A mixed inventory report with crude oil coming in with a larger than expected build was enough to send crude oil prices lower on the session (see below for a more detailed discussion on inventories). Today another Spanish bond auction that was mostly satisfactory has moved the risk markets back to a risk on sentiment including the oil complex. Oil fundamentals and technicals as well as geopolitics are all neutral to bearish at the moment and a substantial portion of the Iranian risk premium has come out of the price of oil. Using the Jan 23rd announcement day for the EU Iranian crude oil purchase embargo the Brent premium has receded to about $9/bbl after peaking at a premium of around $19/bbl. The WTI risk premium has declined to about $4.5/bbl after peaking at around $12/bbl. As long as the rhetoric remains in the background and the May 23rd meeting remains on the schedule I would expect the risk premium to continue to narrow over the coming months.

The oil complex is moving away from being only driven by the evolving geopolitics of the Middle East with fundamentals and technicals moving back into the foreground. When looking at the fundamentals one has to look at both the current or nearby fundamentals which tends to have a much more direct and immediate impact on the spreads and to a lesser extent the flat price and the projected fundamentals or the perception of what the market is likely to be on a forward basis. This time horizon for the fundamentals tends to have a more direct and immediate impact on the flat price of oil.

The nearby fundamentals have been mostly balanced to somewhat oversupplied in some areas of the complex and that has been reflected in many of the highly traded spreads like the cracks, Brent/WTI and Intermarket refined product spreads. With the easing of tensions in the Middle East coupled with the approach of the start up of the Seaway Pipeline we have seen a market that has been in the midst of a major spread realignment for the last several weeks. This pattern still has a bit more to play out before stabilizing at what I would call a true value for the spreads. The supply risk side of the equation is becoming less of a price factor in the short term and this is having a big impact on the Brent/WTI spread in particular.

When one looks at the perception of what the fundamentals may be down the road the market tends to mostly focus on the demand side of the equation. The majority of oil demand growth over the last four or five years has come from the emerging market world with China leading the way higher. At the moment both the emerging market world as well as the developed countries are all in the midst of a slowing of most of the main economies. The main economic and commodity growth engine of the world...China....is also in a slow growth pattern that has been in pace for some time and most of the data is suggesting that this pattern is likely to continue for the next three to six months at least. For the moment I view the projected fundamentals at neutral to bearish as I am expecting oil demand growth to underperform versus most of the current agency (IEA, EIA & OPEC) forecast for most of 2012. As such barring any major flare up in the Middle East I expect there will be ample supply to meet all of the oil demand growth (whatever it turns out to be) through 2012 and likely beyond.

Certainly on a very short term basis.... especially intraday the oil complex will continue to be driven by the direction of the US dollar and global equities. With economic liquidity still flowing into the global financial markets from all corners of the world we can't lose sight of the risk of inflation... which is starting to rise in many areas of the world and thus acting as a support for oil prices as well as the broader commodity complex. So as one can see from this short discussion there are many pull and pushes hitting the oil complex on a daily basis but at the moment when I put them all together I view the market as one that has a higher probability of drifting lower rather than surging higher at the moment. That said I do not expect a major collapse in oil prices anytime soon with the geopolitical risk in the Middle East coupled with the massive amount of stimulus still flowing into the market acting a downside put or floor in the price of oil.

On the equity front the global equity market have been in recovery mode this week as shown in the EMI Global Equity Index table below. The Index is up by 1.4% on the week with the year to date gain now at 9.8%. It is still well off of the high of 15.2% made back in the middle of March. Most of the recovery has been a result of some stability in the European debt scene...in particular Spain coupled with decent corporate earnings so far. At the moment the global equity markets are a positive or bullish support for oil prices.
Wednesday's EIA inventory report was mixed to bullish as it showed a decline in total stocks, a larger than expected build in crude oil stocks. In addition the report showed a surprisingly large and unexpected draw in distillate fuel inventories while gasoline stocks declined much more than the expectations. Total implied demand declined even as demand increased for both gasoline and distillate fuel. Refinery utilization rates increased on the week to 84.6% of capacity an increase of 0.8% in refinery run rates. 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 decreased modestly on the week by 2.2 million barrels after decreasing the previous week. The year over year surplus still narrowed to 30.3 million barrels while the surplus versus the five year average for the same week decreased to 49.8 million barrels. By all measurements total oil supply in the US is still balanced to comfortable irrespective of the evolving geopolitical risk at the moment.

