracy. All other normal drivers will continue to take a back seat for the moment.

The main event for oil prices at the moment is Libya which is still evolving and looking more and more like it is going to be a long term process as the coalition seems to have accomplished its primary objective of creating a no fly zone and slowing Gaddafi forces from simply crushing the opposition in several towns. Gaddafi has shown no sign of leaving anytime soon as the fighting has now moved to a ground battle after the coalition has essentially eliminated his air force. With the coalition still having difficulty in who will be in charge of managing the situation in Libya and all countries...including the US indicating no intention to move ground forces into the arena Gaddafi has little incentive at the moment to head out of dodge. That does not mean he will not eventually leave it just means it does not look like it is going to happen in the short term and as such oil flow is months or longer away from being restored from Libya.

In the Middle East to two main hotspots at the moment seems to be Yemen and Syria both of which have seen increases in the protests with the Syrian government using force to quell the protest. Several protestors have been killed in Syria in the South where the protests are building. As mentioned yesterday the situation in Yemen is not improving with the leaders there indicating the possibility of civil war...much like what is going on in Libya. Each one of the countries in the region is a different story and will evolve differently over the next six months to a year. I do not see any reason to believe that stability will emerge in the Middle East or North Africa anytime soon. In addition a bombing in Israel yesterday also added a huge level of uncertainty on top of a very unstable situation already surrounding Israel and the rest of the Middle East.

I expect oil prices to remain firm for the short to medium term with volatility also at above normal levels. Even if Gaddafi quickly left the country tomorrow oil prices would retrace but with all of the other issues in the region I do not see any sustained period of declining oil prices in the short to medium term. The optimum trading mode for oil prices at the moment is to be long with tight, trailing stops (to protect a sudden downside correction) and to buy dips on any corrective move lower. Also as shown in the following chart of the forward curve for the Nymex WTI contract from today versus just a month ago the contango is slowly beginning to narrow as a result of lost production from Libya and global inventories in the US starting to recede (see more details on Wednesday's inventory report below). As a more conservative trade one may consider entering into a WTI timing or calendar spreads or in other words buying the front of the market and selling the forward period. If the situation in the region continues to deteriorate as discussed above the contango should continue to narrow as Brent has already done over the last several months.

Once again the market mostly ignored yesterday's EIA inventory report which was somewhat mixed to bullish for gasoline. Gasoline stocks declined more than the expectations with total commercial stocks of crude oil and refined products combined declining for the sixth week in a row. There was a modest build in crude oil stocks even as refinery utilization rates actually increased by 0.7% (adding to last week's strong increase of 2.4%) while distillate fuel was about unchanged on the week. The EIA oil inventory report was biased to the bullish side in my view even with the build in crude oil stocks. The data is summarized in the following table along with a comparison to last year and the five year average for the same week.

Total commercial stocks of crude oil and refined products declined by 0.9 million barrels on the week after declining by 5.1 million barrels last week bringing the six week total decline to about 38 million barrels. The year over year surplus of total commercial stocks of crude oil and refined products switched to a deficit of about 400,000 barrels this week while the overhang versus the five year average for the same week also narrowed to 28.3 million barrels.

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The modest build in crude oil inventories of 2.2 million barrels versus most expectations for a much smaller build offset some of the decline in refined and unfinished products but still resulting in total commercial stocks declining. The crude oil inventory overhang versus last year widened to 8.8 million barrels while the surplus versus the five year average also increased to 17.9 million barrels. PADD 2 stocks increased strongly on the week modestly on the week while Cushing, Ok stocks increased only marginally. The situation in the US mid-west is still hovering near record high crude oil inventory levels and basis this week's data there should be no market pressures that is likely to narrow the Brent/WTI spread in a major way. Much like everything else in the oil complex the short term direction of the Brent/WTI spread is being driven by the evolving situation in Libya. When the 30 second news snippets signal market participants to buy the spread narrows...when it appears there will be calm for the moment the spread widens back out as it has in the last twenty four hours.

This region of the US is still sitting with record high inventory levels and as such WTI should still continue to trade at a large discount to Brent which is much more reflective of the events unfolding in the Middle East. The May Brent/WTI spread is currently trading around $10/bbl premium to the Brent contract. WTI and Brent are two different crudes currently being driven by two different scenarios. WTI has become much more sensitive to the geopolitical event occurring in the Middle East while Brent remains decoupled from the huge regional overhang of crude oil inventories in the mid-west portion of the US. Much like the flat price direction of oil one can only look for opportunities to get long Bent/short WTI as the trading pattern is not likely to change anytime soon.

Distillate stocks were about unchanged versus an expectation for a modest decline in stocks. Heating oil/diesel stocks increased by only 7,000 barrels versus an expectation for a draw of around 1.2 million barrels. Diesel stocks built and offset the modest draw in heating oil inventories. The year over year surplus held at 4.5 million barrels while the five year average overhang also stayed the same at 21.6 million barrels.

Gasoline inventories decreased strongly on the week versus an expectation for only a modest decline in stocks. Total gasoline stocks declined by about 5.3 million barrels on the week versus an expectation for a draw of about 1.8 million barrels. That said over the last twelve weeks gasoline stocks are still higher by almost 7 million barrels. However, the surplus versus last year is gone and stocks are back into a deficit versus last year of about 7.6 million barrels while the surplus versus the five year average also turned to a deficit of 2.9 million barrels.

The following table details the week to week changes for each of the major oil commodities at every level of the supply chain. As shown I have categorized gasoline and jet fuel as bullish with crude oil and distillate as bearish. That said I would categorize this week's report as overall bullish. However, we can't lose sight of the fact that overall stocks in the US are still above normal and likely to remain at above normal levels for a considerable period of time even if the destocking pattern we are beginning to see continues to evolve over the next several months.

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 I think we could see a bit of easing in oil prices in the short term but we are once again in the mode of buying the dips as a strategy that will likely have the highest probability of success.

I am maintaining my Nat Gas view and bias to cautiously bullish as Nat Gas prices broke out of the trading range it has been in since January. The price of Nat Gas surged higher on Thursday after a bullish inventory report and is now trading above the upper end of the trading range that has been in place since January. If prices remain above this level the next technical resistance level will be around the $4.30/mmbtu level.

Currently asset classes are mostly higher as shown in the EMI Price Board table below.