The Petroleum complex finally succumbed to bearish fundamentals after crude oil, heating oil and RBOB gasoline achieved new all time record highs. The strength to values had developed despite general skepticism that current fundamentals would be able to sustain them.  Valuations, which had been distorted by an inflow of speculative buying interest tied to growing global fears of an inflationary bubble, asset reallocation and a weak dollar, fell sharply, on a realization that the credit crisis is spreading and could lead to weakening demand.  The flight to quality fears from financial instruments and into more liquid commodities worked against the markets as these assets also declined as the movement from any risky assets leading to concerted selling throughout the commodity complex.

The idea that the petroleum market has detached itself from underlying fundamentals has been well publicized. Talks being held this week by the International Energy Agency with participants including industry representatives, government regulators, and major energy exchanges manifest this concern. Although they are being downplayed as only discussions, the action does point to the inability of key market players on both the consuming and producing side to direct or even forecast prices. The meeting appears to be a recognition that they have lost what little impact they might have had over the pricing function. This was apparent at the OPEC meeting early in March whereby the cartel, recognizing a surplus situation including a weaker demand environment, elected to hold production unchanged. In more normal times the recent build in global stock levels and deteriorating demand prospects into the seasonally weak second quarter would have necessitated an output cut.  Instead, due to the high prices and the associated uncertainty over global investment flows it merely forestalled a decision and actually raised fears that OPEC might also be losing control over the market given their constraints on sustainable capacity and prospective increases in non-OPEC production.

Despite the weakness it will likely be transitory.  The longer-term fears that global tightness in crude oil supplies will persist for an extended period and keep prices for crude near $100.00 have begun to gain more adherents. The Dec 2010 and Dec 2011 are trading near 96.00 and the forward curve has flattened. Only now is the general public beginning to wonder if 70.00 crude oil is a thing of the past. At those lower price levels neither demand nor supplies were making the badly needed adjustments to move into equilibrium. Doubts still remain on whether the adjustments on the supply and demand side seen recently with prices above 90.00 will be enough to avoid further upside pressure in the future as the back months suggest.

2008 Supply and Demand Prospects

The crude oil supply/demand outlook for 2008 is marked by inherent risks. On the demand side, the impact of the credit crisis cannot be ignored. Revisions on the downside continue to be made to global demand in 2008, which is expected to reach 87.5 mb/d.  The high gasoline prices and appearance that the US might be falling into a recession could impact North American demand as the weaker growth seeps into key trading partners such as Canada and Mexico for the 1st half of the year. US gasoline demand appears to have weakened as the higher prices averaging near 3.30 nationwide has encouraged more efficient auto use.  Other OECD countries are also showing signs that growth is slowing, which should help slow demand. Although the dollar has helped cushion some of the impact of higher petroleum prices overseas it also is contributing to a retrenchment in economic growth as well. Non-OECD demand is expected to continue to show growth but at a slower pace than what had been previously expected. Exports to the US are likely to suffer as the economic slowdown in the US takes hold. In addition, some further constraints on growth are likely to emanate from higher prices, tight supplies and coal substitution for diesel in power generation. The areas with the best growth prospects are in many of the oil producing areas such as the Mid East, Russia and Brazil, where rising incomes and accelerated growth continues to boost demand.

The world supply situation has generally been rather stable with an upside bias. Output reportedly reached as high as 87.5 mb/d during Feb on recovery of output in Canada, Mexico and Caspian republics more than offsetting reductions in Norway and OPEC. Recent comments suggesting OPEC needs to boost production does not appear to be necessary at this stage.

The trend higher in inventory levels since December in OECD stocks will likely be a constraining influence on price levels in the near term. US inventory levels have steadily built since the beginning of the year rising by 28.7 mb since Jan 1. Until these inventory levels are pared the market will be hard pressed to make new contract highs.

Refining Margins

The weakness in refining margins, particularly for gasoline, represents a relatively new feature of the market. The gasoline cracks have fell recently on the nearby to a negative margin which compares to a positive margin of $36.00 in May of last year. Conversely, the 2 Oil crack has soared from near 10.00 last year on the active contract to over 20.00 currently basis May. 

The shift in margins likely reflects the following:

-    Demand strength in the US from the transportation industry for diesel.
-    Tightness in heating oil supplies as more production was diverted to ultra low sulphur diesel.
-    Strong shift in Europe to diesel engines due to higher fuel efficiency attracting greater imports from the US.
-    Weaker gasoline demand in the US.
-    Higher US imports of gasoline from Europe.
-    Expansion of refining capacity in Asia.

The weak refining margins raises the prospect that runs will be cut back along with refinery utilization rates. The reduction in runs should help contribute to a further build in crude inventory levels.  

Conclusion

The crude markets inability to follow through on the upside is suggesting the potential for the market to be more sensitive to prevailing supply/demand fundamentals.  The build in inventory levels that was brought about by weakening demand and higher output levels should be a drag on values and lead to a correction toward the 96.00 area in the nearby May.  In addition, pressure on the government to release the strategic oil reserve to temper the rise in heating oil should keep pressure on the May toward the 2.80 area and potentially 2.65 while May RBOB could fall to the 2.45 area basis May.  However the correction is still likely to be temporary. Seasonally demand will rebound enough in the second half of the year to provide the basis for a resumption of declines in inventory levels.

In the interim, the dollar and investment flows between equities and commodities will be a key consideration and could hold the potential for valuations to correct if these positions are more forcefully liquidated.

For more information on Over The Barrel, please contact Steve Platt via email at Stephen.Platt@Archerfinancials.com   or by calling 1.877.377.7931.

The information and comments contained herein are provided as general commentary of market conditions and are not and should not be interpreted as trading advice or recommendation.  The information and comments contained herein are not and should not be interpreted to be predictive of any future market event or condition.  The information and comments contained herein is provided by ADM Investor Services, Inc. and not Archer Daniels Midland Company.  Copyright © ADM Investor Services, Inc.

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