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Speculation & Prices Spike
During the week ending February 24th, the spot month heating oil futures price increased by 12.70 cents per gallon (+3.98%) while the deferred months increased by 11 to 14 cents per gallon making the forward pricing curve higher and more negatively sloped. The one year forward price ended the week at a 3.61 cent (1.09%) discount to the spot price, from a discount of 2.74 cents (0.86%) 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 little if any change in inventory levels with respect to supply and demand. The curve became more negatively sloped as would be expected in a speculation-driven upward move. The deferred months moved up as well reflecting ample inventories in spite of supply disruption risk. Typically, the fear of supply disruption causes the curve to become much more negatively sloped. When inventories are plentiful and demand relatively weak, this is not always the case as we are seeing now.
The US Dollar was lower on the week putting upward pressure on petroleum prices. The US stock market increased exerting slight upward pressure on prices. Petroleum demand for the week was slightly lower which kept downward pressure on prices. Overall petroleum inventories grew by more than expectations and by more than the five year average keeping downward pressure on price. The market spiked higher mainly due to continued fear of supply disruption from the Iranian situation.
Speculation increased dramatically again on the week supporting prices to yet higher levels. 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 decreased by 2.24% on a week over week basis for the week ending February 17th. Demand is down 7.53% vs. one year ago. Some of this decrease in demand has to do with unseasonably warm weather. However, gasoline demand remains at multi-year lows indicating the effects of longer-term conservation efforts and a relatively weak economy.
Prices have gone to the top of the range that they have seen in over the last twelve months that occurred in early April 2011. Curiously, this is also when we saw speculation at roughly the same levels. 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 24th.
Factors affecting the market on the week
During the week ended February 17th, total petroleum inventories increased by 0.78 million barrels vs. a five year average decrease of 1.42 million barrels and vs. an expected decrease of 0.13 million barrels. Inventories increased by 2.19 million barrels vs. the five year average. Total inventories stand at 715.7 million barrels, up from 715.0 million barrels at the end of the previous week. The five year average inventory is 702.1 million barrels, down from 703.6 at the end of the previous week. Current inventories are 1.94% larger than the five year average up from +1.62% at the end of the previous week. Versus the five year average, inventories continue to be positive.
As of February 21st, the net speculative long position in petroleum futures was 392,705,000 barrels up 31,570,000 barrels (+8.74%) from the previous week. This position represents 54.87% of domestic inventories. Speculation is 31.46% above its one year moving average and is only 3.83% 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 21st was 323.93 cents per gallon, up 7.45 cents from 316.48 cents per gallon during the previous week.
Heating oil price and size of speculative net long position in petroleum are 69.24% correlated over the past 52 weeks (an increase on the week) indicating that, on a statistical basis, 47.94% 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 and when speculation levels are high, 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 261.89 cents per gallon or 62.04 cents per gallon less than current prices. The analysis would indicate that about 19.15% of current price is attributable to speculation and its underlying market rationale. The "would be" price was down a few cents on the week but continues to be relatively stable in the $2.60 - $2.65 range.
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 299 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.