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Petroleum Market Commentary - February 15, 2016

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Prices Steady - Speculation Up - US Production Down - Inventory Up

DIESEL:

During the week ending February 12th, the spot month diesel futures price increased by 1.03 cents per gallon (+0.97%) while the deferred months decreased by 0 to 1 cent per gallon making the forward pricing curve relatively unchanged in level and less positively sloped. The one year forward price ended the week at a 20.69 cent premium to the spot price, from a premium of 22.17 cents at the end of the previous week.

The change in level and slope of the diesel forward pricing curve indicates steady demand expectations and lower supplies with respect to demand. Demand includes speculative demand which was higher on the week. When the forward pricing curve decreases in slope (more negative or less positive), this usually indicates tighter inventories and is generally positive for price. When slope increases, this usually indicates more plentiful inventories and is negative for price.

GASOLINE:

During the week ending February 12th, the spot month gasoline futures price increased by 5.05 cents per gallon (+5.09%) while the deferred months increased by 0 to 4 cents per gallon making the forward pricing curve mostly higher and less positively sloped. The one year forward price ended the week at a 9.12 cent premium to the spot price, from a premium of 13.17 cents and the end of the previous week.

The change in level and shape of this forward pricing curve indicates steady demand expectations and lower inventory levels with respect to supply and demand. Supply includes speculation which was higher on the week.

ANALYSIS:

The US dollar was lower on the week which is positive for price by 4.24 cents per gallon. Inventories on the week were higher and higher than expected which is negative for price by about 0.77 cents per gallon. The stock market, as a proxy for demand expectations, was lower which is negative for price. Speculation was higher on the week which is positive for price by about 0.93 cents per gallon. US domestic crude production was lower which is positive for price. Domestic production has gone negative on a year over year basis which means that the slow decline in domestic production is most likely underway.

DEMAND:

Weekly US petroleum demand decreased by 0.70% during the week ending February 5th. Domestic demand is up 0.32% vs. one-year ago and demand is currently 6.29% above the five year average.

PRODUCTION:

Domestic production decreased on the week and has gone negative year over year for the first time in many years. The number of operating oil drilling rigs in the US decreased by 28 on the week and by 31 during the previous week to 6-year lows last seen in January 2010. A lower rig count is positive for price. The lower rig count is expected to cause US production to move downward as part of the global rebalancing of supply and demand. It is expected that US crude production will decrease by 500,000 barrels per day during 2016.

It is expected that Iranian oil production will increase by 500,000 barrels per day in 2016 roughly offsetting the decrease in American production. Holding the rest of the world roughly flat in production level for 2016 and given the expected increase in demand of 2 million barrels per day in 2016, the market is expected to be balanced by year end/early 2017. As this slowly balances itself, prices will increase.









Below is the one-year chart of spot diesel futures prices as of February 5th.



Below is the one-year chart of spot gasoline futures prices as of February 5th.

MARKET FACTORS & COMMENTARY:

: :  Inventories increased by 1.79 million barrels while inventories were expected to increase by 2.35 million barrels on the week. The five-year average inventory increased by 0.86 million barrels. Inventories increased vs. the five year average and decreased vs. expectations.

: :  Storage capacity is nearing its limit especially in Cushing, Oklahoma which is the delivery point for the West Texas Intermediate Crude oil futures traded in New York. If capacity were to be reached, production may necessarily need to be slowed or stopped because there would be nowhere to go with the oil.

: :  The surplus in oil is expected to be larger than thought during the first half of 2016. More supply from Iran and Iraq than expected, and slowing global demand growth are the contributing factors. The global imbalance is expected to increase to 1.75 million barrels per day from 1.50.

: :  American producers may be going bankrupt earlier than thought due to the very low prices which curtails their revenues, and the fact that hedges are rolling off leaving producers exposed to low prices. As this occurs, production may be shut in thus curtailing supply which will contribute to the rebalance of the market.

: :  OPEC adjusted its 2016 forecast for production from non-OPEC producers from -660,000 barrels per day to -700,000 barrels per day in response to low prices. This will mean a victory for OPEC but not one without cost.

: :  It is assumed that OPEC will continue with the current strategy of allowing market price to bring the market back into balance since it seems to be working. If OPEC were to cut production (which would most likely be done unilaterally by Saudi Arabia), then all bets are off.

: :  At the recent gathering of the international petroleum industry, the general expectation is "lower for longer" and no optimism is to be found. This is significant because it will cause investment in exploration and production to sink to dangerously low levels such that supply will not be as easily increased if there is a spike in demand which would be reasonably expected from a period of very low prices. The concern is that not only will supply rebalance with demand, but that capital will go away from exploration & production making further supply growth more expensive and time consuming and raising the risk of a demand spike which will spike prices.

: :  Stock market decreasing by -0.81% on the week is generally negative for economic and petroleum demand expectations and prices. Given the amount that the stock market has fallen in the past 6 weeks, global economic growth expectations are less certain and petroleum demand expectations are adjusted downward.

: :  The US Dollar increasing by 0.03% is negative for petroleum price. Commodities are used as a hedge against inflation and against a falling dollar. A stronger dollar reduces the relative demand for commodities for this purpose and prices decrease accordingly. Conversely, a weaker dollar increases relative demand for commodities and prices increase.

The chart below shows supply and demand history and expectations. When supply and demand begin to rebalance, prices will increase from current levels. This forecast indicates that the market will be slower to balance than was thought in January.



Below is the one-year chart US stock market prices as of February 12th.



Below is the one-year chart for the US dollar index as of February 12th.



INVENTORIES:

During the week ended February 5th, total petroleum inventories increased by 1.79 million barrels vs. a five year average decrease of 0.86 million barrels and vs. an expected increase of 2.35 million barrels. Inventories increased by 2.64 million barrels vs. the five year average and decreased by 0.57 million barrels vs. expectations. Total inventories stand at 918.6 million barrels, up from 916.8 million barrels at the end of the previous week. The five year average inventory is 738.8 million barrels, down from 739.7 million barrels at the end of the previous week.

Current inventories are 24.34% higher than the five year average, up from +23.95% at the end of the previous week.



SPECULATION:

As of February 9th, the net speculative long position in petroleum futures was 102,386,000 barrels, up 6,639,000 barrels (+6.93%) from the previous week. Speculation increased for the first time in two weeks and represents 11.15% of domestic inventories. Speculation is 33.86% below its one year moving average. The corresponding spot month diesel futures price on February 9th was 97.49 cents per gallon, down 3.60 cents from 101.09 cents per gallon during the previous week.

Diesel fuel price and size of speculative net long position in petroleum are 83.48% correlated over the past 52 weeks indicating that, on a statistical basis over the past year that 69.69% of diesel fuel price movements are explained by changes in level of speculation. With the current over supply situation and the expectation that this will persist, long-side speculation will remain relatively low.

The net speculative long position has been variable over the past year ranging between 57 million and 285 million barrels with an average of about 155 million barrels, which is down about 2 million barrels on the week.

Based on a multiple regression analysis considering the level of the dollar, speculation, and inventory over the past five years, the market price for spot month diesel futures is estimated to be 121.62 versus the actual price of 97.49. This indicates that the market is currently undervalued by 24.13 cents per gallon given the assumptions of the pricing model.

CONTACT:

Linwood Capital, LLC is an institutional fuel hedging management, advisory, and consulting firm. Linwood creates and manages customized fuel hedging programs for institutional consumers of petroleum and natural gas.