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Petroleum Market Commentary - February 20, 2012

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Speculation Spikes on Iran Worries - Prices Higher, Curve Flatter

During the week ending February 17th, the spot month heating oil futures price increased by 0.68 cents per gallon (+0.21%) while the deferred months increased by 2 to 4 cents per gallon making the forward pricing curve higher and less negatively sloped. The one year forward price ended the week at a 2.74 cent (0.86%) discount to the spot price, from a discount of 5.21 cents (1.64%) at the end of the previous week.

The change in level and shape of the forward pricing indicates an increase in demand expectations (some of which is speculative demand due to supply disruption risk) and an increase in inventory levels with respect to supply and demand. The curve became less negatively sloped as inventory builds were slightly more than expectations and more than the five year average. Typically, the fear of supply disruption causes the curve to become more negatively sloped. When inventories are plentiful and demand relatively weak, this is not always the case.

The US Dollar was slightly stronger on the week putting slight downward pressure on petroleum prices. The US stock market increased exerting slight upward pressure on prices. While very low, petroleum demand for the week was slightly higher which kept upward pressure on prices. Overall petroleum inventories grew by slightly more than expectations and by more than the five year average keeping downward pressure on price. The market managed to remain relatively elevated due to continued fear of supply disruption from the Iranian situation.

Speculation increased dramatically on the week supporting prices. The statistical relationship between price and speculative levels has continued to become stronger in recent weeks suggesting that the relationship is stronger when speculative levels are higher, which would be expected.

Weekly US petroleum demand increased by 5.89% on a week over week basis for the week ending February 10th. Demand is down 5.08% vs. one year ago. Some of this decrease in demand has to do with unseasonably warm weather in the Northeast and the specific lack of demand for home heating oil. However, gasoline demand remains at multi-year lows indicating the effects of longer-term conservation efforts and a relatively weak economy.

Prices have remained steady at the high end of the range that they have seen in over the last twelve months. This makes adding to hedge positions at these levels unattractive. Hedging in the short-term at these prices is for the management of budget risk only. As prices move and as time passes, the advisability of medium to longer-term hedging will change and become more favorable. As price opportunities present themselves, hedging will become advisable. Currently, the Iranian situation is supporting speculative levels and price. Entering new, longer-term hedges at these levels would involve competing with speculators for long futures positions which would most likely prove disadvantageous in the long-term. In the short-term, this may not be the case.

Below is a one year chart of spot heating oil futures prices, the proxy hedging mechanism for diesel fuel, as of February 17th.

Factors affecting the market on the week

During the week ended February 10th, total petroleum inventories increased by 1.36 million barrels vs. a five year average decrease of 0.63 million barrels and vs. an expected increase of 1.28 million barrels. Inventories increased by 1.99 million barrels vs. the five year average. Total inventories stand at 719.0 million barrels, up from 717.6 million barrels at the end of the previous week. The five year average inventory is 703.6 million barrels, down from 704.2 at the end of the previous week. Current inventories are 2.19% larger than the five year average up from +1.91% at the end of the previous week. Versus the five year average, inventories continue to be positive.

As of February 14th, the net speculative long position in petroleum futures was 361,135,000 barrels up 27,360,000 barrels (+8.20%) from the previous week. This position represents 50.23% of domestic inventories. Speculation is 21.41% above its one year moving average and is 11.57% lower than the 52 week high. Levels are now approaching their early 2011 all-time high levels. The corresponding spot month heating oil futures price on February 14th was 316.48 cents per gallon, surprisingly down 2.61 cents from 319.09 cents per gallon during the previous week.

Heating oil price and size of speculative net long position in petroleum are 62.90% correlated over the past 52 weeks (an increase on the week) indicating that, on a statistical basis, 39.57% of the price movement of heating oil is explained by changes in levels of speculation. This statistical relationship has strengthened in the past several months and continues to become more relevant. When speculation is due to fear of supply disruption, the relationship tends to be stronger in the short-term. A linear regression analysis over the past 52 weeks shows that if speculation were zero and the market forces causing speculation evaporated, that the spot month heating oil futures price would be 263.92 cents per gallon or 52.56 cents per gallon less than current prices. The analysis would indicate that about 16.61% of current price is attributable to speculation and its underlying market rationale. The "would be" price was again virtually unchanged on the week and continues to be relatively stable.

The net speculative long position has been variable over the past year ranging between 70 million and 410 million barrels with an average of about 297 million barrels.

The graph below is three year history of speculative position levels.

Linwood Capital, LLC is an institutional fuel hedging management and consulting firm. Linwood creates and manages customized fuel hedging programs primarily for public clients on a nationwide basis.