Just when you thought Europe was moving into the background the markets were quickly reminded on Friday that the EU sovereign debt problems have not changed and are here to stay until the EU leadership solves them once and for all. As Spanish bond yields soared again the market quickly moved back into a risk aversion mentality and embarked on a modest round of profit taking selling that dominated all of the main risk asset markets throughout the trading session. Spanish bond yields hit another record high even as the EU Finance Ministers gave their final approval to the bank bailout program for Spanish banks. Simply put the market continues to interpret all of the actions by the EU leadership as just not enough to be comfortable that the debt issues that have been evolving for the last three years are truly a problem that has been solved.
Friday's selling action sent the euro down thru another key technical support level hitting the lowest level since 6/14/2010 and seemingly now on a path to test the lows made in early June of 2010. The euro now seems like it is gaining momentum to test the next level of support at 1.1875. If the next level of support is breached the value of the euro versus the US dollar will be back to levels not seen since the second half of 2005! Market players are once again talking about the possibility of the euro and the US dollar trading in parity. If the market does not become convinced that the debt problems have truly been arrested the euro is going to remain under pressure.
Certainly the recipient of a weak euro is the US dollar which will continue to firm and thus act as a negative or bearish catalyst for oil and the broader commodity complex as well as equities if all of the historical relationship remain in play. At the moment the US dollar Index is hovering near levels not seen since the middle of 2010. If the US dollar continues to strengthen it will be very difficult for the short term oil bulls to remain very comfortable barring an elevation of the geopolitical risk and/or an offset to the rising US dollar... more US quantitative easing.
As I suggested last week the risk asset markets... including oil are in a battle between a slowing global economy versus money printing coming from all corners of the world. Supply and demand balances for oil are very comfortable at the moment. There are no shortages of oil anyplace in the world. Global inventories are mostly above normal for both crude oil and refined products. According to reports in the media a larger volume of Iranian crude oil (then originally expected) seems to be in the market as China continues to buy deeply discounted barrels. The only shortage of oil at the moment is not on the supply side rather it is on the demand side as global oil demand growth is continuing to contract with both the US and Europe expected to show a decline in oil consumption in 2012 while the main oil demand growth engine of the world...China...is consuming much less oil than previously forecast. Bottom line barring an increase in the geopolitical risk of a supply interruption and/or more quantitative easing oil prices may be very close to a short term top.
The markets are heading into the lower liquidity part of the summer season as many players move into vacation mode. That said corporate earnings reports will continue to be hitting the media airwaves and have at least a short term impact on equity markets and due to the high level of macro correlation risk they will also impact commodities. In addition the market will be looking at every macro economic data point very closely leading up the next US Fed FOMC meeting on July 31- August 1. The more negative the economic data the more quickly the market will interpret the data point as increasing the likelihood of the Fed embarking on QE3. The coming week is a light week for economic data out of the US with the second half of the week a bit more interesting as jobless claims, durable goods orders, GDP and sentiment data hit the airwaves. These are all gauges that the market will quickly interpret as supportive or not supportive for more quantitative easing.
In spite of the selling on Friday most risk asset markets over the last week... including the oil complex was stronger across the board with WTI and Brent about equal in their weekly moves. The August WTI contract increased by about 4.98% or $4.34/bbl while the September Brent contract ended the week with an increase of 4.33% or $4.33/bbl. The spot Brent/WTI spread widened by only about $0.09/bbl for the week as the normalization process is still interrupted by lower loadings out of the North Sea. I still expect the spread to gradually continue to narrow over the next 3 to 6 months as the surplus in the US mid-west is also starting to recede from a combination of exports of crude oil out of the region through the Seaway pipeline coupled with refinery utilization rates at the highest level in months.
On the distillate fuel front the Nymex HO contract increased by 4.88% or $0.1361/gal on the week even as distillate fuel inventories surged higher for the second week in a row versus an expectations for a more modest build. Gasoline prices increased on the week after a small surprise draw in gasoline stocks. The spot Nymex gasoline price increased 4.51% or $0.1269/gal this past week.
