The sell-off in risk commodities continues as we near the end of another week of trading and investing. Markets do not like uncertainty and that is about all there is around the world right now. The highest level of uncertainty is coming from Europe with Greece holding the top spot followed by Spain. Last night Moody's downgraded 16 Spanish banks. All of the signs are strongly suggesting that the EU does not have the situation under control and there is significant event risk of even more uncertainty if Greece exits the euro.

All asset values have been deflated strongly over the last several weeks with global equities (see below for more details) now showing a loss for 2012 as are most global commodities...including oil. Five and half months of this year are now in the history books and if you bought and held just about any risk asset investment on December 31, 2011 you are losing money. If you missed the big risk asset rally that occurred during the first three or four months of the year you now have another opportunity to try it once again (if you are confident that the selling is over...I am not just yet). Even if Greece were not a major issue at this point in time the market is very uncertain as to the medium term state of the global economy as it is slowing from all corners of the least that is what the macroeconomic data is telling us.

All risk asset markets including oil are in a very oversold state. Yes a dead cat bounce or short covering rally is likely to happen in the not too distant future. But keep in mind that markets can remain technically oversold for an extended period of time when the market trend is very strong to the downside. This trend is very strong to the downside as the vast majority of the risk asset losses occurred during the last two week or so of trading. Just two week ago oil and just about every equity and commodity market was still showing respectable gains for2012. It is time to start to position for a short covering rally but don't assume it will occur may or it may not.

Specifically looking at the oil complex over the last two days there was a big flushing out in the Brent market as the Brent/WTI spread took a strong hit just as the Seaway pipeline readies to start over the weekend. As I have been saying in the newsletter the spread is in the early stages of returning to a more normal and historical pricing relationship with WTI eventually trading with a $1 to $2/bbl quality and location premium over Brent. This week the spread has lost about $1.25/bbl compared to last Friday's close but $3/bbl compared to the highs made on Tuesday of this week.

A significant amount of crude oil will have to flow out of PADD2 and Cushing as Cushing crude oil inventories are at the highest level ever recorded at this location. But the combination of Seaway starting to pump and many refineries coming off of turnaround inventory levels will start to decline (there is also a strong seasonal tendency for inventories to decline going forward). How quickly the Brent/WTI spread will narrow will be directly related to how the market views the rate of crude oil inventory destocking will take place in the mid-west. In my view it is not how fast the spread will narrow but simply the fact that it will narrow over the next six months to a year. If you can handle the potential equity drawdown's along the way selling Brent and buying WTI for a medium term timeframe should be a profitable endeavor. Be aware the main risk factor to this trade is not so much that inventories in the mid-west of the US do not decline rather it is the ever present geopolitical risk in the Middle East and West Africa. Any perceived or actual interruption of supply from these regions will hit the Brent market first and the spread will widen once least for a period of time.

In addition to the Brent/WTI spread slowly working its way toward normalization so will all of the other oil commodities that have been moving based on the directional movement of Brent and not WTI. For example US refined products and many US crude oil grades have been moving up and down with Brent and will now slowly start to transition back to be more closely in sync with WTI or back to their normal historical relationships. Again this transition will take time and will not happen overnight but instruments like the crack spreads (versus WTI) will likely recede as the Brent/WTI spread recedes ...assuming no imminent shortage of refined products emerges during the transition period.

Oil and the rest of the risk asset markets are looking for a short term bottom. Yesterday we saw Gold and other precious metals markets finally find a bid after two weeks of selling. This could be one of the leading indicators that the rest of the risk asset markets are getting closer to a short term bottom and will also embark into a short covering rally. It is also getting to the point that all of the bad news that has been hitting all of the markets may at some point turn out to be good news for the markets (at least for the US markets) as the US Fed may begin to become more friendly toward the idea of another quantitative easing program. The next several months of macroeconomic data...especially employment related data will likely be a good indicator if you are a Fed watcher. QE thinking could begin to build into the market sentiment over the next month or so and if it does it would provide a bottom for oil and most commodity and equity markets. Whether it will be enough to result in any kind of sustainable upside rally is a huge unanswered question. At this point it is something to begin to think about and watch the macroeconomic data.

The global equity markets are now in negative territory for the year as mentioned above and as shown in the following table of the EMI Global Equity Index. The Index has lost 6.4% for the week bringing the year to date loss to 1.8% or back to the level the Index was trading at back in December of last year. Half of the bourses in the Index are now in negative territory for the year with Canada and Europe dominating the bottom spots in the Index. Canada being driven by falling oil prices while Europe is being driven by the current chaos surrounding Greece and other southern EU countries. Germany and China are holding the top spots. Germany is benefiting from a falling euro and a solid economy which is very dependent on exports while China although slowing is starting to benefit from an overall decline in commodity prices.
I am keeping my view to cautiously bearish after oil broke down on all fronts over the last few weeks but with the possibility for a short covering rally occurring at anytime is increasing. Oil is still solidly below the trading range it was in just a few weeks ago and well below several key support areas. WTI is still solidly trading in double digits with Brent slowly heading in that direction.
I am keeping my view at neutral and keeping my bias also at cautiously bullish with an eye toward the upside. The surplus is still building in inventory versus both last year and the five year average and could lead to a premature filling of storage during the current injection season. However, I now believe that we may see other producers starting to signal a cut in production. I am still comfortable being long winter 2013 intermonth spreads as it allows ample time for the market to slowly work its way into a more balanced position. I am now neutral for the front end of the market and will look to add net longs in the front after the market returns to the $2.25 to $2.50/trading range as I view the current price level as overvalued in the front end right now.

Currently markets are mixed as shown in the following table.

Best regards,
Dominick A. Chirichella
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