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Petroleum Market Commentary - March 5, 2012

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Speculation Gone Wild! - All Time High

During the week ending March 2nd, the spot month heating oil futures price decreased by 11.12 cents per gallon (-3.36%) while the deferred months decreased by 5 to 9 cents per gallon making the forward pricing curve lower and less negatively sloped. The one year forward price ended the week at a 1.43 cent (0.45%) discount to the spot price, from a discount of 3.61 cents (1.09%) at the end of the previous week.

The change in level and shape of the forward pricing indicates a decrease 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 would be expected in conjunction with a price decrease. The deferred months moved up on a relative basis reflecting ample inventories and slack consumption 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 higher on the week putting downward pressure on petroleum prices. The US stock market increased slightly exerting slight upward pressure on prices. Petroleum demand for the week was slightly higher which kept upward 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 continued to be sustained at relatively high prices mainly due to the continued fear of supply disruption from the Iranian situation.

Speculation increased dramatically again for the sixth straight week to an all-time high level. 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 0.10% on a week over week basis for the week ending February 24th. Demand is down 7.11% vs. one year ago. Gasoline demand remains at multi-year lows indicating the effects of longer-term conservation efforts and a relatively weak economy.

Prices have come down from the top of the recent price range that we saw at the end of the previous week. Prices remain very elevated however. 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 March 2nd.

Factors affecting the market on the week

During the week ended February 24th, total petroleum inventories increased by 0.49 million barrels vs. a five year average decrease of 0.19 million barrels and vs. an expected increase of 0.25 million barrels. Inventories increased by 0.68 million barrels vs. the five year average. Total inventories stand at 716.2 million barrels, up from 715.7 million barrels at the end of the previous week. The five year average inventory is 702.0 million barrels, down from 702.1 at the end of the previous week. Current inventories are 2.03% larger than the five year average up from +1.94% at the end of the previous week. Versus the five year average, inventories continue to be positive.

As of February 28th, the net speculative long position in petroleum futures was 408,731,000 barrels up 16,026,000 barrels (+4.08%) from the previous week. This position represents 57.07% of domestic inventories. Speculation is 36.58% above its one year moving average and is at a new 52 week high. Levels are now slightly above their early 2011 previous all-time high levels. The corresponding spot month heating oil futures price on February 28th was 322.38 cents per gallon, down 1.55 cents from 323.93 cents per gallon during the previous week.

Heating oil price and size of speculative net long position in petroleum are 72.35% correlated over the past 52 weeks (an increase on the week) indicating that, on a statistical basis, 52.35% 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 259.82 cents per gallon or 62.56 cents per gallon less than current prices. The analysis would indicate that about 19.41% 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 $2.55 - $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.