Nat Gas futures increased surged on the week after a smaller than expected injection into inventory. The August Nat Gas futures contract increased by 7.2% or $0.207/mmbtu on the week and is now trading around well above the key psychological level of $3.00/mmbtu.
Just about every risk asset market was lower on Friday with the excepting of Nat Gas. I have not been able to make that kind of comment very much over the last several years... in fact it was just the opposite statement as Nat Gas was in such a strong downtrend. Nat Gas has staged a decent recovery rally since bottoming out after hitting a low of around the $1.90/mmbtu level on April 20th. Since then the spot futures price has risen by about $1.15/mmbtu or about 60%. The recovery so far has been driven based on an improvement in the current fundamentals. The overhang or surplus in inventory compared to last year and the five year average for the same week peak around the 900 BCF level. Since then the overhang in inventory has been steadily declining and is now hovering around the 500 BCF level. The inventory overhang has declined by about 45% since peaking. Simply put that is why Nat Gas prices have moved higher.
The two main reasons why the inventory overhang has been declining is a modest voluntary reduction in supply and an improvement in demand. The demand impact has been a much more significant impact on the overall supply and demand balances than the supply cuts seen to date. The improvement in demand over last year has been three-fold... a small increase in industrial consumption related to the small increase in economic activity in the US, coal to Nat Gas switching and an increase in cooling related Nat Gas demand due to the extreme heat during the first half of the summer. The increase has resulted in weekly injections underperforming. The injection season to date has averaged 67.3% of last year's fill rate and 67.6% of the injection level of the five year average.
As I have been discussing the economics of coal to Nat Gas switching has moved back to being more economically favorable to coal than Nat Gas for the majority of the time over the last several weeks. With high inventories of coal at many utility locations coupled with unfavorable economics for Nat Gas over coal I would expect some utilities to move back to coal... if they have not already done so. The big increase in Nat Gas demand as a result of coal to Nat Gas switching has peaked and is now on the down swing. Future injections will be impacted.
Cooling related Nat Gas demand is also likely to start receding as the latest temperature forecast by NOAA is projecting above normal temperatures over a smaller portion of the US than what was actually experienced during the first part of the summer. The extreme is projected to be mainly in the mid section of the US... bad for the crop but not as severe for cooling demand as this section of the US is a lower population area compared to the coastal areas...which are both projected to experience normal to even below normal temperatures into very early August. Unless the projected area of the country expecting extreme heat increases significantly I now expect cooling related Nat Gas demand to also have peaked.
The last variable in the short term that has been keeping Nat Gas prices bid has been the large amount of nuclear power generation capacity that is currently down versus last year and the five year average. As of today 9,200 MW of capacity is out of service versus 2,700 MW last year and 4,400 MW for the five year average for the same week. However some of the capacity that was shut down over the last several days is already back into restart mode suggesting that nuclear capacity should be closer to normal for this time of the year in the not too distant future.
Overall I still view Nat Gas futures prices as overvalued versus the current fundamentals. There is still an exposure of the industry prematurely hitting maximum storage capacity especially if some of the increases in demand do start to recede as describes above. Also do not lose sight of the simple fact that even if the industry does not prematurely hit storage limitations there will be a record amount of Nat Gas in storage prior to the start of the upcoming winter heating season. there will not be a shortage or supply related issues anytime soon ...barring some unforeseen tropical activity in the US Gulf of Mexico.
On the financial front equity markets around the world were mostly higher on the week. The financial markets were mostly impacted by better than expected corporate earnings as well as growing belief that more easing is on the way. Global equity values increased as shown in the EMI Global Equity Index table below and is now marginally in positive territory for the year.
The EMI Index increased by 0.5% on the week and is in now back in positive territory for the year by 0.1%. Over the last week the Index increased in value in most all of bourses with three bourses still in negative territory for the year. At the moment the global equity markets are struggling to stay in positive territory except for Germany which is soaring higher based on the falling euro which is a major benefit to this export driven economy.
The euro lost ground on the week while the US dollar firmed marginally. Last week the global equity markets were a neutral price driver for oil and most commodity markets for most of the week until the selling on Friday.
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 still 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 becoming more susceptible to a round of selling.
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