Crude oil inventories increased (by 3.8 million barrels) versus an expectations for a smaller build. With an increase in stocks this week the crude oil inventory status versus last year is now showing a surplus of around 9.8 million barrels while the surplus versus the five year average for the same week came in around 25.6 million barrels. PADD 2 crude oil inventories increased by about 1.2 million barrels while Cushing, Ok crude oil inventories also increased by about 0.6 million barrels on the week.

Crude oil inventories in the mid-west region of the US have been in a decline and are still at levels not seen since 2010 when the Brent/WTI spread was trading at significantly lower levels. However, the increase in inventories this week is mostly bullish for the Brent/WTI spread. However, the spread has been in a downside correction for the last week or so as the realities of the Seaview pipeline are beginning to work through the market sentiment.

Distillate stocks decreased strongly versus an expectation for a small seasonal build. Heating oil/diesel stocks decreased by 2.9 million barrels. The combination of a robust export markets and an early start to the planting season pushed distillate implied demand higher on the week. The year over year deficit came in around 21.9 million barrels while the five year average moved back to a small deficit to about 3.2 million barrels.

Gasoline inventories declined strongly and much greater than the expectations as a result of the industry's transition to summer grade gasoline. Total gasoline stocks decreased by about 3.6 million barrels on the week versus an expectation for a draw of about 1.0 million barrels. The surplus versus last year came in at 4.3 million barrels while the deficit versus the five year average for the same week was about 20.7 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 presented a mixed categorization but one that is biased to being bullish on the week as total inventories declined on the week.
Yesterday the CFTC voted to finalize the rules defining a swap dealer and giving guidance as to which firms will be subject to the new oversight of their derivatives trades. The new rules will determine which firms will have to register with the regulators and employ margin and collateral for their trades (much like in the regulated futures markets). The SEC approved these rules earlier on Wednesday.

I am keeping my view at neutral for oil as WTI remains within my predicted trading range of $102 to $107/bbl. At the moment the oil complex is going through a spread realignment driven by a reduction in the tensions in the Middle East and thus a receding of the Iranian risk premium along with a sentiment swing in the Brent/WTI spread due to the early start of the Seaway pipeline. I am more comfortable staying on the sidelines today for the flat price market.
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.

So far Nat Gas futures are about unchanged for the week. Short covering on Monday, selling on Tuesday and back to short covering today. This is a market that is looking for guidance for the next big move. Needless to say the world knows that Nat Gas is bearish and has been in a long term downtrend going all the way back to the beginning of 2010. The world also knows that Nat Gas can't physically go to zero. Thus many participants at all levels of the trading infrastructure are looking at the risk/reward ratio of being short. It is changing as the price of Nat Gas continues to decline. Traders and investors are trying to time the next major move which many are starting to believe will be to the upside.

Eventually the producing sector will cut production either voluntarily or be forced to cut production due to hitting maximum storage capacity in one or more of the main regions of the US. Based on my calculation I estimate that the industry is going to have to cut between 400 to 600 BCF from current production levels sometime prior to the start of the upcoming heating season. When that level of cuts are announced the market will bottom and turn upward. If the producing sector keeps production curtailed for an extended period of time the upward move could be a strong one...possibly bringing prices back to the $3/mmbtu level.

A significant supply cut would provide needed bullish support until the next wave of demand driven consumption sets in. At the moment it does not look like demand will be an upside price driver this summer as most forecasts are calling for a normal summer. Therefore the next opportunity for a demand push will not likely arrive until the upcoming heating season hits in the fourth quarter of this year. This is basically what the market is looking at and they seem to be responding to it by less aggressive shorting of the market and a bit more bottom picking starting to emerge. I am still expecting lower prices but I think we are getting closer to a bottom... another $0.25 to $0.40/mmbtu lower.

Currently markets are mixed as shown in the table below.

Best regards,
Dominick A. Chirichella
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