The weekend meeting between Iran and the West ended pretty much as I predicted it would. The communiqué indicated that progress was made and another meeting was scheduled for May 23 in Baghdad. As long as talks continues the likelihood for a military intervention by Israel, the US or a pre-emptive strike by Iran is on the low side. While Saturday's talks did not yield any new promises, the West felt comfortable over Iran's willingness to engage in discussions on its nuclear program. The West indicated they now want to move to a more sustained process of serious dialogue. Whether or not that turns out to be the case after the next set of meeting is a big question mark. There is certainly a view that Iran may be willing to continue with discussions to buy time to continue its enrichment process and to get the West to back off on some of the sanctions. Also an unknown at this time. For the moment both sides are comfortable to move forward with diplomacy and as mentioned above it will at least postpone any military action for the time being or new sanctions. However, caution is the keyword as Iran can switch their attitude at any point in time. A peaceful end goal is very far off.
The main positive for the first round of talks with Iran is it should serve as a signal for the risk premium in the price of oil to begin to recede a bit going forward. If the talks continue I would expect oil prices to slowly move back to the levels they were at prior to the announcement of the EU embargo on oil prices back in late January. Pre announcement WTI was trading at 98.46/bbl while Brent was at $109.86/bbl. The combination of the tensions possibly easing between Iran and the West and signs that the global economy is containing to slow should act as a one two punch to push prices lower in the short to medium term.
Last week saw most of the macroeconomic data continue to suggest that both the developed and emerging market economies are slowing. In addition the ongoing EU sovereign debt issues moved back into the forefront with Spain's debt problems now in focus. In my view the single biggest headwind for oil prices is the growth rate of the Chinese economy. The vast majority of oil demand growth has come from the emerging market world over the last four years or so with a major portion of it coming from China. If China's economy continues to slow oil demand growth will also slow. There are various views as to whether or not China's economy is setting up for a hard landing or in fact it may have bottomed with this week's GDP rate coming in at 8.1%.
I do not think that China will experience a very hard landing but then again I do not think that China's economy has bottomed just yet. The government has been adding a variety of stimulus to the economy but not nearly as aggressively as it has in the past. This is primarily due to the ongoing concerns of inflation risk that is continuing to dampen the easy money policy of the Central Bank. This past week China reported a 8.1% growth rate for the first quarter that was the lowest since the first quarter of 2009 but above the 7.5% target rate recently set by the government. China's economy has been slowing since peaking at a 12% rate back in the first quarter of 2010 and is now about 4% lower. The trend looks lower yet but I do not expect the economy to drop to the levels seen at the height of the global recession when China's economy dropped to around a 6% growth rate.
Over the weekend the Chinese government announced it was doubling the size of the trading band for its currency the Yuan versus the US dollar. China is slowly trying to liberalize its exchange rate regime and make its currency more market oriented. China showed a trade deficit in February and a small surplus in March suggesting to the Chinese government that its currency is already approaching fair value and as such this seemed like a logic al time to widen the currency trading band.
Why do I focus so much on China? Simple... from the oil demand growth side of the equation China is the main oil growth engine in the world. With oil consumption highly correlated to economic growth one has to place a lot of emphasis on China's economic activity. For the moment China is a bearish price driver and will remain in that mode until there is a clear sign that the economy has bottomed and is turning higher.
Over the last week the oil complex was mixed with crude oil a bit lower while refined products were marginally higher. The May WTI contract decreased about 0.46% or $0.48/bbl offsetting the gains from the previous week. The June Brent contract ended the week with a decrease of 1.8% or $2.22/bbl. The June Brent/WTI spread narrowed by about $1.10/bbl and has been contracting since peaking close to the $20/bbl level. The combination of the market looking toward the start of the Seaway pipeline in June (expected to move about 150,000 bpd of oil out of PADD 2 to the US Gulf) and the easing of the tensions in the Middle East has been enough to send some of the spread bulls to the sidelines. Barring any change in the current geopolitics of the Middle East I would expect the spread to gradually continue to narrow over the next 3 to 6 months as the surplus in the US mid-west continues to recede.
