A bit of geopolitics and an upcoming appearance by US Fed Chairman Ben Bernanke before Congress today has sent the oil bears to the sidelines along with some light buying and fresh enthusiasm from the QE crowd over the last twenty four hours. The short covering started yesterday on news that a US Navy vessel fired on a fishing boat off of the coast of Dubai after the vessel ignored warnings not to approach. According to the UAE state news agency the person killed and the three people injured were Indian fisherman. The boat was warned not approach by voice, radio and light signals before firing. Obviously US Naval vessels are extremely sensitive to small boats approaching after the USS Cole was bombed by a suicide bomber boat in Yemen in 2000.

Obviously the market quickly interpreted the incident as the beginning of the Iranians attempting to disrupt traffic in the Straits of Hormuz. There is no indication that the vessel had anything to do with Iran as incidents between the US and Iranian naval fleets over the last few months have been very quiet. That said the incident was a reminder to the market this region of the world remains very volatile with the possibility of a disruption in the supply of oil still a possibility at any time. Negotiations are scheduled to resume on July 24th between Iran and the west in Istanbul as both side attempt to come to some form of a solution that will significantly reduce the tensions and be acceptable to both sides. Recall that the Iranian Foreign Minister indicated about a week or so ago that Iran was ready to make a deal. Time will tell but for the short term the geopolitical risk is once again slowly building into the price of oil.

The sanctions seem to be working to some degree as it is the main reason why Iran is still at the negotiating table. However, according to a report in Reuters China is scheduled to increase its imports of Iranian oil in July to a new all time record high of almost 600,000 bpd or about 54% of Iran's total exports....so much for solidarity in trying to reign in Iran's nuclear program. China seems to be approaching everything going on with Iran simply as a business opportunity as Iran and China reportedly have negotiated large discounts in the price of Iranian oil. In addition Indian oil purchases are expected to increase by about 80,000 bpd bringing Indian imports of Iranian crude to a bit above the average from last year.

Needless to say there is plenty of oil around and with the additional purchases of oil by China and India. Iran is going to remain somewhat firm in its stance with the west and the actions of China and India will serve to embolden the resolve of the Iranian government and prolong the time when a final solution is actually achieved. With Iranian oil exports somewhat rebounding it also supports the view that there is ample supply of oil in the world with no signs of a shortage of oil anyplace in the world. In fact the supply and demand balance remain biased to the supply side as demand growth continues to languish as a result of the faltering global economy. I still believe that some sort of a deal will materialize over the next several months or so and there will not be any military intervention in the region nor a major disruption in the supply of oil.

Today the QE crowd will once again get the opportunity to analyze every word spoken by the US Fed Chairman when he gives his semi-annual testimony before the US Congress. Obviously the market has been on high alert for a new round of QE from the US central bank as the US economic data continues to disappoint (bearish US retail sales data released yesterday) and suggestive that the US economy is going nowhere quick and in fact is slowing further. The IMF lowered their projections of growth for the global economy as well as the US economy yesterday. As I have been discussing market participants are clearly in a mode of bad news is actually a positive for the markets as it suggests that the US central bank is more likely to embark on a new QE program. Whether or not they will (I still think it is only a 50/50 chance) I do not believe Mr. Bernanke will use the Congressional venue to signal the US Fed is going to start another QE program. As such I think the market will be disappointed this week and will have to wait for the next Fed meeting for any new signals.

Market participants currently seem biased to the view that more easing is coming from both China and the US and even possibly the ECB. I certainly agree that more is coming from China but am less convinced about the US and the ECB as I discussed in detail yesterday. I also think that more QE from the developed world will not nearly be as effective as the early rounds were as it is now approaching the point of diminishing returns with interest rate across the curve at all time record lows. The developing world is a different story as interest rates are still much higher and easing should have a more definitive short term impact.

Equity markets are still hovering in negative territory for the year as shown in the EMI Global Equity Index table below. The Index is down by 0.4% for the week resulting in the year to date loss widening to 0.9%. The view that more easing may be on the way is not resulting in a early rally (so far) but may be at least slowing the decline in equity values. Three of the ten bourses in the Index remain in negative territory with Germany still surging higher on a lower euro while Brazil is still at the bottom of the Index. Overall global equities have been a neutral to marginally biased to the bearish side for oil and the boarder commodity complex over the short term.
This week's oil inventory reports will be released at its regularly scheduled date and time. The API inventory report will be released late this afternoon with the more widely followed EIA data hitting the media airwaves at 10:30 AM EST on Wednesday. At the moment oil prices are still being mostly driven by the events discussed above along with the direction of the euro and the US dollar as well as by a view that the global economy is continuing to slow. The tensions evolving in the Middle East between Iran and the West seem to be ratcheting up again even though another meeting is scheduled for July 24th. As such we may not see much of a reaction from market participants to this week's round of oil inventory data as the macro risk of the markets is currently the main concern of all market players. This week's oil inventory report will likely be a background price catalyst unless the actual outcome is significantly different from the market projections.

My projections for this week's inventory report are summarized in the following table. I am expecting the US refining sector to continue its campaign of converting a portion of the surplus crude that has been building for the last several months into refined products... in particular gasoline and distillate fuels whose inventories have been in decline. I am expecting a draw in crude oil inventories and a build in both gasoline and distillate fuel stocks as the heart of the summer driving season is now in full play. I am expecting crude oil stocks to decrease by about 1.5 million barrels. If the actual numbers are in sync with my projections the year over year surplus of crude oil will come in around 21.2 million barrels while the overhang versus the five year average for the same week will narrow to around 36.3 million barrels.
I am also expecting a modest draw in crude oil stocks in Cushing, Ok as the Seaway pipeline is now pumping and refinery run rates are continuing at high levels in that region of the US. This would be bearish for the Brent/WTI spread in the short term which is now trading around the $15.25/bbl premium to Brent level. I am still of the view that the spread will continue the process of normalization over the next 3 to 6 months.

With refinery runs expected to increase by 0.1% I am expecting modest build in gasoline stocks. Gasoline stocks are expected to increase by 1.3 million barrels which would result in the gasoline year over year deficit coming in around 2.7 million barrels while the deficit versus the five year average for the same week will come in around 4 million barrels.

Distillate fuel is projected to increase by 1.5 million barrels. If the actual EIA data is in sync with my distillate fuel projection inventories versus last year will likely now be about 22.6 million barrels below last year while the deficit versus the five year average will come in around 20.6 million barrels. Exports of distillate fuel have been the main storyline this year with exports running around 1 million bpd.

I still think the oil price is overvalued. However, the combination of the evolving geopolitical concern around Iran and the Middle East as well as the view that the global Central Banks are more likely to ease monetary policies further as well as initiating a new round of stimulus should contribute the market stabilizing (after some profit taking selling). For the moment the oil complex is trying to establish a new trading range.
I am keeping my view at neutral as the hot weather that has persisted across major portion of the US has subsided a bit and the rest of July is not likely to be as hot over the entire US as it was for the second half of June. In addition the economics of coal switching now favors coal which will result in a reduction in Nat Gas demand. Finally Nat Gas at current price levels is overvalued and is likely to decline further and settle into the $2.25 to $2.70 trading range.

Currently markets are mostly higher as shown in the following table.
Best regards,
Dominick A. Chirichella
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