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Petroleum Market Commentary - April 2, 2012

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Lower Prices - Lower Speculation

During the week ending March 30th, the spot month heating oil futures price decreased by 4.17 cents per gallon (-1.30%) while the deferred months decreased by 5 to 7 cents per gallon making the forward pricing curve lower and slightly negatively sloped again. The one year forward price ended the week at a 0.26 cent (0.08%) discount to the spot price, from a premium of 1.68 cents (0.52%) at the end of the previous week. The curve remains virtually flat on a year over year basis.

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 a slight decrease in inventory levels with respect to supply and demand. The curve became slightly negatively sloped which is typically associated with a less well-supplied market. The very high level of speculation continues to sustain prices but is also attracting supply which is tending to keep inventories strong.

The US Dollar was lower on the week putting upward pressure on petroleum prices. The US stock market increased exerting upward pressure on prices. Petroleum demand for the week was higher which kept upward pressure on prices. Overall petroleum inventories increased by more than expectations and by more than the five-year average keeping downward pressure on prices. The market continues to be sustained at relatively high prices mainly due to the continued fear of supply disruption from the Iranian situation and the accompanying speculative activity.

Speculation decreased again during the week allowing prices to go lower yet remains at extremely high 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 increased by 3.00% on a week over week basis for the week ending March 23rd. Demand is down 5.30% 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 remain high but in the lower half of the range that we have seen over the past six weeks. This makes adding to long-term hedge positions at these levels unattractive while it may be advantageous to add to very short-term hedges if needed. Short-term hedging at these prices may also be advisable for the management of budget risk. As prices move and as time passes, the advisability of medium to longer-term hedging will change and may become more favorable. As price opportunities present themselves, hedging will become advisable. Currently, the Iranian situation continues to support speculation albeit at slightly lower levels. The slope of the forward pricing curves suggest that some break in prices may be in the works especially if Saudi Arabia significantly increases supply in anticipation of a disruption due to Iran. 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 30th.

Factors affecting the market on the week

During the week ended March 23rd, total petroleum inventories increased by 2.85 million barrels vs. a five year average increase of 0.26 million barrels and vs. an expected increase of 0.65 million barrels. Inventories increased by 2.60 million barrels vs. the five year average. Total inventories stand at 712.6 million barrels, up from 709.8 million barrels at the end of the previous week. The five year average inventory is 695.8 million barrels, up from 695.6 at the end of the previous week. Current inventories are 2.41% larger than the five year average up from +2.04% at the end of the previous week. Versus the five year average, inventories continue to be positive.

As of March 27th, the net speculative long position in petroleum futures was 374,098,000 barrels down 7,698,000 barrels (-2.02%) from the previous week. This position represents 52.50% of domestic inventories. Speculation is 24.86% above its one year moving average and is 8.47% below the 52 week high level four weeks ago. Levels continue to be sustained at the general levels of 2011 during the Libyan crisis. The corresponding spot month heating oil futures price on March 27th was 321.86 cents per gallon, down 1.81 cents from 323.67 cents per gallon during the previous week.

Heating oil price and size of speculative net long position in petroleum are 83.13% correlated over the past 52 weeks (an increase on the week) indicating that, on a statistical basis, 69.10% 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 250.67 cents per gallon or 71.19 cents per gallon less than current prices. The analysis would indicate that about 22.12% of current price is attributable to speculation and its underlying market rationale. The "would be" price was down on the week and continues to move lower.

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 300 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.