On the distillate fuel front the Nymex HO contract was about unchanged on the week even as distillate fuel inventories decreased much more than expected last week and as US distillate fuel exports increased on the week. The spot Nymex HO contract increased by 0.17% or $0.0054/gal. Gasoline prices increased on the week as gasoline stocks declined. The spot Nymex gasoline price increased by 0.17% or $0.0056/gal this past week.
On the week Nat Gas futures declined once again and dropped below the psychological $2.mmbtu level and is now trading with a $1 handle even as the inventory injection came in less than expected and below the five year average for the same week. The spot Nat Gas futures contract lost another 5.17% or $0.108/mmbtu on the week as it is now trading with a $1 handle. Now that Nat Gas has ventured below the psychological $2/mmbtu level what is next on the agenda for this market. Will it go much lower? Will any producers come to the rescue of the decline in prices by cutting production? At what price point will production cuts be announced? At what level of Nat Gas in inventory will producers start to throttle back production? These are just some of the questions that are looming in my mind and I would suspect in many Nat Gas traders & investors minds. I like many players do not have the answers... or else I would have led with answers rather than questions. However, I certainly have an opinion or two as to how the whole market is likely to shake out from here.
With total Nat Gas inventories now at 60.4% of maximum workable capacity I am certain that has the attention of many producers as well as storage operators. As it looks at this point in time the moment of truth could come as early as sometime this summer or early fall at the latest especially for the producing region which is almost at 78% of workable storage capacity. There is somewhere between 400 to 600 BCF of production that is going to have to be left behind just to get to the beginning of the upcoming winter heating season. So who will be the first producers to cut production?
The companies with little or no hedges left on their books like Chesapeake will likely be the first companies to start to cut production. In fact they have already made some cuts early in the year but not nearly enough to make a difference. With the Producing region the closest to hitting max capacity cuts could come as early as May or June. If they do not happen I would say we could see another big push to the downside in Gas prices possibly as low as the $1.50's before it finally bottoms out.
Barring a very active hurricane season and/or a very hot summer cooling period Nat Gas prices will continue to slowly decline until the producing sector acts accordingly. I see more and more bottom pickers playing in the futures market right now but that is normal and was also the case when the price of Nat Gas futures crossed the $3/mmbtu level. There is nothing to suggest that we have formed a bottom yet. The main signal to watch will be any and all announcements by the major producers insofar as cutting production. Overproduction is what pushed Nat Gas prices to the low level it is at and cutting production is the only realistic solution to stop the decline.
On the financial front equity markets around the world ended mostly lower r as the downside correction continues. The financial markets were mostly impacted by a series of macroeconomic data in several locations around the world...in particular China that indicated that economic growth may be slowing. Global equity values decreased as shown in the EMI Global Equity Index table below.
The EMI Index decreased by 1.6% on the week. Over the last week the Index decreased in value even as the euro increased slightly while the US dollar weakened on the week. Last week the global equity markets were a bearish price driver for oil and most commodity markets. Last week was a risk off trading week for most risk asset markets with that sentiment carrying over into this start of this trading week after the bearish US data last week.
I am keeping my view at neutral for oil as WTI remains within my predicted trading range of $102 to $107/bbl. I am a bit surprised that the oil complex is trading like it is... somewhat discounting the negative data out of the largest oil demand growth engine in the world...China. That said Geopolitics will remain the main price driver leading up the Iran/West meetings on April 14th but until I get more clarity as to how the meeting is likely to turn out I am more comfortable staying on the sidelines today.
I am still keeping my view at and bias at bearish. My overall view remains biased to the bearish side. The surplus is still building in inventory versus both last year and the five year average is going to lead to a premature filling of storage during the current injection season. As such for the short to medium term I doubt Nat Gas is going to reverse the downtrend it has been in for an extended period of time. We may certainly see times when short covering rallies take hold but I do not expect a sustained trend change.
Currently markets are lower as shown in the table below.
Dominick A. Chirichella
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