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Petroleum Market Commentary - March 7, 2012

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French Elections - Disappointing Jobs - Prices Down

Previously limited to April 2013, the New York Mercantile Exchange has listed heating oil futures contracts through January 2016. Starting with the May 2013 contract, the delivery specification will change to the specification for ultra-low sulfur diesel. During the first week of trading, the settlement prices for the new contracts were artificially elevated. They have decreased to a more expected level at which business has been occurring.

During the week ending May 7th, the spot month heating oil futures price decreased by 17.47 cents per gallon (-5.49%) while the deferred months decreased by 16 to 35 cents per gallon (although prices were arguably inaccurate due to the introduction of the new contracts) making the forward pricing curve positively sloped. The one year forward price ended the week at a 4.71 cent (1.57%) premium to the spot price, from a discount of 1.62 cents (0.51%) at the end of the previous week. The curve is positive for the next year and then slopes negative thereafter.

The change in level and shape of the forward pricing curve indicates lower demand expectations and an increase in inventory levels with respect to supply and demand. The curve became positively sloped over the next year which is typically associated with more plentiful inventories with respect to demand. Demand includes speculative demand. Speculation was higher as of Tuesday the 1st before prices declined later in the week. Speculation continues to support price while it has attracted supply and curtailed demand which will be negative for price as we have seen. The Iranian situation continues to improve meaning that there is less likelihood of supply disruption which is negative for speculative levels and price.

The US Dollar was stronger on the week which is negative for petroleum prices. The US stock market decreased on the week exerting downward pressure on prices. Petroleum demand for the week was slightly lower which kept downward pressure on prices. Overall petroleum inventories decreased by more than expectations and by more than the five-year average. This kept upward pressure on prices.

Speculation increased during the week as of May 1st and remains at high levels from a historical perspective. The statistical relationship between price and speculative levels is high but decreased slightly on the week. This would be expected as the level of speculation has decreased over the past several weeks. The correlation between price and level of speculation is stronger when speculation levels and prices are higher.

Weekly US petroleum demand decreased by 1.13% on a week over week basis for the week ending April 27th. Demand is down 1.68% vs. one year ago.

Prices dropped to 3 and a half month lows to the middle of the range that we have seen for the past 12 months. This makes incrementally adding to short, medium and long-term hedge positions at these levels relatively attractive. As prices move and as time passes, the advisability of hedging will change. As further price opportunities present themselves, hedging will become more attractive. Entering new, longer-term hedges at these levels would involve less competition with speculators for long futures positions giving a relative advantage to the hedger

Below is a one year chart of spot heating oil futures prices, the proxy hedging mechanism for diesel fuel, as of May 4th.

Factors affecting the market on the week were:

During the week ended April 27th, total petroleum inventories decreased by 1.07 million barrels vs. a five year average increase of 2.36 million barrels and vs. an expected increase of 1.00 million barrels. Inventories decreased by 3.43 million barrels vs. the five year average. Total inventories stand at 709.6 million barrels, down from 710.7 million barrels at the end of the previous week. The five year average inventory is 694.2 million barrels, up from 691.9 at the end of the previous week. Current inventories are 2.22% larger than the five year average down from +2.72% at the end of the previous week. Versus the five year average, inventories continue to be positive.

As of May 1st, the net speculative long position in petroleum futures was 342,280,000 barrels up 29,248,000 barrels (+9.34%) from the previous week. This is an increase off of the three and a half month lows the previous week. This position represents 48.24% of domestic inventories. Speculation is 16.77% above its one year moving average and is 16.26% below the 52 week high level. Levels have moved back up into the range that we saw several months ago and during the Libyan crisis a year ago. The corresponding spot month heating oil futures price on May 1st was 317.71 cents per gallon, up 4.76 cents from 312.95 cents per gallon during the previous week.

Heating oil price and size of speculative net long position in petroleum are 82.02% correlated over the past 52 weeks (a slight decrease on the week for the fourth week in a row) indicating that, on a statistical basis, 67.27% 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, has stabilized as the level of speculation has fallen, and continues to be significant. 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 246.13 cents per gallon or 71.58 cents per gallon less than current prices. The analysis would indicate that about 22.53% of current price is attributable to speculation and its underlying market rationale. The "would be" price was down again 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 293 million barrels. This one year moving average decreased about 1 million barrels on the week as the high levels from last year roll off . This one year moving average continues to decline.

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.